Mea

MANAGERIAL ECONOMICS
and
FINANCIAL ACCOUNTING
M. Kasi Reddy
Associate Professor
School of Management Studies
Chaitanya Bharathi Institute of Technology
Hyderabad
S. Saraswathi
Senior Assistant Professor
School of Management Studies
Chaitanya Bharathi Institute of Technology
Hyderabad
New Delhi - 110001
2012
MANAGERIAL ECONOMICS AND FINANCIAL ACCOUNTING
M. Kasi Reddy and S. Saraswathi
2007 by PHI Learning Private Limited, New Delhi. All rights reserved. No part of this book may
be reproduced in any form, by mimeograph or any other means, without permission in
writing from the publisher.
ISBN-978-81-203-3321-5
The export rights of this book are vested solely with the publisher.
Second Printing
January, 2012
Published by Asoke K. Ghosh, PHI Learning Private Limited, Rimjhim House, 111, Patparganj
Industrial Estate, Delhi-110092 and Printed by Mudrak, 30-A, Patparganj, Delhi-110091.
Contents
Preface
xiii
1. MANAGERIAL ECONOMICS: THE BASICS ............................................... 137
Learning Objectives
1
Introduction to Economics
1
Scarcity and Efficiency
2
Three Problems of Economic Organization
3
Limited Means and Unlimited Ends
3
Choosing between Ends
3
Deriving Maximum Satisfaction
4
Income and Employment
4
Economic Development
4
Evolution of Economics
4
Classical Stage
5
Neo-classical Stage
6
New Stage
7
Modern Stage
9
Nature and Scope of Managerial Economics
9
Nature of Managerial Economics
9
Scope of Managerial Economics
19
Relationship of Managerial Economics with Other Disciplines
21
Relationship with Microeconomics
22
Relationship with Macroeconomics
22
Relationship with Mathematics
23
Relationship with Management Theory and Accounting
23
iii
iv
CONTENTS
Relationship with Statistics
24
Relationship with Operations Research
24
Relationship with Econometrics
25
Relationship with Decision Theory
25
Basic Concepts of Managerial Economics
26
Opportunity Cost Principle
26
Incremental Principle
27
Principle of Time Perspective
27
Discounting Principle
28
Equimarginal Principle
28
Managerial EconomistRole and Responsibilities
29
Role of a Managerial Economist

29
Responsibilities of a Managerial Economist
30
Summary
31
Exercises
33
2. DEMAND ANALYSIS .................................................................................... 38155
Learning Objectives
38
Introduction
38
Consumer Behaviour
39
UtilityThe Basis of Consumer Demand
39
Measurement of Utility
39
Total Utility
40
Marginal Utility
40
Law of Diminishing Marginal Utility
40
Why does Marginal Utility Decrease?
41
Assumptions of the Law
41
Exceptions to the Law
42
Law of Equimarginal Utility
43
Indifference Curve Analysis
44
Indifference Schedule
44
Indifference Curve
45
Indifference Map
45
Meaning of Demand
47
Individual Demand
48
Market Demand
48
Demand Schedule, Demand Curve and Demand Function
49
Demand Schedule
49
Demand Curve
51
Demand Function
53
CONTENTS
v
Determinants of Demand
54
Price of Commodity
55
Other Factors
56
Types of Demand
61
Derived Demand and Autonomous Demand
62
Demand for Producers Goods and Demand for Consumers Goods
63
Demand for Durable Goods and Demand for Non-durable Goods
63
New and Replacement Demand
64
Industry Demand and Firm Demand
64
Short-run Demand and Long-run Demand
65
Total Market Demand and Market Segment Demand
65
Law of Demand
65
Assumptions of the Law of Demand
67
Chief Characteristics of the Law of Demand
67
Why does the Demand Curve Slope Downwards?
68
Exceptions to the Law of Demand
69
Change in Demand
71
Movement along Demand Curve (Extension and Contraction in Demand)
71
Shifts in Demand Curve (Increase and Decrease in Demand)
72
Shift or Change in Demand versus a Movement along a Demand Curve
(Change in Quantity Demanded)

75
Elasticity of Demand
75
Elastic Demand and Inelastic Demand
77
Types of Elasticity of Demand
77
Methods of Measurement of Elasticity of Demand
85
Arc Elasticity
89
Income Elasticity of Demand
89
Cross-elasticity of Demand
92
Promotional Elasticity of Demand
94
Demand Forecasting
94
Passive Forecasts and Active Forecasts
95
Making a Forecast
96
Criteria for the Choice of a Good Forecasting Method

97
Types of Forecasting Problems and Methods
97
Selecting a Forecasting Method
98
Methods of Demand Forecasting
98
Market Structures
112
Market Structure Concept
112
Determinants of Market Structure
113
Classification of Market Structures
113
vi
CONTENTS
Perfect and Imperfect Markets
114
Perfect Competition
114
Imperfect Competition
130
Monopoly
130
Duopoly and Oligopoly
140
Monopolistic Competition
143
Summary
144
Exercises
145
Problems
155
3. PRODUCTION AND COST ANALYSIS ................................................... 156213
Learning Objectives
156
Introduction
156
Meaning of Production
157
Factors of Production
158
Land
158
Labour
158
Capital
159
Organization or Enterprise
160
Production Function
160
Assumptions of Production Function
162
Laws of Production
163
Production Function with One Variable Input
163
Production Function with Two Variable Inputs
166
Marginal Rate of Technical Substitution (MRTS)
168
Production Function with All Variable Inputs
171
Optimal Combination of Inputs
171
Producers Equilibrium
172
Cobb-Douglas Production Function
173
Economies and Diseconomies of Scale
174
Economies of Scale
174
Diseconomies of Scale
177
Cost Analysis
178
Actual Cost and Opportunity Cost
179
Incremental Costs (Differential Costs) and Sunk Costs
180
Explicit (or paid-out) Costs and Implicit (or imputed) Costs
180
Past Costs and Future Costs
181
Short-run and Long-run Costs
181
Fixed and Variable Costs
182
Out-of-pocket and Book Costs
182
Replacement Costs and Historical Costs
183
CONTENTS
vii
Urgent and Postponable Costs
183
Sunk, Shutdown and Abandonment Costs
183
Escapable and Unavoidable Costs
183
Cost-Output Relationship
184
Cost-Output Relationship in the Short Run
184
Marginal Cost
187
Relationship between Average Cost and Marginal Cost
187
Short-run Output Cost Curves
188
Cost-Output Relationship in the Long-Run
189
Break-Even Analysis
191
Determination of Break-Even Point
192
BEP in Terms of Physical Units
192
Break-Even Point in Terms of Sales Value
193
Contribution
193
Break-Even Chart
194
Alternative Form of Break-Even Chart
195
Profit-Volume (P/V) Analysis and P/V Ratio
195
Margin of Safety
198
Angle of Incidence
199
Assumptions in Break-Even Analysis
199
Managerial Uses of Break-Even Analysis
200
Limitations of Break-even Analysis
200
Summary
209
Exercises
210
4. CAPITAL MANAGEMENT AND INVESTMENT DECISIONS ............ 214284
Learning Objectives
214
Introduction
214
Significance of Capital
215
Capital Management
215
Working Capital
215
Capital Budgeting
232
Capital Budgeting Decisions
232
Meaning of Capital Budgeting
233
Importance of Capital Budgeting
233
Kinds of Capital Investment Proposals
234
Cash Flows and Accounting Flows

234
Factors Affecting Capital Investment Decisions
235
Capital Budgeting Process
235
Problems and Difficulties in Capital Budgeting
237
Methods of Capital Budgeting
237
viii
CONTENTS
Sources of Capital
266
Shares
266
Debentures
268
Retained Earnings
270
Loans
270
Summary
271
Exercises
273
Problems
276
5. ACCOUNTANCY ......................................................................................... 285450
Learning Objectives
285
Introduction
285
Meaning of Accounting
286
Definition of Accounting
286
Need for Accounting
287
Accountancy, Accounting and Book-Keeping
288
Objectives of Accounting
288
Parties Interested in Accounting Information
289
Branches of Accounting
291
Financial Accounting
291
Cost Accounting
291
Management Accounting
292
Advantages of Accounting
292
Limitations of Financial Accounting
292
The Accounting Process
293
Systems of Accounting
294
Generally Accepted Accounting Principles (GAAP)
295
Accounting Concepts
296
Accounting Conventions
299
Double Entry System
300
Meaning of Account
301
Rules of Debit and Credit
302
Advantages of Double Entry System
305
Journal
305
Advantages of Journal
307
Limitations of Journal
307
Compound Journal Entry
309
Opening and Closing Entries
312
Some Important Points in Journalising
315
CONTENTS
ix
Ledger
316
Ledger Posting
317
Balancing of Account
319
Interpretation of Ledger Accounts
319
Advantages of Ledger
320
Differences between Journal and Ledger
320
Subsidiary Books
326
Advantages of Subsidiary Books
326
Cash Journal or Cash Book
327
Purchases Journal or Purchases Book
327
Invoice
327
Posting of Purchases Book
329
Ledger Accounts
330
Sales Journal or Sales Book
330
Recording in the Sales Book
331
Ledger Posting
331
Purchases Returns Book
333
Debit Note
333
Recordings in the Purchases Returns Book
334
Posting the Purchases Returns Book
334
Sales Returns Book
336
Credit Note
336
Recording in the Sales Returns Book
336
Posting in the Sales Returns Book
336
Bills of Exchange
338
Definition of a Bills of Exchange
338
Bills Receivable and Bills Payable Books
338
Journal Proper
341
Types of Transactions Recorded in Journal Proper
342
Trial Balance
342
Preparation of Trial Balance
343
Limitations of Trial Balance
344
Errors
345
Cash Book
346
Dual Role of the Cash Book
347
Kinds of Cash Books
347
Simple Cash Book or Single Column Cash Book
347
Cash Discount
349
Double Column Cash Book
349
x
CONTENTS
Three-Column Cash Book
354
Posting
355
Balancing
356
Cash Book with Discount and Bank Columns Only
358
Petty Cash Book
359
Imprest System
360
Bank Reconciliation Statement
362
Method of Recoding Banking Transactions
362
Causes of Difference between Cash Book and Pass Book
363
Transactions that Appear in the Cash Book but not in the Pass Book
363
Transactions Appear in the Pass Book with No Entry in the Cash Book
364
Preparation of Bank Reconciliation Statement
365
Bank Overdraft
368
Final Accounts
370
Capital and Revenue
370
Classification of Expenditure
371
Revenue Expenditure Becoming Capital Expenditure
372
Classification of Receipts
373
Trading and Profit and Loss Account
373
Trading Account
374
Manufacturing Account
380
Profit and Loss Account
383
Important Points for Preparing Profit and Loss Account
385
Closing Entries for Profit and Loss Account
386
Closing of Drawings Account
386
Balance Sheet
391
Financial Analysis
413
Ratio Analysis
414
Ratio
414
Summary
424
Exercises
426
Problems
435
6. TYPES OF BUSINESS ORGANISATION ................................................. 451505
Learning Objectives
451
Introduction
451
Factors Influencing the Choice of Suitable Form of Organisation
452
Types of Business Organisation

453
Private Undertakings
454
Public Undertakings
454
CONTENTS
xi
Joint Sector Undertakings
454
Public Enterprises
488
Summary
497
Exercises
499
Glossary ................................................................................................................ 507521
Bibliography ......................................................................................................... 523525
Model Questions ................................................................................................... 527554
Present Value Tables (A.1 to A.4) ....................................................................... 555570
Index ..................................................................................................................... 571578
Preface
A business manager relies on economic and financial analysis for taking various decisions.
Managerial economics and financial accounting have therefore always been integral parts of business
studies. Besides, courses on these subjects are of recent origin in undergraduate engineering
disciplines. This book would therefore be useful not only to students pursuing engineering courses but
also to students of M.B.A, M.Com., and C.A. courses.
The book presents the concepts and methods of managerial economics and financial
accounting, which help managers to arrive at the most appropriate solutions to business
problems. The objective of this book is not only to present the theory of the firm but also to bridge
the gap between economic theory and practical application. The emphasis is on
presenting modern economic and financial analysis in a way that is intuitive, interesting, and useful
for students who have had no prior exposure to these fields.
Managerial economics is concerned with resource allocation, strategic, and tactical
decisions that are made by analysts, managers, and consultants in the private, public, and not-forprofit sectors of the economy. Managerial economists seek to achieve the objectives of the
organization in the most efficient manner, while considering both explicit and implicit
constraints on achieving the objective(s). Financial accounting, on the other hand, provides the
necessary financial information to the management. The major emphasis in managerial
economics as well as financial accounting is on providing the analytical tools and managerial insights
that are essential for the solution of those business problems that have significant consequences, both
for the firm and the society at large.
The text is divided into six chapters. The first chapter provides an overview of managerial
economics, and introduces the key economic concepts and tools. In this chapter, the decision-making
process and the relationship between managerial economics and other areas of business and
economic analysis are discussed. The chapter also gives a brief description of the nature, scope, and
subject matter of economics. The second chapter deals with various aspects of
demand analysis, estimation and forecasting. It also presents the theory of price determination under
different kinds of market conditions characterized by perfect competition, monopoly, xiii
xiv
PREFACE
monopolistic competition, and oligopoly. The third chapter presents production and cost
analysis. It is concerned with the theory of production, the cost concepts, and the costoutput
relationship. It also presents a brief description and various applications of break-even analysis
carried out by business decision-makers. The fourth chapter focusses on capital management, which
comprises working capital management and fixed capital management (that is,
investment analysis). The fifth chapter presents accounting concepts, conventions, journal, ledger,
trial balance, final accounts, and the Bank Reconciliation Statement. It also dwells upon financial
analysis. The sixth chapter presents the various types of business organizations and their suitability
for different business activities.
We sincerely hope that the students, learned teachers, and other readers will find the book useful.
Suggestions and criticism for enhancing the utility of the book are welcome. We are thankful to
Prentice-Hall of India for their interest, encouragement and co-operation, and for making our effort
successful by publishing this book.
M. Kasi Reddy
S. Saraswathi
CHAPT E R
1
Managerial Economics: The Basics
LEARNING OBJECTIVES
After studying this chapter you will be able to understand:
what is Economics
how Economics contributes to business decisions
what is Managerial Economics
how Economics is different from Managerial Economics
the characteristics and significance of Managerial Economics
the nature and scope of Managerial Economics
the relationship of Managerial Economics to other disciplines
the basic concepts of Managerial Economics
the role and responsibilities of managerial economists
INTRODUCTION TO ECONOMICS
Economics is a social science. It studies economic phenomena and related behaviour of the people.
Economic behaviour relates to an essentially conscious effort to derive maximum gains from the use
of scarce resources and opportunities available. Economics is fundamentally the study of how people
allocate their limited resources, which have alternative uses, to produce and consume goods and
services to satisfy their endless wants or to maximize their gains.
Economics as a branch of knowledge is concerned with the study of the allocation of scarce resources
among competing ends. Problems of resource allocation are constantly faced by
individuals, enterprises and nations. Over the years, the science of economics has developed a
variety of concepts and analytical tools to deal with such allocation problems.
Of all subjects, Economics is most closely associated with everyday life at all levels. As a voter, you
will make decisions on issueson government deficit, on taxes, on free trade, on 1
2
inflation and unemploymentthat cannot be understood until you have mastered the rudiments of this
subject. Choosing your lifes occupation is the most important economic decision you will make.
Your future depends not only on your own abilities but also on how economic
forces beyond your control affect your wages. Also, Economics may help you to invest the nest egg
you save from your earnings. Of course, studying Economics cannot make you a genius.
But without Economics the dice of life are loaded against you.
Scarcity and Efficiency
Over the last 30 years the study of Economics has expanded to include a vast range of topics.
Consider the following list:
Economics studies how the prices of labour, capital and land are set in the economy,
and how these prices are used to allocate resources.
Economics explores the behaviour of the financial markets, and analyses how they
allocate capital to the rest of the economy.
Economics examines the distribution of income, and suggests ways in which the poor
can be helped without harming the performance of the economy.
Economics looks at the impact of government spending, taxes and budget deficits on
growth.
Economics studies swings in the unemployment and production cycle, and develops
government policies for improving economic growth.
Economics examines the patterns of trade among nations, and analyses the impact of
trade barriers.
Economics looks at growth in developing countries, and proposes ways to encourage
the efficient use of resources.
Thus, Economics is the study of how societies use scarce resources to produce valuable
commodities and distribute them among different people. Beyond this definition are two key ideas in
Economics: that goods are scarce and that society must use its resources efficiently.
Indeed, Economics is an important subject because of the fact of scarcity and the desire for efficiency.
If infinite quantities of every good could be produced or if human desires were fully
satisfied, what could be the consequences? People would not worry about stretching out their limited
incomes, because they could have everything they wanted; businesses would not need to fret over the
cost of labour or healthcare; governments would not need to struggle over taxes or spending
because nobody would care. Moreover, since all of us could have as much as we pleased, no one
would be concerned about the distribution of incomes among different people or classes.
In such an Eden of affluence, there would be no economic goods, that is, goods that are
scarce or limited in supply. All goods would be free, like sand in the desert or seawater at the beach.
Prices and markets would be irrelevant. Indeed, economics would no longer be a useful subject. But
no society has reached a utopia of limitless possibilities. Goods are limited, while wants seem
limitless.
MANAGERIAL ECONOMICS: THE BASICS
3
Given unlimited wants, it is important that an economy makes the best use of its limited
resources. That brings us to the critical notion of efficiency. Efficiency denotes the most effective use
of a societys resources in satisfying peoples wants and needs. The essence of Economics is to
acknowledge the reality of scarcity, and then figure out how to organize
society in a way which produces the most efficient use of resources. That is where Economics makes
its unique contribution.
Three Problems of Economic Organization

Every society must answer three fundamental questions.
What commodities are to be produced and in what quantities? A society must determine
how much of each of the many possible goods and services it will make, and when they
will be produced.
How are goods produced? A society must determine who will do the production, with
what resources, and what production techniques they will use.
For whom are goods produced? Who gets to eat the fruit of economic activity? Or, to
put it formally, how is the national product divided among different households?
Societies answer these questions in different ways. Societies are organized through alternative
economic systems, and economics studiesthe various mechanisms that a society can use to
allocate its scarce resources. There are mainly two systems of organizing an economy. At one
extreme, the government makes most economic decisions. At the other extreme, decisions are made in
markets where individuals or enterprises voluntarily agree to exchange goods and
services, usually through payment of money.
Limited Means and Unlimited Ends
For gaining a rough idea of Economics, let us consider the following example. Ashok has just joined
a college. Suppose his father has agreed to give him Rs. 5,000 per month to enable him to carry on his
studies in the college. With this limited money at his disposal, he has to meet all his needs. He has to
pay tuition fee, hostel fee, mess charges and other dues of the college; he may like to go to a cinema
or entertain friends at a restaurant, buy books, stationery, etc.
In fact, he wants to do or to buy many things. But the amount of money that he has is limited whereas
his wants, as we have seen, are unlimited. Economics can help him in such a situation.
It will help him to derive maximum satisfaction from the limited amount of money he has.
Choosing between Ends
Economics tells us how a person can satisfy his unlimited wants with his limited means. In other
words, how he can use the scarce goods that he has with him to his best advantage, or how to
economise. A man has only a limited amount of cash, housing accommodation or other things. But he
wants to put them to so many uses. With the limited amount of cash he has, he wants to buy so many
things, but he cannot buy them all. He must, therefore, choose what 4

to buy and what not to buy. This is Economics. Economics is a science of choice when faced with
scarce means and unlimited ends.
Deriving Maximum Satisfaction
In short, Economics teaches us to make the best use of our limited resources. It tells us how the scarce
means at our disposal can be put to several alternative uses so as to derive maximum benefit out of
them. It thus means sophisticated application of prudence or wisdom in the use of things. We should
use them in such a manner as to get the greatest amount of satisfaction possible. Economics tells us
how to do it.
Income and Employment
A recent idea in Economics is that besides studying the behaviour of an individual consumer or
producer deriving maximum benefit from the use of his limited resources, Economics should also be
concerned with the levels of income and employment in a country as well as the causes of their
fluctuation. Its study is thus intended to promote economic stability.
Economic Development
In respect of under-developed economies, Economics concerns itself with the study of
economic growth. The theory of economic growth and the theory of income and employment
are two recent additions to the subject of Economics.
Thus, Economics is a very wide-ranging subject. It concerns itself not only with the
behaviour of individual consumers and individual producers or firms, but also with industries,
national income and economic growth. The span of Economics is almost all-pervasive. The
concepts and theories of Economics help us to economise, i.e. to achieve maximum output by using
minimum input.
EVOLUTION OF ECONOMICS
The word Economics is derived from the Greek words oikos (for house or settlement) and nomos
(for laws or norms), which together mean skilled in household management. Although the word is
very old, the discipline of Economics as we understand it today is a relatively recent development.
Modern economic thought emerged in the 17th and 18th centuries as the western world began its
transformation from an agrarian society to an industrial one.
The term Economics was coined around 1870 and popularized by influential neoclassical economists
such as Alfred Marshall (who gave us the definition of welfare), as a substitute for the earlier term
political economy, which referred to the economy of polities or competing states. The term political
economy was used through the 18th and 19th centuries, with Adam Smith, David Ricardo and Karl
Marx as its main thinkers. Today it is frequently referred to as the Classical economic theory.
Economics is a relatively new science; it came into being a little over two centuries ago, as shown in
Table 1.1. So far it has developed into four main stages: the Classical (Adam MANAGERIAL
ECONOMICS: THE BASICS
5
Smith, 1776) Stage, the Neo-Classical (Alfred Marshall, 1885) Stage, the New (Lionel Robbins,
1932) Stage and the Modern (J.M. Keynes, 1936) Stage. Corresponding to these stages, there are four
distinct definitions of the subject. Initially it was considered a science of wealth, through its fourfold
activity of consumption, production, distribution and exchange.
Marshall related the subject to economic welfare, which is most closely connected with the
attainment and the use of material requisites of well-being. However, Lionel Robbins (1932) gave the
subject a positive scientific basis. The modern view of Economics is that it is much more than merely
a theory of value or of resource allocation. The credit for bringing about a revolution in economic
thinking goes to the late Lord J. M. Keynes.
Table 1.1 Evolution of Economics
Stage
Period
Economist
Focus
Classical
1776
Adam Smith
Science of wealth
Neo-classical
1885
Alfred Marshall
Science of welfare
New
1932
Lionel Robbins
Science of scarcity or choice
Modern
1936
J. M. Keynes
Administration of scarce resources and of the
determinants of employment and income
Samuelson
Theory of economic growth and of economic
stability
Classical Stage
The Classical Stage was represented by Adam Smith. Adam Smith is generally regarded as the father
of Economics. The author of The Wealth of Nations which was published in 1776, Smith defined
Economics as an inquiry into the nature and causes of the wealth of nations, i.e. the science of wealth.
Smith offered another definition: Economics is The Science relating to the laws of production,
distribution and exchange. Wealth was defined as the specialization of labour which allowed a
nation to produce more with its limited supply of labour and resources.
Many other earlier economists also defined Economics in a similar way. John Stuart Mill
defined Economics as The practical science of production and distribution of wealth.
For Mill, wealth is defined as the stock of useful things. According to the French economist J. B. Say,
Economics is a study of the laws which govern wealth. According to the American economist F. A.
Walker, Economics is that body of knowledge which relates to wealth.
Definitions in terms of wealth emphasize production and consumption, and do not deal
with the economic activities of those not significantly involved in these two processes (for example,
retired people or beggars). This approach was criticized for paying exclusive attention to wealth, as
if wealth was everything, and little attention was paid to man for whom wealth is really meant; John
Ruskin referred to political economy as a bastard science, the science of getting riches. Many
economists condemned this worship of Mammon (the god of wealth).
They accused Economics of selfishness and meanness, and therefore called it a dismal science.
Therefore, this definition was ultimately rejected.
6
Neo-classical Stage
In the Neo-classical Stage, Economics was called the Science of Material Welfare. Alfred
Marshall, a pioneer neo-classical economist, reoriented Economics towards the study of
humanity and provided economic science with a more comprehensive definition. Marshall, in his
famous book Principles of Economics, published in 1890, defines Economics as follows: Political
Economy or Economics is a study of mankind in the ordinary business of life. It examines that part
of individual and social action which is most closely connected with the attainment and with the
use of material requisites of well-being.
The following are the implications of this definition:
1. Economics is a study of mankind.
2. Human life has several aspectssocial, religious, economic and political; but
Economics is concerned only with the economic aspect of life.
3. Promotion of welfare is the ultimate goal, but the term welfare is used in a narrow sense to mean
material welfare only.
From the definition, it is quite clear that although Economics still studies wealth, wealth is not
considered primarily important. In other words, it has been given a secondary place, the first place
being given to man. It is for mans sake and for the sake of his welfare that wealth is studied. Thus
Economics could no longer be considered a science of selfishness or a dismal
science. Rather, it acquired great social importance because the promotion of human welfare became
its chief aim.
Besides Marshall, there are other economists who have defined Economics in terms of
welfare. According to Pigou, The range of enquiry becomes restricted to that part of social welfare
that can be brought directly or indirectly into relation with the measuring rod of money. According to
Edwin Cannan, The aim of political economy or Economics is the
explanation of the general causes on which the material welfare of human beings depends.
Material welfare is that form of welfare which can be measured in money terms, and is
very different from general welfare which, being abstract, is difficult to be measured in quantitative
units. Because of its focus on welfare, this particular branch of Economics is also known as Welfare
Economics. Wealth is a very convenient measure of human motives which
underlie all economic activity. Wealth represents the material means of satisfying human wants and
consequently of promoting human welfare. So far as Economics studies wealth, it can be legitimately
regarded as studying the causes of material welfare.
Marshall clearly shows that economic activity is different from other activity. For example, a person
visits a friend (social activity), a voter casts his vote in an election (political activity), and a person
goes to a temple, mosque or church (religious activity). A farmer going to the fields or a worker going
to a factory performs an economic activity. They work to earn money.
With that money they will buy things to satisfy their wants. In other words, Economics deals with
wants, efforts and satisfaction.
In the words of Marshall, man earns money to get material welfare. Marshall gives
importance to welfare and man. This definition came to be called the Welfare definition.
7
The definition given by Marshall remained current for a long time, but early in the 1930s, a
distinguished economist named Lionel Robbins challenged this definition. The main points of his
criticism of Marshalls definition are given as follows:
1. It is a classification rather than a definition. It classifies economic phenomena into material and
non-material types.
2. It confines itself to material welfare and thus unnecessarily narrows down the field
of study of Economics by ignoring the non-material aspects thereof.
3. This definition ignores non-material services like those of teachers, doctors, etc.
which also make an important contribution to economic welfare.
4. The distinction made in this definition between ordinary business of life and
extraordinary life is not clear.
5. According to this definition, Economics deals with persons living only in society. It
ignores others who also may have an economic problem.
6. Robbins main quarrel with the Marshallian definition is that the definition points
only to the material aspect, whereas actually Economics deals with both material
goods and non-material services. Hence, although the contents are correct, the label
is wrong.
New Stage
In the New Stage, Economics was described as the Science of Scarcity or Science of Choice.
Most contemporary definitions of Economics involve the notions of choice and scarcity.
Perhaps the earliest of these is by Lionel Robbins. A significant contribution was made by Robbins at
the London School of Economics on The Basis of Scarcity. He constructed a new definition of
Economics in 1932 in his book entitled The Nature and Significance of Economics Science. He
defined Economics as follows:
Economics is a science which studies human behaviuor as a relationship between ends and scarce
means which have alternative uses.
In this way, Robbins has at once relieved Economics of both wealth and welfare considerations.
It is now considered a science purely of human behaviour in specific situations. Such an
economic situation is one which is marked, on the one hand, by multiple ends (wants and their
satisfaction) and, on the other, by scarce or limited resources (money, land, water, energy, capital,
etc.). This necessarily compels individuals to economize and optimize; for instance, one attempts to
maximize ones satisfaction, profits, wages, salaries, etc. and at the same time minimize the use of
ones resources (expenditure, cost of production and effort). This is likely to ensure the best results
for all economic activities.
Yet Economics is neither the science of ends as such nor of scarcity. Resources, though scarce, are
capable of alternative uses. Land can be used for cultivation, construction, or commercial purposes.
Labour can also be employed in various waysin factories, in
construction, in agriculture, etc. Capital can be used for the purchase of factory equipment, for raw
materials, or for investing in shares and bonds, etc. Again, from among a variety of options like
purchasing a car, purchasing a house, or travelling abroad, the one which is urgent and 8
the most satisfying can be chosen. Hence, under Economics, one studies the most useful way in which
an individual or the society as a whole allocates its scarce resources.
Virtually all textbooks have definitions that are derived from this definition. Though the exact
wording differs from author to author, the standard definition is something like this: Economics is the
social science which examines how people choose to use limited or scarce resources in attempting
to satisfy their unlimited wants.
Robbins is not without his critics. His definition has been criticised on several grounds: 1. It ignores
normative or ethical aspects of economic phenomena. It has been pointed
out that Robbins definition, though admittedly more scientific, is colourless,
impersonal and neutral as regards ends. If Economics is to serve as an engine of social
betterment, it cannot altogether do away with normative or ethical significance. The
function of economists is not only to explain and explore but also to advocate and
condemn.
2. Robbins, it is said, has reduced Economics to mere valuation theory. But actually
Economics is much more than a study of value or resource allocation. In Economics,
we do not merely study how resources are allocated and how prices are determined.
Robbins definition merely assigns to Economics an allocative role.
3. Robbins definition does not cover Keynesian Economics. As such, it does not tell
us how the level of income and employment in a country is determined. In other
words, it does not explain fluctuations in the levels of income and employment in an
economy. This is a very serious omission, because today macro-economics forms a
very important part of the study of Economics.
4. The theory of economic growth or development has recently become a very important
branch of Economics. But Robbins definition does not cover it. The theory of
economic growth explains how an economy grows and the factors which bring about
an increase in national income and productive capacity of the economy. But Robbins
takes the resources as given and discusses only their allocation.
5. Robbins definition does not explain the problem of unemployment. For some
countries, this is an urgent problem. There is abundance of manpower rather than
scarcity of it, whereas Economics, according to Robbins, studies the problem of

scarcity.
6. Robbins definition lacks a human touch. It is very well to emphasize that
Economics is something more than a science, a science shot through with the infinite
variety of human life, calling not only for systematic thinking but for human
sympathy, imagination and in an unusual degree for the saving grace of
commonsense. But apparently, none of these is visible in his definition.
7. There is no doubt that Robbins has made Economics more abstract and complex and
hence difficult and unfruitful. This takes away its utility for the common man. Utility
of Economics lies, in a large measure, in its being a concrete and realistic field of
study.
Thus, we see that Robbins idea of Economics is not the last word on the subject. In order to have a
clear idea about the nature of Economics, we must take note of some recent
developments in economic theory.
9
Modern Stage
During the last forty years or so, economic thinking has moved much further from Robbins
view. According to Robbins, Economics is concerned with the best possible use of limited
resources. But it is now supposed that Economics is much more than merely a theory of value or of
resource allocation. The credit for bringing about a revolution in economic thinking goes to the late
Lord J. M. Keynes. In terms of the Keynesian point of view, Economics can be
defined as The study of the administration of scarce resources and of the determinants of
employment and income. In other words, it studies the causes of economic fluctuations to see how
economic stability could be promoted. Thus, besides studying the theory of value or of resource
allocation, Economics studies how the levels of income and employment in an
economy are determined.
In Benhams words, Economics is a study of the factors affecting the size, distribution
and stability of a countrys national income.
More recently, the theory of economic growth has come to occupy an important place in
the study of Economics with reference to under-developed economies. It studies how the
national income grows over the years. An economy like that of India, which is at the mercy of
monsoons, needs economic stability besides economic growth. Thus, a study of economic
growth and economic stability forms an integral and important part of the study of Economics.
A good and adequate definition of Economics must cover them.
In short, Economics may be defined as a social science concerned with the proper use and
allocation of resources for the achievement and maintenance of growth with stability or as a social
science concerned chiefly with the way the society chooses to employ its limited
resources, which have alternative uses, to produce goods and services for present and future
consumption. However, beyond this there are a range of definitions, past and present, which have
been applied first to the term political economy and then to the modern term Economics.
John Maynard Keynes once remarked that Economics is the science of thinking. Broadly
speaking, Economics has moved from the study of wealth to the study of welfare and today
to the study of trade-offs.
NATURE AND SCOPE OF MANAGERIAL ECONOMICS
Managerial Economics is a specialized discipline of management studies which deals with the
application of economic theory and techniques to business management. Managerial Economics is the
integration of economic theory and business practices for the purpose of facilitating decision-making
and forward planning by the management. Managerial Economics also draws
together and relates ideas from various functional areas of management like production,
finance, marketing and accounting. A managerial economist has to integrate concepts and
methods from all these disciplines and functional areas, in order to understand and analyse practical
managerial problems.
Nature of Managerial Economics
Managerial Economics is concerned with the economic problems that the management team of
every business needs to solve. A study on the nature of Managerial Economics is relevant and 10
helpful for managerial decision-making. The nature of Managerial Economics is studied as
follows:
Microeconomics and Macroeconomics
In the 1930s, Ragnar Frisch classified Economics into two branches, viz., Microeconomics and
Macroeconomics. These terms are derived from the Greek words micros and macros, which mean
small and large respectively. An economic system may be looked at as a whole or
in terms of its innumerable decision-making units such as consuming units (e.g. individual consumers
and households), producing units (e.g. farms, manufacturing and mining concerns), individual factors
of production (e.g. labourers, landowners, business owners and
entrepreneurs), and individual industries (e.g. cotton textile, iron and steel, toy-making). When we
analyze the problems of the economy as a whole, we carry out a macroeconomic study. On the other
hand, an analysis of the behaviour of any particular decision-making unit, such as a firm, an industry
or a consumer, constitutes Microeconomics.
Microeconomics is also called price theory and Macroeconomics is also called income theory.
Price theory explains the composition or allocation of total production, whereas income theory
explains the level of total production. These terms are explained below in some detail.
Microeconomics.
The term micro means a millionth part. In Microeconomics, a small
part or component of the whole economy is analysed. For example, we may study either an
individual consumers behaviour, or that of an individual firm, or what happens in any
particular industry. If the issue is analysis of price, in Microeconomics we study the price of a
particular product or of a particular factor of production, not the general price level in the country.
Similarly, if it is a demand that we are analysing, in Microeconomics it is the demand of an individual
or that of an industry that is studied, and not the aggregate demand of the entire community. Likewise,
the income of an individual or an industry, and not the national income of a country, comes within the
purview of Microeconomics. In respect of employment, it is the employment situation in a firm or in
an industry that is considered in Microeconomics and not the aggregate employment in the whole
economy.
An important feature of the micro approach is that while conducting economic analysis on
a micro basis, generally an assumption of full employment in the economy as a whole is made.
By that assumption, the economic problem is mainly of resource allocation or of price. Alfred
Marshalls Principles of Economics (1890) is the first book on Microeconomics. Till recently,
Economics concerned itself mainly with the theory of value and distribution, and ignored the study of
the economic system as a whole.
Macroeconomics or Theory of Income and Employment.
In recent years, strong attention
has been given to the analysis of the economic system as a whole. The credit goes to the late Lord J.
M. Keynes. His The General Theory of Employment, Interest and Money (1936) is the first book on
Macroeconomics. Of course, the term Macroeconomics was first coined by Ragnar Frisch, the first
Nobel Laureate economist, in 1933. In Macroeconomics we study the
aggregates and averages of the entire economy, such as national income, aggregate output, total
employment, total investment, savings and consumption, aggregate demand, aggregate supply,
11
general level of prices, etc. In other words, in Macroeconomics, we study how these aggregates and
averages of the economy as a whole are determined and what causes fluctuations in them.
From theoretical reasoning and on the basis of empirical knowledge, we now know that the
old assumption of full employment is not valid. Therefore, it is very vital that we should investigate
how these aggregates of the economy are determined, and provided their
determinants are known, how to ensure the maximum level of income and employment in a
country.
Macroeconomics also deals with how an economy grows. It can be said, therefore, that
Macroeconomics examines the forest rather than the individual trees. It analyses the chief
determinants of economic development, and various stages and processes of economic growth.
Economic growth is a long-run problem and as such it is a post-Keynesian development, as
Keynes was pre-occupied with the short-run problem of economic fluctuations. The theory of
economic growth is in a greatly developed state these days. A general growth theory applies to both
developed and underdeveloped economies. But special growth theories have been
propounded for accelerating the growth of underdeveloped economies.
Integration of Microeconomics and Macroeconomics.
It may be emphasised that neither of

the two approaches outlined above can alone adequately help us in analyzing the functioning of the
economic system. What is true of the parts may not be true of the whole and what is true of the whole
may not apply to the parts. Therefore, it is very essential to integrate the two approaches, if we wish
to get correct solutions to our macroeconomic problems. Take for example a period of prosperity in
an economy. Even in such boom conditions, it is not
uncommon to come across examples of individual industries which may be languishing.
Likewise, in a period of deep depression, there may yet be some individual industries which enjoy
great prosperity. Now, to apply the macro approach to such individual industries would obviously be
wrong; and it would be equally wrong to apply the microanalysis of these
industries to the economic system as a whole.
What is needed is a proper integration of the macro and micro approaches to such
problems. In fact, there are few macro problems which have no microelements involved and
few micro problems that are without macroaspects. It is therefore only proper to marry the two
approaches both in analyzing the economic problems and in prescribing policy measures for tackling
them. Ignoring one and exclusively concentrating attention on the other may often lead, not only to
inadequate or wrong explanations, but also to inappropriate or even disastrous remedial measures.
Thus, according to the views of economists today, the subject matter of Economics includes price
theory (or Microeconomics), income and employment theory (Macroeconomics) and
growth theory. Hence, broadly speaking, Economics may be described as a study of the
economic system under which men work and live. It deals with decisions regarding the
commodities to be produced and the services to be rendered in the economy, the methods to produce
them most economically and distribute them properly, and also the means to provide for the growth of
the economy. There are six distinct aspects of the two approaches that are shown in Table 1.2.
12
Table 1.2 Microeconomics and Macroeconomics
Aspects
Microeconomics
Macroeconomics
Units of the study

Individual consumers, producers,
Aggregate units such as state,
workers, traders, etc.
national or international economy.
Activities
Optimization and maximization of
Long-term growth; maintenance of
personal gains and profits.
high levels of production and
employment.
Origin
Micro activities that emerge on the
Problems of long-term growth that
demand side of the consumers
depend upon the supply of
choices.
productive resources.
Conditions
This approach is functional under static This approach is functional under
conditions and small time intervals.
dynamic conditions and complex
long-run changes.
Methods
It is concerned with small adjustments It deals with complex, dynamic

for which the application of a marginal changes inviting the use of
method is suitable.
advanced mathematical techniques.
Levels
Micro adjustments in resource
Attempts are made to find suitable
allocation are made in response to
conditions for long-term expansion
changes in relative prices of goods
in output as a whole, assuming
and services. The aggregate level of
relative prices as constant (or
income or total economic activities is significant).
considered to be constant.
This distinction between Micro- and Macroeconomics as presented above is only a matter of
theoretical convenience. The two approaches are complementary and not competitive; one
cannot consider these to be watertight compartments. Moreover, the distinction is to be
understood as relative in nature. The problems of a city municipal corporation are macro in nature as
compared to those of individual citizens, but a city unit is micro as compared to the state, and the state
unit is micro as compared to the nation. Further, the national unit can be considered micro in the
context of the global economy. Again, all economic problems and
activities, whether micro or macro, are ultimately connected with the issues of choice and
optimization. They emerge out of and are concerned with human behaviour.
Decision-making
We have already learnt that Economics is concerned with the study of the allocation of scarce
resources among competing ends. Resource allocation problems are constantly faced by
individuals, enterprises and nations. Over the years, the science of Economics has developed a
variety of concepts and analytical tools to deal with such allocation problems.
The main function of a management executive in any business organization is taking
decisions regarding day-to-day business activities and establishing plans for the future based on past
data. Some examples of the types of managerial problems that managers in different
organizational settings face every day are: what product to produce, what price to charge, where and
how to get financing, where to locate, how to advertise, what method of production to use,
13
whether or not to invest in new equipment, etc. In all cases the managers are faced with
alternative choices.
Decision-making thus means the process of selecting one action from two or more
alternative courses of action. Managerial decisions involve various steps. Decisions have farreaching effects on the firm and are often not easy to make. In these circumstances, it is recommended
that systematic efforts be made to arrive at the right decision as shown in
Fig. 1.1. The question of selection or choice arises because resources such as capital, labour, land
and management are limited and can be employed in alternative ways. Once the decision is made to
achieve a particular goal, plans regarding production, pricing, capital, raw materials, labour, etc. are
prepared. Thus, planning goes hand in hand with decision-making.
Step 1: Establish or identify objectives
Step 2: Define problem
Step 3: Identify possible solutions
Step 4: Evaluate alternative solutions
Step 5: Select the best possible solution
Step 6: Implement the decision
Step 7: Evaluate and control
Fig. 1.1 Decision process.
Since decisions depend on the objectives of a firm, it is important to be clear about them from the
outset. If a doctor is unable to diagnose the disease, his prescriptions may not cure the patient. A
question of decision will arise only when there are alternatives; if there are no alternatives there is no
decision problem. However, in todays complex world the firm is left with a number of alternatives
and also many constraints on it. A clear understanding of these needs to be obtained through a
thorough scanning of the environmentthe opportunities and the constraints. Evaluation requires
strong effort. It would require gathering of relevant data and their analysis through appropriate
techniques. The next step is choosing the best among the alternatives, followed by implementation of
the decision, which requires resources. The
managerial decision process does not end with implementation; its performance must be
monitored, so that projection errors are reduced in the future period.
The business decision-making process has lately become rather complex due to ever
growing complexity of the business world. In the older days, business units were set up and 14
managed by individuals or business families on the basis of managerial skills acquired through family
training and own experience. But today, drastic changes have taken place in the size and nature of the
business. Growth of large-scale industries, growth of large varieties of industries, diversification of
industrial products, expansion and diversification of business activities of organizations, emergence
of multinational corporations, etc. have contributed to an increase in inter-firm and international
rivalry, competition, risk and uncertainty. In this kind of business environment, decision-making
becomes a very complex affair. The growing complexity of
business decision-making has inevitably increased the application of economic concepts and tools of
economic analysis in the business field. The application of economic concepts and analytical tools
greatly helps the business managers in assessing and predicting market
conditions and the business environment. The economic theories and analytical tools which are used
in business decision making has led to the emergence of a separate branch of study called
Managerial Economics or Business Economics.
In this information age, changes occur very fast. In the past, changes took place in years; at present
changes take place in months and in the future we may see that changes occur in days. By the time we
learn new things they may becomes obsolete. If undue delay is made in decision-making,
opportunities might turn into threats. Hence, in a dynamic economy, decisions have to be made within
a time constraint. Economic tools and techniques help a manager to arrive at the right decisions
within a limited time-period.
What is Managerial Economics?
Managerial Economics (also called Business Economics), a subject first introduced by Joel Dean in
1951, is essentially concerned with the economic decisions of business managers. It is a branch of
Economics that applies microeconomic analysis to specific business decisions (i.e.
Economics applied in business decision-making). Managerial Economics may be viewed as

Economics applied to problem solving at the level of the firm. The problems ofcourse relate to
choices and allocation of resources, which are basically economic in nature and are faced by
managers all the time. It is that branch of Economics, which serves as a link between
abstract theory and managerial practice. It is based on economic analysis for identifying problems,
organizing information and evaluating alternatives. In other words, Managerial
Economics involves analysis of allocation of the resources available to a firm or a unit of
management among the activities of that unit. It is thus concerned with choice or selection among
alternatives. Managerial Economics is by nature goal-oriented and prescriptive, and it aims at
maximum achievement of objectives.
Managerial Economics help managers to learn the economic principles which are relevant
to decision-making in such areas as production, personnel, marketing and finance. A clear
understanding of economic principles will help the manager in his activities. For example, XYZ
Ltd. has limited financial, human, and physical resources. XYZ Ltd. managers seek to
maximize the financial return from these limited resources. They should apply Managerial
Economics to develop pricing and advertising strategies, design their organizations, and manage
purchasing.
Managerial Economics applies economic theory and methods to business and administrative
decision-making. Managerial Economics prescribes rules for improving managerial decisions.
15
Managerial Economics also helps managers to recognize how economic forces affect
organizations and describes the economic consequences of managerial behaviour. It links
traditional Economics with the decision sciences to develop vital tools for managerial decisionmaking. This process is illustrated in Fig. 1.2.
Fig. 1.2 The role of Managerial Economics in managerial decision-making.
Managerial Economics has applications in both profit and non-profit sectors. For example, an
administrator of a non-profit hospital strives to provide the best medical care possible given limited
medical staff, equipment and related resources. Using the tools and concepts of
Managerial Economics, the administrator can determine the optimal allocation of these limited
resources. In short, Managerial Economics helps managers to arrive at a set of operating rules that aid
in the efficient use of scarce human and capital resources. By following these rules, businesses, nonprofit organizations and government agencies are able to meet objectives
efficiently.
Thus, Managerial Economics applies the principles and methods of Economics to analyse
problems faced by the management of a business or other types of organizations and helps to find
solutions that advance the best interests of such organizations.
16
Definitions of Managerial Economics
Managerial Economics has been defined in different ways by different scholars. Some of the popular
definitions of Managerial Economics are given below:
Managerial Economics consists of the use of economic modes of thought to analyse business
situations.
McNair and Meriam
Managerial Economics is the integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning by management.
Spencer and Siegelman
Managerial Economics is defined as price theory in the service of business executives.
Watson
Managerial Economics is viewed as a fundamental academic subject, which seeks to
understand and to analyse the problems of business decision making.
Hague
Managerial Economics is defined as the application of economic theory and methodology to
business administration practice.
Brigham and Pappas
Managerial Economics is the application of economic principles and methodologies to the
decision-making process within the firm or organization.
Douglas
Managerial Economics refers to the application of economic theory and the tools of analysis of
decision science to examine how an organization can achieve its objectives most effectively.
Salvatore
Managerial Economics is the application of economic analysis to business problems; it has its
origin in theoretical microeconomics.
Howard Davies and Pun-Lee Lam
We may, therefore, define Managerial Economics as the discipline which deals with the
application of economic theory to business management. Managerial Economics thus lies on the
borderline between Economics and Business Management and serves as a bridge between the
two disciplines.
Characteristics of Managerial Economics
To understand the subject matter of Managerial Economics more clearly, it would be useful to point
out the following characteristics:
1. Managerial Economics is concerned with the study of a firm and not the entire
economy; thus it is microeconomic in character.
17
2. The contents of Managerial Economics are largely based on the Theory of the firm.
However, for the analysis of profits it takes the help of the Theory of distribution.
3. Managerial Economics is normative rather than positive in character. That is, it is
concerned with the type of decisions which the firm should make in order to prosper,
which involves value judgments and not a mere description of behaviour of the firm.
4. Managerial Economics takes the help of macro-economics to understand and adjust
to the environment in which the firm operates. This understanding helps a manager
to play a crucial role in the success of the organization.
5. Managerial Economics is goal-oriented and prescriptive. It deals with how decisions

should be made by managers to achieve organizational goals.
6. It is both conceptual and metrical because it takes the help of conceptual frameworks
to understand and analyse the decision problems as well as quantitative techniques to
measure the impact of different factors and policies.
Managerial Economics vs. Economics
There is no difference between Managerial Economics and Economics in theory; standard economic
theory provides the basis for Managerial Economics. The difference is in the way economic theory is
applied. The differences between Managerial Economics and Economics are explained in Table 1.3.
Table 1.3 Managerial Economics vs. Economics
Managerial Economics
Economics
It is the study of how resources should be
It is the study of how resources are
allocated in a particular firm.
allocated in a society as a whole.
It involves application of economic principles to
It deals with the body of the principles itself.
the problems of the firm.
It is individualistic.
It is holistic.
It is microeconomic in character.
It is both macro- and microeconomic in
character.
It deals only with a firm.
It deals with a firm and its industry.

It is narrow in scope.
It is wider in scope.
It adopts and reformulates economic models
It hypothesizes economic relationships and
to suit specific conditions and serves specific
builds simplified economic models.
problem-solving processes. Thus, it modifies
and enlarges economic models.
It uses variables such as objectives of the firm,
It uses only theoretical assumptions.
multi-product
nature
of
manufacture,
constraints
on
resource
availability,
environmental aspects, legal constraints, etc.
18
Significance or Usefulness of Managerial Economics
Managerial Economics helps the manager to achieve several objectives. These are as follows: 1.
Managerial Economics provides a number of tools and techniques to build models.
With the help of these models the manager handles real-life situations.
2. Managerial Economics also incorporates useful ideas from other disciplines such as
psychology, sociology, etc. if they are found relevant for decision-making.
3. Managerial Economics provides most of the concepts that are needed for the analysis
of business problems. These concepts have proved their value in solving various kinds
of managerial problems. The concepts of elasticity of demand, fixed and variable
costs, short and long run costs, opportunity costs, net present value, etc. all help in
understanding and solving problems.
4. Managerial Economics is helpful in making decisions such as: What products and
services should be produced? What inputs and production techniques should be used?
How much output should be produced and at what price should it be sold? What are
the best sizes and locations of new plants? When should equipment be replaced? How
should the available capital be allocated? How to take investment decisions? How
much should the firm advertise and how to allocate an advertisement fund between
different media?
5. Managerial Economics helps us to understand the economic behaviour of individuals.
6. Managerial Economics provides good knowledge about the cause and effect of
various economic phenomena.
Figure 1.3 illustrates that Managerial Economics also relies on economic methodology,
analytical tools, and the principles of accounting, finance, marketing, personnel, administration and
production.
Positive vs. Normative Economics
As shown in Fig. 1.3, there are two broad approaches to economic methodology. Economics
provides us with a way of thinking, and one of the most important aspects of that way of
thinking is the distinction between positive economics and normative economics. Normative
questions involve value judgments. An example of a normative question is Should we raise the
minimum wage?. Positive questions, on the other hand, are aimed at determining the
implications or consequences of an action. An example of a positive question about the
minimum wage would be Will the unemployment rate increase if the minimum wage is
raised?.
Economists have found the positive-normative distinction useful because it helps people
with very different views about what is desirable to communicate with each other. Economics equips
us to deal better with positive questions than with normative ones, because the latter involve value
judgments. But positive questions are often crucial for understanding and
examining normative questions. For example, the desirability of raising the minimum wage (a
normative issue) depends, in large measure, on whether unemployment goes up and by how
much (a positive issue).
19
Fig. 1.3 Nature of Managerial Economics.
Scope of Managerial Economics
As regards the scope of Managerial Economics, no uniform pattern has been followed by
various authors. However, the following aspects may generally fall under Managerial
Economics:
1. Demand analysis and forecasting
2. Cost and production analysis
3. Pricing decisions, policies and practices
4. Profit management
5. Capital management
6. Competition
7. Product policy, sales promotion and market strategy.
20
In recent years, there is a trend towards integration of Managerial Economics and
Operations Research. Hence techniques such as linear programming, inventory models, theory of
games, etc. have also been regarded as part of managerial economics.
Demand Analysis and Forecasting
When a business manager decides to venture into a business, the very first thing he needs to find out is
the nature and amount of demand for the product, both at present and in the
future. A firms performance and profitability depends upon accurate estimates of demand.
The firm will prepare its production schedule on the basis of demand forecast. Demand
analysis helps to identify the factors influencing the demand for a firms product and thus helps a
manager in business planning. Demand analysis and forecasting thus help him in the choice of the
product and in planning output levels. The main topics covered under
demand analysis and forecasting are the concepts of demand, demand determinants, law of
demand, its assumptions, elasticity of demand (price, income and cross elasticity), demand
forecasting, etc.
Cost and Production Analysis
In the modern world a consumer expects a good-quality product at a reasonable price from the firm. It
is possible only when a business manager has a control over the costs. An element of cost uncertainty
exists, as all the factors determining cost are not always known or controllable.
Cost control is essential for pricing policies. A business manager is confronted with the problem of
choosing the best input-mix and technology. He can maximize his profits only if he can produce the
decided level of output at minimum possible cost. It is necessary for the manager to know the
relationship between the costs and the output, both in the short run and in the long run, to position his
products amidst the competitive environment.
Production analysis is narrower in scope than cost analysis. Production analysis
frequently proceeds in physical terms while cost analysis proceeds in monetary terms. The main
topics covered under cost and production analysis are: cost concepts and classifications, cost-output
relationships, economies and diseconomies of scale, production functions and
cost control.
Pricing Decisions, Policies and Practices

Once a particular quantity of output is ready for sale, the firm has to fix its price given the conditions
in the market. Pricing is a very important aspect of Managerial Economics as a firms revenue
earnings largely depend on its pricing policy. A correct pricing policy makes a firm successful, while
incorrect pricing may lead to its elimination. The topics covered under this area are: price
determination in various market forms such as perfect market, monopoly, oligopoly, etc., pricing
methods such as differential pricing and product-line pricing, and price forecasting.
21
Profit Management
Business firms are established with the objective of making profits and it is thus the chief measure of
success. For maximizing profits the firm needs to take care of pricing, cost aspects and long-range
decisions, i.e., it has to evaluate its investment decisions and carry out the best policy of capital
budgeting for the firm under a given set of conditions. If we know the future, profit analysis would be
an easy task. However, in a world of uncertainty our expectations are not always realized, so that
profit planning and measurement constitute a difficult area of Managerial Economics. The important
aspects covered under this area are: nature and
measurement of profit, profit policies, and techniques of profit planning like break-even analysis,
cost-volume-profit analysis, etc.
Capital Management
The most complex and troublesome duty of the business manager is to decide the firms capital
investment. The greater the investment the more complex the decision. Capital management
implies planning, acquisition, disposition and control of capital expenditure. The main topics covered
under this area are cost of capital, rate of return and selection of projects.
Competition
Study of markets is one of the important aspects of the work of a managerial economist. A manager
should have clear knowledge of different markets existing in the environment. The environment is not
constant and goes on changing. Thus, the manager should know clearly
about perfect and imperfect markets so as to introduce the product in such markets where he can
increase the sales revenue. The main aspects are perfect market, monopoly market,
monopolistic market, oligopoly market, and price fixation under different market conditions.
Product Policy, Sales Promotion and Market Strategies
These have of late also become a part of the managerial economists responsibility. Under this head,
product mix, sales production strategy, market strategies, etc. are the important areas.
RELATIONSHIP OF MANAGERIAL ECONOMICS
WITH OTHER DISCIPLINES
An important feature of Managerial Economics is its relationship with other disciplines.
Although essentially a branch of Economics, the subject draws upon a number of other
disciplines for propounding its theories and concepts for managerial decision-making.
Managerial Economics provides a link between economic theory and the decision sciences
in the analysis of managerial decision making (see Fig. 1.4).
22
Management Problems
Economic Theory
Decision Sciences
Application of economics and decision sciences
to solve management problems
Solutions to
problems faced by
managers
Fig. 1.4 Relationship of Managerial Economics to other disciplines.
Relationship with Microeconomics
It should be obvious that the roots of Managerial Economics spring from microeconomic
theory. Price theory, demand concepts and theories of market structure, to take a few examples, are
elements of Microeconomics which Managerial Economics draws upon. The dependence of
the latter on microeconomic theory is very much like the dependence of medicine on biological
sciences and of engineering or technology on physics. It is important to note that Managerial
Economics has an applied bias and an interest in applying economic theory in order to solve real-life
problems of an enterprise. Mere teaching of microeconomic theory will not therefore be a substitute
for the teaching of Managerial Economics. However, a study of microeconomic theory is a prerequisite for all students of Managerial Economics.
Relationship with Macroeconomics
Economic agents, whether they are individuals or large business enterprises and organizations, do not
operate in a vacuum. Instead, they operate within a macroeconomic environment
provided largely by the economic and other policies of the governments of the countries of their
domicile and/or operations. Consequently, the particular macroeconomic environment the business
organizations face represents some form of a constraint of which firms must be aware, and take
cognizance of, since this economic environment underpins much of their activity. At the same time, it
must also be recognised that the policies and activities of business
organizations, in general, affect the overall economic environment, through their role in the
determination of the circular flow of income or output.
For example, of primary concern to Managerial Economics are aspects of fiscal and
monetary policy which determine rates and levels of taxation as well as interest rates that have
23
an impact on the investment and saving plans of economic agents. These plans affect growth, which in
turn determines levels of income and economic activity. When it comes to forecasting sales, business
firms have to incorporate into their models various macroeconomic variables such as disposable
national income, interest rates, inflation rates, etc. that enter the modelling exercise as predetermined
variables. Therefore, a managerial economist must be aware of the role and significance of the
macroeconomic environment and how this environment is likely to affect the plans and policies of the
business organization. Thus, for a proper economic interpretation of results of the quantitative
exercise, a good understanding of Macroeconomics is both desirable and necessary.
Relationship with Mathematics
Since Managerial Economics is concerned with the process of optimization, the various
quantitative methods provided by Mathematics are useful and indispensable tools for the sharper
understanding of the subject as well as for its applications to everyday business issues. This is
because they provide the necessary quantitative evidence to back up complementary discursive
arguments in a debate. Quantitative methods help management in the provision of optimal
solutions to a number of problems, and such solutions, even when not attained in practice, are
nevertheless, indicative to the management of the direction of change required.
Relationship with Management Theory and Accounting
Managerial Economics has also been influenced by the developments in management theory and
accounting. Maximization of profit has been regarded as a central concept in the theory of the firm in
Microeconomics. Organization theorists in recent years have talked about satisficing
as opposed to maximizing as an objective of the enterprise. Managerial Economics should take of
these new concepts and changing views of enterprise goals, which may have important implications
for the analytical approaches and tools relevant for problem-solving.
Managerial Economics is also closely related to Accounting, which is concerned with
recording the financial operations of a business firm. Accounting information is one of the principal
sources of data required by a managerial economist for decision-making. For instance, the profit and
loss statement of a firm tells us how well the firm has done and the information it contains can be
used by a managerial economist to throw significant light on the future course of actionwhether it
should improve or close down. The relationship between these two
subjects can be understood better when the relationship between Management Accountancy and
Managerial Economics is understood. Management Accountancy tries to furnish the necessary
information required by the managers, while managers take the help of principles, methods and
techniques of Managerial Economics to make correct decisions. Accounting data, however, are also
to be provided in a form so as to fit easily into the concepts and analysis of Managerial Economics.
A student of Managerial Economics should therefore be familiar with the generation,
interpretation and use of accounting data. In fact, the focus of accounting within the enterprise is fast
changing from scorekeeping to managerial decision-making. This trend has led to 24
the evolution of a new specialization termed Managerial Accounting, which has much in common
with Managerial Economics.
Relationship with Statistics
Managerial Economics relies on Statistics in a number of ways. Statistics deals with the theory and
methods of collecting, tabulating and analysing numerical data. These are necessary
functions for the process of providing quantitative evidence for management decisions. At the heart of
statistics lies the idea of statistical inference, by which we mean the process of inferring, from data
by referring to a small part ( sample), statement relative to the whole ( population), and also provide
a measure of the uncertainty surrounding the inference made.
The process of sampling a small, well-stratified section of the potential consumer base to infer
consumer preferences as regards, for example, new products is of major concern to
management.
Given that in Economics in general and Managerial Economics in particular we cannot
perform controlled experiments, statistical inference provides a powerful tool of quantitative analysis
and the use of probability theory becomes central to the work of a practising
managerial economist. In addition, most economic statements are conditional. For example, we
expect a particular economic variable to move (change) in a particular direction provided certain
other variable(s) related to the first variable are changed. While mathematical methods can establish
the nature of the functional relationship between the variables, we are also interested in testing such
hypothesis. Thus, hypotheses testing in Managerial Economics is another area where Statistics can
provide significant help.
Relationship with Operations Research
During the Second World War and the years that followed, a great deal of inter-disciplinary research
was undertaken in the United States and other Western countries to solve the complex operational
problems of planning and resource allocation in defence and key industries.
Mathematicians, statisticians, engineers and scientists worked together in teams and developed
models and analytical tools which together have since grown into a specialization known as
Operations Research. Much of the development of techniques and concepts such as linear
programming, inventory models and game theory is due to the work of operations researchers.
While economists have given considerable attention to problems involving maximization of
profits and minimization of costs, it were the operations researchers who focussed attention on the
concept of optimization. The framework of optimization has been used a great deal in Managerial
Economics, which had originally started with the marginal analysis technique
borrowed from economic theory. Incremental or marginal reasoning is closely linked to the logic
underlying the models of Operations Research.
Similarly, Operations Research has influenced Managerial Economics through its new
concepts and models for dealing with risk and uncertainty. Though economic theory has always
recognized these factors as germane to decision-making in the real world, the framework for taking
them into account in the context of actual problems has been operationalized only
25
through the recent contributions of mathematicians and statisticians. These scientists have thus done a
great deal to sharpen the tools and analytical models available to Managerial Economics.
However, it should be remembered that the practice of Operations Research requires highly
specialized quantitative skills, whereas the reasoning underlying Managerial Economics can be
mastered by managers even if their mathematical prowess is modest.
Also, various methods of Operations Research such as stock control, queues, linear
programming, transportation problems, scheduling, network analysis, theory of games and so on are
of direct relevance and help to the managerial economist.
Relationship with Econometrics
Econometrics is derived from Greek and literally means measurement in economics. More
particularly, Econometrics is concerned with the application of statistical and mathematical
techniques for the analysis of economic data. The chief role of Econometrics is the
specification, estimation and testing of economic models, and so it is used for the analysis and
verification of economic models or theories. Therefore, it becomes evident that Econometrics plays a
crucial role in Managerial Economics as regards, for example, the forecasting of sales, cost or any
other function we are interested in.
Clearly, for a managerial economist interested in the values of the estimated parameters of functional
relationships used in decision-making, such as elasticities, rates of change,
multipliers, and their economic interpretation, a basic understanding of econometric methods, their
assumptions and limitations is very useful if not indispensable.
Relationship with Decision Theory
Decision theory deals with the process of formation of expectations under conditions of
uncertainty. In addition it recognises that the management may very well have a multiplicity of goals
and objectives, some of which may be conflicting. On the other hand, neo-classical economic theory
assumes conditions of certainty and perfect foresight and operates under a single objective, be it
utility maximization for the consumer or profit maximization for the firm. On the practical level it
would appear that decision theory could make a very useful contribution to solving managerial
problems, as its basic premises tend to be more in accord with actual day-to-day management
concerns. This should not be surprising. The task of
Managerial Economics is to help understand the managerial process, and in this respect
Managerial Economics follows an eclectic approach by borrowing ideas from different
disciplines and fields of business administration and synthesizing them in a way that produces the
desired result.
Therefore, economic theory can be complemented by decision theory for the benefit of the
business organization. In this respect, in the bulk of the book the analysis is conducted using the
simplifying assumptions of neo-classical economic theory in order to derive insights and optimum
solutions.
Thus, the subject of Managerial Economics stands firmly rooted in the foundation provided by
economic theory. It has been enriched by the growing influence of quantitative sciences 26
through the medium of Operations Research. The influence of accounting, in terms of concepts and
data as well as of advances in management theory, has strengthened its applied bias and its ability to
be an aid to real-life problem-solving within the enterprise.
BASIC CONCEPTS OF MANAGERIAL ECONOMICS
Economic theory offers a variety of concepts which can be of considerable assistance to the managers
in decision-making practices. These tools are helpful for managers in solving
business-related problems. These are thus taken as guides in making decisions.
The following are the basic economic tools for decision-making:
1. Opportunity cost principle
2. Incremental principle
3. Principle of time perspective
4. Discounting principle
5. Equimarginal principle.
Opportunity Cost Principle
Both Macroeconomics and Microeconomics make abundant use of the fundamental concept of
opportunity cost. In everyday life, we apply the notion of opportunity cost even if we are unable to
articulate its significance. For instance, when a person devotes his entire time to his own business, he
hopes that he will earn at least as much as he can by working for someone else. When an investor
buys shares on the stock market, he makes implicit comparisons with what his money could earn in a
bank. In these cases, decision-making takes into account the costs of opportunities foregone. The
opportunity cost of a decision is therefore the cost of sacrificing the alternatives to that decision. It
also means the cost of something in terms of an opportunity foregone (and the benefits that could be
received from that opportunity) or the most valuable foregone alternative. For example, if a city
decides to build a hospital on vacant land that it owns, the opportunity cost is of some other thing that
might have been done with the land and construction funds instead. In building the hospital, the city
has foregone the opportunity to build a sports centre on that land, or a parking lot, or the ability to sell
the land to reduce the citys debt, and so on.
In order to compare the alternatives, it is necessary that the costs of the sacrifices involved be
measured. If there are no sacrifices, there are no costs involved. Managerial decisions must be based
on a clear understanding of the costs of alternative decisions and how relevant these costs are in a
given situation. Thus, the opportunity cost of a decision means the sacrifice of alternatives that is
required by that decision.
Let us consider the following examples:
(a) The opportunity cost of the funds employed in ones own business is the interest that can be earned
on those funds if they are employed in other ventures.
(b) The opportunity cost of using a machine to produce one product is the foregone
income which would have been possible from other products.
27
(c) The opportunity cost of holding Rs. 1000 as cash in hand for one year is the 10%
rate of interest which would have been earned had the money been kept as fixed
deposit in a bank.
(d) The opportunity cost of a high school graduate joining college is the income he would earn by
entering the workforce.
Incremental Principle
It is related to the marginal cost and marginal revenue concepts in economic theory.
Incremental concept involves estimating the impact of decision alternatives on costs and
revenues, emphasizing the changes in total cost and total revenue resulting from changes in prices,
products, procedures, investments or whatever else may be at stake in the decisions.
The two basic components of incremental reasoning are:
1. Incremental cost
2. Incremental revenue.
Incremental cost may be defined as the change in total cost resulting from a particular
decision. Incremental revenue is the change in total revenue resulting from a particular
decision.
The incremental principle may be stated as follows:
A decision is a profitable one if
(a) it increases revenue more than cost
(b) it decreases some costs to a greater extent than it increases others
(c) it increases some revenues more than it decreases others and
(d) it reduces cost more than revenues.
Principle of Time Perspective
The time perspective principle argues that the decision-maker must give due consideration both to the
short- and long-run effects of decisions on revenues as well as costs, giving appropriate weights to
the various time-periods, before arriving at a decision. A very important requirement in decisionmaking is to maintain the right balance between long-run and short-run
considerations.
In the market we come across many new products, which are sold below cost or on
relatively small margins in the beginning with the hope of commanding a good market and
thereby making profits in the long run. If the managers did not have time perspective in their minds,
they would never have resorted to such practices. This is called the price penetration (i.e. fixing low
price initially and increasing it gradually as demand rises) concept.
For example, suppose there is a firm with temporary idle capacity. An order for 5000 units comes to
the managements attention. The customer is willing to pay Rs 4 per unit or Rs. 20000
for the whole lot but not more. The short-run incremental cost (ignoring the fixed cost) is only Rs. 3.
Therefore the contribution to overhead and profit is Re. 1 per unit (Rs. 5000 for the lot).
28
From the above example the following long-run repercussions of the order are to be taken
into account:
1. If the management commits itself to too much of business at low price or with small
contribution it will not have sufficient financial capacity to take up business with
higher contribution.
2. If the other customers come to know about this low price, they may demand a similar
low price. Such customers may complain of being treated unfairly and discriminated
against.
The above example therefore shows why it is important to give due consideration to the time
perspective.
Discounting Principle
One of the fundamental ideas in Economics is that a rupee is worth less tomorrow than today.
Since future prospects are unknown and incalculable, there is a lot of risk involved in all this.
Todays loan is certain but a promise to repay it tomorrow is uncertain, since the promise may not be
honoured. This may be either because the payee has no money or because he is
dishonest. This point could be made clear through the proverb A bird in hand is worth than two in
the bush. Moreover, the return in future is less attractive than the same return today.
The future must, therefore, be discounted for both the elements of delay and risk of future.
Suppose a person is offered a choice between a gift of Rs. 100 today or Rs. 100 next year.
Naturally he will choose Rs. 100 today. This is true for two reasons:
(i) The future is uncertain and there may be uncertainty in getting Rs. 100 if the present opportunity is
not availed of.
(ii) Even if he is sure to receive the gift in future, todays Rs. 100 can be invested so as to earn
interest, say 8%, so that one year later Rs. 100 will become Rs. 108.
This principle deals with the allocation of parts of an available resource among alternative activities.
According to this principle, an input should be so allocated that the value added by the last unit is the
same as in all other cases. Let us understand this generalization with the help of an example.
Suppose that a firm has 100 units of labour at its disposal. The firm is engaged in four
activities which need labour services, viz., A, B, C and D. It can enhance any one of these activities
by adding labour but only at the cost of other activities. It should be clear that if the value of the
marginal product is higher in one activity than in another, an optimum allocation has not been attained.
Therefore, it would be profitable to shift labour from a low marginal value activity to a high marginal
value activity, thus increasing the total value of all products taken together. For example, if in activity
A the value of marginal product of labour is Rs.
20 while that in activity B is Rs. 30, it is profitable to shift labour from activity A to activity B,
thereby enhancing activity B and reducing activity A. The optimum level will be reached when the
value of the marginal product is equal in all the four activities.
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MANAGERIAL ECONOMISTROLE AND RESPONSIBILITIES
Role of a Managerial Economist
The primary tasks of a management executive in a business organization are making decisions and
processing information. In order to take rational decisions, managers must be able to obtain, process
and use information. Economic theory helps managers to know what
information should be procured, how to process it and how to use the valuable information for
decision-making. Therefore, the managerial economist has gained an increasing importance in
business in recent years. He can be very useful for successful management, as his contribution can be
substantial in solving the problems of decision-making and forward planning.
The tasks of processing information and making decisions take two general forms:
(a) Specific decisions
(b) General tasks.
Specific Decisions
There are several specific decisions that managers might have to take, e.g., whether or not to close
down a unprofitable branch of a firm; whether or not a store should stay open for more hours than
usual in a day; or whether to pay for outsourced computing or copying services rather than to install
an in-house computer or copier. After conducting a survey of British industry, K. J. W. Alexander and
Alexander G. Kemp came to the conclusion that the
managerial economist undertakes the following specific functions:
(a) Market research

(b) Economic analysis of competing companies
(c) Demand forecasting
(d) Production scheduling
(e) Capital projects
(f) Economic analysis of the industry
(g) Investment appraisal
(h) Security management analysis
(i) Advice on foreign exchange management
(j) Advice on trade
(k) Pricing and related decisions
(l) Analysing and forecasting environmental factors.
All these and myriad other managerial decisions require the use of basic Economics.
General Tasks
Economic theory helps decision-makers to know that information is necessary to make an
intelligent decision or to find the correct solution to a problem. This necessitates learning how to
process and use that information. After obtaining the desired information, the manager must analyse
this information and use it in correspondence with the theoretical and statistical tools available, to
make the best decision possible under the circumstances.
30
One of the principal objectives for any manager is to determine the key factors, which will influence
the business in the future period. A business is influenced by two kinds of factors:
Internal factors
External factors.
Internal factors lie within the scope and limits of a firm and hence within the control of management.
They are commonly known as business operations. External factors lie outside the control of
management because they are external to the firm and are said to constitute the business environment.
For example, a business firm is free to take decisions like what to invest, how much to invest, where
to invest, how much labour to employ and how to pay for them,
how to fix prices, etc. But all these decisions are taken within the scope of a particular business
environment. Some examples of these two kinds of factors are indicated in Table 1.4.
Table 1.4 Examples of internal and external factors
Internal factors
External factors
Production, sales and inventory schedules
General condition of the economy
of the firm
Future trend forecasts
Demand for the product
Pricing and profit policies
Input cost of the firm
Input mix and technology
Market conditions
Investment decisions
Firms share in the market
Decision-making and planning
Governments economic policies
The role of the managerial economist is to understand these factors and to suggest policies which the
firm should follow to make their best use.
Responsibilities of a Managerial Economist
The managerial economist has an important role to play in the running of a business. Therefore, he
must thoroughly recognize his responsibilities and obligations in order to serve the
management to the best of his ability.
The most important part of the obligations of a managerial economist is that his objectives must
coincide with that of the business. Since in most of the cases the firms try to maximize profits on their
invested capital, the managerial economist must also help in achieving this goal.
So long as he maintains that conviction and helps in enhancing the ability of the firm to maximize
profits, he will be a successful managerial economist.
The other most important responsibility of a managerial economist is to try to make an
accurate forecast. Most management decisions necessarily concern the future, which is rather
uncertain. By making best possible forecasts and through constant efforts to improve them he should
aim at minimizing, if not completely eliminating, the risk involved in uncertainties so as to ensure that
the management can follow a more orderly course of business planning. He will have to work on the
basis of data on the market conditions, the general economic
31
environment, the relevant government policies, etc. For forecasting, he uses the techniques of
profitability. A managerial economist is supposed to forecast the trends and shifts in activities of
importance to the firm, be it sales, profits, demand or cost.
If a managerial economist can keep on providing successful forecasts at the right time, he is bound to
be a successful executive. Here a couple of important points need to be mentioned.
First, if the managerial economist finds that due to some sudden and unaccounted factors the presented
forecast has become obsolete, it is his duty to work out the new forecast and present it at the earliest
possible time. By drawing timely and prompt attention to required changes in forecasts, he serves
well both the management and his own interest.
Secondly, a managerial economists calibre is generally judged by his ability to obtain
necessary information quickly by personal contacts rather than by lengthy research from either readily
available sources or obscure reference sources. Though thorough familiarity with
reference sources and material is essential, it is even more important that he knows the places from
where to get the additional information quickly. He must, therefore, personally know those
individuals who are specialists in the areas of his concern. For this he needs to join professional
associations and take active part in them. Though within the business there may be enormous
knowledge and experience available for the management, a managerial economist can justify his
existence only if he supplements his knowledge and experience with additional information.
Finally, the contribution of a managerial economist will be adequate only when he is a
member of full status in the business team. He must be ready to take up challenging tasks.
Whenever some special assignments come to him, he should be ready to undertake them with
full seriousness. For, a managerial economist can only function effectively in an atmosphere where
his success or failure can be traced, not only to his basic ability, training and experience, but also to
his personality and capacity to win continuing support for himself and his
professional ideas. Of course, he should be able to express himself clearly and simply, and he must
always try to minimize the use of technical terminology in communicating with other
management executives.
To conclude, a managerial economist plays a very important role by helping management
in successful decision-making and forward planning. But to discharge his role successfully, he must
recognize his responsibilities and obligations. To some business executives, however, a managerial
economist is still a luxury or perhaps even a necessary evil. It is not surprising, therefore, to find that
while their status is improving and their importance is gradually rising, managerial economists in
certain firms still feel quite insecure. Nevertheless, there is a definite and growing realization that
they can contribute significantly to the profitable growth of firms and effective solution of business
problems. However, a lot depends upon managerial
economists themselves as to how they project themselves and perform on the job.
SUMMARY
Managerial Economics attempts to integrate economic theory with business practice for the purpose
of facilitating decision-making. In general, economic theory is the study of how
individuals and societies choose to utilize scarce productive resources to satisfy unlimited wants.
32
Economic theory is concerned with how society answers basic economic questions such as what
goods and services should be produced and in what amounts, how these goods and services
should be produced, and for whom should these goods and services be produced.
Economics is a relatively new science and has developed through four main stages: the
Classical stage which focussed on wealth, the Neo-classical stage which highlighted the role of
welfare, the New stage with its focus on scarcity or choice and the Modern stage which is concerned
primarily with administration of scarce resources, determinants of employment and income, and of
economic growth and stability.
The study of Economics is divided into two broad subcategories: Microeconomics and
Macroeconomics. Microeconomics examines individual decision-making, at the level of firms and

households, and the way these entities interact with specific industries and markets.
Macroeconomics is concerned with the economic system as a whole. It analyses the income,
expenditure, employment and growth of the entire economy. These two approaches are
complementary and not competitive.
Decisions have far-reaching effects on the firm and are often not easy to make. In these
circumstances, it is recommended that systematic efforts be made to arrive at the right decision.
Managerial Economics is a branch of Economics that applies microeconomic analysis to
specific decisions. It also bridges economic theory and economics in practice. It is microeconomic
application-oriented and normative, rather than positive, conceptual and metrical, and is useful in
understanding and adjusting to the environment and in decision-making. Managerial Economics
studies demand analysis and forecasting, production, cost analysis, price
determination and policy, profit management, capital management, competition and product
policy, sales promotion and market strategy. It is closely related to Economics, Statistics,
Mathematics and Accounting.
There is no difference between Managerial Economics and Economics in theory; the
difference is in the way economic theory is applied. Economics is the study of how societies use
scarce resources to produce valuable commodities and distribute them among different
people. On the other hand, Managerial Economics is concerned with resource allocation in a
particular organization that is engaged in the production and distribution of goods and services.
Although Managerial Economics is a branch of Economics, the subject draws upon a
number of other disciplines like Mathematics, Management Theory and Accounting, Statistics,
Operations Research, Econometrics, Decision Theory, etc. for propounding its theories and concepts
for managerial decision-making. Further, the managerial economist applies certain fundamental
concepts such as opportunity cost, incremental principle, principle of time
perspective, discounting principle and equimarginal principle.
The managerial economist has a very important role to play in enhancing the ability of the firm to
maximize profits. His prominent responsibilities involve determination of objectives, forward
planning, and use of valuable information for decisions and forecast.
33
EXERCISES
Fill in the blanks:
1. One of the major reasons to study Economics is ___________.
(a) To learn a way of thinking
(b) To understand society
(c) To understand global affairs
(d) To be an informed voter
(e) All of the above
2. The word Economics is a term derived from ___________.
(a) Greek
(b) Latin
3. The science that deals with the production, allocation, and use of goods and services, and seeks to
study how resources can be best distributed to meet the needs of the greatest
number of people is ___________.
(a) Sociology
(b) Psychology
(c) Anthropology
(d) Economics
4. Economics is primarily a study of ___________.
(a) Man
(b) Wealth
5. Economics was classified into Microeconomics and Macroeconomics by ___________.
(a) Ragnar Frisch
(b) J. M. Keynes
(c) Benham
(d) Robbins
6. ___________ is called price theory and ___________ is called income theory.
(a) Economics
(b) Managerial Economics
(c) Microeconomics
(d) Macroeconomics
7. The study of entire economic systems is called
(a) Macroeconomics
(b) Microeconomics
(c) Economics
8. Mans wants are ___________ and the means to satisfy them are ___________.
(a) Unlimited
(b) Limited
(c) Both
(d) None of the above
34
9. ___________ is the study of the economic behaviour of individual consumers, firms and
industries, and the distribution of production and income among them.
(a) Managerial Economics
(b) Microeconomics
(c) Macroeconomics
(d) Economics
10. The author of The Wealth of Nations is ___________.

(a) Marshall
(b) Ricardo
(c) Robbins
(d) Adam Smith
11. Economics is a __________ science.
(a) Social
(b) Political
(c) Natural
12. Economics is a/an _____________.
(a) Art
(b) Science
13. ___________ is regarded as the father of Economics.
(a) Adam Smith
(b) Alfred Marshall
(c) Lionel Robbins
(d) J. M. Keynes
14. Economics was called The Science of Material Welfare in the ___________ stage.
(a) Classical
(b) Neo-classical
(c) New
(d) Modern
15. Microeconomic theory is also known as ____________.
(a) Price theory
(b) Income theory

(c) Demand theory
16. Business decisions are built on this basis when the goal of the business is to maximize profits or
to make adequate profits: ___________.
(a) Cost
(b) Value
(c) Price
(d) Cost, Value and Price
35
17. Managerial Economics is also called ___________.
(a) Microeconomics
(b) Business Economics
(c) Macroeconomics
(d) Economics
18. Managerial Economics is defined as the application of economic theory and methodology to
business administration practice by ___________
(a) Watson
(b) Hague
(c) Douglas
(d) Brigham and Pappas
19. The primary tasks of a management executive in a business organization are
___________.
(a) Decision-making and forward planning
(b) Organizing and controlling
(c) Staffing and directing

(d) Co-ordinating and supervising
20. Managerial Economics bridges the gap between economic theory and ___________.
(a) Business practice
(b) Statistics
(c) Decision-making
(d) Mathematics
21. What are the two approaches for economic analysis?___________.
(a) Positive and Normative
(b) Micro and Macro
22. Economics is a ___________ science.
(a) Positive
(b) Normative
23. Managerial Economics is ___________.
(a) Prescriptive
(b) Descriptive
(c) Both Prescriptive and Descriptive
24. Managerial Economics is ___________ economic in character.
(a) Micro
(b) Macro
25. Managerial Economics draws more of its principles from ___________.
(a) Macroeconomics
(b) Microeconomics
36
26. The ___________ principle deals with the allocation of an available resources among
alternative activities.
(a) Discounting
(b) Opportunity cost
(c) Equimarginal
(d) Time perspective
27. _________ provides a link between economic theory and the decision sciences in the
analysis of managerial decision-making.
(a) Statistics
(b) Operations Research
(c) Managerial Economics
(d) Macroeconomics
28. A rupee tomorrow is worth less than a rupee today is a/an _____________ principle.
(a) Opportunity cost
(b) Discounting
(c) Equimarginal
(d) Incremental
29. The price of a computer mouse is a _______ concern.
(a) Microeconomic
(b) Macroeconomic
30. The rate of inflation is a _______concern.
(a) Microeconomic
(b) Macroeconomic
31. The number of unemployed people in India is a _________ concern.
(a) Microeconomic
(b) Macroeconomic
Answers
1. (e)
2. (a)
3. (d)
4. (b)
5. (a)
6. (c, d)
7. (a)
8. (a, b)
9. (b)
10. (d)
11. (a)
12. (b)
13. (a)
14. (b)
15. (a)
16. (d)
17. (b)
18. (d)
19. (a)
20. (a)
21. (a)
22. (b)
23. (a, b)
24. (a)
25. (b)
26. (c)
27. (c)
28. (b)
29. (a)
30. (b)
31. (b)
Short Answer Questions
1. Define Managerial Economics.
2. How can you distinguish Managerial Economics from Economics?
3. What do you mean by the principle of time perspective?
4. Explain the use of Managerial Economics to engineers.
5. Explain the relationship between Managerial Economics and Computer Science.
6. How is Managerial Economics related to Statistics, Mathematics and Accounting?
37
7. Briefly explain the significance or importance of Managerial Economics.
8. Distinguish beween macroeconomic conditions and microeconomic analysis.
9. Point out the importance of Managerial Economics in decision-making.
Essay Type Questions

1. Explain the principles of Managerial Economics that are useful in decision-making.
2. Define Managerial Economics and explain its characteristics. How is it useful to
engineers?
3. Explain the opportunity cost principle and the discounting principle, which are to be
considered while taking business decisions.
4. Describe the nature and scope of Managerial Economics. What is its relevance to an
engineer?
5. Managerial Economics is the integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning by management.
Discuss.
6. Define Managerial Economics and describe its relationship with other sciences.
7. (a) Briefly explain the chief characteristics and significance of Managerial Economics.
(b) How do you explain the concept of incremental reasoning as a fundamental concept
of Managerial Economics?
8. Explain the basic concepts of Managerial Economics and explain them.
9. What role does the managerial economist play in business?
10. Explain the various functions of the managerial economist.
11. Managerial Economics is Economics applied in decision-making. Discuss.
12. Managerial Economics is the study of allocation of resources available to a firm or some other
unit of business among the activities of that unit. Explain.
13. Show the significance of economic analysis in business decisions.
14. Discuss in detail the role of Economics in the engineering industry and its influence on technical
decisions.
15. Economics is an inseparable aspect of engineering. Explain.
.
CHAPT E R
2
Demand Analysis
LEARNING OBJECTIVES
the meaning of demand, individual demand and market demand
the determinants of demand
the law of demand; assumptions and exceptions to the law of demand
the factors that affect demand
how the price of a good affects a consumers demand for it
a demand schedule, demand curve and demand function
the difference between extension of demand and increase in demand
the difference between contraction of demand and decrease in demand
demand forecasting and its methods
market structures, types and price determination under different markets
INTRODUCTION
The success of any business largely depends on sales, and sales depend on market demand
behaviour. Market demand analysis is one of the crucial requirements for the existence of any
business enterprise. Every business organization is interested in its own profit and/or sales, and both
of these depend partially upon the demand for its product. Analysis of market demand for the product
is necessary for the management in order to take decisions regarding
production, cost allocation, product pricing, advertising, inventory holdings, etc. How much the firm
must endeavour to produce depends mainly upon the demand for its product. If demand
falls short of production, the two must be balanced by creating a new demand through more and better
advertisements. If there is no demand for the product, its production is unwarranted.
If the future demand for the product is likely to be more, the more the inventories that the 38
DEMAND ANALYSIS
39
firm should hold. If the demand for the product is large, a higher price can be charged, with other
things remaining the same.
Market demand analysis helps the manager to make decisions regarding: (a) sales
forecasting with a sound basis and greater accuracy; (b) guidelines for demand manipulation through
advertising and sales promotion programmes; (c) production planning and product
improvement; (d) pricing policy; (e) determination of sales quotas and performance appraisal of
personnel in the sales department; and (f) size of market for a given product and
corresponding market share.
For all these purposes, demand analysis is essential for successful production planning and business
expansion in managerial decision-making.
Demand for a product depends on several factors, and it varies in keeping with variation
in any one or more of these factors. Demand analysis seeks to identify and analyse the factors that
influence demand. The study of demand is necessary for a decision-maker for production planning,
analysing the impact on profits, attaining the firms objectives, etc. Analysis is one area of economics
that has been used most extensively by business. The decision which the management takes, with
respect to any functional area, always hinges on an analysis of demand.
Demand analysis seeks to identify and measure the forces that determine sales; it reflects the market
conditions for the firms product. Once demand analysis is done, alternative ways of creating,
controlling or managing demand can be inferred.
Consumer Behaviour
The management is always interested in knowing the market demand for their product. Market demand
is merely the sum total of the individual consumers demand. Therefore, the theory of demand is
generally discussed under two headsindividual demand and market demand.
Since the behaviour of individual demand depends upon consumer behaviour, we begin our
discussion with the theory of consumer behaviour.
UtilityThe Basis of Consumer Demand
Consumers have demand for a commodity because they derive or expect to derive pleasure or
satisfaction from it. The satisfaction which a consumer gets by having or consuming goods or services
is called utility by economists. The same commodity gives different utility to different consumers.
Even for the same consumer, utility varies from unit to unit, from time to time and from place to place.
Measurement of Utility
Utility is the capacity to satisfy a want. Goods having this capacity give satisfaction to the consumer.
Utility is subjective as it is perceived only by the individual consumer. Nobody else gets to see it or
know it. One person may get high utility and another person may get low utility from the same good.
Also, the same person may obtain high utility at one time and low utility at another time from the same
good. How can we know the utility perceived by the consumer?
40
One should be able to imagine the utility obtained by the consumer after completely identifying
himself with him. There is no other way. Some economists measure utility in terms of units or utils.
Alfred Marshall measured utility by the money price offered for a good. Suppose one is prepared to
pay Re. 1 worth of utility. Suppose another is prepared to pay Rs. 3 for the same good. Then that good
has Rs. 2 worth of utility for him. Thus, utility can be measured by its money worth to the consumer
according to Marshall. Having explained the concept of utility, we now turn to the following concepts
about utility that are used in utility analysis: (1) total utility and (2) marginal utility.
Total Utility
Total utility refers to the sum total of satisfaction which a consumer receives by consuming the
various units of a commodity. The more units of a commodity he consumes, the greater
will be his total utility or satisfaction from it up to a certain point. If he keeps on increasing the
consumption of the commodity, he will reach a saturation point which represents maximum utility. If
he consumes further, his total utility starts declining.
Marginal Utility
Marginal utility is another important concept used in economic analysis. The marginal utility of a
good is defined as the change in total utility resulting from a unit change in the
consumption of the good, i.e.,
' TU
MUX = ' QX
where MU D
X,
TUX and D QX are marginal utility, change in total utility and change in quantity of good X
respectively.
The law of diminishing marginal utility states that the marginal utility derived on the
consumption of every additional unit goes on diminishing, other things remaining the same. It is the
experience of every consumer that as he goes on consuming a particular commodity, each successive
unit gives him less and less satisfaction. In other words, at each step its marginal utility (not total
utility) goes on decreasing.
Suppose one enjoys a mango. He gets some utility from it. Next he eats another mango
almost immediately. He does not get as much satisfaction as he got from the first one. The third mango
does not gives him even so much satisfaction as the second did. This is the case with most of the
commodities for every consumer.
Marshall described this experience thus: The additional benefit which a person derives
from a given increase of his stock of a thing diminishes with every increase in the stock that he
already has.
DEMAND ANALYSIS
41
In this statement of the law, the word additional is very important. It is only the additional (or
marginal) benefit which decreases and not the total benefit. Table 2.1 relating to an imaginary
consumer consuming mangoes illustrates the law:
Table 2.1 Total utility and marginal utility
Mangoes (number)
Total utility (units)
Marginal utility (units)
1
100
100
2
1
80
80
3
240
60
4
280
40
5
300
20
6
300
0
7
280
20
In Table 2.1, the total utility obtained when one unit of the good is consumed is 100 units.
When two mangoes are consumed the total utility goes up to 100 + 80 or 180 units. When three
mangoes are consumed, it goes up to 180 + 60 or 240 units. Total utility thus increases as more and
more units of the good are consumed.
Marginal utility is the increase in total utility when one more unit is consumed. For
instance, total utility is 100 units when the first unit is taken. When two units of the good are taken,
total utility is 180 units. Therefore, the increase in total utility when the second unit is added to the
consumption is 80 units. This is the marginal utility at this stage. Similarly, the total utility when three
mangoes are consumed is 240 units. The increase in total utility as a result of the third unit is 60 units.
This is the marginal utility when three units are taken.
Why does Marginal Utility Decrease?

The utility gained from a unit of a commodity depends on the intensity of the desire for it.
When a person consumes successive units of a commodity, his need is satisfied to various
degrees in the process of consumption, and the intensity of his need goes on decreasing.
Therefore, the utility obtained from each successive unit goes on decreasing.
Assumptions of the Law
This law of diminishing marginal utility holds good only under certain conditions. These
conditions are referred to as assumptions of the law. These are as follows:
Units of Reasonable Size.
The unit of the consumer good must be a standard one; if the units
are either too small in size or either too big the law may not hold.
No Change in Tastes and Preferences.
The consumers tastes or preferences must remain
the same during the period of consumption.
42
Moderately Long Intervals.
There must be continuity in consumption. There should not be
excessively long intervals of time between consumption of one unit and that of another unit.
If a long gap occurs, the same want may reappear. Therefore marginal utility may not diminish.
Independent Utilities.
The utility of each good is assumed to be dependent on the
consumption of that good only. If the utility of the good depends on the availability of another good, it
may not obey the law of diminishing utility.
No Change in Income.
If income increases, marginal utility of money may decrease. If

income decreases, marginal utility may go up. Therefore, the measure of utility, say, a paisa,
undergoes a change in its significance. Therefore, it is assumed that the marginal utility of money
remains constant.
Identical Units of the Good.
All units of the good must be the same in size, quantity, etc.
Otherwise utility may not diminish.
Exceptions to the Law
There are certain exceptions to this law. This law does not operate under the following
conditions:
Unusual Persons.
While discussing this law, we assume that we are talking of normal
persons. But there are some unusual people too, e.g., misers. The more money a miser is able to
hoard, the greater is the satisfaction that he derives. Therefore, the law does not apply to unusual
persons like misers, drunkards, musicians, etc. who want more and more of the
commodity they are in love with.
Dissimilar Units.
If the units are not identical the law will not apply.
Very Small Units.
If we are given water by the spoonful when we are very thirsty, each
successive spoonful will give us more satisfaction.
Excessively Long Intervals.
Suppose we take our morning meal at 11 a.m. and our dinner
at 8 p.m. If we eat nothing in between, the dinner will probably give even greater satisfaction than the
breakfast. Therefore, the law applies only when the consumption of the units of the commodity is
repeated within a reasonable period of time.
Rare Object Collections.
This law does not apply in the case of rare object collections. If
a person has a hobby of collecting rare coins, the larger the number he collects the greater will be the
pleasure.
Change in Consumers Income, Change in Fashion and Change in Other Possessions of
the Consumer.
These also upset the law of diminishing marginal utility.
In spite of the above limitations, the law has universal application. This is so because it expresses a
basic principle of human behaviour.
DEMAND ANALYSIS
43
Law of Equimarginal Utility
The law of equimarginal utility is another fundamental principle of Economics. This law is also
known as the law of substitution. We have already seen that human wants are unlimited, whereas the
means to satisfy these wants are limited. So the consumer has to distribute the spending of available
resources on all the goods desired by him. How to distribute is the real problem. Every prudent
consumer will try to make the best use of the money at his disposal and derive maximum satisfaction.
In order to get maximum satisfaction out of the funds we have, we must carefully weigh
the satisfaction obtained from each rupee that we spend. The marginal utilities of all
commodities are not the same. Each commodity has a price, and each of them provide lesser and
lesser utility as more units of it are purchased. He has to decide how he should spend his limited
income on different goods, so as to get maximum possible satisfaction. This problem of allocation of
income between goods can be solved with the help of the law of equimarginal utility.
The marginal utilities of two commodities need not be equal at the beginning of
consumption. Marginal utility of one commodity may be greater or lesser than that of another
commodity. Then the consumer buys more of the good which has higher marginal utility. So
its marginal utility for him declines. He buys less of the good which has less marginal utility.
Then its marginal utility goes up. At one stage the marginal utility of both the commodities become
equal. This is the process of substitution of one good for the other. The one with higher marginal
utility will be substituted for the one which lower marginal utility. So this principle is also called the
principle of substitution.
When marginal utilities are made equal, total utility is at its maximum. In other words,
the consumer maximizes his total utility by allocating his income among the goods and services
available to him in such a way that the marginal utility from one good equals the marginal utility from
the other good. In other words,
Marginal utility of product X
Marginal utility of product Y
=
Price of X
Price of Y
where, X and Y refer to the products bought.
Suppose that a mango and an orange both cost Rs. 10. The consumer has Rs. 50 with him.
What combination will give him maximum satisfaction? When will he be in equilibrium? He
will not buy only mangoes or only oranges with the money available. A combination of 3
mangoes and 2 oranges will give him maximum satisfaction. (Why not 3 oranges and 2
mangoes? We can see that the total satisfaction of buying 3 mangoes is more than 3 oranges.) It is
because the marginal utility derived from the third mango is equal to that obtained from the second
orange.
From Table 2.2, it can be concluded that
1. The first preference would be for a mango because it provides higher marginal utility.
2. The second unit can only be an orange. Why? The second unit of a mango gives 32
units of marginal utility whereas the orange gives 35 units.
3. In case the consumer has 50 rupees extra, he would buy either a mango or an orange
because both yield equal marginal utility.
44
Table 2.2 Marginal utility schedule of a consumer
Units bought
Marginal utility obtained from
Mangoes
Oranges
140
35
2
32
28
3
28
20
4
20
1
0
5
1
0
8
Indifference Curve Analysis
Prof. J.R. Hicks has given a new approach to the study of consumer behaviour. This
approach to consumer behaviour is known as indifference curve analysis. The indifference curve
technique does not make the above two dubious assumptions of the Marshallian
utility analysis model. The basis of the indifference curve technique is that the consumer has a scale
of preferences and utilities (or satisfaction) which can be compared as greater, lesser or equal. The
consumer formulates his scale of preferences independent of
market prices, keeping in view the list of commodities in order of their capacity to
satisfy his wants. Here, one combination of two commodities may give him greater,
smaller or equal satisfaction as compared with another combination, based on his scale of
preferences. An indifference curve may be defined as the locus of various points, each of which
represents a different combination of two goods but yields the same level of
utility or satisfaction. Since each combination of two goods yields the same level of utility, the
consumer is indifferent between any two combinations of goods when it comes to
making a choice between them. This is therefore also known as the equal utility curve.
When such combinations are plotted graphically, the resulting curve is known as the
indifference curve. The indifference curve is also called the iso-utility curve. Different combinations
for the consumer are presented in Table 2.3, which may be called an
indifference schedule.
Indifference Schedule
An indifference schedule is a table showing the various combinations of two or more
commodities which give equal satisfaction to the consumer. Table 2.3 shows the indifference
schedule of combinations of two goods X and Y. The last column of the table shows an undefined
utility (u) derived from each combination of X and Y.
DEMAND ANALYSIS
45
Table 2.3 Indifference schedule
Combination
Good X
Good Y
Utility
A
1
50
u
B
2
35
u
C
3
25
u
D
4
20
u
E
5
1
6
u
F
6
1
4
u
The above schedule is prepared based on the assumption that the consumer demanding two
goods X and Y simultaneously. The above six combinations give equal satisfaction to the consumer.
Thus he is indifferent between these six combinations. One unit of X and 50 units of Y or 2 units of X
and 35 units of Y and also other combinations represent same level of satisfaction. Thus, A, B, C, D,
E, F all these combinations are equally preferable. The consumer especially prefers none of these
combinations.
Indifference Curve
Commodity X is represented along the X-axis and commodity Y along the Y-axis. We can mark the
points A, B, C, D, E and F on a graph. By joining these points we get a downward sloping curve,
which we call an indifference curve.
Fig. 2.1(a) Indifference curve.
Indifference Map
In Fig. 2.1(a), the indifference curve ( IC) is drawn on the basis of the indifference schedule given in
Table 2.3. The combinations of the two commodities, X and Y, given in the 46
indifference schedule or those indicated by the indifference curve are by no means the only
combinations of the two commodities. The consumer may be faced with many other
combinations with lesser amount of one or both the goodseach combination yielding the same level
of satisfaction but less than the level of satisfaction indicated by IC in Fig. 2.1(a).
Therefore, another indifference curve can be drawn, say through points h, i and j. Note that this
indifference curve falls below the IC given in Fig. 2.1(a). Similarly, the consumer may be faced with
many other combinations with greater amounts of one or both the goods, with each combination
yielding equal levels of satisfaction which are greater than the satisfaction indicated by the lower
indifference curves. Thus, another indifference curve can be drawn above the IC given in Fig. 2.1(a),
say through points k, l and m. This exercise may be repeated as many times as one wants, each time
generating a new indifference curve. Thus it is possible to draw a number of indifference curves
without intersecting or touching the other, as shown in Fig. 2.1(b).
Y
time)
Y
of
unit
4
per
IC
Commodity
3
IC
2
(Quantity
IC
1
IC
X
Commodity X
(Quantity per unit of time)
Fig 2.1(b) Indifference map.
The set of indifference curves IC 1 , IC 2 , IC 3 and IC 4 drawn in this manner make up the
indifference map. In fact, an indifference map may contain any number of indifference curves, ranked
in the order of consumers preferences.
Properties of Indifference Curve
The properties of an indifference curve are as follows:
It Slopes Downwards from Left to Right.
To maintain the total units of satisfaction, if the
consumption of product X is increased, the consumption of product Y has to be reduced. This leads to
a downward slope in the curve.
DEMAND ANALYSIS
47
It is Convex to the Origin.
Here the consumer is substituting one product for the other. So
the rate at which the substitution takes place determines the degree of convexity. This is called the
marginal rate of substitution, which implies the quantity of product X given up to obtain a certain
quantity of product Y.
It cannot Intersect with Another Indifference Curve.
Two indifference curves intersect
with each other because each is defined at a particular level of satisfaction. In case the consumer
wants either greater or lesser satisfaction he chooses that particular indifference curve to operate.
Two indifference curves can neither touch nor intersect, as they do not have a common point.
MEANING OF DEMAND
The knowledge of demand for a commodity is very essential for the successful running of any
commercial enterprise. Decisions regarding the quantity of production, sales, inventories, etc.
depend on a reasonable estimate of the demand for the product. In the absence of demand,
production becomes unwarranted. On the other hand, if the demand is very high the firm may have to
work hard to produce the required quantity of output.
In society, all people are busy in some kind of activity. All of their activities show that they are either
creating or meeting the demand for some kind of goods and services. Demand is, in fact, the basis of
all productive activities. Just as necessity is the mother of invention, demand is the mother of
production. Increasing demand for a product offers high business
prospects in future and decreasing demand for a product reduces business prospects.
In ordinary speech, the word demand is used rather loosely, and it is often confused with desire.
Desire is the wish to have something or to enjoy a service. But demand implies more than mere
desire. It means that the person is willing and able to pay for the object he desires.
Thus, conceptually, the term demand implies a desire for a commodity backed by the ability and
willingness to pay for it. Both willingness and ability to pay are essential. If a man is willing to pay
but he is unable to pay, his desire will not become demand. In the same manner, if he is able to pay
but is not willing to pay, his desire will not be changed into effective demand. In order to change
desire into demand, it is essential that he should be both willing and able to pay.
The following is a good definition of demand:
By demand we mean the various quantities of a given commodity or service which consumers
would buy in one market in a given period of time at various prices, or at various incomes, or at
various prices of related goods.
Bober
Therefore, the demand for a good is made up of the following three things:
(a) the desires to acquire it
(b) the willingness to pay for it, and
(c) the ability to pay for it.
In other words,
Demand = Desire to acquire + Willingness to pay + Ability to pay
48
In absence of any of these three characteristics, there is no demand. For example, a teacher may
possess both the willingness to pay as well as the ability to pay for a liquor bottle, yet he does not
have demand for it. This is because he does not desire to have an alcoholic drink. Similarly, a trader
might have the desire to have a TV, he might be rich enough to be able to pay for it, but if he is not
willing to pay for the TV, he does not have demand for this product. Also, a worker might possess
both the desire for a scooter as well as the willingness to pay for it, but if he does not possess enough
money to pay for it, he does not have demand for the scooter.
In contrast to these three situations, a lawyer, who has the desire for a car, as well as both the will
and ability to pay for it, has demand for the car. Thus, demand in economics means
effective demand, i.e., one which meets all its three characteristicsdesire, willingness and ability
to pay. On the other hand, demand means desire backed by willingness and ability to pay.
Besides, demand also signifies a price and a period of time in which the demand is to be
fulfilled. Demand is the quantity of a specific good that people are willing and able to buy during a
specific period, given the choices available. To sum up, we can say that the demand for a product is
the desire for that product backed by willingness as well as ability to pay for it. It is always defined
with reference to a particular time, place, price and given values of other variables on which it
depends.
Individual Demand
The word demand has a specific meaning in Economics. Demand by one buyer for a
commodity is called individual demand. Demand for a commodity by an individual is the quantity of
that commodity that the individual is willing to buy at a price over some period of time. Thus, the
definition of demand includes (i) the quantity of a commodity that a buyer is willing to buy, (ii) the
price of the commodity at which he is willing to buy that quantity, and (iii) the time period during
which he is willing to buy that quantity at the given price. The time period may be a day, a week, a
month, a year or any other period. Consider the following statements:
(i) The demand for mangoes by a consumer is 5 kg per day.
(ii) The demand for mangoes by a consumer is 5 kg when the price of mangoes is Rs.
10 per kg.
(iii) The demand for mangoes by a consumer is 5 kg per day when the price of mangoes
is Rs. 10 per kg.
The first two statements are incorrect. In the first statement the price of mangoes is not stated.
Demand is always with reference to a price. The second statement is incorrect because it does not
state the time period. Demand is always with reference to a time period. The third statement is
correct as it states the quantity of the commodity as well as the price and time period over which the
said quantity is demanded.
Market Demand
There are many buyers of a commodity. If we add the quantity of the commodity that each
of its buyers is willing to buy at a price over a time period, we will get the market demand
DEMAND ANALYSIS
49
of the commodity. Thus, market demand means the total quantity of a commodity that all its buyers are
willing to buy at a given price over a time period. In case of market demand too, any statement about
the market, which does not state the price or the time period, will be an incorrect statement.
DEMAND SCHEDULE, DEMAND CURVE AND
DEMAND FUNCTION
Demand is a relationship between two economic variables: (i) the price of the particular good, and
(ii) the quantity of the good that the consumers are willing to buy at that price during a specific time
period, all other things being equal. In short, the first variable is the price and second is quantity
demanded.
Demand can be represented either numerically with a table that shows the quantity demanded at each
given price called the demand schedule, or can be represented on a graph as a line or curve called
the demand curve by plotting the quantity demanded at each price, or described mathematically by a
demand equation called the demand function.
Demand Schedule
A tabular statement of quantities of a commodity demanded at different prices in a given period of
time is called a demand schedule. There are two types of demand schedule: (i) the individual demand
schedule and (ii) the market demand schedule.
Individual Demand Schedule
An individual demand schedule is a list of the various quantities of a commodity which an individual
consumer purchases at different alternative prices in the market. An imaginary demand schedule of an
average consumer for milk is given in Table 2.4.
Table 2.4 Individual demand schedule for milk
Price of milk per litre (in Rs.)
Quantity of milk demanded per day (in Litres)
1
6
1
.0
1
4
1
.5
12
2.0
10
2.5
8
3.0
The schedule (Table 2.4) shows the changes in the quantity demanded of milk by an individual buyer
of milk due to changes in the price of milk. At a price of Rs. 16 per litre the quantity demanded by
him per day is 1 litre. As the price falls gradually to Rs. 14, Rs. 12, Rs. 10 and Rs. 8 per litre, the
quantity demanded rises to 1.5 litres, 2.0 litres, 2.5 litres and 3.0 litres respectively. In this schedule,
the starting price from below is Rs. 8 per litre and the quantity 50
demanded of milk is 3.0 litres As the price of milk rises from Rs. 8 to Rs. 10 per litre the quantity
demanded falls from 3.0 litres to 2.5 litres, and so on. As the table shows, as the price of milk per
litre decreases, the daily demand for milk increases. This relationship between quantity demanded of
a product and its price is the basis of the law of demand.
Market Demand Schedule
Market demand is the sum of the quantities demanded by all the buyers of a commodity at a given
price and during a given period of time. In other words, the total quantity that all the consumers of a
commodity are willing to buy per unit of time at a given price, all other things remaining the same, is
called the market demand for that product. The analysis of market demand for a product is an
essential for the firm to increase its share in the market or for retaining its market share. Based on the
market demand for the product, the firm may plan for future production, inventories of raw materials
and advertisement, and setting up sales outlets.
Therefore, information pertaining to the magnitude of the current and future demand for the product is
essential. From the individual demand schedules of a commodity, we can prepare the market demand
schedule of that commodity. Let us take an example. Suppose there are four buyers A, B, C and D of
milk in the market. The demand schedule of each of these buyers
is given in Table 2.5.
Table 2.5 Market demand schedule
Price of milk
Quantity demanded by each buyer per day
Market demand per day
per litre (in Rs.)
(in litres)
(in litres)
A
B
C
D
(1)
(2)
(3)
(4)
(5)
(6)
16
1.0
0.5
0.0
0.0
1.5 (1.0 + 0.5 + 0 + 0)
14
1.5
1.0
0.5
0.25
3.25 (1.5 + 1.0 + 0.5 + 0.25)
12
2.0
1.5
1.0
0.5
5.0 (2.0 + 1.5 + 1.0 + 0.5)
10
2.5
2.0
1.5
1.0
7.0 (2.5 + 2.0 + 1.5 + 1.0)
8
3.0
2.5
2.0
1.5
9.0 (3.0 + 2.5 + 2.0 + 1.5)
In the above table, Column 1 shows the price of milk per litre, Columns 2, 3, 4 and 5 show the
quantities of milk bought by buyers A, B, C and D respectively at each price, and Column 6 shows the
market demand for milk. When the price of milk is Rs. 16 per litre, A buys 1
litre per day, B buys 0.5 litre per day and C and D do not buy it. So, if we add the quantities of milk
demanded by A, B, C and D when it is Rs. 16 per litre, we get the market demand,
which is equal to 1.5 litres (1 + 0.5 + 0 + 0). In the same way, if we add the quantities demanded by
A, B, C and D at each price, we get the demand of milk per day at each price.
You must notice that the relationship shown by this schedule, between the price of a
commodity and its quantity demanded, remains the same as shown by the individual demand,
schedule, because the market demand schedule is nothing but a summation of individual
demand schedules.
DEMAND ANALYSIS
51
Demand Curve
A demand curve is a graphical presentation of a demand schedule. When price quantity
information of a demand schedule is plotted on a graph, a demand curve is drawn. A demand curve
thus depicts the picture of the data contained in the demand schedule. There are two types of demand
curves: (i) the individual demand curve and (ii) the market demand curve.
Individual Demand Curve
If we plot the individual demand schedule on graph paper we will get a curve, which is the individual
demand curve. On the basis of the individual demand schedule (Table 2.4) showing price and quantity
of milk, the individual demand curve is drawn in Fig. 2.2.
Fig. 2.2 Individual demand curve for milk.
In Fig. 2.2, the points a, b, c, d and e represent the five combinations of price and quantity demanded
of milk given in Table 2.4 (refer to the individual demand schedule). Point a shows that at the price of
Rs. 16 per litre, the quantity demanded of milk is 1 litre per day. Point b shows that the quantity
demanded is 1.5 litres when the price is Rs. 14 per litre. Similarly, each of the points c, d and e show
that the quantities demanded is 2.0, 2.5 and 3.0 litres respectively. If we join points a, b, c, d and e,
we get an individual demand curve for milk as shown in Fig. 2.2. In the figure, this curve is labelled
DD. This curve falls from left to right.
This shows that as the price of milk falls its quantity demanded rises. When price is Rs. 16
per litre per day the quantity demanded is 1 litre as shown by point a. When price is Rs. 14
per litre the quantity demanded rises to 1.5 litres per day as shown by point b. When price is Rs. 12
per litre the quantity demanded rises to 2.0 litres per day as shown by point c and so on. Thus a
demand curve moves downward from left to right, indicating the inverse
relationship between the price of a commodity and its quantity demanded. Thus, the demand curve
shows a functional relationship between the alternative prices of a commodity and its corresponding
quantities which a consumer would like to buy during a specific period of time, say, a day, a week, a
month, a season or a year.
52
Market Demand Curve
Just as we plotted the individual demand schedule on graph paper, we can plot the market
demand schedule. Then we will get the following Fig. 2.3.
Consumer A
Consumer B
16
16
14
14
(Rs/lit)
(Rs/lit)
12
12
price
price
10
10
Milk
Milk
8
8
1.0
1.5
2.0
2.5
3.0
0.5
1.0
1.5
2.0
2.5
Quantity demanded for milk (litres)
16
Consumer D
16
Consumer C
14
14
12
(Rs/lit)
(Rs/lit)
12
price
price 10
10
Milk
Milk
8
8
0.0
0.5
1.0
1.5
2.0
0.0
0.5
1.0
1.5
P
16
Market demand
14
Q
(Rs/lit)
R
12
price
S
10
Milk
T
8
1
2
3
4
5
6
7
8
9
10
Fig 2.3 Market demand schedule.
DEMAND ANALYSIS
53
Points P, Q, R, S and T show the quantity demanded of milk per day in the market at each of the prices
given in Table 2.5. Point P shows that the market demand per day of milk is 1.5 litres when the price
of milk is Rs. 16 per litre. Similarly point Q shows that the market demand of milk is 3.25 litres when
price is Rs. 14 per litre. If we join these points we get a curve. This curve is the market demand
curve. It shows the total demand per day of all buyers of milk at different prices.
Notice that the market demand curve also falls downward from left to right, indicating the inverse
relationship between the price of a commodity and its market demand.
Demand Function
Demand function is a mathematical expression of relationship between the quantity demanded of a
commodity and its determinants. When this relationship relates to the demand by an
individual consumer it is known as the individual demand function, while if it relates to the market it
is called the market demand function.
It can be expressed as follows:
Individual Demand Function
QdX = f ( PX, Y, P 1 ,, Pn1, T, A, Ey, Ep, u) (1)
where
QdX = Demand for product X
PX = Price of product X
Y = Consumers income
P 1, , Pn1 = Prices of all the other related products
T = Consumers tastes and preferences
A = Advertising
EY = Consumers expected future income
EP = Consumers expectations about future prices
u = Other determinants of demand for product X
Market Demand Function
QdX = f ( PX, Y, P 1,, Pn 1, T, A, Ey, Ep, P, D, u) (2)
where
QdX, PX, Y, P 1 Pn 1, T, A, Ey, Ep, and u are the same as that given in the individual demand
function
P = Population
D = Distribution of consumers in various categories, depending on demographic factors.
From the above two Equations (1) and (2), we find that the price of complements have
a negative relationship with the demand for product X. On the other hand, if the price of a substitute
increases, or the consumer expects to have higher income in future, or he expects 54
price of good X to rise in future, he will demand a larger quantity of good X. Thus, these variables
have a positive relationship with the quantity demanded. The same relationship also exists between
population and demand. The other factors like income of the consumer,
consumers tastes and preferences and distribution of consumers can have either negative or positive
relationship with the quantity demanded.
DETERMINANTS OF DEMAND
The demand for a commodity by a buyer is generally not a fixed quantity. It is affected by many
factors. The factors that influence the demand are called the determinants of demands (see Fig. 2.4).
The determinants of demand are also known as demand shifters. The following factors affect an
individuals demand for a commodity:
Factors determining demand
1. Price of the commodity
2. Other factors which include:
(a) Income of the consumer
(b) Consumer tastes and preferences
(c) Prices of related goods
(d) Expectations of future price changes
(e) Advertising efforts
(f) Quality of the product
(g) Distribution of income and wealth in the community
(h) Standard of living and spending habits
(i) Age structure and sex ratio of population
(j) Level of taxation and tax structure
(k) Climate or weather conditions
(l) Population
Fig. 2.4 Determinants of demand.
The factors affecting demand for a commodity have been divided under two groups. In the first group
we have included only the price of the commodity, and in the second group, named other factors, we
have included the income of the consumer, consumer tastes and preferences, prices of the related
goods, expectations of future price changes and population. This grouping is done because the nature
of effects of each group on demand is different. Firstly, we study how changes in the price of a
commodity affect its demand. While doing so we assume that the
demand of the commodity is not affected by any of other factors included in second group.
This assumption is stated as other things remaining the same. Similarly, while studying the effects of
changes in the factors included in second group on the demand of a commodity, we assume that the
price of the commodity does not change. This assumption is stated as price remaining the same. We
will now discuss the effects of changes in each group of factors on demand.
DEMAND ANALYSIS
55
Price of Commodity
While studying the effects of changes in the price of a commodity on its quantity demanded by a buyer,
we assume that no other factor affects the demand of this commodity.
You must have observed that when the price of a commodity falls, you tend to buy more
of it and when its price rises, you tend to buy less of it. This is a general reaction of a buyer of a
commodity to the changes in its price. In Economics we state this as: Other things
remaining the same, when the price of a commodity falls its quantity demanded by a buyer
rises and when its price rises its quantity demanded falls. In other words, there is an inverse
relationship between the price of a commodity and its quantity demanded by its buyers. There are two
reasons for inverse relationship between price and quantity demanded of a commodity: (a) Income
effect
(b) Substitution effect.
Income Effect
Income effect is the change in real income or purchasing power of the buyer of the commodity.
Purchasing power or real income means the quantity of goods and services that one can buy with the
given money income. An increase in purchasing power means that more can be bought with the same
money income, and a decrease in purchasing power means that less can be bought with the same
money income.
When the price of a commodity falls, the purchasing power of its buyer increases. The
buyer of it can buy more of it by spending the same amount on it. Let us take an example.
Suppose a person buys 15 litres of milk per month when the price of milk is Rs. 8 per litre.
He is spending Rs. 120 per month on milk. Suppose the price of milk falls to Rs. 6 per litre.
The purchasing power of this buyer has increased because he can now buy more milk (20 litres) by
spending the same amount (Rs. 120) on milk. Thus a fall in price of milk leads to a rise in its demand
because the purchasing power of its buyer increases, i.e., he can buy more milk by spending the same
amount on purchase of milk. Similarly, if the price of milk rises from Rs. 8 per litre to Rs. 10 per
litre, the buyer now can buy only less milk by spending the same amount on purchase of milk. In this
example, he can now buy only 12 litres of milk per month by spending the same amount of money, i.e.,
Rs. 120 on it. In other words, due to a rise in the price of milk, the purchasing power of its buyer falls
and so the quantity demanded of milk falls.
Thus, due to a fall in the price of a commodity, the quantity demanded by its buyer rises because his
purchasing power increases. Similarly, due to a rise in the price of a commodity the quantity
demanded by its buyer falls because his purchasing power falls.
Substitution Effect
Two commodities are said to be substitutes of each other when one can be used of other. For
example, kerosene oil, LPG, electricity are all substitutes when used as domestic fuel; tea and coffee
are substitutes of each other. When the price of a commodity falls and the price of its substitute
commodity remains the same, the buyer of this commodity may start substituting it 56
for the other commodity. This will result in the rise in demand of the commodity whose price has
fallen. For example, you may be using kerosene oil and electric heater for cooking. If the price of
kerosene oil falls, you may find it more economical to use kerosene oil and start using less of
electricity for cooking. This means the quantity demanded of kerosene oil will rise. This rise has
resulted from substitution of kerosene oil for electricity used for cooking. Similarly, if the price of
kerosene oil rises you may now decide to use more of electricity for cooking and it leads to a fall in
the quantity demanded of kerosene oil by you. Thus, as a result of a fall in the price of a commodity
its quantity demanded rises, and as a result of a rise in its price its quantity demanded falls, due to the
availability of substitute commodity.
High price for a commodity decreases demand
Low price for a commodity increases demand
Other Factors
Now we study the effects of other factors on the demand of a commodity. While doing so we assume
that the price of the commodity does not change. The other factors that affect the demand of a
commodity are:
Income of the Consumer
Price of the commodity remaining the same, an increase in the income of its buyer increases his
purchasing power. He can now buy more of this commodity. So a rise in income of the
buyer of a commodity leads to a rise in its demand. Similarly a fall in income of the buyers of a
commodity leads to a fall in its demand, price of the commodity remaining the same.
Thus, there is a direct relationship between income and demand. Normally, this is how change in
income affects demand. However, in some cases it may be that, when the income of the
buyer of a commodity increases, he may buy less quantity of it and not more of it. If this happens then
the commodity was an inferior commodity for the buyer. As soon as his income increases he prefers
to buy less of this inferior commodity and substitutes it by a superior commodity. So if the income of
the buyer of a commodity and its demand by him are inversely related then the commodity must be an
inferior commodity. Let us take an example, suppose a consumer buys in a month 10 kg of rice whose
price is Rs. 5 per kg. He cant afford to buy better variety of rice because the price of such rice is Rs.
10 per kg. This consumer is spending Rs. 50 per month on the purchase of rice and consumes 10 kg of
rice per month.
Suppose his income increases and now he can afford to spend Rs. 60 per month on the
purchase of 10 kg of rice. What will he do? He may now buy some quantity of the rice whose price is
Rs. 10 per kg and may buy less of rice whose price was Rs. 5 per kg. He may buy
8 kg of rice whose price was Rs. 5 per kg and 2 kg of rice whose price is Rs. 10 per kg. Thus he will
get 10 kg of rice by spending Rs. 60 on it in a month. In this way an increase in the income of the
buyer of rice has resulted in a fall in the demand for rice that he was buying.
Thus the rice that he was buying will be called an inferior commodity.
DEMAND ANALYSIS
57
Hence in case of a normal good, there is a direct relationship between the income of its
buyer and his demand for it. In case of inferior goods, there is an inverse relationship between the
income of its buyer and his demand for it.
Superior goods or normal goods
As income increases, a superior goods demand increases
As income decreases, a superior goods demand decreases
Superior goods are most common goods

Inferior Goods
As income increases, an inferior goods demand decreases
As income decreases, an inferior goods demand increases
Consumer Tastes and Preferences
The demand for a good is also affected by the tastes and preferences of its buyer. If a consumer no
longer likes a commodity, he will not buy it or may buy less of it. Similarly if a person develops a
taste for a good, he may start buying it or may start buying more of it. Thus the demand for a good is
also influenced by the tastes of the buyers.
An increased taste in a product increases its demand
A decreased taste in a product decreases its demand
For example, one of the factors which influence the purchase of home is liking. This we call tastes or
preferences. It involves the fact that there are certain psychological reasons for liking or disliking a
particular good. Our principle is: The more (less) we like a good or service, the greater (less) is our
demand for it.
Prices of Related Goods
Prices of related goods also affect the demand of a good. Related goods can be of two types: (i)
substitute goods and (ii) complementary goods.
Substitute Goods.
Two goods are said to be substitutes of each other when one can be used
in place of other. The higher the price of substitute goods, the higher the demand will be for this good.
For example:
1. Tea and coffee are substitute goods. If the price of a substitute good rises, the demand of a good,
for which it is a substitute, will rise because the buyers of the substitute
good will buy less of it and more of the other good. For example, if price of tea
rises, some buyers of tea may start buying coffee in place of tea. This leads to a
rise in demand for coffee because of a rise in price of tea, a substitute of coffee (see
Fig. 2.5).
2. If the price of chicken increases, people will turn away from chicken to its substitute, beef. The
demand for beef will increase.
58
D
tea
P2
of
P1
Price
D
O
Q1Q2
Amount demanded of coffee
Fig. 2.5 Substitute goods.
3. As the price of Coca-Cola rises, people stop buying it and buy Pepsi.
4. What happens to the demand for homes if the price of apartments falls? If apartments can be rented
for Rs. 3,000 per month, more people would want to live in apartments
and fewer in homes. Therefore, our inference is: As the price of the substitute
(apartments) rises (falls), the demand for the product (homes) rises (falls).
Complementary Goods.
Two goods are said to be complementary of each other when they
are used together. For example:
1. If the price of pen falls its demand may rise; this will lead to a rise in demand for
ink also. So the price of pen has affected the demand for ink.
2. It is also likely that the demand for butter will fall if the price of bread rises (see Fig. 2.6).
D
P2
(Rs.)
bread
P1
of
D
Price
O
Q1
Q2
Amount demanded of butter
Fig. 2.6 Complementary goods.
DEMAND ANALYSIS
59
3. Peanut butter and jelly are used with one another. If the price of peanut butter
increases, people will purchase less peanut butter. Since jelly is used with peanut
butter, people will use less jelly. The demand for jelly will decrease.
4. Assume that you are willing to pay the price and have sufficient income. What other
factors might enter into your decision? One factor might involve the method you will
use to pay for this homeborrowing money. The price of borrowing money is called
the interest rate. Homes and borrowing money tend to go together. What happens to the demand for
new homes if the interest rate rises? The answer is that it falls. When
interest rates rise, people are less likely to borrow. If they do not borrow, they will
not be able to buy homes.

5. If the price of petrol rises then the demand for scooters will fall.
6. The demand for automobiles will fall if the price of gasoline rises.
Therefore, our inference is: If the price of the complement rises (falls), the demand for the product
(homes) falls (rises).
Expectations of Future Price Changes
If people expect prices to rise in the near future, they will try to buy more now in order to avoid
paying a higher price later and vice versa. This is often the case on budget day, when consumers rush
to fill their petrol tanks prior to an expected increase in taxation and therefore the price of fuel. The
reverse is also true, in that an expectation that prices are about to fall will decrease current demand,
as consumers await the expected price reduction.
If consumers expect a price increase in near future, demand increases
If consumers expect a price decrease in the near future, demand decreases
In the case of homes, we have often observed people buying not just one home but five
or six. Why would one do this? One answer is that the buyer expects the price to rise in the near
future. Of course, the buyer does not know that the price will rise. So, there is a gamble here; the
buyer expects the price to rise. These expectations affect our demand for many
products. For example, people commonly buy stock or foreign monies because they expect the price
of the stock or of the foreign money to rise soon. Our inference here is: If buyers expect the price to
rise (fall), the demand will rise (fall) today.
There are other kinds of expectations one might have that will affect the demand for
products. If one expects that the product will soon be unavailable, the demand will rise today.
This was the case for gasoline in the early 1970s and again in September, 2001. Expecting that gas
stations would soon be out of gasoline, buyers rushed to stock up. Also, if one expects that ones
income will fall, the demand for most products will fall. During recessions, people often lose their
jobs or otherwise have their incomes reduced. Even though this has not yet happened to you, you may
be worried that it will. As a result, you may reduce your buying of many
products.
60
Advertisement
A firm can influence the buying behaviour of consumers through advertisement. By allocating more
budget for advertisement, the firms make efforts to influence the buyers and create
demand for the product or services.
Allocation of more budget for advertisement leads to more demand
Allocation of less budget for advertisement leads to less demand
Quality of the Product
A product of high quality will have greater demand and vice versa.
High quality of the product leads to high demand
Low quality of the product leads to less demand
Distribution of Income and Wealth in the Community
If there is equal distribution of income and wealth, the market demand for many products of common
consumption tends to be greater than in the case of unequal distribution.
Equal distribution of income and wealth leads to greater demand
Unequal distribution of income and wealth leads to lesser demand
Standard of Living and Spending Habits
When people prefer to adopt a high standard of living and are willing to spend more, the
demand for comfort and luxury items will tend to be higher.
High standard of living leads to high demand for comfort and luxury products
Low standard of living leads to low demand for comfort and luxury products
Age Structure and Sex Ratio of Population
If the population has high percentage of children, there will be more demand for childrens products
like toys, video games, school items, etc. Similarly, sex ratio also has an impact on demand for
goods. For example, if the population has more males than females, there will be more demand for
mens products than womens.
More population of females leads to high demand for female-used products
Less population of females leads to low demand for female-used products

DEMAND ANALYSIS
61
Level of Taxation and Tax Structure
A high tax rate would generally mean low demand for goods in general and low tax rate means high
demand for goods.
High tax rate leads to low demand for goods
Low tax rate leads to high demand for goods
Climate and Weather Conditions
There are some goods which are seasonal in nature. They will be demanded only in a particular
season. Weather conditions also create demand for some products. For example, woollen
clothes, umbrella, AC, etc.
During a particular season, there is more demand for seasonal products
During an off-season, there is less demand for seasonal products
Population
The size, and make-up of the population affect demand. If there is a growing population, more food is
demanded. If the population is stable but ageing, things that old people need will increase in demand,
such as health care. The market demand is simply the sum of the individual demands. If, at the price of
Rs. 11, Ravi wants to buy 10 Coke cans, Manohar wants to buy 6 coke cans and Rekha wants to buy 8
coke cans, then of course the market demand is 24 cans.
If Rahul becomes a buyer and wishes to buy 6 cans, the market demand rises to 30 cans.
More consumers increases the products demand
Fewer consumers decreases the products demand
Therefore, if there are more buyers, there must be more market demand.
Technical Progress
Inventions and discoveries bring new things to the market, with the result that old things are no longer
desired. For example, radio sets were replaced by TV sets and typewriters were
replaced by computers.
Thus, the demand for a given product will rise if: incomes rise (for a normal good) or fall (for an
inferior good), the price of a complement falls, the price of a substitute rises, people like the product
better, people expect the price to rise soon, people expect the product not to be available later,
people expect their incomes to rise in the near future, and there are more buyers. The opposite will
cause the demand for the product to fall.
TYPES OF DEMAND
There are large number of goods and services available in every economy. Their classification is
important in order to carry out a meaningful demand analysis for managerial decisions and 62
policy decisions. Demand for various goods is generally classified on the basis of the nature of
goods, consumers and suppliers of goods, degree of dependence, duration of consumption of a good,
period of demand, nature of use of goods, etc. The types of demand are the
following:
1. Derived demand and autonomous demand
2. Demand for producers goods and demand for consumers goods
3. Demand for durable goods and demand for non-durable goods
4. New and replacement demands
5. Industry demand and firm demand
6. Short-run demand and long-run demand
7. Total market demand and market segment demand
Derived Demand and Autonomous Demand
Derived demand refers to demand for goods which are needed for further production; it is the demand
for producers goods like industrial raw materials, machine tools and equipment. Thus, the demand
for an input is a derived demand; its demand depends on the demand for output
where the input enters. For example, the demand for cement is derived from the demand for housing.
Similarly, demand for cars battery or petrol is a derived demand, for it is linked to the demand for a
car. Demand for sugar is linked with the demand for milk, drinks, etc. The demand for all producers
goods is derived or induced. In fact, the quantity of demand for the final output as well as the degree
of substitutability or complementary between inputs would determine the derived demand for a given
input. For example, the demand for gas in a fertilizer plant depends on the amount of fertilizer to be
produced and substitutability between gas and coal as the basis for fertilizer production. Thus, if
demand for final product increases, the demand for derived demand goods also increases; if the
demand for the final product decreases, demand for derived goods also decreases.
Autonomous demand, on the other hand, is not derived or induced. The goods whose
demand is not tied with the demand for some other goods are said to have autonomous demand.
In other words, it is the one where a commodity is demanded because it is needed for direct
consumption. For example, demand for food items, readymade garments and houses etc. Unless a
product is totally independent of the use of other products, it is difficult to talk about autonomous
demand. In the present world of dependence, there is hardly any autonomous
demand. Nobody today consumes just a single commodity; everybody consumes a bundle of
commodities. Even then, all direct demand (goods that are demanded for their own sake) may be
loosely called autonomous. In this sense, all consumers goods have direct demand.
However, the distinction between autonomous and derived demand is more of a degree than
of a kind. The same good may have autonomous demand in one case and derived demand in
another. For example, demand for sugar will be autonomous when it is used directly for
consumption like in tea, drinks, milk, etc. When it is used as a input to make sweets, biscuits, etc. the
demand will be a derived one. Thus, goods that are demanded for their own sake have autonomous
demand, while goods that are needed in order to obtain some other goods possess derived demand. In
this sense all consumer goods have autonomous demand, while all
producers goods have indirect demand.
DEMAND ANALYSIS
63
Demand for Producers Goods and Demand for
Consumers Goods
Producers goods are the goods which are used to produce further goodsfor example, tools, steel,
plant, machinery, etc. Producers goods may be further sub-divided into consumable goods like coal,
oil, etc., and durable goods like machines, equipment, tools, etc. The
consumers goods are the goods which are ultimately consumed by consumers, i.e., milk, soft drinks,
bread, etc. Consumer goods may be further sub-divided into durable and non-durable goods. Durable
goods are those goods, which lasts for a long time, for example, shoes, TV, car, refrigerator, furniture,
etc. Non-durable goods are those which cannot be consumed more than once. For example, soaps,
salt, sweets, bread, milk, drinks, etc.

However, the distinction between producers goods and consumers goods depends upon
who buys the goods and why. For example, a refrigerator used in a company is a producer
good, whereas if it is for household purpose it is a consumer good. Similarly, if furniture is used in
the drawing room of a house, it is a consumers good; while it is used in the reception room of a firm,
it is a producers good. A distinction is useful for a proper demand analysis because the demand for
consumers goods depends on households income, that for producers
goods varies with the production level, profits, etc.
Demand for Durable Goods and Demand for Non-durable Goods
Both consumers goods and producers goods are further classified into perishable/non-durable/
single-use goods and durable/non-perishable/repeated-use goods. The former refers to final output
like bread or raw material like cement, which can be used only once. The latter refers to items like a
shirt, car or machine, which can be used repeatedly. In other words, we can classify goods into
several categories: single-use consumer goods, single-use producer goods, durable-use consumer
goods and durable-use producer goods (see Fig. 2.7).
Goods
Consumers goods
Producers goods
Durable
Non-durable
Durable
Non-durable
Clothes
Soaps
Building
Raw materials
Houses
Salt
Plant
Fuel & power
Furniture
Milk
Machinery
packing material
TV
Gas
Office
Refrigerator
Drinks
Furniture
Cars
Fig. 2.7 Durable goods and non-durable goods.
This distinction is useful because durable products present more complicated problems of
demand analysis than non-durable products. Non-durable items are meant for meeting
immediate (current) demand, but durable items are designed to meet current as well as future 64
demand as they are used over a period of time. The durable goods are generally more expensive than
the non-durable, and their demand alone is subject to preponement and postponement,
depending on current and future market conditions. When durable items are purchased, they are
considered to be an addition to stock of assets or wealth. Because of continuous use, such assets like
furniture or washing machine suffer depreciation and thus call for replacement.
Thus, durable goods demand has two varietiesreplacement of old products and expansion of total
stock. Such demands fluctuate with business conditions, speculation and price
expectations. Real wealth effect influences demand for consumer durables.

New and Replacement Demand
If the purchase or acquisition of an item is meant as an addition to stock, it is called new demand. If
the purchase of an item is meant for maintaining the old stock of capital or asset, it is a replacement
demand. Such replacement expenditure is to overcome depreciation in the existing stock. The demand
for spare parts of a machine is replacement demand, but the
demand for the latest model of a particular machine (say, the latest generation computer) is new
demand.
You may now argue that replacement demand is induced by the quantity and quality of
the existing stock, whereas the new demand is of an autonomous type. However, such a
distinction is more of degree than of kind. For example, when demonstration effect operates, a new
demand may also be an induced demand. You may buy a new VCR because your
neighbour has recently bought one. Yours is a new purchase, yet it is induced by your
neighbours demonstration.
Industry Demand and Firm Demand
An industry is the aggregate of firms (companies). Thus the firms demand is similar to an individual
demand, whereas the industrys demand is similar to aggregated total demand. Firm demand is
confined to demand for a product produced by a specific firm, for example, the demand for cement
produced by the Cement Corporation of India, demand for steel produced
by TISCO, demand for engineers by a single firm, demand for Maruti car, etc. When we add
demand for a particular product faced by all the firms producing that product, we get industry
demand. In other words, industry demand refers to the aggregate demand for a commodity produced
by several firms, for example the demand for cement produced by all cement
manufacturing units, the total demand for steel in the country, demand for engineers by the industry as
a whole, demand for all kinds of cars, etc.
The determinants of a companys demand may not always be the same as those of an
industrys. The inter-firm differences with regard to technology, product quality, financial position,
market (demand) share, market leadership and competitivenessall these are possible explanatory
factors. In fact, a clear understanding of the relation between company and industry demand
necessitates an understanding of different market structures.
DEMAND ANALYSIS
65
Short-run Demand and Long-run Demand
Short-run demand refers to demand with its immediate reaction to price changes, income
fluctuations, etc. for goods that are demanded over a short period of time. The fashionable consumer
goods (fashion clothes), seasonal goods (ice creams, cold-drinks, umbrella, raincoats) and scarcity of
goods (decrease in supply of gas increases the demand for electric cooker, kerosene and cooking
coal) come under this category.
Long-run demand refers to that demand which does not react immediately due to price
change. It will take some time for change in demand. In other words, it refers to that which will
ultimately exist as a result of the changes in pricing, promotion or product improvement, after enough
time has been allowed to let the market adjust itself to the new situation. For example, if price falls
for a particular product, then in the short run its demand will increase due to higher use. Considering
the short period, the main concern of a firm is to find out whether the competitors will follow the
same strategy. In the long run, competitors entry into the market, more substitutes, complexity in
environment, etc., which are likely to affect the firms interest, are the one of main concern for the
firm.
Total Market Demand and Market Segment Demand
Demand for a product can be studied either in totality or according to particular market
segments, viz., geographical spread, product uses, distribution channels, product varieties, etc.
This division of demand into different segments gives rise to the concept of market segment demand.
Market segment demand refers to demand for the product in a specific market
segment, while total market demand refers to the total demand for the product from all market
segments. For example, one can talk about the domestic demand for Maruti cars versus the total
(domestic + foreign) demand for that product, demand for steel for household versus demand for steel
for industrial uses, etc.
In other words, different individual buyers together may represent a given market segment, and
several market segments together may represent the total market. For example, Titan may compute the
demand for its watches in the home and foreign markets separately and then
aggregate them to estimate the total market demand for its watches.
The distinction takes care of different patterns of buying behaviour and consumers
preferences in different segments of the market. Such market segments may be defined in terms of
criteria like location, age, sex, income, nationality, and so on.
LAW OF DEMAND
Suppose you want to buy mangoes at Rs. 30 per kg, you buy 10 kg. If the price of mangoes
increases to Rs. 60 per kg, then how much will you buy? Definitely a lesser quantity. What kind of
relationship is there between the price and quantity demanded? There is an inverse relationship.
The relation of price to sales is known as the Law of Demand (see Table 2.6 and
Fig. 2.8). The law of demand expresses the relation between quantity of a commodity
66
demanded and its price. The law states that demand varies inversely with price, not necessarily
proportionately. If the price decreases, demand will increase, and vice-versa.
Table 2.6 Law of demand
Price (in Rs.)
Quantity demanded (in units)
6
40
5
60
4
80
3
1
20
2
1
80
Fig. 2.8 Law of demand.

The law of demand states that Ceteris paribus (other things remaining the same), higher the price,
lower the demand and vice versa. The law is stated primarily in terms of the price and quantity
relationship. The quantity demanded is inversely related to its price. Here we consider only two
factors, i.e., price and quantity demanded.
The law of demand relates to the simplified demand function
D = f ( P)
where D represents the demand, P the price and f connotes a functional relationship. It, however,
assumes that other determinants of demand are constant, and only the price is the variable and
influencing factor. The relation between price and quantity of demand is usually DEMAND
ANALYSIS
67
an inverse or negative relationship, indicating higher the price, lower the demand and vice versa.
All the other factors which determine the demand are assumed to be constant. Those factors are
called the assumptions of the law of demand.
Assumptions of the Law of Demand
The law of demand is conditional. It is based on certain conditions. It states that other things
remaining constant, when price falls demand rises and vice versa. It relates to the change in price
variable only, assuming that other factors remain constant. The law of demand, thus, is based on the
following assumptions:
1. Income of the consumer is constant.
2. There is no change in the availability and the price of the related commodities (i.e.
complementary and substitutes).
3. There are no expectations of the consumers about changes in future price and
income.
4. Consumers taste and preferences remain the same.
5. There is no change in size, age structure and sex ratio of the population.
6. There is no change in the distribution of income and wealth of the community.
7. There is no change in the population.
8. There is no change in weather conditions.

Chief Characteristics of the Law of Demand
The following are the chief characteristics of the law of demand:
Inverse Relationship
The relationship between price and quantity demanded is inverse. That is, if the price rises demand
falls, and if the price falls the demand rises. This is shown by the downward sloping demand curve.
Price is an Independent Variable and the Demand is Dependent
It is the effect of price on demand and not vice versa. As per the law of demand, price is regarded as
an independent variable and demand a dependent variable.
Other Things Remain the Same
The law of demand assumes that other things remain the same.
Reasons Underlying the Law of Demand
The inverse relationship can be explained in terms of two reasons, viz.,
68
Income Effect.
The decline in the price of a commodity leads to an equivalent increase in
the income of a consumer because he has to spend less to buy the same quantity of goods. The part of
the money left can be used for buying some more units of a commodity. For example, suppose the
price of mangoes falls from Rs. 30 per dozen to Rs. 15 per kg. Then with the same amount you can
buy 2 kg.
Substitution Effect.
When the price of a commodity falls, the consumer tends to substitute
that commodity for another commodity which is relatively dearer. For example, suppose the price of
Urad falls, it will be used by some people in place of other pulses. Thus the demand will increase.
Why does the Demand Curve Slope Downwards?
The law of demand states that, other things remaining the same, an individual consumer will buy more
units of a commodity at a lower price and less of that commodity at a higher price.
Generally, the demand curve slopes downwards from left to right. Some of the reasons for the
downward slope of demand curve are:
Traditional View
Law of Diminishing Marginal Utility.
As one goes on consuming more and more units of
a commodity its utility to him goes on diminishing.
Diverse Uses of a Commodity.
A commodity tends to be put to more use when it becomes
cheaper. Thus, the existing buyers purchase more and some new consumers enter the market.
Thus, more demand is created when price falls.
Change in the Number of Consumers.
When the Price of commodity is reduced then many
other consumers who were not consuming the commodity earlier will start purchasing it now.
Thus the existing buyers purchase more and some new consumers enter the market.
Modern View
Income Effect.
A fall in the price of a superior good will lead to a rise in the consumers
real income. The consumer can, therefore, buy more of it. On the contrary, rise in the price of a
superior good will result in a decline in the consumers real income; the consumer will, therefore,
buy less of it. The consequent increase or decrease in a consumers demand for the good under
consideration may be attributed to the income effect. Lower price has positive income effect: it
increases the purchasing power of a buyers income, enabling the buyer to purchase more of the
product.
Substitution Effect.
A fall in the price of a good, while the prices of its substitutes remain
unchanged, will make it attractive to the buyers who will now demand more of it. On the
contrary, a rise in the price of a commodity, while the prices of its substitutes remain
unchanged, will make it unattractive to the purchasers who will now purchase less of it. Lower
DEMAND ANALYSIS
69
price has positive substitution effect: a decrease in price is an incentive for buyers to shift towards
this product and away from alternative products.
Exceptions to the Law of Demand
It is a universal phenomenon of the law of demand that when the price falls, the demand rises, and
vice versa. But sometimes, there are cases where this equation does not apply, i.e., with a fall in
price, demand also falls and with a rise in price, demand also rises. This is a situation which is
contrary to the law of demand. Cases in which this tendency is observed are referred to as exceptions
to the law of demand. The demand curve for such cases will be upward sloping as shown in Fig. 2.9
and it is described as an exceptional demand curve. The following are the exceptional cases:
Giffens Goods
Sir Robert Giffen of England observed that in the 19th century low-paid British workers were
purchasing more bread when its price was rising. When the price of bread was falling, instead of
buying more bread they were buying less. He was puzzled by this paradox of buying more at rising
prices and buying less when prices were falling. Bread was the staple food of low wage earners.
They consume bread and meat as their diet. These people purchase more of bread when its price
rises. When the price was falling, instead of buying more they tried to buy less of bread and use the
savings for the purchase of meat. This behaviour is now called Giffens paradox and such goods are
termed inferior or Giffen goods when compared to other goods (see Fig. 2.9). It is a special type of
inferior goods where the increase in the price results into the increase in the quantity demanded. This
happens because these goods are consumed by poor
people who would like to buy more if the price increases. For example, in the case of a poor person
who buys inferior quality vegetables, if the price of such vegetables increases then they prefer to buy
more because they think that it would be of a better quality.
Y
D
Price
D
O
Demand
X
Fig. 2.9 Giffen goods.
Conspicuous Consumption
The goods, which are purchased for snob appeal, are called goods for conspicuous
70
consumption. They are also called as Veblen goods because the economist Veblen coined this term.
According to Veblen, some people buy a commodity for the sake of enhancing their
prestige and status in society. The examples of such commodities are diamonds, jewellery, luxury car,
etc. They are prestige goods. They would like to hold it only when they are costly and rare.
So, what can be the policy implication of this for the manager of a company who produces
it? A producer can take advantage by charging high or premium prices.
Speculative Market
When people speculate about changes in the price of a commodity in the future, they may not act
according to the law of demand. In this case, the higher the price the higher will be the demand. It
happens because of the expectation of increased price in the future. For example, some people tend to
buy more shares when their prices are rising, in the hope that the rising trend would continue, so they
can make good profits in future.
Consumers Psychological Bias or Illusion
Sometimes, the consumer judges the quality of a good from its price. Consumers think that the product
is superior if the price is high. Such consumers may purchase high-price goods because of the feeling
that the product possesses a better quality. For example, some consumers do not buy when there are
some offers like discounts, rebates etc., thinking that the goods may be of bad quality.
Fear of Scarcity
During the times of emergency or war, people may expect shortage of a commodity. At
that time they may buy more of a quantity even at a higher price to keep stocks for the
future.
Basic Necessities
In the case of basic necessity products, the quantity demanded will remain the same irrespective of
the change in price. For example, when price of salt increases, consumers will not consume more salt
and vice versa.
The exceptional demand curve shows a positive relationship between the price and the
quantity demanded as shown in Fig. 2.10.
The diagrammatic representation of the upward sloping demand curve is given in
Fig. 2.10.
In Fig. 2.10, DD is the demand curve which slopes upward from left to right. It appears that when OP
is the price, OQ is the demand and when the price rises from OP to OP 1; demand also rises from OQ
to OQ 1. It represents a positive relationship between price and quantity demanded.
DEMAND ANALYSIS
71
Fig. 2.10 Exceptional demand curve (upward-sloping).
CHANGE IN DEMAND
The phrase change in quantity demanded is related to the law of demand. When the price of a
commodity falls, the consumer demands more of a commodity, and vice versa. The quantity of a
commodity demanded changes with change in its price.
Change in demand refers to a shift in the demand curve as contrasted to a movement along
the same demand curve. Change in demand for a commodity may occur due to change in the
price of the commodity or due to some reasons other than the change in price of commodity.
These reasons may be change in population, change in the level of income, change in the price of
related goods, etc. Thus, change in demand is classified into two types:
1. Movement along the demand curve
2. Shifts in the demand curve.
This classification is shown in Fig. 2.11.
Fig. 2.11 Classification of change in demand.
Movement along Demand Curve
(Extension and Contraction in Demand)

A movement along the demand curve is caused by a change in price of the good or service.
When the quantity demanded of a commodity rises with a fall in its price, it is known as
72
extension of demand. It is the downward movement along a demand curve, which indicates a higher
quantity demanded for a given fall in the price of the good. While the quantity
demanded of a commodity falls with a rise in the price, it is called contraction of demand. It is the
upward movement along a demand curve, which indicates that a lower quantity is
demanded for a given increase in the price of the good.
From Fig. 2.12, it can be seen that when the price decreases from OP to OP 1, the quantity demanded
extends from OQ to OQ 1. Thus, a fall in the price of the good results in an extension of demand
(quantity demanded will increase). On the other hand, if the price rises from OP
to OP 2, the demand contracts from OQ to OQ 2. Here we travel up and down on the same demand
curve, signifying that the demand changes only due to a change in price.
Fig. 2.12 Extension and contraction in demand.
Shifts in Demand Curve (Increase and Decrease in Demand)
A shift in the demand curve is caused by a change in any non-price determinant of demand
like peoples income, rise in the price of substitutes, fall in the price of complements, change in
tastes, multiple uses of the product, technological change, etc. In other words, the increase or
decrease in demand due to change in factors other than price is called shift in demand curve, because
the demand curve shifts upward to the right or downward to the left as and when the demand
increases or decreases.
An increase in demand means that at the same price, the consumers are willing to buy more of a
quantity. An increase in demand will shift the demand curve to the right. A decrease in demand would
mean that at the same price, consumers buy less of a quantity due to factors like fall in consumers
income, etc. A decrease in demand will shift the demand curve to the left.
In Fig. 2.13, increase and decrease in demand is shown simultaneoulsy. Increase means
greater demand at the same price or the same quantity demanded at a higher price. When the
DEMAND ANALYSIS
73
Fig. 2.13 Increase and decrease in demand.
demand changes due to change in factors other than price, the demand curve shifts either
upward or downward. The rise in demand which results in upward shifting of the demand curve is
known as increase in demand. The fall in demand results in downward shifting of the demand curve,
known as decrease in demand.
Increase in demand shifts the demand curve from the original demand curve D to D 1. It shows that
buyers are willing to buy a higher quantity at the same price. Decrease in demand shifts the demand
curve downward from curve D to D 2. This shows that the buyers are ready to buy a lesser quantity at
the same price.
Thus, increase and decrease in demand necessitates a shift of the demand curve upwards
or downwards, whereas expansion and contraction in demand may lead to movement along the
same demand curve.
The movements can be caused by the following (see Table 2.7):
Change in Consumer Income
If consumer income increases, then consumers buy more normal or luxury items and the
demand curve shifts to the right. Because a consumers demand for goods and services is
constrained by income, higher income levels relax that constraint somewhat, allowing the
consumer to purchase more products. Correspondingly, a decrease in income shifts the demand curve
to the left. When the economy enters a recession and more people become unemployed, the demand
for many goods and services shifts to the left.
Change in the Price of Other Goods
If prices of related goods change, the demand curve for the original good can change as well.
Related goods can be either substitutes or complements.
74
(a) Substitutes are goods that can be consumed in place of one another. If the price of a substitute
increases, the demand curve for the original good shifts to the right. For
example, if the price of Pepsi rises, the demand curve for Coke shifts to the right.
Conversely, if the price of a substitute decreases, the demand curve for the original
good shifts to the left. Given that chicken and mutton are substitutes, if the price of
mutton falls the demand curve for chicken shifts to the left. If the price of a substitute good increases,
then the demand for the other good would increase as consumers
switch their consumption patterns.
(b) Complements are goods that are normally consumed together. If the price of a
complement increases, the demand curve for the original good shifts to the left. In
contrast, if the price of a complement decreases, the demand curve for the original
good shifts to the right. If for example the price of computers falls, then the demand
curve for computer software shifts to the right. If the price of a complementary good
increases, the demand for the good will fall. This will result in a leftward shift in
the demand curve of any complementary good.
Changes in Tastes and Fashions
If the preference for a particular good increases, the demand curve for that good shifts to the right. If a
good becomes fashionable then the demand for the good will shift to the right.
Population Change
An increase in population shifts the demand curve to the right. Imagine a a bookstore in a college
town in which most students return home for the summer. Demand for books shifts to the left while the
students are away. When they return, however, demand for books increases even if the prices are
unchanged.
Seasonal Factors
Seasonal factors can also affect the demand for a product. Buyers purchase certain products heavily
during certain times of the year. For instance, the demand for sweets, crackers and clothes will be
higher during Deepavali than during other times of the year.
Expectations about Future Prices and Incomes
Suppose that you have been considering buying a new car or a new computer. If you acquire new
information that leads you to believe that the future price of this commodity will increase, you are
probably more likely to buy it today. Thus, a higher expected future price will increase current
demand. In a similar manner, a reduction in the expected future price will result in a reduction in
current demand (since youd prefer to postpone the purchase in anticipation of a lower price in the
future). If expected future income rises, demand for many goods today is likely to rise. On the other
hand, if expected future income falls (perhaps because of rumours of future layoffs or the beginning of
a recession), individuals may reduce their current demand for goods so that they can save more today
in anticipation of the lower future income.
DEMAND ANALYSIS
75
Table 2.7 Causes for increase and decrease in demand
Increase in demand
Decrease in demand
Rise in the consumer's income.
Fall in the consumer's income
Rise in the price of substitute goods
Fall in the price of substitute goods
Fall in the price of complementary goods
Rise in the price of complementary goods
Favourable change in tastes and preferences No change in tastes and preferences
Increase in population
Decrease in population
Season
Off-season
Expected rise in future prices
Expected fall in future prices
Shift or Change in Demand versus a Movement along a Demand
Curve (Change in Quantity Demanded)
It is essential to distinguish between a movement along a demand curve and a shift in the demand
curve. A change in price results in a movement along a fixed demand curve. This is also referred to as
a change in quantity demanded. For example, an increase in video rental prices from Rs. 150 to Rs.
200 reduces the quantity demanded from 30 units to 20 units. This price change results in a movement
along a given demand curve. A change in any other variable that influences the quantity demanded
produces a shift in the demand curve or a change in demand (see Table 2.8).
Table 2.8 Change in demand vs change in quantity demanded
Shift in demand curve/Change
Movement along a demand curve/
in demand
Change in quantity demanded
Occurs when demand changes due to
Occurs due to change in price, other
non-price, i.e., other factors, price
factors remaining the same
remaining the same
Change in other factors results in shifts
Change in price results in movement
of the entire curve
along the demand curve
ELASTICITY OF DEMAND
The law of demand explains what happens to the demand for a commodity for a change in
price. The law merely explains the direction in which the demand changes for a change in
price. When price increases, demand decreases and when price decreases, demands increases
but by how much? This can be answered by the measurement of elasticity. Elasticity is the most
commonly used measurement of the sensitivity of the demand function to changes in any of
its variables.
Elasticity is the concept in economics that measures the responsiveness of one variable in response to
another variable. The best measure of this responsiveness is the proportional or 76
percent change in the variables. Marshall introduced the concept of elasticity of demand.
Elasticity is the proportional (or percent) change in one variable relative to the proportional change
in another variable. Elasticity is the ratio of the percentage change in the the quantity demanded to the
percentage change in other variable, may be price, income, etc. The formula is
Percentage change in the dependent variable
Elasticity = Percentage change in the independent variable
In symbols,
Y/ Y
Y
X
Y
X
F
'
'
'
'X/X
Y
'X
'XY
where
e = Elasticity
Y = Quantity of the dependent variable
X = Quantity of the independent variable
D = Change in values of the variables
Thus, the elasticity of a function is simply the rate of change, DY/DX, combined with a multiplicative
factor, X/Y, which makes it independent of units.
Importance of the Concept of Price Elasticity of Demand.
The concept of elasticity of
demand has great practical importance in managerial decision-making. The following are the
applications of price elasticity to managerial decision-making:
Setting Prices.
Knowledge of price elasticity will help a business to take the right
decisions. If the demand for the product is price-elastic, the firm can increase the sales revenue by
reducing the price. On the other hand, if the demand for the product is price-inelastic, it can increase
the sales revenue by increasing the price of the commodity.
Formulating Government Policy.
If the product is price inelastic and if the product is
an essential commodity, when the commodity is in short supply, the government has to
introduce some sort of rationing system so that it can distribute the essential commodity equitably
among all sections of the society. The finance minister also takes the note of elasticity of demand
when selecting commodities for taxation. If he wants to be certain of the revenue, he takes those
commodities for which the demand is inelastic. If the demand is elastic, people will buy less of them
and the government would get less revenue.
Joint Products.
In case of joint products, separate costs of production of the two
commodities are not ascertainable. In such cases, the price of each will depend on the elasticity of
demand of each.
Industrial Production.
The volume of industrial output depends upon the nature of

demand. If the demand is elastic, sales can be increased by reducing price slightly, and the output too
will increase.
DEMAND ANALYSIS
77
Determination of Wages.
Elasticity can also influence wages. If demand for a particular
type of labour is inelastic, it can succeed in rising wages.
International Trade.
The concept of elasticity of demand is also of great use in
international trade. The country will benefit from international trade if the demand for imports is very
elastic but that for exports is inelastic.
Elastic Demand and Inelastic Demand
A change in demand is not always proportionate to the change in price. When a small change in price
leads to a greater change in demand, then it represents elastic demand. When the price of a
refrigerator falls, many consumers may postpone their purchase. Here the demand is
elastic. Even when there is a greater change in the price of the commodity it may induce only a slight
change in demand. This represents inelastic demand. For example, if the price of salt varies the
consumers buy almost the same quantity. In this case the demand is inelastic.
Types of Elasticity of Demand
Elasticity of demand can be divided into four types:
1.
Price elasticity of demand, which measures the responsiveness of sales to change in price.
2. Income elasticity of demand, which measures the responsiveness of sales to change in consumer
income.
3. Cross elasticity of demand, which measures the responsiveness of sales of one
commodity to change in the price of another commodity.
4. Promotional elasticity of demand, which measures the responsiveness of sales to change in the
amount spent on advertising and promotion.
Price Elasticity of Demand
The law of demand states that the quantity demanded of a good will vary inversely with the price of
the good during a given time-period, but it does not tell how much the quantity
demanded will change in response to a price change. To measure the responsiveness of the
quantity demanded of a good to a change in the price of the good, a measurement called price
elasticity is used. The price elasticity of demand denotes the degree of responsiveness of the quantity
demanded of good X to change in its price PX. In other words, the price elasticity number ( E) simply
tells you that if the price goes up by a certain percent, the quantity demanded responds to it by a
certain percentage. The way we define the price elasticity of demand is as follows:
The price elasticity of demand measures the responsiveness of the quantity demanded to
the price of the good, with all other factors remaining constant. Therefore, the price elasticity of
demand can be defined as a measure of the responsiveness of the quantity demanded to
changes in price.
78
It is calculated by using the formula
e
Percentage change in quantity demanded
p=
Percentage change in price
The point elasticity for measuring the price elasticity of demand is:
'Q
Q
'QP
e

D='P
'PQ
P
or, if the function is known,
e
dQ P
D = dP Q
The arc elasticity of demand (e D) may be calculated by using the formula
( Q Q )( Q Q )
2
1
2
1
F
D
(
2
P
1
P )( 2
P
1
P)
where
Q 1 = Quantity before change in price
Q 2 = Quantity after change in price
P 1 = Original price
P 2 = New price
D Q = Change in quantity demanded
D P = Change in price
If the answer is between 0 and 1, the relationship is inelastic.
If the answer is between 1 and infinity, the relationship is elastic.
Since demand curves are downward-sloping, the percentage change in the quantity
demanded of a good is always of an opposite sign, as the percentage change in the price of the good
and so the elasticity is a negative number. In practice, it is customary to ignore the negative sign and
report the elasticity of a good as a positive number.
Illustration 2.1: If
Q 1 = 150
Q 2 = 110
P1=9
P 2 = 10
(110 150)
150
e
2.4005
p=
10 9
9
DEMAND ANALYSIS
79
When we analyze price elasticities we are concerned with their absolute value and so we
ignore the negative value. We conclude that the price elasticity of demand when the price increases
from Rs. 9 to Rs. 10 is 2.4005.
Illustration 2.2:
From Table 2.9, if the price of a commodity increases from Rs. 7 to
Rs. 8 and the quantity you buy falls from 250 units to 220 units, then your elasticity of demand would
be calculated as
(QQ)
2
1
220 250
Q1
250
F
0.84
p
(PP)
87
2
1
P
7
1
Thus the price elasticity of demand when price increases from Rs. 7 to Rs. 8 is 0.84.
Table 2.9 Price elasticity of demand
Price (Rs.)
Quantity demanded (units)
7
250
8
220
9
1
80
1
0
1
30
11
70
Types of Price Elasticity.
Price elasticity of demand is classified into the following five
types based on the degress of elasticity of demand:
1. Perfectly elastic demand
2. Perfectly inelastic demand
3. Unit elastic demand
4. Relatively elastic demand

5. Relatively inelastic demand.
Perfectly Elastic Demand (e d = ). The elasticity of demand is elastic if the percentage change in the
quantity demanded is larger than the percentage change in price. In this case, the price elasticity of
demand is larger than 1.00. If the price elasticity of demand is infinite, demand is perfectly elastic.
This is illustrated by a horizontal demand curve and is shown in Fig. 2.14.
Figure 2.14 shows an infinitely elastic demand curve DD
1 which is a horizontal
straight line parallel to the axis of X. It shows that demand varies without any change in the price.
80
Fig. 2.14 Perfectly elestic demand curve.
Perfectly Inelastic Demand (e d = 0). The elasticity of demand is inelastic if the percentage change
in the quantity demanded is smaller than the percentage change in price. In this case, the price
elasticity of demand is less than 1.00. If the price elasticity of demand is 0, demand is perfectly
inelastic. This is illustrated by a vertical demand curve and is shown in Fig. 2.15.
Y
D
P1
( e = 0)
d
Price
P
O
D1
X
Quantity
Fig. 2.15 Perefectly inelastic demand.

Figure 2.15 shows perfectly inelastic demand or zero elasticity. The demand curve DD is a vertical
straight line perpendicular to the axis of X and parallel to the axis of Y. It shows that demand remains
the same even though the price falls or rises. In this case elasticity of demand is zero. No amount of
change in price induces a change in demand.
In the real world, there is no commodity whose demand is absolutely inelastic, i.e., change in its
price will fail to bring about any change at all in the demand for it. Some extension or contraction is
bound to occur. That is why economists say that elasticity of demand is a matter of degree only. In the
same manner, there are few commodities in whose case the demand is perfectly elastic.
DEMAND ANALYSIS
81
Thus in real life, the elasticity of demand of most goods and services lies between the two limits
given above, viz. infinity and zero. Some have highly elastic demand while others have less elastic
demand.
Unit Elastic Demand (e d = 1). The elasticity of demand is unity if the percentage change in the
quantity demanded equals the percentage change in price. For example, a 25% rise in price will bring
a 25% decrease in quantity demanded. This is a case of unitary price elasticity.
In this case, the price elasticity of demand equals 1.00 (i.e. Ed = 1).
The demand curve will not be a straightline, but can be illustrated with a demand curve
such as that shown in Fig. 2.16.
Fig. 2.16 Unit elastic demand.
Figure 2.16 shows that when price increases from P to P 1, quantity demanded also decreases from Q
to Q 1 proportionately.
Relatively Elastic Demand (e d > 1). There are commodities for which a small change in price will
drastically reduce the amount of quantity demanded. For example, air travel for vacationers is very
sensitive to price. A rise in air fare will lead the vacationer to choose another mode of transportation
like car or lead him to postpone the vacation plan for the time being. Thus in case of rise in air fare
for the vacationers, we will see a relatively more drastic reduction in quantity demanded and hence
high price elasticity of demand. Demand is said to be highly elastic when even a small change in the
price of a commodity leads to a considerable extension or contraction of the amount demanded of it.
In case a price increase by 10% leads to a fall in quantity demanded by more than the
proportionate amount, that is, more than 25%, we call it elastic demand. Here, Ed > 1.
Figure 2.17 shows that as a result of a lesser percentage change in price, the quantity
demanded extends or contracts by QQ 1, which is a comparatively large change in demand.
82
Fig. 2.17 Relatively elastic demand.
Relatively enelastic Demand (e d < 1). For some commodities, a small increase in price will
change the quantity demanded in a very small amount. You can think of commodities that are
necessities (for example, heating services of homes in winter, air travel for business passengers) or
commodities on which we spend very small amount of income (like salt). These commodities will
have low price elasticity of demand, meaning that a small change in price will have relatively little
impact on the quantity demanded.
Price
D
P1
( e < 1)
d
P
D
Quantity
O
Q
Q
1
Fig. 2.18 Relatively inelastic demand.
In case of a price increase by 25% there is a fall in quantity demanded by less than
proportionate amount, that is, less than 10%, we call it inelastic demand. Here, e d < 1 (see Fig.
2.18). A rise in price from P to P 1 contracts demand from Q to Q 1, which is very small.
The various types of price elasticity are shown in Table 2.10.

DEMAND ANALYSIS
83
Table 2.10 Types of price elasticity
Type
Description of response to
Change
Numerical
Shape of
a change in price
expression
curve
Perfectly elastic
Quantity demanded drops
P Qd = 0
Ed =
Horizontal
to zero with even a small
P Qd = 0
(Infinite)
change in price
Perfectly inelastic Quantity demanded does
P Qd same Ed = 0 (Zero)
Vertical
not respond to changes

P Qd same
in price
Unit elastic
Per cent change in quantity
P Qd
Ed = 1 (One)
Rectangular
demanded is the same
P Qdhyperbola
as the percent change in
price
Relatively elastic
Quantity demanded changes P Qd
Ed > 1 (More
Flat
faster than the change in
P Qdthan one)
price
Relatively inelastic Quantity demanded does
P Qd
Ed < 1 (Less
Steep
not change as fast as price P Qdthan one)
changes
[ Note: Indicates greater change and indicates lesser change.]
Determinants of Price Elasticity of Demand.
We have discussed above that price
elasticity of demand for a product may vary between zero and infinity. The price elasticity of a
product within this range depends on the following factors:
Availability of Substitutes.
The more (and closer) the substitutes available in the
market, the more elastic the demand will be in response to a change in price. In this case, the
substitution effect will be quite strong. Necessities generally have fewer substitutes and have an
inelastic demand; luxuries often have many substitutes, so their demand frequently is elastic.
Fewer substitutes less elastic demand
More substitutes more elastic demand
Luxuries and Necessities.
A necessity has poor substitutes, so the demand for a necessity
is inelastic. Food is a necessity. A luxury has many substitutes, so the demand for a luxury is elastic.
Thus, necessities tend to have a more inelastic demand curve, whereas luxury goods and services
tend to be more elastic. For example, the demand for opera tickets is more elastic than the demand for
urban rail travel. The demand for vacation air travel is more elastic than the demand for business air
travel.
Necessities more inelastic demand
Luxuries more elastic demand
84
Percentage of Income Spent on a Good.
The greater the proportion of income spent
on a good, the larger is its elasticity of demand; the smaller the proportion of income spent on
purchasing the good or service, the more inelastic the demand will be.
Greater percentage of income spent More elastic

Lesser percentage of income spent Less elastic
For example, the demand curve for salt is very steep or relatively inelastic, while the demand curve
for yachts is much flatter or more elastic. While a change in the price of salt will have a small affect
on the quantity demanded of salt, a change in the price of yachts will have a larger affect on the
quantity demanded of yachts because of the relatively elastic demand curve.
Habit Forming Goods.
Goods such as cigarettes and drugs tend to be inelastic in
demand. Preferences are such that habitual consumers of certain products become de-sensitised to
price changes.
Time period.
Demand tends to be more elastic in the long run rather than in the short
run. In general, the more time that has elapsed since a price change, the larger is the elasticity of
demand. Distinguishing between two time frames, the short-run demand and the long-run demand, is
useful.
(i) Short-run demand shows the initial response of buyers to a change in price, and is often inelastic.
(ii) Long-run demand describes the response of buyers to a price change after all adjustments have
been made, and generally is more elastic than short-run demand.
More time more elastic demand
Less time less elastic demand
For example, a demand curve for water is likely to be very steep or relatively inelastic in the short
run. As the adjustment period increases, people become adjusted to using less water (e.g.
wash the car less), so the demand curve becomes flatter or relatively elastic. While a change in the
price of water will have a small affect on the quantity demanded of water in the short run, it will have
a larger effect on the quantity demanded in the long run because of the relatively elastic demand
curve.
For most goods the price elasticity of demand tends to increase over time. Over time,
consumers tend to change their consumption habits and behaviour to adjust to higher (or lower)
prices. Besides, changes in prices could result in the appearance (or disappearance) of
substitutes.
For example, after the two world oil price shocks of the 1970s, the response to higher oil prices was
modest in the immediate period after price increases. But as time passed, people found ways to
consume less petroleum and other oil products. This included measures to get better mileage from
their cars; higher spending on insulation in homes and car pooling for commuters. The demand for oil
became more elastic in the long run.
DEMAND ANALYSIS
85
Thus demand tends to be more elastic if the larger the number of close substitutes; if the good is a
luxury one; the more narrowly defined the market; and the longer the time period (see Table 2.11).
Table 2.11 Elastic and inelastic demand
Demand tends to be more elastic
Demand tends to be more inelastic
If the number of close substitutes is large. If the the number of close substitutes is small.
If the good is a luxury item.
If the good is a necessity.
If the market is narrowly defined.
The market is more broadly defined.
If the time period is long.
If the time period is short.
Methods of Measurement of Elasticity of Demand
In the firms, it is more useful to find out to what extent the demand is elastic or inelastic. For that
purpose it is essential to measure the elasticity. When people buy the same quantity irrespective of
price changes, elasticity is zero. In this case the demand is absolutely inelastic.
On the other hand, whenever price changes quantity also changes. For example, when price
rises, purchases fall or stop. It is absolutely elastic. Between these two extremes (i.e. elastic and
inelastic), there are varying degrees of elasticity.
There are four methods for the measurement of elasticity of demand:
1. Percentage method;
2. Proportional method;
3. Total Outlay method; and
4. Geometric or point elasticity method.
Percentage Method
Under this method, elasticity of demand is measured as percentage change in the quantity
divided by percentage change in price of the commodity.
'Q
P
Point e
d=
1
'P
1
Q
'Q
(PP)
Arc e
d=
1
2
'P
(
1
Q
2
Q)
Proportional Method
In this method, we compare the percent change in price with the percentage change in demand.
The elasticity is the ratio of the percentage change in the quantity demanded to the percentage change
in the price.
86
The formula is:
Proportionate change in quantity demanded
Price elasticity =
Proportionate change in price
For example, the price of a TV brand falls from Rs. 10,000 to 8,000 each, i.e., there is a 20 per cent
fall. As a result of this fall in price, suppose further that the demand for TV sets has gone up from 100
to 150 units, i.e., 50 per cent. Thus elasticity of demand would be: 50
2.5 per cent
20
The concept of price elasticity can be used in comparing the sensitivity of the different types of goods
(i.e. luxuries and necessaries) to change in their prices. Consumers have to buy the basic necessities
irrespective of price change, but they can economise on other products.
Total Outlay Method
According to this method, we compare the total outlay of the purchaser (or total revenue, i.e., total
value of sales from the point of view of the seller) before and after the variations in price.
Elasticity of demand is expressed in three ways:
(a) Unitary elastic
(b) Greater than unity

(c) Less than unity.
Unitary Elastic.
Even though the price has changed, the total amount spent (total revenue
of the seller) remains the same. When price increases, purchases also increase at the same percentage
and vice versa (see Fig. 2.19).
Fig. 2.19 Unitary elastic demand.
Greater than unity.
Elasticity is said to be greater than unity (i.e. the demand is elastic)
between two prices, when, with the fall in price the total amount spent (total revenue of the seller)
increases or the total amount spent (total revenue) decreases as the price rises.
DEMAND ANALYSIS
87
Less than unity.
Elasticity between two prices is considered to be less than unity (i.e. the
demand is inelastic or less elastic) when the total amount spent (total revenue) increases with a rise
in price and decreases with a fall in price.
A simple method of measuring the price elasticity of demand is the total outlay method.
The total outlay method has two steps. This method is only an approximate method of
determining elasticity. The first is to prepare a total outlay or total revenue table for the good or
service under investigation. The second step is to look at the change in total revenue received and to
compare it with the direction of the price change that caused the change in total revenue.
Consider Table 2.12. As price changes from Re. 1 per unit to Rs. 2 per unit, total outlay (total
revenue) rises from Rs. 800 to Rs. 1,400. Total outlay and price have both risen.
Economists say the demand for this good in this price range is inelastic, and that the good has price
elasticity of less than 1 in this price range.
Table 2.12 Total outlay
Price per unit

Quantity demanded
Total outlay or total revenue (in Rs.)
1.00
800
800
2.00
700
1400
3.00
600
1800
4.00
500
2000
5.00
400
2000
6.00
300
1800
7.00
200
1400
8.00
100
800
A given percentage change in price has resulted in a lesser percentage change in quantity demanded.
Price has doubled; that is, increased by 100% (from Re. 1 to Rs. 2). However, the quantity demanded
has only fallen by 100 (i.e. from 800 units to 700 units). This is a decrease of only 100/700 = 14%.
The owner of the firm producing this good can see that increasing price will have
beneficial effects on total revenue and on total profits. The increase in price has seen demand fall
(this is the law of demand in action), but despite this the total revenue received will increase. When
price rises from Rs. 6 to Rs. 7, however, total outlay (total revenue) falls from Rs. 1,800 to Rs.
1,400. Total outlay fallen when price has risen. This movement, in opposite directions, indicates that
the demand for this good is elastic (in this price range). Economists say the good has price elasticity
of more than 1 (i.e. 1.3). The owner of this firm can see that increasing price is a bad idea: total
revenue received will fall. It is likely that profit will fall if prices are increased from Rs. 6 to Rs. 7.
It is observed from the above table that when price changes from Rs. 4 per unit to Rs. 5, total outlay
remains the same. This indicates the good has unitary elasticity (an elasticity of 1.00).
But, you notice that the percentage decrease in quantity demanded is not equal to the
percentage increase in price. Price has risen from Rs. 4 to Rs. 5 (a 25% rise) and quantity demanded
has fallen from 500 to 400 units, a 20% fall.
88
The differences in percentage change highlight that the total outlay method is only an
approximate measure of elasticity.
Geometrical or Point Elasticity Method
Marshall also suggested another method called the point elasticity method or geometrical
method for measuring price elasticity at a point on the demand curve. This method tells us to measure
elasticity of demand at any point on a demand curve. The demand curve is shown in Fig. 2.20. When a
point is plotted on the demand curve like point P in the figure below, it divides the curve into two
segments. The point elasticity is thus measured by the ratio of the lower segment of the curve below
the given point to the upper segment of the curve above the point.
Y
A
Upper
segment
( U)
P
Price
L
PB
e=
=
U
PA
Lower
segment
( L)
X
O
B
Quantity demanded
Fig. 2.20 Demand curve in geometrical method.
In other words,
Lower segment of demand curve
Point elasticity = Upper segment of demand curve
Lower portion of tangent
Point elasticity = Upper portion of tangent

Symbolically,
L
FU
DEMAND ANALYSIS
89
where, e stands for point elasticity, L stands for lower segment, and U for the upper segment.
In Fig. 2.19, AB is the straight-line demand curve and P is a given point. Thus, PB is the lower
segment and PA the upper segment.
L
PB
\
F
U
PA
when we measure the two parts of the demand curve, we find that PB is 3 cm and PA is 2 cm, then
elasticity at point P is 3/2 =1.5.
This measure is called a point elasticity measurement because it effectively measures elasticity at a
point on the demand curve, assuming infinitely small changes in price and quantity variables.
Arc Elasticity
One way to estimate the elasticity of a point is to use the Arc elasticity equation. The measure of
elasticity of demand between any two finite points on a demand curve is known as Arc elasticity.
Two points that are equidistant along the supply or demand curve from the point desired are chosen.
The averages from those two points are then used in the above equations:
'Q
QQ
1
2
F
'P
PP
1
2
2
The income of the consumer affects the demand for a commodity. The income elasticity of
demand is the percentage change in the quantity demanded of a good that results from a one percent
change in income. It measures how the demand for a product responds to a change in income. The
income elasticity of demand is defined as the percentage change in the quantity demanded divided by
the percentage change in income, that is:
Percentage change in quantity demanded
Income elasticity of demand =
Percentage change in income
The measures of income elasticity of demand may be either positive or negative numbers and these
have been used to classify products into normal or inferior goods or into necessities
or luxuries (see Fig. 2.21).
If as a result of an increase in income the quantity demanded of a particular product
decreases, it would be classified as an inferior good. The opposite would be the case of a
normal good. Margarine has in past studies been found to have a negative income elasticity of
demand, indicating that as family income increases, its consumption decreases possibly due to
substitution of butter.
90
Y
Zero
Positive
Negative
income
income
Quantity
income
elasticity
elasticity
demanded
elasticity
(inferior
good)
X
1/1
1/2
O
Income
Fig. 2.21 Income elasticity of demand.
Normal Goods
A good is a normal good if its income elasticity is positive. This means that when income rises,
quantity demanded risesmost goods are normal goods. We make a distinction between normal
necessities and normal luxuries (both have a positive coefficient of income elasticity).
Also, as shown below, there are different types of normal goods:
Necessity Goods.
Necessities have an income elasticity of demand of between 0 and +1. In

other words, a good is a necessity if its income elasticity is positive, but less than 1. This means that
if income rises by 10%, quantity demanded rises by less than 10%. Therefore, as peoples income
rises, they spend a smaller percentage of their income on necessities. The class examples of this
would be the demand for fresh vegetables, toothpaste and newspapers. Demand is not very sensitive
at all to fluctuations in income; in this sense, total market demand is relatively stable, following
changes in the wider economic (business) cycle. Fresh vegetables, instant coffee, natural cheese, fruit
juice, shampoo, toothpase, detergents, rail travel, spending on utilities are the examples of normal
necessity.
Luxury Goods.
A good is a luxury good if its income elasticity is positive, and greater than
1. On the other hand these are said to have an income elasticity of demand > +1. (Demand rises more
than proportionate to a change in income.) This means that if income rises by
10%, quantity demanded rises by more than 10%. Therefore, people spend more of their
income on luxuries when they have larger incomes. Normal luxury, designer clothes, private
education, private health care, fine wines, international air travel, etc. are examples of normal luxury.
DEMAND ANALYSIS
91
Inferior Goods
A good is an inferior good if its income elasticity is negative. This means that when income rises,
quantity demanded falls. In a recession the demand for inferior products might actually grow
(depending on the severity of any change in income and also the absolute coefficient of income
elasticity of demand). For example, if we find that the income elasticity of demand for cigarettes is
0.3, then a 5% fall in the average real incomes of consumers might lead to a 1.5% fall in the total
demand for cigarettes (ceteris paribus). Frozen vegetables, cigarettes, processed cheese, margarine,
bus travel are examples of inferior goods.
As income of the consumer increases from Rs. 3000 to Rs. 4,000, quantity demanded
increases from 1 to 2 units for superior goods, whereas for inferior goods demand decreases from 5
to 4 units. This is presented in Table 2.13.
Table 2.13 Income demand schedule
Income (Rs.)
Demand for superior goods
Demand for inferior goods

3000
15
4000
2
4
5000
3
3
6000
4
2
7000
5
1
Normal goods have positive income elasticities; inferior goods have negative income
elasticities. Some other major features are:
1. If the income elasticity exceeds 1.00, an increase in income increases demand more
than proportionally. Luxuries often have income elasticities of demand larger than
1.00.
2. If the income elasticity is positive but less than 1.00, an increase in income increases demand but
by a smaller proportion. Necessities frequently have positive income
elasticities of demand smaller than 1.00.
3. If the income elasticity is negative, an increase in income decreases the demand for
the product.
Inferior: Ei < 0
Normal: Ei > 0
Types of income elasticity of demand
1. Positive income elasticity of demand ( Ei > 0)
2. Zero income elasticity of demand ( Ei = 0)
3. Negative income elasticity of demand ( Ei < 0).
Positive Income Elasticity.
When the demand of a commodity increases with increase in
income and vice versa, then it is called positive income elasticity of demand.
92
The income demand curve will be shown as positively sloping from left to right as shown
in Fig. 2.22 upwards to the right. The goods which come under this type are called normal goods.
Fig. 2.22 Positive income elasticity.
Zero Income Elasticity.
When the demand for a commodity does not respond to changes in
income, it is referred to as zero income elasticity. For example, if a consumer income rises from Rs.
5,000 to Rs. 6,000, he consumes the same quantity of salt; thus the demand for salt does not change
due to change in consumers income. The zero income elasticity is shown in Fig. 2.23(a).
Negative Income Elasticity.
When the demand of a commodity diminishes with an increase
in income of the consumer, it is said to be negative income elasticity (see Fig. 2.23(b)). The goods
which come under this type are inferior goods.
Fig. 2.23(a) Zero income elasticity.
Fig. 2.23(b) Negative income elasticity.
The cross-elasticity of demand shows how the demand for a good reacts to a change in the price of
another product. It measures the responsiveness of demand for a product to a change in the price of
other related products. The cross-elasticity of demand equals the percentage change in DEMAND
ANALYSIS
93
the quantity demanded of the good divided by the percentage change in the price of the other good.
That is,
Percentage change in quantity demanded of good A
Cross-elasticity of demand =
Percentage change in price of good B
We normally focus on the links between changes in the prices of substitutes and complements.
The cross elasticity of demand for substitute goods is negative (see Fig. 2.24); the cross-elasticity of
demand for complementary goods is positive (see Fig. 2.25).
Y
Price of
good Y
X
O
Quantity demanded of good X
Fig. 2.24 Income elasticity of substitutes.
Y
Price of
good Y
X
O
Quantity demanded of good X

Fig. 2.25 Income elasticity of complements.
The main use of cross-price elasticity concerns changes in the prices of substitutes and
complements. With substitute goods such as brands of cereal or washing powder, an increase in the
price of one good will lead to an increase in demand for the rival product. Cross-price elasticity will
be positive. In recent years, the prices of new cars have been falling. This should increase the
demand for new cars and reduce the demand for second-hand cars and mass
transport services such as bus travel (ceteris paribus).
94
With goods that are in complementary demands such as the demand for DVD players and
DVD videos, when there is a fall in the price of DVD players we expect to see more DVD
players bought, leading to an expansion in market demand for DVD videos.
When there is no relationship between two products, the cross-price elasticity of demand
is zero.
good 1
%' Q
Substitutes
d
F
!0
d
good 2
%' P
good 1
%' Q
Complements
d
F
0
d
good 2
%' P
Advertising occupies an importance place in a competitive market economy. One of the factors which
influences demand is advertising. How far the demand for a product will be influenced by
advertisement and other promotional activities may be measured by advertising elasticity of demand.
The promotional elasticity measures the responsiveness of demand to changes in
advertising or other promotional expenses. The formula for advertising elasticity of demand is: Q Q
2
1
Proportionate change in sales
QQ
2
1
F
a
Proportionate change in advertising expenditure
AA
2
1
AA
2
1
where
Q stands for sales
A stands for advertising expenditure.
Factors Determining Promotional Elasticity of Demand
The various determinants of advertising elasticity of demand are as follows:
State of Product Market.
Advertising expenditure will be high when the product is in initial
and mature stages and low in growth and decline stages. The advertising given during initial and
maturity stages is for information and remind the customers about the product.
Type of Product.
Advertising elasticity will tend to be higher for luxuries than for
necessities.
Competitors.
The advertising elasticity depends upon the effectiveness of advertising. It
depends upon how the other competitors react to the advertising campaign of this firm.
Market Share.
The larger the firms market share, the lower the advertising elasticity of
demand is likely to be, and vice versa.
DEMAND FORECASTING
Forecasting is an integral part of almost all business enterprises. Forecasting is the process of
predicting the future. In other words it is the estimation of the value of a variable (or set of DEMAND
ANALYSIS
95
variables) at some future point in time. A forecasting exercise is usually carried out in order to
provide an aid to decision-making and in planning the future. Typically all such exercises work on the
premise that if we can predict what the future will be like we can modify our behaviour now to be in
a better position, than we otherwise would have been, when the future arrives. Applications for
forecasting include:
Inventory Control/Production Planning.
Forecasting the demand for a product enables us
to control the stock of raw materials and finished goods, plan the production schedule, etc.
Investment Policy.
Forecasting financial information such as interest rates, exchange rates,
share prices, the price of gold, etc. This is an area in which no one has yet developed a reliable
(consistently accurate) forecasting technique (or at least if they have they havent told anybody!)
Economic Policy.
Forecasting economic information such as the growth in the economy,
unemployment, the inflation rate, etc is vital both to government and business in planning for the
future.
Forecasts are needed throughout an organizationand they should certainly not be
produced by an isolated group of forecasters. Neither is forecasting ever finished. Forecasts are
needed continually, and as time moves on, the impact of the forecasts on actual performance is
measured; original forecasts are updated; and decisions are modified, and so on.
Forecasting is based on a number of assumptions:
1. The past will repeat itself. In other words, what has happened in the past will happen again in the
future.
2. As the forecast horizon shortens, forecast accuracy increases. For instance, a forecast for
tomorrow will be more accurate than a forecast for next month; a forecast for
next month will be more accurate than a forecast for next year; and a forecast for
next year will be more accurate than a forecast for ten years in the future.
3. Forecasting in the aggregate is more accurate than forecasting individual items. This
means that a company will be able to forecast total demand over its entire spectrum
of products more accurately than it will be able to forecast individual stock-keeping

units (SKUs). For example, General Motors can more accurately forecast the total
number of cars needed for next year than the total number of cars needed for five
or ten years in the future.
4. Forecasts are seldom accurate. Furthermore, forecasts are almost never totally
accurate. While some are very close, few are right on the money. Therefore, it is
wise to offer a forecast range. If one were to forecast a demand of 100,000 units
for the next month, it is extremely unlikely that demand would equal 100,000
exactly. However, a forecast of 90,000 to 110,000 would provide a much larger
target for planning.
Passive Forecasts and Active Forecasts
There are two kinds of forecasts: passive forecasts and active forecasts. Passive forecasts predict the
future situation in the absence of any action by the firm while active forecasts estimate the 96
future situation taking into account the likely future actions of the firm. For example, a firm takes no
policy action to influence its future sales, then measures sales. This gives a passive sales forecast
which may not be desirable. A firm desires to initiate some actions with a view to influence its future
sales. This gives the active forecasts. A business firm would be interested in both passive and active
forecasts. Just these two may not be enough; the firm may like to examine the sensitivity of its sales in
relation to a host of its alternative policy decision. For example, a firm may wish to predict its sales
at different prices for its product, at different prices of substitutes and complement products, different
advertisements, different incomes, etc.
All this is essential for any firm to survive in the marketplace.
Making a Forecast
William J. Stevenson lists the following as the basic steps in the forecasting process (see Fig. 2.26):
Step 1: Determine the forecasts purpose
Step 2: Establish a time horizon
Step 3: Select a forecasting technique
Step 4: Gather and analyze data

Step 5: Make the forecast
Step 6: Monitor the forecast
Fig. 2.26 Forecasting process.
Determine the Forecasts Purpose.
Factors such as how and when the forecast will be used,
the degree of accuracy needed, and the level of detail desired determine the cost (time, money,
employees) that can be dedicated to the forecast and the type of forecasting method to be utilized.
Establish a Time Horizon.
This occurs after one has determined the purpose of the forecast.
Longer-term forecasts require longer time horizons and vice versa. Accuracy is again a
consideration.
Select a Forecasting Technique.
The technique selected depends upon the purpose of the
forecast, the time horizon desired, and the allowed cost.
Gather and Analyze Data.
The amount and type of data needed is governed by the
forecasts purpose, the forecasting technique selected, and any cost considerations.
Make the Forecast.
Here the forecast is stated and recorded.
Monitor the Forecast.
Evaluate the performance of the forecast and modify, if necessary.
DEMAND ANALYSIS
97
Criteria for the Choice of a Good Forecasting Method
William J. Stevenson lists a number of criteria that are needed for a good forecast:
Accuracy.
Some degree of accuracy should be determined and stated so that comparison can
be made to alternative forecasts.
Reliablility.
The forecast method should consistently provide a good forecast if the user is
to establish some degree of confidence.
Timeliness.
A certain amount of time is needed to respond to the forecast so the forecasting
horizon must allow for the time necessary to make changes.
Ease of Use and Understanding.
Users of the forecast must be confident and comfortable
working with it.
Cost-effectiveness.
The cost of making the forecast should not outweigh the benefits obtained
from the forecast.
Types of Forecasting Problems and Methods
One way of classifying forecasting problems is to consider the timescale involved in the
forecast, i.e., how far forward into the future we are trying to forecast. Short, medium and long-term
are the usual categories but the actual meaning of each will vary according to the situation that is
being studied, e.g. in forecasting energy demand in order to construct power stations 510 years
would be short-term and 50 years would be long-term, whilst in forecasting consumer demand in
many business situations up to 6 months would be short-term and over
a couple of years would be a long-term. Table 2.14 shows the timescale associated with
business decisions.
Table 2.14 Types of business decisions

Timescale
Type of decision
Examples
Short-term (up to 36 months)
Operating
Inventory control, production planning,
distribution, etc.
Medium-term(36 months to 2 years)
Tactical
Leasing of plant and equipment,
employment changes, etc.
Long-term (above 2 years)
Strategic
Research
and
development,
acquisitions and mergers, product
changes, etc.
The basic reason for the above classification is that different forecasting methods apply in each
situation, e.g. a forecasting method that is appropriate for forecasting sales next month (a short-term
forecast) would probably be an inappropriate method for forecasting sales in five years time (a longterm forecast). In particular note here that the use of numbers (data) to which quantitative techniques
are applied typically varies from very high for short-term forecasting to very low for long-term
forecasting when we are dealing with business situations.
98
Selecting a Forecasting Method

There is no single forecasting method that is always more appropriate than other methods. In a sense
forecasting is as much art as science. The factors to be considered while selecting a forecasting
method are:
1. Availability and accuracy of historical data
2. Time available to make the analysis
3. Degree of accuracy expected
4. Length of the forecast period
5. Cost of making the analysis and preparing periodic forecasts.
The choice of a particular forecasting method should be decided by comparing the relative costs and
benefits of each forecasting method.
Methods of Demand Forecasting
Since forecasts play an important role in decision-making, it is crucial to use the best available
technique to minimize forecast inaccuracy. However there is no unique method, which always
guarantees the best result. The choice of a method often depends upon data availability, urgency of
forecast, etc.
Forecasting techniques range from the simple to the extremely complex. There are two
approaches to the problem of business forecasting. One is to obtain information about the intentions of
consumers through collecting experts opinion or by conducting interviews with consumers. The other
is to use past experience as a guide and, by extrapolating past statistical relationships to suggest the
level of future demand. The first method is called qualitative method which is appropriate for shortterm forecasting and the second is called quantitative method which is appropriate for long term
forecasting. The various forecasting methods are given in Table 2.15.
Table 2.15 Forecasting methods
Qualitative techniques
Quantitative techniques
1. Consumer survey method
1. Mechanical extrapolation/Trend projection
(a) Complete enumeration survey method
(a) Fitting trend line by observation

(b) Sample survey method
(b) Time series analysis employing least
(c) End-use method
squares method (linear and non-linear)
(c) Forecasting by decomposing a time
2. Sales force opinion method
series
3. Expert opinion method
(d) Smoothening
methods:
moving
4. Market experiments
averages and exponential smoothening
(a) Experimentation in laboratory
(e) ARIMA method
(b) Test marketing
2. Barometric techniques
3. Statistical methods
(a) Nave models
(b) Correlation and regression method
4. Econometric method
5. Simultaneous equation method
DEMAND ANALYSIS
99
Qualitative Techniques
When sufficient demand data for statistical analysis are not available, it may become necessary to
perform marketing research in which the analyst obtains certain information directly from the
consumer rather than from statistical data. Some of the reasons why direct approaches might be
necessary or desirable are:
1. A new product is being introduced: A direct approach is necessary because no data
exist for statistical analysis.
2. Changes are suspected in qualitative variables, such as taste, preference or consumer
expectations: Statistical data on variables such as price are analysed on the assumption
that such qualitative variables are constant. If they have changed, the statistical data
are meaningless.
3. Market experimentation is necessary: In order to develop a pricing strategy, the firm
needs to determine price elasticities in geographically separate markets.
The following are the description of qualitative techniques for demand forecasting:
Consumer Surveys.
Consumer surveys can be used to ask consumers directly about
buying behaviour, using a number of ways: face-to-face, telephone, direct mail, Internet, spot survey
at store checkout point, etc. For example, the airlines could ask a randomly
selected, statistically valid group of consumers about their travel plans, prices, services,
convenience, feelings toward the competitor, the impact of a recession or expansion on travel plans,
etc.
Consumer surveys are conducted by asking questions of a representative sample of
present or potential buyers. Consumers are asked for their reactions to hypothetical changes in
demand variables such as price, income, prices of substitutes and complements products,
advertising expenditures, etc. Consumers expectations regarding future prices, inflation, income, and
the availability of substitutes goods can have a strong influence upon the demand function.
Consumer survey can be done in three ways: This may be attempted with the help of
complete survey of all consumers (called complete enumeration), or by selecting a few consuming
units out of the relevant population (called sample survey). In case the commodity under
consideration is an intermediate product, then the industries using it is as end product (called end-use
method) are surveyed.
Complete Enumeration Survey Method.
Under this method, the forecaster undertakes
a complete survey of all consumers of the commodity whose demand he wishes to forecast. He asks
every consumer the amount of that commodity he would like to buy in the forecast period.
Once this information is collected, the sales forecasts are obtained by simply adding the probable
demands of all consumers. For example, if there are n consumers and their probable demands for
commodity X in the forecast period are x 1, x 2, x 3, x 4, , xn, the sales forecast would be:
X = x 1 + x 2 + x 3 + x 4, , xn
100
Merits
Demerits
1. First-hand unbiased information (forecaster
1. It is tedious, cumbersome and costly.
does not introduce any bias of his own, he
just collects information and aggregates).
2. Sales forecast is usually be accurate.
2. At times, consumers may not reveal their
purchase plan because of personal
privacy.
3. Suitable for products having a small number
3. Strong possibility of data error (i.e. there is
of consumers.
a risk that the data may have been wrongly

recorded and compiled).
4. Not feasible for products having numerous
consumers.
Sample Survey.
Under this method, the forecaster selects a few consuming units out of
the relevant population and then obtains the probable demands of each of the selected units in the
forecast period. The total demand of sample units are added to get the total demand of all consumers.
For example, there are 10,000 consumers of good X, the forecaster may choose, 500 consumers out of
these. If the probable demands of these selected units in the prediction period are x 1, x 2, x 3,, X
500, respectively, the forecast for aggregate demand will be given by: n 1 x 1 + n 2 x 2 + n 3 x 3 +
+ n 500 x 500
Merits
Demerits
1. Less tedious and less costly
1. Inaccuracy in case of non-cooperation
2. Less data error
from the selected consumer units.
3. Yield good results if a sample is properly
2. The test must be continued for long period,
chosen.
otherwise false predictions may be made.
4. Most appropriate method for new products/
3. It is difficult to select a test area which
brands.
is typical of the total market.
4. The larger the sample size, the more
tedious and costly the survey is.

End-use Method.
In this method, the sale of the product under consideration is projected
on the basis of demand survey of the industries using this product as an intermediate product.
For example, the forecasts of demand for cement in India in 2006 can be obtained as:
( S)2006 = ( Sc)2006 + ( Se)2006 ( Sm) 2006 + as 1 ( X 1)2006 + as 2 ( X2)2006 + + asn(
Xn)2006
where
S = Aggregate cement demand,
Sc = Final consumption demand for cement,
Se = Export demand for cement,
Sm = Import of cement,
XI = Output of industry I using cement as its intermediary good,
asi = Cement requirement of industry I per unit of its output,
i = 1, 2, n, and subscript 2006 stand for the year to which the data belongs, and S 2006 =
Aggregate cement demand in the year 2006
DEMAND ANALYSIS
101
Merits
Demerits
1. It provides sector-wise demand forecasts.
1. It is costly and time consuming.
2. It yields accurate predictions.
2. It requires complex and diverse calculations.
3. Information may be useful in manipulating
3. It requires every industry to furnish its

future demand.
plan of production correctly and in advance.
4. It does not require any historical data.
Sales Force Opinion Method.
This method is also known as collective opinion or reaction
survey method. Under this method the salesmen have to report to the head office of their estimates of
expectations of sales in their territories. Such information can also be obtained from the retailers and
wholesalers by the company. By aggregating these forecasts a
generalization on an average is made, which is also based on the value judgement and collective
wisdom of top sales executives, the marketing manager and the business or managerial
economist. Sometimes even experts opinion is obtained from the dealers, distributors,
suppliers, or from the executives of trading associations, or marketing consultants.
Merits
Demerits
1. It is cheaper and easy to handle as it
1. It is subject to bias of reporting agency.
does not involve any elaborate statistical
2. It is subjective.
measurement.
3. Its accuracy depends on intelligence of the
2. It is less time-consuming.
reporting salesman.
3. It is based on value judgement of the
4. It cant be relied upon for long-term
salesmen.
business planning.
4. It is useful for forecasting demand for
5. The sales force may give biased views
new products.
as the projected demand affects their future
job prospects.
Expert Opinion Method.
Under this method, views are obtained from a group of specialists
outside the firm. Delphi method is one of the examples of expert opinion method. Delphi
technique involves asking a body of experts to arrive at a consensus opinion as to what the future
holds.
Merits
Demerits
1. It is simple to conduct.
1. Possibility of divergent views due to lack
2. Best suited in situations where
of basic data in experts.
intractable changes are occurring.
2. Experts may be biased.
3. The forecast is reliable as it is based on
3. It is subjective.
the opinion of people who know the product
well.
4. It is inexpensive and less time-consuming.
Market Experiments.
A market experiment is performed under actual market conditions.

The markets chosen for an experiment must be similar yet segregated from one another. The 102
firm may take different demand determinants in these markets and noting results. For example, the
firm might charge different prices in different markets and compare results. With the help of
demographic factors, firms can perform experiments in several markets to determine how demand is
affected by characteristics such as age, occupation, educational status, size of the family etc. Market
experiments must be conducted on a scale sufficiently large to ensure
validity of the results, even though experimentation on a large scale is very expensive and can be
quite risky.
There are two types of market experimentation:
(a) Experimentation in laboratory
(b) Test marketing.
Experimentation in Laboratory.
In this method a small laboratory is formed by
creating an artificial market situation. To study consumer reaction to a change in demand variables, in
the controlled conditions of the consumer clinic, the selected consumers are given a small amount of
money and asked to buy certain items. The consumer behaviour in the clinic is thus observed and
inferences are drawn.
Merits
Demerits
1. It can study consumer reactions to a
1. It is expensive and time-consuming
change in demand variables.
method.
2. It can be observed and inferences can be
2. The stimulated market situation may not
drawn.
be fully representing the actual market

situation.
Test Marketing.
In this method, a market experiment is performed under actual market
conditions. The firm conducts the experiment in the selected market, under controlled
conditions, by varying one or more of demand determinants like price, advertisement, etc.
Consumer behaviour in the market is then observed and recorded.
Merits
Demerits
1. Acceptability of the product can be judged
1. It is very expensive method.
in a limited market.
2. It reveals the quality of the product to the
2. Demand is estimated on the basis of actual
competitors before it is launched in the
purchases.
market.
3. Customer psychology is more focussed.
3. It is quite risky method.
4. It is difficult to plan market experimentation
under heterogenous market conditions.
5. It is difficult to know the influence of
price on demand, as other demand
determinants are also likely to change
along with the price change.

DEMAND ANALYSIS
103
Quantitative Techniques
The following are the quantitative techniques:
Mechanical Extrapolations (or Trend Projection) Method.
Extrapolation techniques are
essentially mechanical and are not closely integrated with relevant economic theory and
statistical data. These methods are based on the past sales pattern. They are used when the available
sales data relate to different time period. It is therefore, known as time series analysis or trend
projection method, and is based on the assumption that future events are a continuation of the past, and
therefore historical data can be used to predict the future.
A time series is a sequence of values corresponding to particular points or periods of time.
Data such as sales, production and prices, when arranged chronologically, are thereby ordered in
time and hence are referred to as time series. Time series techniques examine the past behaviour of a
phenomenon over time, and use this historical analysis to forecast future
behaviour. This can be done as in the following example:
The historical analysis may demonstrate a linear trend.
The linear trend is removed to determine the underlying variation.
There may then be a seasonal variation, which is identified and removed.
The remaining variations can then be identified as random and quantified. This variation may well
have an assignable cause, but we are stating that at present we do not know
what that is and are just measuring the spread of the variation to assist in future
forecasting.
Future demand is therefore predicted taking into account trends, seasonal factors and
baseline variation.
This type of forecasting is accurate for most short-term applications. For example, by using this
technique it can be shown that most demand for emergency care is highly predictable. It comprised
seasonal, daily variations and other linear trends. This knowledge allows for more effective
deployment of capacity, and also provides an opportunity to reshape services at times of low demand.
The simple line chart is the most common graphic device for depicting a time series, with the
dependent variable such as sales or production or prices scaled on the vertical axis, and the
independent variable, time, expresses in years or months or any other temporal measure, scaled on the
horizontal axis.
Components of Time Series.
The four major components of time series are:
(i) Trend ( T)
(ii) Seasonal variations ( S)
(iii) Cyclical variations ( C)
(iv) Irregular forces ( I).
Trend represents the long-run growth or decline of the series.
Seasonal variations due to weather and customs manifest themselves during the same approximate
time-periods each year.
Cyclical variations, covering several years at a time, reflect economic prosperities and recessions.
104
Irregular forces such as strikes, wars, and boycotts are erratic in their influence on a particular series
but nevertheless must be recognized.
Of the four forces affecting economic time series, the seasonal factor is fairly easy to
measure and predict. The irregular factor is unpredictable but can be adjusted by a smoothing-out
process such as a moving average. Hence the trend, which represents persistent growth or decline and
cyclical variation, which is presumably recurrent, have occupied the chief attention of forecasters
using time-series analysis.
Merits
Demerits
1. It is very simple.
1. Based on the assumption that past rate of

2. It yields good forecasts.
change of the variable under forecast will
3. It is quick and inexpensive.
continue in the future.
4. It does not require the knowledge of
2. Inappropriate for short-term forecasts.
economic theory and the market.
3. It cant explain the turning points of
5. It needs the time series data only on the
a business cycle.
variable whose future values are to be
4. There is no analysis of casual relations
forecast.
between the demand and time series.
6. Appropriate for long term forecasts.
Methods of Trend Projection
(a) Fitting trend line by observation
(b) Least squares method
(c) Forecasting through decomposing a time series
(d) Smoothing methods
Moving averages
Exponential smoothening
(e) ARIMA method.
Fitting a trend line by observation involves merely the plotting of actual sales data on a chart and
then estimating just by observation where the trend line lies. The line can be extended towards a
future period and corresponding sales forecast is read from the graph.
Least squares method uses statistical formula to find the trend line which best fits the available
data. The trend line is the estimating equation, which can be used for forecasting demand by
extrapolating the line for future and reading the corresponding values of sales on the graph. The
estimating linear trend equation of sales is written as:
Sales = a + b (year number)
or
S = a + bT
where a and b are the constants representing the intercept and slope respectively of the estimated
straight line. In order to determine the values of a and b, the following two normal equations need to
be solved:
S S = Na + b S T
S ST = a S T + b S T 2
where N represents number of years or months for which data is available.
DEMAND ANALYSIS
105
Illustration 2.3: The annual sales of a company are as follows:
Year
2001
2002
2003
2004
2005
Sales (in 000s)
45
56
58
46
75
Using the method of least squares, estimate sales for the year
Solution
Year
Sales (S)
t
t2
St
200145
1 1 45
2002
56
2
4
112
2003
58
3
9
174
2004
46
4
16
184
2005
75
5
25
375
N=5
S x = 280
St=15
S t 2 = 55
S St = 890
Take normal equations
S S = Na + b S t
(1)
S ST = a S t + b S t 2
(2)
Substituting the computed values, we have:
280 = 5 a + 15 b
(3)
890 = 15 a + 55 b
(4)
For solving them, let us multiply Eq. (3) with 3 and subtracting from Eq. (4), we get
840 = 15 a + 45 b
890 = 15 a + 55 b
840 = 15 a + 45 b
50 = 10 b
50
or
b=
5
10
Substituting the value of b in Eq. (3), we get
280 = 5 a + 15(5)
or
280 75 = 5 a
or
205 = 5 a
or
a = 41
106
Thus the trend equation becomes S = a + bT, or
S = 41 + 5 T
The years 2009 and 2010 take on the year numbers 9 and 10. By substituting these values for T, we
get the forecasted sales for these years as Rs. 86,000 and Rs. 91,000 respectively.
Forecasting by decomposing a time series requires the data available quarterwise or monthwise, as
it is possible then to identify the seasonal effect. And if this data is available for a sufficiently long
period of time, the trend and cyclical effects can also be found out.
Smoothing techniques can be of two kinds:
(i) Moving averages
(ii) Exponential smoothing.
Moving averages:
Seasonal variation can be incorporated routinely into forecasts by
means of a seasonal index, which can be calculated by a moving-average technique. A moving
average is calculated by adding each periods value over some desired length of time and then
dividing by the number of periods.
Another simple technique is the use of averaging. To make a forecast using averaging, one simply
takes the average of some number of periods of past data by summing each period and dividing the
result by the number of periods. This technique has been found to be very effective for short-range
forecasting.
Variations of averaging include the moving average, the weighted average, and the
weighted moving average. A moving average takes a predetermined number of periods, sums
their actual demand, and divides by the number of periods to reach a forecast. For each
subsequent period, the oldest period of data drops off and the latest period is added. Assuming a
three-month moving average and using the data from Table 2.16, one would simply add 45
(January), 60 (February) and 72 (March), and divide by three to arrive at a forecast for April: 45 60
72 177
59
3
3
To arrive at a forecast for May, one would drop Januarys demand from the equation and add the
demand from April.
Table 2.16 Three-month moving average forecast
Period
Actual demand (000s)

Forecast (000s)
January
45
February
60
March
72
April
58
59
May
40
63
June
57
DEMAND ANALYSIS
107
Merits
Demerits
1. It is simple to use and easy to understand.

1. Forecaster has to retain a great deal of
data.
2. It gives the best possible trend values.
2. All data in the sample are weighed equally.
Exponential Smoothing: The forecasting method called exponential smoothing gets around the
above limitations. The averaging method takes the previous n periods actual demand, calculates the
average demand over the n periods and uses this average to forecast the next periods demand. The
main drawback of this approach is that in its basic form it gives similar weight to all the previous n
periods. It also only uses data from the n periods. Both these problems can be overcome by using the
exponential smoothing technique.
Exponential smoothing forecasts demand in the next period by taking into account the
actual demand in the current period and the forecast, which was previously made for the current
period. In this way the previous data has a diminishing effect on the next forecast.
ARIMA method was developed by Box and Jenkin. This method of forecasting uses autoregressive
integrated moving averages (ARIMA). This method is highly suitable to situations where the inherent
pattern in the underlying series is highly complex and difficult to
understand.
Barometric Techniques.
Mechanical methods of forecasting, particularly time-series
analyses, are used under the assumption that the future is an extension of the past, the use of
barometric techniques is based on the idea that the future can be predicted from certain
happenings in the present. Whereas barometric methods involve the use of statistical
indicatorsselected time series that, when used in conjunction with one another or when
combined in certain ways, provide an indication of the direction in which the economy, or a
particular industry or product, is heading. The series chosen thus serve as barometers of economic
change.
There are three kinds of relationships among economic time series:
(i) Leading series
(ii) Coincident series, and

(iii) Lagging series.
A leading series consists of the data that move ahead of the series being compared. For
example, applications for the amount of housing loan over time is a leading series for the demand of
construction material. When data in series moves up and down along with some
other series, it is known as coincident series. For example, a series of data on national income is
often coincident with the series of employment in an economy. When the data moves up and down
behind the series being compared, it is known as a lagging series. For example, data on industrial
wages over time is a lagging series when compared with series of price index for industrial workers.
108
Merits
Demerits
1. It is a simple method.
1. It can be used for short-term forecasts only.
2. It predicts directional changes quite
2. It does not predict the magnitude of changes
accurately.
very well.
3. Finding out a leading indicator for any series is
not always feasible.
4. The lead time is maintained consistently by
a very few time series.
Statistical Methods. These can be of two kinds:
(i) Naive models
(ii) Correlation and regression methods.
Naive Models.
Nave forecasting models are based exclusively on historical observation
of sales or other variables (see Table 2.17).
Table 2.17 Naive forecasting
Period
Forecast (000s)
January
45
February
60
45
March
72
60
April
58
72
May
40
58
June
40
Merits
Demerits
1. It is very simple.
1. It doesnt consider any possible causal
2. It is inexpensive to develop, store data and
relationships that underlie the forecasted
operate.
variable.
2. It is based on the assumption that past
trend follows in the future also.
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. Of these two variables, one is dependent variable and the other is an
independent. If the high values of one variable are associated with the high values of another, they are
said to be positively correlated ( r > 0). For example, if the sales have increased due to rise in the
advertising expenditure, we can say that the sales and advertisement are positively correlated.
Similarly, if the high values of one variable are associated with the low values of another, then they
are said to be negatively correlated ( r < 0). For example, if DEMAND ANALYSIS
109
the price of a product has reduced and as a result, there is increase in its demand, the demand and the
price are negatively correlated.
Correlation analysis can be of two types:
(i) Simple or partial correlation. When only one independent variable (say, income) is taken to
explain variations in dependent variable (say, sales).
(ii) Multiple correlation. When there are more than one independent variable (say income, price,
advertisement, etc.) taken to explain variations in dependent variable
(say, sales).
To know the closeness of variables, we find the correlation coefficient ( r) by the following
formula:
N 6 XY 6 X 6 Y
r
2
2
2
2
[ N 6 X (6 X) ][ N 6 Y (6 Y ) ]
6 xy
r
2
2
6x6y
where,
x = deviation of X from its assumed mean;
y = deviation of Y from its assumed mean;
S = sign of summation;
N = number of items in each set of variables.
Higher the value of r, greater is the closeness of the variables X and Y. For example, by finding such
values of r for each of the independent variable with the dependent variable (say, sales) and
comparing them, we can identify a set of independent variables which vary closely with the
independent variable.
Illustration 2.4: Find the correlation coefficient from the following data:
Year
1999
2000
2001
2002
2003
3004
2005
Sales (000)
150
152
154
157
155
162
150
Advertisement (000)
60
54
56
52
54
75
100
Solution:
Year
Sales (X) x = ( X X )
x2
Adv. (Y) y = ( Y Y )
y2
xy
2000
172
8
64
60
0
0
480
20011
74
6
36
56
4
1
6
336
2002
177
3
9
58
2
4
174
2003
175
5
25
54
6
36
270
2004
182
2
4
56
4
16
112
2005
200
20
200
76
16
256
1520
S X = 1080
Sx=0
S x 2 = 538 S Y = 360
Sy=0
S y 2 = 328 S xy = 372
110
6X
1080
X
180
N
6
6Y
360
Y
60
N
6
6 xy
372
372
r
0.885
2
2
420
538
66
328
x
y
Since the value of r is greater than 0.5 it implies that there is a strong tendency for variation in sales
and advertisement. It implies that when advertisement expenditure increases the sales also increases.
There is a positive correlation between these two variables.
Regression Method.
Regression is the study of relationships among variables, a principal
purpose of which is to predict, or estimate the value of one variable from known or assumed values
of other variables related to it.
To make predictions or estimates, we must identify the effective predictors of the variable of interest.
Which variables are important indicators? Which can be measured at the least cost?
Which carry only a little information? Which are redundant? Predicting a change over time or
extrapolating from present conditions to future conditions is not the function of regression analysis. To
make estimates of the future, use time series analysis. Begin with a hypothesis about how several
variables might be related to another variable and the form of the

relationship.
These are statistical techniques to determine the best fit expression, which describes the
relationship between the variable being forecast and other variables. For instance, by
determining the relationship between admissions for pneumonia and average daily winter
temperatures, we ought to be able to define the line of best fit the mathematical relationship between
the temperature and cases of pneumonia and so predict what the demand will be.
You have probably already met linear regression where a straight line of the form
Y = a + bX is fitted to data. It is possible to extend the method to deal with more than one independent
variable X. Suppose we have k independent variables X 1, X 2, ... , Xk then we can fit the regression
line
Y = a + b 1 X 1 + b 2 X 2 + L + bkXk
This extension to the basic linear regression technique is known as multiple regression.
Plainly knowing the regression line enables us to forecast Y given values for the Xi, where i = 1, 2, K,
k.
A regression using only one predictor is called a simple regression. Where there are two or more
predictors, multiple regression analysis is employed.
DEMAND ANALYSIS
111
Merits
Demerits
1. It is based on causal relationships.
1. It is costly and time consuming.
2. It is prescriptive as well as descriptive.
2. It requires the use of some other forecasting
3. It produces reliable and accurate results.
method to estimate the values of the
explanatory (causal) variables in the

4. It not only forecasts the direction but also
prediction period.
the magnitude of the change.
3. It uses complex calculations.
5. It is quite consistent.
6. Cross-section data may be used to
4. Forecast is on the basis of the past average
predict sales through this method.
relationship.
Econometric Models.
Based on the idea that changes in economic activity can be explained
by a set of relationships among economic variables, there has grown a branch of applied science
known as econometrics. Breaking the word into its two parts, econo and metrics, it is evident that
its subject matter must deal with the science of economic measurement. It explains past economic
activity and predicts future activity by deriving mathematical equations that will express the most
probable interrelationships among a set of economic variables. The economic variables may include
disposable income, money flows, inventories, government revenues and expenditures etc. By
combining the relevant variables, each a separate series covering a past period of time, into what
seems to be the best mathematical arrangement, econometricians
predict the future course of one or more of these variables on the basis of the established
relationships.
Econometric methods, such as autoregressive integrated moving-average model (ARIMA),
use complex mathematical equations to show past relationships between demand and variables that
influence the demand. An equation is derived and then tested and fine-tuned to ensure that it is as
reliable a representation of the past relationship as possible. Once this is done, projected values of
the influencing variables (income, prices, etc.) are inserted into the equation to make a forecast.
Merits
Demerits
1. It explains past economic activity and predicts

1. It uses complex mathematical equations.
future activity by deriving mathematical
equations.
2. It is time consuming.
2. It expresses the most probable
interrelationships among a set of economic
variables
Simultaneous Equations Model.
The simultaneous equations method, also called the
complete system approach of forecasting is a very sophisticated statistical method of forecasting.
It involves the development of a complete model which can explain the behaviour of all the variables
which the decision unit, firm or industry can control. The number of equations in such a model equals
the number of dependent (controllable) variables. Inevitably, certain outside forces, exogenous
variables, also affect the behaviour of dependent (endogenous)
variables.
112
There are many relatively uncomplicated problems in business and economics that can be
solved by expressing the underlying structure in the form of a single mathematical equation.
Merits
Demerits
1. The forecaster needs to estimate the future
1. It assumes that past statistical relationvalues of only the exogenous variables.
ships will hold good in the prediction
2. The values of exogenous variables are

period.
supposed to be easier to predict than those of
2. It is highly complicated, rather time
endogenous variables.
consuming and costly method.
3. It requires historical data on all the
variables concerning the decision unit.
There is no unique method for forecasting the sales of any commodity or any other variable.
The forecaster may try one or the other method depending upon his objective, data availability, the
urgency with which forecasts are needed, resources he intends to devote to this work, and the type of
commodity whose demand he wants to forecast.
MARKET STRUCTURES
The market is a set of conditions in which buyers and sellers come in contact for the purpose of
exchange. In economics, however, the term market does not refer to a particular place as such but it
refers to a market for a commodity or commodities. In the words of Cournot, a French economist,
Economists understand by the term market not any particular market place in which things are bought
and sold but the whole of any region in which buyers and sellers are in such free intercourse with one
another that the price of the same goods tends to equality easily and quickly.
Thus, the essentials of a market are: (a) a commodity which is dealt with; (b) the existence of buyers
and sellers; (c) a place, be it a certain region, a country or the entire world; and (d) such intercourse
between buyers and sellers that only one price should prevail for the same commodity at the same
time.
Markets may be categorized into product market and factor market. A product market or
commodity market refers to an arrangement in effecting buying and selling of commodities.
A factor market is one in which factors of production such as land, labour and capital are transacted.
Market Structure Concept
The concept of market structure is central to both economics and marketing. Both disciplines are
concerned with strategic decision-making. In decision-making analysis, market structure has an
important role through its impact on the decision-making environment. The extent and
characteristics of competition in the market affect choice behaviour among the actors. Market
structure refers to all characteristics of a market that influence the behaviour of buyers and sellers
when they come together to trade.
DEMAND ANALYSIS
113
Determinants of Market Structure
The key factors in defining a market structure are:
(a) Short-run and long-run objectives of buyers and sellers in the market
(b) Beliefs of buyers and sellers about the ability of themselves and others to set prices (c) Degree of
product differentiation
(d) Technologies employed by agents in the market
(e) Amount of information available to agents about the good and about each other
(f) Degree of coordination or noncooperation agents may exhibit
(g) Extent of entry and exit barriers.
A buyer or seller (agent) is said to be competitive if the agent assumes or believes that the market
price is given and that the agents actions do not influence the market price. We
sometimes say that a competitive agent is a price taker.
In economics, markets are classified according to the structure of the industry serving the market.
Industry structure is categorized on the basis of market structure variables, which are believed to
determine the extent and characteristics of competition. Those variables, which have received the
most attention, are number of buyers and sellers, extent of product substitutability, costs, ease of entry
and exit, and the extent of mutual interdependence.
Markets may be classified on the basis of different criteria, such as geographical space or area, time
element and the nature of competition (see Fig. 2.27). The classification of different types of market
structures are as follows:
Area
Time element
Competition
Local market
Very short period market
Perfect competition
Regional markets
Short period market
Imperfect competition
National markets
Long period market
1. Monopoly
World markets
Very long period market
2. Oligopoly
3. Monopolistic competition
Fig. 2.27 Market classification criteria.
Perfect competitionmany sellers of a standardized product;
Monopolistic competitionmany sellers of a differentiated product;
Oligopolyfew sellers of a standardized or a differentiated product; and
Monopolya single seller of a product for which there is no close substitute. Also see Table 2.18.
114
Perfect and Imperfect Markets
A market is said to be perfect when all the potential sellers and buyers are promptly aware of the
prices at which transaction takes place and all the offers made by other sellers and buyers, and when
any buyer can purchase from any seller and conversely. On the other hand, a market is said to be
imperfect when some buyers or sellers or both are not aware of the offers being made by others.
Naturally, therefore, different prices come to prevail for the same commodity at the same time in an
imperfect market. In a perfect market, on the other hand, the same price rules throughout the market.
These four market structures each represent an abstract (generic) characterization of a type of real
market.
Table 2.18 Types of market structure
Type of
Number
Similar or
Cost of
Barriers Examples
Special
market
of firms
differentiated
information
to entry
characteristics
products
Perfect
Many
Identical
Low
Low
Financial
Economic profits equals
competition
markets, etc. zero in the long run.
Price equals marginal
cost and, in the long
run, the minimum of the
average total cost.
Monopoly
One
Identical
Low
High
Public
Economic profit can
utilities like
exceed zero in the long
telephone,
run. Price exceeds
electricity,
marginal cost and there
etc.
is deadweight loss
due to an underprovision of output.
Monopolistic
Many
Differentiated
Costly
Low
Restaurants,
Economic profit equals
competition
retail serzero in the long run.
vices, manu- Price exceeds marginal
facturing: tea, cost but is less than the
toothpaste,
minimum of average
TV sets,
total cost.
shoes, refrigerators, etc.
Oligopoly
Few
Similar or
Small to
High but Wholesale,
There is indeterminate
differentiated
significant
not
construction
firm behaviour as there
impossi- energy,
is an incentive to
ble
manufacturcompete or collude.
ing, computing
Perfect Competition
Perfect competition refers to the market structures where competition among the sellers and buyers
prevails in its most perfect form. In the perfectly competitive market, a single market DEMAND
ANALYSIS
115
price prevails for the commodity, which is determined by the forces of total demand and total supply
in the market. The terminology Perfect Competition is quite common but not quite universal. The
term Pure Competition is also sometimes used. The term P-Competition, is used where P can stand
for perfect, pure or price competition.
Characteristics of Perfect Competition
A perfect competitive structure is defined by certain characteristics. For an industry to have a perfect
competitive structure, it must have all the characteristics given below:
Many Buyers and Sellers.
A perfectly competitive industry contains a large number of small
firms, each of which is relatively small compared to the overall size of the market. This ensures that
no single firm can exert market control over price or quantity. If one firm decides to double its output
or stop producing entirely, the market is unaffected. The price does not change and there is no
discernible change in the quantity exchanged in the market.
Homogenous Product.
Each firm in a perfectly competitive market sells an identical
product, what is often termed homogeneous goods. The essential feature of this characteristic is not
so much that the goods themselves are exactly or perfectly the same, but that buyers are unable to
discern any difference. In particular, buyers cannot tell which firm produces a given product. There
are no brand names or distinguishing features that differentiate products.
Perfect Knowledge of Market Conditions.
In perfect competition, buyers are completely
aware of sellers prices, such that one firm cannot sell its good at a higher price than other firms.
Each seller also has complete information about the prices charged by other sellers so they do not
inadvertently charge less than the going market price. Perfect knowledge also extends to technology.
All perfectly competitive firms have access to the same production techniques. No firm can produce
its good faster, better, or cheaper because of special
knowledge of information.
Free Entry and Exit of Firms.
Perfectly competitive firms are free to enter and exit an
industry. They are not restricted by government rules and regulations, start-up cost, or other barriers
to entry. While some firms incur high start-up cost or need government permits to enter an industry,
this is not the case for perfectly competitive firms. Likewise, a perfectly competitive firm is not
prevented from leaving an industry as is the case for government-regulated public utilities.
Perfect Mobility of Factors of Production.
A necessary assumption of perfect competition
is that factors of production are perfectly mobile. Perfect mobility of factors alone can ensure easy
entry or exit of the firms.
Government Non-intervention.
Perfect competition also implies that there is no government
intervention in the working of market economy. There are no tariffs, subsidies, control on supply of
raw material, licensing policy or other government interference. Government non-intervention is
essential to permit free entry of firms and for automatic adjustment of demand and supply through the
market mechanism.
116

Absence of Transport Costs Element.
It is essential that competitive position of no firm is
adversely affected by the transport cost differences. It is thus assumed that there is absence of
transport cost as all firms are closer to the market or there is equal transport cost faced by all, as all
firms are supposed to be equally far away from the market.
Equilibrium of the Firm and Industry under Perfect Competition
Equilibrium indicates a situation in which there is a complete adjustment of the various forces
operating there, and there is no inducement to change. The consumer is said to be in
equilibrium, when he derives maximum satisfaction.
A firm is said to be in equilibrium when it has no incentive either to expand or to contract its output.
A firm would not like to change its level of output only when its total profits are maximum. A rational
entrepreneur will expand output if he thinks he can increase his total profits and he will contract his
output if he thinks he can avoid losses and thus increase his total profits. Hence, making a maximum
profit or incurring a minimum loss is an important condition of a firms equilibrium.
The equilibrium of the firm is usually discussed in terms of marginal cost and marginal
revenue. Before the conditions of equilibrium of a firm are explained, it is necessary to describe the
concept of marginal revenue and its relation with average revenue.
Average revenue and marginal revenue. Average revenue is the revenue per unit of the commodity
sold. It is found by dividing total revenue by number of units sold. But, since different units of a
commodity are sold at the same price in the market, average revenue equals the price at which the
commodity is sold. Thus, average revenue means price. It is revenue for the seller and price for the
consumer.
Marginal revenue at any level of the firmss output is the net revenue earned by selling
an additional unit of the product. It is the additions to the total revenue that is earned by selling n units
of product instead of n 1 units, where n is any given number. Marginal revenue can also directly
found by taking out the difference between the total revenue before and after selling the additional
unit.
In a perfect competitive market, whatever the quantity produced and sold, the price would be the
same. Hence, under perfect competition, price = AR = MR. Average revenue and marginal revenue
would be the same in a perfect market.
Marginal cost is the additional cost incurred by a firm for producing one unit in addition to the total
output. Marginal revenue is the additional revenue obtained by a firm by selling one more unit
additionally. The total profits of a firm can be increased by expanding output as long as the addition
to the total revenue is greater than the addition made to the total cost.
That is, a firm increases its output so long as its marginal revenue is more than its marginal cost. The
firm stops production, when MR=MC. Beyond this point, if production is expanded the MC would be
greater than MR and the firm gets loss. Hence, the output is stopped only when MR=MC. The level of
output where MR=MC is the point of maximum profit. Hence the firm attains equilibrium position
when MR = MC. At an equilibrium position the MC curve must cut MR curve from below. If the MC
curve cuts MR curve from above, the firm has scope to increase its output as the MC falls. It is only
with the upward sloping MC curve the firm attains equilibrium. While MC is rising, it cuts MR curve
from below. This can be understood with the help of Fig. 2.28.
DEMAND ANALYSIS
117
Fig. 2.28 Firm's equilibrium position under perfect competition.
In Fig. 2.28, MC curve is cutting the MR curve at two points, namely, at T and R. At both these points
MC=MR. But after the point T the MC is falling and lower than MR. Hence production need not be
stopped at T. Beyond the point R, MC is greater than MR. Hence production cannot be made after R.
Hence the output should invariably be stopped at point R, there MC is cutting MR from below. Hence
R is the point of equilibrium.
Thus we conclude that for a firm to be in equilibrium position, two conditions must be
satisfied under perfect competition:
(i) MC = MR; and
(ii) MC curve must cut MR curve from below at the equilibrium output.
Equilibrium in the Short Run.
The short run has been defined as a period of time sufficient
to allow the firm to adjust its output by increasing or decreasing the amount of variable factors of
production, but during which fixed factors of production cannot be altered. Thus, in the short run, the
size and kind of plant cannot be changed, nor can new firms enter the industry.
In explaining the equilibrium of firm under perfect competition both in the short run and long run, we
assume that all firms are working under identical cost conditions. This means that average cost and
marginal cost curves are identical for all the firms. The entrepreneurs of all the firms are equally
efficient. Further we assume that the factors of production used by the different firms are
homogeneous and are available at given and constant prices.
In the short run a firm may get either super-normal profits, losses or normal profits. All the three
possibilities are discussed in the following lines:

Firms getting super-normal profits.
In Fig. 2.29, at point Q, MC = MR. OM is the
equilibrium output and OP is the equilibrium price. RM is the average cost. The difference between
average revenue and average cost is the profit per unit, i.e., QR ( MQ MR).
\
Total profits = Profits per unit Total output, i.e., total profits = QR OM
QR SR (\ OM = SR) = PQRS.
118
Fig. 2.29 Firm's equilibrium position under super-normal profits.
The area of the rectangle PQRS shows the super-normal profits that a firm can get. As all the firms
are working under identical cost conditions, all firms must be making super-normal profits. As all the
firms in the industry have identical cost curves with the firm represented in the figure, all would be
making super-normal profits.
There will be a tendency for the new firms to enter the industry to compete away these
super-normal profits. But the short run is not a period sufficient for the new firms to enter.
Therefore, the existing firms will continue to earn super-normal profits at the price OP in the short
period.
Thus, with price OP, all the firms in the industry will be in equilibrium at Q but industry, as a whole,
will not be in equilibrium as there will be a tendency for the new firms to enter the industry.
Firms Getting Normal Profits.
Firms get normal profits only when AR=AC. In Fig.
2.30 E is the point of equilibrium where MC=MR. OM is the equilibrium output and OP
is the price. At E the AR=AC. Hence firms must be making normal profits. (Normal profits are
included in average cost curve.) Since all the firms in the industry are making only normal profits,
there will be no tendency either for the new firms to enter or for the existing firms to quit the industry.
Fig. 2.30 Firm's equilibrium position under normal profits.
DEMAND ANALYSIS
119
Thus, even in the short run, the industry will be in equilibrium with price OP and firms producing OM
at point E. In other words, even in the short run, full equilibrium, i.e., equilibrium of all firms as well
as of the industry as a whole, will be achieved with price OP
and the firm producing at point E or output OM. But the attainment of full equilibrium in the industry
in the short run is a rare phenomenon. Very rarely the firms get normal profits in the short run.
Firms getting losses.
The inefficient firms may be getting losses in the short run. When
AC > AR the firm makes losses.
It can be seen in Fig. 2.31 that OM is the equilibrium output and OP is the price and MQ
is the average cost which more than the average revenue. The difference is QE ( MQME) is the loss
per unit.
\
Total losses = Loss per unit Total output
= QE OM
= QE RE = PQER
The rectangle PQER represents the total losses obtained by the firm.
Fig. 2.31 Firm's equilibrium position under losses.
Thus, the firm in the short run may make either super-normal profits, normal profits or
losses. Now a question naturally arises as to why the firm continues operating if it is incurring losses.
If it cannot leave the industry (because of short period), why does it not at least shut down to avoid
losses?
Even if a firm is shut down, it will have to beat the fixed costs in the short run, because the short
period is a period during which firms cannot alter their fixed capital equipment. Only variable cost
can be avoided by stopping a production. It implies that when a firm is closed down, its losses would
be equal to the total fixed costs. Hence if losses are lesser than the fixed costs the firm cannot be
closed down, as it can minimize the losses. That is, it will cover entire variable costs and part of the
fixed cost. If losses are more than the total fixed costs the firm will shut down to avoid losses.
120
Equilibrium in the Long Run and Equilibrium of an Industry.
In the long run, the
firm is said to be in equilibrium when the following two conditions are satisfied: (a) MR =
MC and (b) AR = Minimum AC. These conditions can be understood with the help of Fig. 2.32.
Fig. 2.32 Equilibrium position in the long run.
In Fig. 2.32, LAC is the long-run average cost curve and LMC is the long-run marginal cost curve. At
price OP 1 the point of equilibrium would be Q; where AR > AC. Hence the firm will be earning
super-normal profits. Since all the firms are assumed to be identical, all would be earning supernormal profits. Hence, there will be incentive for the new firms to enter the industry. As a result, the
price will be forced down to the level OP at which price; the firm is in equilibrium at R and is
producing OM output.
At point R or equilibrium output OM, the price is equal to average cost, and hence the firm will be
earning only normal profits (normal profits are included in average cost).
Therefore, at price OP, there will be no tendency for the outside firms to enter. Hence, the firm will
be in equilibrium at OP price and OM output.
On the contrary, a firm under perfect competition cannot be in the long-run equilibrium
at price OP
2. Though the price OP 2 is equal to marginal cost at point S, or at output OM 2 but price OP
2 is lower than the average cost at this point and thus the firm will be incurring losses.
Since all the firms in the industry are identical in respect of cost curves, all would be incurring
losses. To avoid these losses, some of the firms will leave the industry. As a result, the price
DEMAND ANALYSIS
121
will rise to OP, where again the firms are making normal profits. When the price OP is reached, the
firms would have no further tendency to quit. Thus, we conclude that at price OP, the firm under
perfect competition is in equilibrium in the long run when price = MC =
Minimum AC.
Now, at price OP, besides all firms, being in equilibrium at output OM, the industry will also be in
equilibrium, since there will be no tendency for new firms to enter or the existing firms to leave the
industry, because all will be earning normal profits. Thus, at OP price, full equilibrium, i.e.,
equilibrium of all the individual firms and also of the industry, as a whole, is achieved in the long run
under perfect competition.
Price-Output Determination under Perfect Competition
Perfect market is a market in which there are a large number of sellers of a homogeneous
product. Each supplier supplies a very small quantity of the total supply. No single seller is powerful
to influence the market price. Nor can a single buyer influence the market price. The price in a perfect
market is determined by the market forces, i.e. market demand and market supply. Market demand
refers to the demand for the industry as a whole. It is the total quantity demanded by each individual
consumer or user at different prices. Similarly market supply is the total quantity supplied by the
individual firms in the industry.
In the demand analysis, we concluded that a demand curve normally slopes downwards.
It means that, other things remaining equal, large quantity of a commodity will be demanded at a
lower price than at a higher price. Similarly, we have concluded in the supply analysis that the supply
curve normally slopes upwards. It means the producers will offer to sell a large quantity of the
product at a higher price than at lower price. Thus quantity demanded and quantity supplied will vary
with price. The price which tends to settle down in the market is one at which quantity demanded is
equal to quantity supplied. Only at that price all buyers and sellers will be satisfied. The price at
which, demand and supply are equal is known as an equilibrium price, since at this price the forces of
demand and supply are balanced, or in equilibrium. The quantity bought and sold (or the amount
supplied or demanded) at this
equilibrium price is known as equilibrium amount.
Graphical Representation.
In terms of both demand and supply schedules and curves, we
can understand clearly the forces of demand and supply in the determination of market price.
Table 2.19 gives the demand and supply schedule relating to a product. In
Fig. 2.33, DD is the demand curve and SS is the supply curve. A glance at the table and the figure will
show how the price is determined by demand and supply.
Table 2.19 Product demand and supply schedules
Price per unit (Rs.)
Quantity demanded (units)
Quantity supplied (units)

1
5
27
54
1
2
30
48
9
36
36
6
45
21
3
60
0
122
From Table 2.19, we can see that the market price will be Rs. 9. At that price the entire market is
cleared. There is no unsatisfied buyers and no unsatisfied sellers. This price is called equilibrium
price. It brings into equilibrium demand and supply. Such price satisfies all buyers and sellers. Of
course this equilibrium price may not be reached at once. There may have to be an initial period of
trial and error around this equilibrium level before price finally settles down and supply balances
demand.
If, for example, the price is Rs. 15 (i.e. above equilibrium level) the quantity offered in supply (54
units) by sellers will be greater than the quantity demanded (27 units), and there will be a tendency
for the price to fall. If at Rs. 15, all the sellers may not be able to sell all the quantity they want to
sell, and therefore they cut down the price to attract customers.
As the price falls, the quantity demanded will extend and the quantity supplied will contract as shown
in Table 2.19. At the price of Rs. 9 per unit, supply balances demand and all the quantity of the
product, which all sellers are willing to sell, will be purchased by the buyers.
Similarly, if the price is Rs. 6, i.e., below equilibrium price, the quantity demanded (45
units) by the buyers will exceed the quantity offered for supply (21 units). Therefore, the price of the
product will tend to rise, since, quantity demanded exceeds quantity supplied. The buyers who are
willing to buy at this price find that the quantity supplied is not sufficient to satisfy their wants, i.e.,
the sellers are not willing to supply as large a quantity as the buyers demand.
Some of the consumers, who have not been able to satisfy their demand, will be induced to bid the
higher price with the hope of getting more supplies. This action unsatisfied buyers will force up the
price in the market up to the equilibrium level.
Thus, Rs. 9 is the equilibrium price and 36 units is the equilibrium quantity, because only at this price
of Rs. 9 per unit, there will be no tendency for the price to rise or fall. Only at this price, there will
be no unsatisfied buyers and sellers. Thus, the equilibrium between demand and supply, or market
equilibrium, determines the price in the market. Price comes to settle in the market at the level where
demand and supply curves intersect each other.
We show the price determination in Fig. 2.33. DD is the demand curve and SS is the supply curve.
One intersects the other at point E. The price is Rs. 9. The quantity sold in the market is OM.
D
S
15
12
9
Price
E
S
6
3
D
M
O
10
20
30
36
40
50
60
Quantity
Fig. 2.33 Equilibrium price: Intersection of supply and demand.
DEMAND ANALYSIS
123
Effect of Change in Demand and Supply.
The equilibrium price will change if either
demand or supply curve changes due to change in demand or supply conditions. Given the
supply curve, an increase in demand (i.e. shift of demand curve to the right) will rise the price and a
decrease in demand (i.e. shift of the demand curve to the left) will lower the price. On the contrary,
an increase in supply (i.e. shift of the supply curve to the right) demand curve remains in supply (i.e.
shift in the supply curve to the left) will rise the price. The change in equilibrium price as a result of
change in demand or supply curves is shown in Fig. 2.34.
Fig. 2.34 Effect of change in demand.
Changes in Demand.
In Fig. 2.34, SS is the supply curve and DD is the original demand
curve. On X-axis, we show the quantity and on Y-axis price. Supply curve is kept fixed. The
equilibrium point is E. The demand and supply curves intersect at E. OP is the equilibrium price.
Suppose, if demand rises, price goes up and vice versa. For example, in Fig. 2.34, the
demand curve shifts upwards and to the right from DD to D 1 D 1 whereas supply curve remains the
same. Demand curve intersects the supply curve at E 1. As a result, the price goes up from OP to OP
1, so also the quantity increased from OM to OM 1. The equilibrium price is OP 1.
Suppose, if demand decreases, the demand curve shifts downwards. It becomes D 2 D 2. It intersects
the supply curve at E 2. The equilibrium price is OP 2. If there is a decrease in demand price will
fall. The quantity decreases from OM to OM 2.
Changes in Supply.
If there are changes in supply the supply curve shifts. We assume
that demand curve DD remains the same, and supply curve changes see Fig. 2.35. The original price
is OP. Supply and demand curves intersect at point E. The equilibrium price is OP.
Suppose there is an increase in supply, the supply curve shifts to the right from SS to S 1 S 1, the
equilibrium price will fall to OP 1, and the equilibrium quantity will extend from OM to OM 1.
Demand and supply curves intersect at point E 1. If supply decreases from SS to S 2 S 2, 124
S2
S
D
S1
Y
P2
E2
P
E
E
Price P 1
1
S2
D
S
S1
X
M
M
2
M1
Quantity
Fig. 2.35 Effect of change in supply.
the equilibrium price will rise to OP 2 and the equilibrium quantity will fall to OM 2. The supply
curve S 2 S 2 intersects the demand curve at point E 2. Price rise from OP to OP 2. Thus, we see that
changes either in demand or in supply will change the equilibrium price.
From the above analysis, we can understand that the price is determined by the interaction of demand
and supply. But it should be remembered that demand and supply are themselves
governed by a host of other factors. Demand and supply is only a superficial formula. Professor
Samuelson rightly remarks that demand and supply are not ultimate explanations of price. They are
simply useful catch-all categories for analyzing and describing the multitude of forces, causes and
factors influencing on price. For example, the cost of production is the main
determinant of supply curve. A change in the cost of production will change the supply curve and thus
will change the equilibrium price. Similarly, the market for a product may change because the
incomes of the consumers have changed or the total number of consumers has
changed because of the change in the size of population. Thus, the factors like cost of
production, income of the consumers and size of the population also take part in determining price but
all of them work either through supply or through demand.
Importance of Time Element.
We have seen that the price in perfect competition is

determined by the equilibrium between demand and supply. Whether demand plays more
important part or supply plays a more important part depends on time. The shorter the period, the
greater is the importance of demand and longer the period, the greater is the importance of supply in
determining price. Marshall explained the role of time element in the
determination of price because supply conditions vary with the length of period under
consideration.
On the basis of response of supply overtime to a given and permanent change in demand,
Marshall suggested three periods of time, viz., market period, short period and long period.
DEMAND ANALYSIS
125
Price Determination in the Market Period or Very Short Period.
The period is very
short being only a single day or few days. The fundamental feature of the market period is that it will
be so short and the supply of the commodity is limited to the existing stocks or at the most to the
supplies in sight. In this period supply tends to remain fixed. If demand suddenly goes up the price
will rise and if demand suddenly falls, the price will fall. Thus demand plays a decisive part in
determining price in such a short period. Price in such period is not related to cost of production.
Hence the market price of a commodity may vary from day to day and from time to time depending
upon the conditions of demand.
Supply in this period depends on the nature of commodity, i.e., in case of perishable
commodities like fish, this market period may be a day and for a common textile industry it may be a
few weeks. However, the role of supply differs in the market period for the perishable goods and
durable goods.
In case of perishable goods (like vegetables, fish, etc.) the entire supply must be sold at the earliest.
On the other hand, though goods like calendars, greeting cards, etc. do not deteriorate physically but
their utility reduces fastafter sometime these are no more
demanded. In both the cases the supply curve of the commodity is a vertical straight line as shown in
Fig. 2.36.
Y
D1
D
D2
E1
P1
Price
E
P
P2
E2
D1
D
D2
X
O
M
Quantity
Fig. 2.36 Market price of a perishable commodity.
As the demand for perishable and seasonal goods suddenly goes up, price rises. If, on the other hand,
as demand falls the price goes down. The original demand curve is DD. The equilibrium price is OP.
If demand increases (as a result of changes in the conditions of demand) the curve shifts upwards and
becomes D 1 D 1. The new equilibrium price is OP 1. If demand decreases, the demand curve will
be shift downwards. The price will fall. The new
equilibrium price is OP 2.
In case of durable goods, supply can be adjusted to demand. If demand for the commodity
declines the firms in the industry will preserve or keep back some of the goods from the market and
carry them over to the next market period. On the other hand, if demand goes up it will be met out of
the accumulated stocks. But if demand increases even beyond the level of
accumulated stock of the commodity, it will not be possible to the firm to supply any additional
quantity of the good. Thus, the supply curve for a durable good is upward sloping up to a distance and
then becomes vertical (see Fig. 2.37).
126
Fig. 2.37 Market perioddurable goods.
A firm selling a durable good has a reservation price influenced by the cost of production.
The price at which a seller will refuse to sell is called the reserve price. The reserve price will
depend upon the sellers expectations regarding the future price, the sellers liquidity
preference, the durability of the good, future cost, charges which have to be incurred for carrying
stocks, etc.
In Fig. 2.37, SRFS is the supply curve of the durable goods and OQ is the total quantity of the goods.
Up to the price OP 1 ( =QF), the quantity supplied varies with price so that at a higher price more is
supplied that at a lower price. At the price OS, nothing is sold, the whole stock being held back.
Therefore the SF portion of the supply curve slopes upwards from left to right. At the price OP 1 (
=QF), the whole stock is offered for sale, and beyond OP 1, the quantity supplied remains the same
whatever the price. Therefore, beyond price OP 1, the market supply curve has been shown as
vertical straight line. DD is the demand curve which slopes downwards from left to right.
Market price is determined at OP (= RM) as at this price both demand and supply are equal at point
R. At this price the OM quantity from the stock is sold, while the rest of the stock, i.e., MQ (= RC) is
held back from the market.
If demand increases from DD to D 1 D 1, the price will rise to OP 2 (= QF) and the whole stock OQ
will be sold. In case the demand further increases from D 1 D 1 to some higher level, the quantity
supplied or sold will remain the same, i.e., equal to OQ, which is the entire stock.
Only the price will rise so that at the new equilibrium level quantity demanded is equal to the
availability of supply. If the demand decreases from DD to D 2 D 2, the price will fall to OP 2
(R 1 M 1 ) and the amount sold will fall to OM 1.
Price Determination in the Short-run Period.
In the short period the firm can vary its
supply by changing the variable factors of production but not the scale of its plant. The period relates
to the production and sale of a commodity with existing plant and machinery.
DEMAND ANALYSIS
127
Scale of operations will not change. The number of firms in the industry cannot increase
or decrease in the short run. Thus, the supply of the industry can be changed only within the limits set
by the plant capacity of the existing firms. The short period normal price is
determined by the interaction of short period supply and demand curves as shown in Fig. 2.38.
D1
Y
D
SRS
MPS
P
E1
1
P
E
2
2
Price
P
D1
E
D
X
O
M
M1
Quantity
Fig. 2.38 Determination of short-run price.
In Fig. 2.38, DD is the demand curve as usual slopes downwards from left to right. MPS
is the market period supply curve and SRS in the short-run supply curve of the industry. If demand
increases from DD to D 1 D 1, the market price will rise sharply from OP to OP 1. Supply of output
remaining unchanged. As the supply is fixed market supply curve is shown as vertical straight line. It
intersects DD curve at E. The output is OM. The initial equilibrium price is OP.
If demand increases from DD to D 1 D 1 the market price will rise from OP to OP 1.
Equilibrium occurs at E 1. The quantity exchanged remains at OM. As the demand increased the
existing firms will increase output by making intensive use of the existing fixed capital equipment and
by increasing the amount of variable factors of production. The supply of
commodity will increase as a result of the expansion of output by existing firms in response to an
increase in demand. The supply in this period is represented by the SRS curve. The new demand D 1
D 1 curve intersects the SRS curve at E 2. The price OP 2 is the short run normal price.
It is higher than the initial market price OP, but not as high as the second market price of OP 1.
The quantity supplied has also increased from OM to OM 1. At the determined price a firm can sell
any amount of output since its supply forms a very small part of total supply.
Price Determination in the Long-run Period.
In the long-run there is a sufficient time
to build new equipment and alter their scale of operations of the firms. New factories and machines
can also be built. Moreover, in the long run, new firms can also enter the industry and thus add to the
supplies of the product. A long period equilibrium is brought about between demand and supply. In
the long run, the supply of the firms in the industry can be adjusted to meet the changes in demand. In
the long run for a given change in the quantity demanded 128
the changes in the supply will depend on the cost conditions of the industry. Therefore, the price
determination can be discussed under increasing, constant or decreasing cost conditions.
These are discussed below.
Increasing Cost Industry.

In Fig. 2.39, the determination of long run price is shown in
case of an industry which is operating under increasing cost conditions and so is called an increasing
cost industry. LPS is the long-run period supply curve, with initial equilibrium of industry at point E.
At equilibrium the industry is supplying output OQ at price OP. Now, if the demand curve shifts from
DD to D
1 D 1 the new equilibrium is established at E 1 where the
industry supplies OQ 1 of output at price OP 1. The additional quantity supplied as a result of
increase in demand has pushed up the cost of production in the industry, leading to an increase in the
price of the product.
Fig. 2.39 Increasing cost industry.
LPS is the long-run period supply curve, with initial equilibrium of industry at point E.
At equilibrium the industry is supplying OQ output at OP price. Now, if the demand curve shifts from
DD to D 1 D 1 the new equilibrium is established at E 1 where the industry supplies OQ 1 of output
at OP1 price. The additional quantity supplies, as a result of increase in demand, has pushed up the
cost of production in the industry, leading to an increase in the price of the product.
Decreasing Cost Industry.
When the firms in the industry are able to produce additional
output at a lower cost, that industry is called a decreasing cost industry. The economies are more
than the diseconomies because of large-scale production. The larger the scale, the lower the cost on
account of the operation of law of increasing returns. Average cost and marginal cost will decline.
The supply curve of the industry slopes downwards, as shown in Fig. 2.40.
In Fig. 2.40, the initial equilibrium point is E where the price is OP and the output OQ.
If demand increases from DD to D 1 D 1, the price decreases from OP to OP 1 while the output
increases from OQ to OQ 1.
DEMAND ANALYSIS
129
Constant Cost Industry.
If economies and diseconomies of scale exactly balance, the
returns are constant. The average and marginal costs remain constant. The long-run supply curve is
perfectly elastic. Let us show this in Fig. 2.41.

Y
D1
D
E
P
E1
P1
LPS
Price
D1
D
X
O
Q
Q1
Quantity (Output)
Fig. 2.40 Decreasing cost industry.
Fig. 2.41 Constant cost industry.
DD is the initial demand curve, while the rise in demand is shown by the new demand curve D 1 D 1.
The rise in demand does not affect the price. The old price EQ is equal to the new price E 1 Q 1.
From the above analysis, it is clear that the long period normal price can be higher, lower or the same
as the initial price, depending upon the supply conditions in the industry. It depends upon the internal
and external economies and diseconomies of scale. However, short period normal price will be
higher than the long period normal price because in the long run all adjustments are possible.
130

IMPERFECT COMPETITION
Imperfect competition takes three main forms:
(a) Monopoly
(b) Oligopoly
(c) Monopolistic competition.
Monopoly
The monopoly is that market form in which a single producer controls the whole supply of
a single commodity, which has no close substitutes. In other words, a monopoly market is one in
which there is only one seller of a product having no close substitute. Two important points should be
noted in regard to this definition.
First, there must be single producer or seller in the market, if it is to be called a monopoly.
Since there is only one firm under monopoly, that single firm constitutes the whole industry.
Therefore, the distinction between the firm and industry disappears under conditions of
monopoly.
Secondly, the commodity produced by the producer should not have close substitutes, if
he is to be called a monopolist. This ensures that there must not be any rival of the monopolist.
This second condition can also be expressed in terms of cross-elasticity of demand. If there is to be
monopoly, the cross-elasticity of demand between the product of the monopolist and the product of
any other producer must be very low.
Absolute and Limited Monopoly
There is a distinction between absolute and limited monopoly. An absolute or pure monopoly refers
to a form of market which is controlled by a single producer, and he is in a position to charge any
price for his product. For absolute monopoly power, the firm must have control over the supply of all
goods and services in the country as a whole. Such pure monopoly is merely a theoretical concept. It
is a rare phenomenon in reality. Any commodity is bound to have a substitute, though it may be a very
remote one. For example, a stereo record player is a remote substitute for television as a means of
entertainment.
In reality, we find a limited monopoly or a relative monopoly. The monopolist in the real world has a
limited degree of monopoly power, as he is the producer controlling the market supply of a particular
product, which has no close substitutes. Some economists, however, prefer to use the term simple
monopoly instead of a limited monopoly. Simple monopoly
implies absence of close substitutes, but it does not mean absence of competition, as it has to face
competition from remote substitutes. There may not be immediate rivals to a simple
monopolist but his degree of monopoly power is not absolute, as the possibility of competition at any
time is not completely ruled out. For example, the railways in India are a public
monopoly, but there are different substitutes available for the purpose, e.g. road transport services,
airways, etc. These different substitutes, however, cannot be regarded as close substitutes of railway
services.
DEMAND ANALYSIS
131
Monopoly may change if:
(a) Consumer demands pattern change.
(b) Close substitutes emerge for the monopolists product.
(c) New firms are able to enter the industry.
(d) Government intervenes to control the monopoly.
Causes of Monopoly
Monopoly can exist only when there are strong barriers to the entry of rivals. Following are the main
causes that lead to monopoly situation:
(1) In some industries competition is impractical, inconvenient or simply not workable.
Such industries are called natural monopolies. Automatically, such industries may acquire monopoly
power. For instance, in the case of public utilities like telephone service, water supply, transport,
electricity, etc., the supply by more than one firm is basically inconvenient and relatively costly to
consumers. Hence monopoly is preferred in such cases. Thus, the
government grants exclusive rights to a particular firm for operating public utilities like gas supply,
electricity, etc. but the government reserves the right to regulate the operations of such monopolies to
prevent abuses of monopoly power it has granted.
(2) Exclusive knowledge of techniques of production also creates monopoly to a firm. If
the firm alone possesses the technical know-how about the production of a commodity, the
entry of rivals in the market is not possible and automatically the firm acquires monopoly position.
The monopolist can fix the price of his product and can pursue an independent price policy.
Power to influence price is the very essence of monopoly and it is called monopoly power.
A monopolist can either fix the price of his product leaving the quantity sold to the
consumer, or he can fix the quantity he wants to produce and sell and leave the price to be determined
by the demand of the consumers in the market. It means he cannot sell larger
quantities at higher prices because he has no control over market demand.
Main Features of Monopoly
1. The monopolist is the single producer or seller of a particular good or service in the market. Thus,
under monopoly firm and industry are identical.
2. Rivalry from the producers of substitutes is so remote as to be insignificant. Indirect rivalry may
exist in the form of the existence of substitutes but close substitutes will
not exist.
3. The monopolist is a price maker and not a price taker. His price fixing power is
absolute. He can fix the price for the product as he likes. He can vary price from
buyer to buyer.
4. A monopoly firm itself being the industry, it faces a downward sloping demand curve
for its product. That means it cannot sell more output unless the price is lowered.
5. In the monopoly market, there are legal, technical, economic or natural obstacles,
which may restrict the entry of new firms.
132
The monopoly is not a permanent phenomenon. The firm which appears to be
monopoly now may not remain a monopoly in future.
A firm may enjoy the exclusive ownership or control of the raw materials, patent
rights, secret methods of production, or specialized skills, which might give
monopoly power to that firm. For example, Hoechst held a monopoly for sometime
in oral medicines for diabetes because they were the first to find out the methods of
reducing blood sugar by an oral dose.
6. Legislative enactments regarding patents and copyrights, trademarks, etc. grant
monopoly to the firms and such legal provisions prevent the entry of rivals in the
market.
7. The entry of new competitors may be blocked or the rivals may be eliminated by
aggressive cut-throat tactics of the monopolist like aggressive price cutting, product
disparagement, hiring away of strategic personnel of rivals, pressure on banks not to
grant credit and pressure on resource suppliers to withhold materials, spurious and
exhausting law suits and spying and sabotage.
8. Large and old existing firms enjoy economies of large scale on technological grounds
by employing huge amount of capital. As a result, they have low cost of production
and are able to supply goods at low prices, which obstructs new firms in the business.
In this way, such firms may tend to hold a degree of monopoly power.
9. Long standing firms may have good reputation in the business. They are always in
an advantageous position compared to the new entrants with regard to financial
arrangements and build up a new clientele. This also confers an element of monopoly
on such a firm.
10. Ignorance, laziness and prejudice of the buyers may create monopoly in favour of a
particular producer.
Price-Output Determination under Monopoly in the Short Run
In the preceding discussion, we have seen how price is determined under perfect competition.
But in real life, perfect or even pure competition is unrealistic because in the real world we hardly
come across perfect competition. On the other hand, in the world of reality we find conditions of
imperfect competition. Imperfect competition covers all situations where there is neither pure
competition not pure monopoly. The situation in the real world lies between these two extremes.
Price-output analysis in the case of a monopoly is also an analysis of the equilibrium of the firm and
industry under monopoly. A monopoly industry constitutes only one firm, hence no separate analysis
of equilibrium of the firm and of the industry is necessary. The price-output equilibrium of the firm
means that the price and output determination under monopoly.
The price-output determination under monopoly is based on the following assumptions.
1. There is only a single seller or firm in the market facing many buyers.
2. The entire market supply is controlled by the firm, as there are no close substitutes
for its product.
3. The monopoly firm itself being the industry is the price maker.
DEMAND ANALYSIS
133
4. The firm attempts to maximize its profits.
5. Monopolist does not change discriminating prices and the cross-elasticity of demand
with other products is almost negligible.
6. Under monopoly, competition from the rivals is not possible because there are entry
barriers.
Based on the above assumptions, the monopolist has to make two decisions: (1) to
determine the price for his product, and (2) to determine the equilibrium or optimum level of output.
The monopolist can control both the price and supply of the product. But at any point of time he can
fix only one of them. He cannot determine both the price and output separately.
Either he can decide the price of the product on the basis of market demand or he can decide the
quantity of output and has to set the price as per the demand condition. Thus the monopolist cannot
decide both the price of the product and quantity of output. He can either decide the quantity or the
price, but not both as per his choice.
In the discussion of perfect competition, we saw that the demand curve or the average
revenue curve of a firm is perfectly elastic and is represented by a horizontal straight line parallel to
the X-axis, because the producer under perfect competition cannot affect price by his own action. He
has to accept the ruling price in the market and at this price, he can sell any quantity of the commodity.
But a firm under monopoly faces a downward sloping demand curve or average revenue
(AR) curve. If the monopolist reduces the price of his product the quantity demanded increases, and if
he raises the price the quantity demanded decreases.
Further, in perfect competition, since the average revenue curve is perfectly elastic and a horizontal
straight line to the X-axis, the marginal revenue is always equal to the average revenue, i.e., the
marginal revenue (MR) curve coincides with the average revenue curve.
But in a monopoly, since the average revenue falls as more units of output are produced
and sold the marginal revenue is always less than the average revenue. In other words, under
monopoly the marginal revenue curve lies below the average revenue curve.
From the above discussion we can understand that even the monopolist is not free of the
market forces in deciding price of his product. He cannot set the price high without losing sales, and
also cannot rise sales without reduce the price. The question is: Which particular price-output
combination on his demand curve will the monopolist choose? This depends not only
on the demand conditions but also on the cost situation faced by the monopolist.
On the cost side, as in perfect competition, the average cost curve ( AC) is generally U-shaped. The
marginal cost curve ( MC) cuts the average cost curve ( AC) at its minimum point. The marginal cost
means additional cost incurred by the producer in order to produce one more unit additionally. It is an
addition made to the total cost. Suppose, the cost of producing 10 units is Rs. 1,000 and when 11 units
are produced the total cost may be Rs. 1,080.
Hence the addition made to the total cost is Rs. 80, which is the marginal cost.
The main object of the monopolist, like every other producer, is to maximize his total
money profits. Therefore, he will produce upto a point and charge a price which gives him the
maximum money profits. His profits will be maximum when marginal cost ( MC) is equal to marginal
revenue ( MR). He will continue to expand output so long as marginal revenue exceeds marginal cost
because profits will go on increasing as long as marginal revenue exceeds 134
marginal cost. At the point where MR is equal to MC, the profits will be maximized. If the production
is carried beyond this point the profits will start decreasing.
The price-output equilibrium of the monopolist can be easily understood with the help of
Fig. 2.42.
Y
Profits
MC AC
Q
P
R
enue/Costv S
Re
E
AR
MR
X
M
O
Output
Fig. 2.42 Price determination under monopoly in the short run.
In Fig. 2.42, AR is the demand curve or average revenue curve, and MR is the marginal revenue curve
which lies below AR. AC is the average cost curve and MC is the marginal cost curve. It can be
observed from the figure that until OM output, the MR is greater than MC, but beyond OM the MR is
less than MC. Therefore, the monopolist will be in equilibrium at output OM, where MR=MC and
profits are maximum.
The price or the demand or average revenue at which output OM is sold in the market is MQ (= OP).
Average cost is equal to MR. Thus, it is clear that given the cost-revenue situation as shown in the
figure, a monopolistic firm will be in equilibrium at output OM and will be charged price equal to
MQ (= OP). At output PM, while MQ is the average revenue, MR is the average cost. Therefore, QR
is the profit per unit.
Total profits = Profit per unit Total output sold
= QR OM
= QR SR ( OM= SR)
= PQRS
Thus, the total profits earned by a monopolist in equilibrium are equal to the area of the rectangle
PQRS, i.e., the shaded area in the figure.
Short-run and Long-run View.
We have discussed above the equilibrium of the monopolist
without making any distinction between his behaviour in the short run and the long run. The above
analysis is general and applies for both short-run and long-run situations. In the short DEMAND
ANALYSIS
135
run, the monopolist must be very careful about the variable costs. His price should not go below his
average variable costs, otherwise he will stop producing.
In the long run, the monopolist can change the size of the plant in response to a change
in demand. In the long run he will make adjustments in the amount of the factors, fixed and variable,
so that marginal revenue equals not only short-run but also long-run marginal costs.
This reflects the fact that the scale of the whole firm has been adjusted for maximization of profits.
Short-run Equilibrium.
A monopolist may be earning profit or incurring losses in the short
run. There may be several reasons why a monopolist can make losses.
If the demand and cost conditions are not favourable, the monopolist may suffer short-run losses.
Despite his monopoly in the market, the firm suffers a loss in the shortrun because of a weak demand
and high costs. If there is an impending danger of entry of potential rivals, the firm may reduce its
price even below cost and incur short-run losses, with the hope of earning long-run monopoly profits.
Of course, like the perfectly competitive producer, the monopolist firm suffers a loss in the short-run,
but it must earn normal profits or more in the long run, otherwise it will leave its business. It can be
seen in Fig. 2.43.
Fig. 2.43 Short-run equilibrium of the firm.
Under perfect competition, the firm is price taker and under the monopoly the firm is the price maker.
However, the monopolist can only fix up either the price or the output and he cannot decide both. The
negative slope of the demand curve of monopoly indicates that the price and the output are
interdependent. Therefore the monopolist either fixes the price or sells the quantity that the consumers
will demand, or he determines the quantity to be sold and lets the market decide the price. He cannot
decide the price and the quantity simultaneously.
Long-run Equilibrium.
In the long run, the monopolist can change the scale of his output
in response to a long run change in demand. In the monopoly, the entry of new firms being ruled out,
excess profits (super-normal profits) are possible even in the long run. In the long 136
run the monopolist has the time to adjust his plant and other infrastructural facilities to any extent to
maximize his profits. The monopolist need not search for any optimum scale of plant because there is
no competition in the market. Due to lack of competition, he need not use his existing plant at an
optimum capacity. The main aim of monopolist to stay in the business is that he should not make
losses in the long run. The size of the plant and the extent of utilization of existing plant of a
monopolist will depend upon the extent of market demand. Whether the monopolist remains at
optimum level or below the optimum level or above the optimum level depends upon the market size.
Therefore, the price determination under monopoly in the long run can be discussed in three cases.
They are:
(1) Where the market size is so small that it does not allow the monopolist to reach the
optimum size, i.e. minimum point of long-run average cost ( LAC). In this case the market size is so
small and it does not permit the expansion to the minimum of the long-run average cost ( LAC), and
thus the monopolist will be operating below the optimum size plant and also underutilizing the given
plant. In Fig. 2.44, the equilibrium point is shown.
Y
SMC
Profits
LMC
LAC
SAC
B
P
enuev
K
C
A
L
Cost/Re
E
AR
X
O
Q
MR
Output
Fig. 2.44 Long-run equilibrium at underutilised capacity.
In Fig. 2.44, the SAC is tangent to LAC to the left of its minimum point and on the falling portion of
LAC. The SMC will be equal to LMC at equilibrium point E. The LAC will be minimum at the
intersecting point of LMC and LAC, i.e. at L but the optimal use of the existing plant is at the point
where the SAC is touching the LAC, i.e. at K, implying that the plant is underutilized.
(2) Where the market size is so large that the monopolist must build a plant larger than
the optimal size and overutilize it. In this case the SAC is tangent to LAC. On the right of the minimum
point and of the LAC curve and the equilibrium level of output is to the right of minimum point of SAC
curve also. We can understand this with the help of Fig. 2.45.
DEMAND ANALYSIS
137
Y
SMC
Profits
LMC
LAC
B
P
SAC
enue/Cost
E
v
Re
C
AR
A
MR
O
X
Output
Fig. 2.45 Long-run equilibrium of overutilised capacity.
Thus, under this case increasing the plant size maximizes the profits of the monopolist,
besides increasing the total costs as the plant size is larger than the optimal size, and the given plant is
overutilized. Normally, this case is found in public utilities, power plants, etc.
Where the market size is just sufficient to allow the firm to operate at minimum longrun average cost. In this case the market size will be just sufficient to enable the monopolist to have
an optimum size plant and utilize it at full capacity. Here, the SAC is tangent to LAC
at its minimum point, which is also the minimum point of SAC. The LMC is also tangent to SMC at the
equilibrium point E. The monopolist sells output equal to OQ at a price OP. Figure 2.46 shows the
equilibrium of the firm.
Y
SMC LMC SAC

LAC
P
enuev
Cost/Re
E
AR
MR
X
O
Q
Output
Fig. 2.46 Long-run equilibrium at an optimum-utilised capacity.
138
Discriminating Monopoly or Price Discrimination.
Sometimes the monopolist can
charge different prices for the same commodity from different buyers, provided these buyers form
different markets or belong to what are called non-competing groups. This is known as discriminating
monopoly or price discrimination. Mrs. Robinson defines it as charging
different prices for the same product or same price for the differentiated product. The product may
be differentiated by time, appearance or place so that the purchasers are not able to shift to the low
price commodity. The product is basically the same but may have slight or illusory difference. For
example, a cinema theatre has different charges on the basis of the location of seats, though the same
movie is shown at a particular time and the cost of its exhibition does not differ between customers.
No doubt, the comforts differ between classes, but they are generally not in proportion to the charge
differences.
Forms of Price Discrimination.
Price discrimination may take different forms. The

common forms of price discrimination are:
1. When different prices are charged for the same product or service from different
buyers, it is called personal discrimination. For example, a doctor may charge high operation fees to
a rich patient and lower fees to a poor one.
2. When a monopolist charges different prices in different markets located at different
places, it is called location or geographical discrimination. For example, a monopolist may charge
higher price in a foreign market and lower price in the
domestic market for his product. Similarly, a film producer may see distribution
rights to different film distributors in different territories at different prices.
3. Price discrimination may be made on the basis of the age of the buyers. Usually, buyers are
grouped into children and adults. Thus, for instance, in railways and bus
transport services, it is a common practice of price discrimination that persons below
12 years of age are charged at half the rates.
4. On the basis of size or quantity of the product, different prices may be charged. For example, an
economy size after-shave lotion bottle is relatively cheaper than a small
size bottle.
5. Based on the qualitative differences, different prices may be charged for the same product. For
instance, a publisher may sell a deluxe edition of the same book at a
higher price than its paperback edition.
6. Based on special facilities or comforts, different prices may be charged for different customers.
Railways, for instance, charge different fares for first class and second
class travel. Similarly, in cinema halls, different rates are charged for stalls, upper
stalls, dress circle and balcony.
7. Some firms sell almost the same product under different brand names at different
prices. Here, consumer ignorance of the similarity in quality prevents a large-scale shift of customers
from one brand to another.
8. When different prices are charged for different uses, it is called trade or use discrimination. For
example, electricity charges are low for agricultural purposes than for domestic purposes. Similarly,
lower rates for the first few telephone calls, lower
rates for the evening and night trunk calls will be charged by the telephone
department.
DEMAND ANALYSIS
139
Conditions Essential for Price Discrimination.
The following conditions must be
fulfilled for the implementation of price discrimination:
1. There should be monopoly in the market for charging different prices because even
though different buyers would know that they are differently charged, they have no
alternative source of buying the product.
2. Market segmentation should be possible. The monopolist should be in a position to
divide the market into sub-markets by classifying the buyers into separate groups.
When total market is divided into sub-markets, each sub-market acquires a separate
identity so that one sub-market has no connection with the others. Again customers
have no inclination to move from a high-priced market to a low-priced market due
to either ignorance or inertia.
3. Depending on the preference of buyers, their income, their location and the ease of
availability of substitutes, the product has different elasticity with different customers.
Whenever the elasticity of demand differs between buyers they can be charged
different prices for the same good.
4. It should not be possible to transfer any unit of commodity from one sub-market to
another sub-market. It means buyers in the low-priced market should not be in a
position to resell the commodity in the dearer market.
5. In certain cases the firms have a legal sanction for price discrimination. This is quite common in
transport companies, airways, railways, etc., which charge different fares
from different classes of customers. Similarly, electricity companies also charge
different tariffs for different uses.
6. Through artificial differences in the same product, such as differences in packaging,
brand name, etc., an apparent product differentiation may be created so that it can
be sold to the poor and the rich consumers at different prices.
7. When consumers have an irrational attitude that high-priced goods are always high
on quality, a monopolist can resort to price discrimination.
8. When price differences between two markets are very small, the consumers do not
think it worthwhile to consider such discrimination. For instance, in the distribution
of cooking oil (e.g. Dalda, Vanaspati), there is a marginal zonal price differential,
so that we hardly pay any attention to such differences of 5 to 10 paise per kilogram
in different zones.
Objectives of Price Discrimination.
Price discrimination is resorted to in order to:
1. Appropriate the consumers surplus so that it accrues to the producer rather than to
the consumer.
2. Dispose of inventories whenever accumulated above the desired level. The firms
generally resort to reduced price for a short span of time or for a group of buyers.
3. Develop a new market; the firm might sell its product at a price lower than what it
charges in its old market.
4. Make the maximum use of unutilized capacity by charging lower price from the
buyers who may help in its utilization.
5. Earn monopoly profits by charging different prices in different markets for the same
product.
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6. Destroy competition or to make the competition amenable to the wishes of the seller.
7. Raise future sales by quoting lower rates in the present so that people develop a taste in future for
allied commodities produced by the same manufacturer.
Duopoly and Oligopoly
Duopoly and oligopoly are two special situations of monopolistic competition. Duopoly is a market
situation in which there are two sellers selling an identical product. There shall not be any agreement
between them regarding price or output. The two sellers are completely
independent but both will take into consideration the others policies.
Duopoly may be of two types:
(a) Duopoly without product differentiation
(b) Duopoly with product differentiation.
Duopoly without Product Differentiation
Under duopoly the simplest cases will be those where the two monopolists are supposed to be selling
an identical product and there is no product differentiation. Very likely there will be collusion
between the two. They may agree on a price, or decide quotas, or divide the territory in which each is
to market his goods. Obviously, this collusion creates monopoly conditions in the market and price
determination will be similar to that under monopoly. If both the firms are selling their products at the
same price, the total demand in the market is shared by both the firms. As the products are
homogeneous, if any one firm tries to increase the price it will lose its sales. Hence both firms must
sell at the same price. In these conditions, each firm fixes the price just like in a monopoly. Only in
that way will they be maximizing profits.
In case there is a price war between them, they will be able to earn only normal profits
as under perfect competition. If their costs are different, the one with lower costs will squeeze out the
other and a simple monopoly would be established. It is possible that, in the short run the duopoly
price may be lower than the competitive price, with none of the producers earning normal profits. In
the long run, this price may be somewhere between the monopoly price and the competitive price.
Duopoly with Product Differentiation
When there is product differentiation, the price of one firm has no influence on the second firm. The
market would be divided into two separate markets for each firm. One firm need
not be afraid of the second one. Similarly, even if a firm decreases the price of its product, the second
firm need not follow it. A firm producing a relatively high-quality product can fix a high price and can
make super-normal profits.
Oligopoly Market
Oligopoly refers to that form of imperfect competition where there will be only a few sellers.
It is also referred to as competition among the few. Stigler defines oligopoly as that situation in
which a firm bases its market policy in part on the expected behaviour of a few close rivals.
DEMAND ANALYSIS
141
As the number of firms under oligopoly is less, each firm can influence the price output
policy of the other firms. Broadly, oligopoly is of two types: (1) perfect or pure oligopoly and (2)
imperfect or differentiated pure oligopoly. Under pure oligopoly, goods produced by the firms are
homogeneous, e.g. steel, cement and aluminium. In industries under imperfect
oligopoly, the products are heterogeneous, e.g. cycles, TVs, automobiles etc.
Features of Oligopoly
1. There are a few sellers supplying either homogeneous or differentiated products.
2. Detailed market information relating to cost price, and product quality are usually not published.
3. Firms in the oligopoly market face strong restrictions on entry or exit.
4. The firms have a high degree of interdependence in their business policies about
fixing of price and determination of output.
5. Advertising and selling costs have strategic importance to oligopoly firms. Each firm
tries to attract consumers towards its products by incurring excessive expenditure on
advertisements.
6. As all firms are interdependent, co-operation among firms is a must. Still we find
competitive trend also. Instead of co-operation, the firms will come into clash. Cooperative and collusion trend and also competitive trend would prevail under
oligopoly.
7. As few number of sellers are there, each seller will be able to control a considerable part of the
market and thus monopoly element will exist.
8. Under oligopoly, the price of each firm unchanged due to fear of retaliation from
rivals if it reduces the price. It therefore resorts to advertisement-based competition
rather than price cut. Hence, there is price rigidity in an oligopolistic market.
Pricing under Oligopoly.
To find a single generalized solution to the problem of oligopoly
pricing is not possible. This is because of the difficulty of knowing the exact position of the demand
curve facing a firm under oligopoly. An oligopoly firm believes that if it reduces the price of its
product, rival firms would follow and neutralize the expected gain from price reduction. But if it
raises price, rival firms would either maintain their prices or may even cut their prices down. In
either case, the price raising firm stands to lose at least a part of its market share. This behavioural
assumption is made by all the firms with respect to others. Therefore, the oligopoly firms find it more
desirable to maintain their price and output at the existing level.
Price rigidity under oligopoly can be explained with the help of a kinked demand curve.
The kinked demand curve concept was developed by Paul M. Sweezy. The kinked demand
curve represents a situation in which the firm has no incentive either to increase the price or to
decrease the price but keep the price rigid at a particular level.
If a firm increases the price other firms may not increase. But if price is cut, other firms may also cut
the price. This is not beneficial in anyway. Hence price rigidity is continued.
Under such conditions the demand curve of a firm found to be kinked. The demand curve will 142
have a kink at the present price. In Fig. 2.47, the demand curve with a kink at a point X
has been shown.
Fig. 2.47 Kinked demand curve.
OP is the price at which the firm is selling the product and the output is OM. The YX
portion of the AR curve is elastic. Below Y is the XZ portion of the AR curve is inelastic. This shows
if a firm increases the price above OP and other firms maintain the old price, then the demand for the
firms product would fall off. The corresponding MR curve is also downward sloping. If the firm
decreases the price, the demand curve becomes much less elastic while XZ
is inelastic. This is because any price reduction by one firm will be followed by all other firms and
the sales may not increase, more than at OP price. Thus, when the demand curve is XZ
the MR curve is negative ( CD or MR2) when there is no scope to get profits either by increasing the
price or by decreasing the price the same price would be continued. Hence the price OP
is rigid.
Criticism
1 The kinked demand theory explains the price rigidity but it does not explain how the
price under oligopoly is determined.
2. This theory has no relevance when product differentiation is adopted.
3. When price leadership is there and when there is cartel, this theory is not valid.
4. This theory may be true when there is economic depression but not otherwise.
5. According to Stigler, there is no kink in the demand curve of oligopolistic firms in
reality.
Price Leadership under Oligopoly.
The price leadership is said to exist when firms fix
their prices in a manner dependent upon the price charged by one of the firms in the industry.
Under price leadership, one firm assumes the role of a price leader and fixes the price of the product
for the entire industry. The other firms in the industry simply follow the price leader and accept the
price fixed by him and adjust their output to this price.
DEMAND ANALYSIS
143
There are different types of price leadership. The main types are:
1. Price leadership of a dominant firm, which involves generally one firm which
produces the bulk of the product of the industry. By virtue of this position, it is able
to dominate the entire market. It fixes the price and the other firms simply accept
this price. The other firms are not in a position to exercise any influence on the
market price. Generally, the dominant firm fixes the price considering its own interest
to maximize profits.
2. Barometric price leadership, where an old, experienced and large, usually the largest firm,
assumes the role of a leader but undertakes also to protect the interest of other
firms instead of merely promoting its own interest. It fixes the price, which is found
to be suitable for all the firms in the industry.
3. Exploitative or aggressive price leadership, where one big firm comes to establish its supremacy
in the market by following aggressive price policies. This firm compels
other firms to follow it and accept the price fixed by it. In case any firm shows any
independence, this firm threatens them and any coerces them to follow its leadership
and finally the price set by this firm comes to be accepted willingly or unwillingly.
Monopolistic competition is defined as market setting in which a large number of sellers sell
differentiated products. Monopolistic competition has the following features:
(i) Large number of sellers
(ii) Free entry and exit
(iii) Perfect factor mobility
(iv) Complete dissemination of market information
(v) Differentiated product.
We can compare the monopolistic and perfect forms of competition with the help of
Table 2.20.
Table 2.20 Monopolistic vs perfect competition
Monopolistic competition
Perfect competition
Products are differentiated by brand name,

Products are homogeneous.
design, colour, shape, packaging, trade
mark, etc.
Firms decisions and business behaviour
Decision making is independent of other
are not absolutely independent of each
firms.
other.
Number of sellers is large but limited.
Number of sellers is very large.
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SUMMARY
Demand analysis is essential for successful production planning and business expansion in
managerial decision making. The consumers demand for commodity because they derive or
expect to derive pleasure or satisfaction. The satisfaction which a consumer gets by having or
consuming goods or services is called utility. Total utility refers to the sum total of satisfaction which
a consumer receives by consuming the various units of commodity. Marginal utility of a good is
defined as the change in total utility resulting from one unit change in the
consumption of the good. The law of diminishing marginal utility states that the marginal utility
derived on the consumption of every additional unit goes on diminishing, other things remaining the
same. An indifference curve is a curve that shows different combinations of the two goods yielding
the same level of utility to the consumer. This is also known as equal utility curve. An indifference
schedule is a table showing the various combinations of two or more commodities which give equal
satisfaction to the consumer.
Demand means effective demand, that is, one which meets with all its three characteristics, i.e.
desire, willingness and ability to pay. It also signifies a price and a period of time in which demand
is to be fulfilled. Individual demand is the demand by one buyer for a commodity.
Market demand means the total quantity of a commodity that all its buyers are willing to buy at a
given price over a time period. Demand can be represented either numerically with a table called the
demand schedule that shows the quantity demanded at each given price, or can be represented on a
graph as a line or curve called demand curve by plotting the quantity demanded at each price, or
described mathematically by a demand equation called the demand function.
The factors that influence demand are called the determinants of demand. Price, income of the
consumer, consumer tastes and preferences, prices of related goods, expectations of future price
changes, advertising efforts, quality of the product, distribution of income and wealth in the
community, standard of living and spending habits, age structure and sex ratio of population, level of
taxation and tax structure, climate or weather conditions and population characteristics are the
determinants of demand. Demand for various goods is generally classified on the basis of the nature
of goods, consumers and suppliers of goods, degree of dependence, duration of consumption of a
good, period of demand, nature of use of goods, etc. The types of demand are: Derived demand and
autonomous demand, demand for producers goods and
consumers goods, demand for durable goods and non-durable goods, new and replacement
demands, industry demand and firm demand, short-run demand and long-run demand, and total market
demand and market segment demand.
The law of demand expresses the relation between quantity of a commodity demanded and
its price. It states that other things remain constant when price falls, demand rises and vice versa. A
movement along the demand curve is caused by a change in price of the good or
service. A shift in the demand curve is caused by a change in any non-price determinant of demand.
Elasticity is the concept in economics that measures the responsiveness of one variable in response to
another variable. When a small change in price may bring about a big change in demand, then it
represents elastic demand. Due to changes in price if the demand remains more or less constant then it
represents inelastic demand. Elasticity of demand can be divided into four types: Price elasticity of
demand, which measures the responsiveness of sales to DEMAND ANALYSIS
145
change in price; income elasticity of demand, which measures the responsiveness of sales to changes
in consumer income; cross-elasticity of demand, which measures the responsiveness of sales of one
commodity to change in the price of another commodity; and promotional
elasticity of demand, which measures the responsiveness of sales to change in the amount spent on
advertising and promotion.
Forecasting is the process of predicting the future. There are two kinds of forecasts: passive forecasts
and active forecasts. Passive forecasts predict the future situation in the absence of any action by the
firm while active forecasts estimate the future situation taking into account the likely future actions of
the firm. Forecasting techniques range from the simple to the extremely complex. There are two
approaches to the problem of business forecasting. One is to obtain information about the intentions of
consumers through collecting experts opinion or by
conducting interviews with consumers. The other is to use past experience as a guide and by
extrapolating past statistical relationships to suggest the level of future demand. The first method is
called the qualitative method which is appropriate for short-term forecasting, and the second is called
quantitative method which is appropriate for long-term forecasting.
Market structure refers to all characteristics of a market that influence the behaviour of buyers and
sellers when they come together to trade. The various types of markets are: Perfect competition,
monopoly, monopolistic competition, duopoly, oligopoly, etc.
EXERCISES
State which of the following statements are true and which are false:
1. The share market is always subject to speculative demand.
2. Demand for tea is an autonomous demand.
3. The relationship between price and demand is inverse, other things remaining constant.
4. Market demand curve is the horizontal summation of individual demand curves.
5. Giffen goods and speculative goods are exceptions to the law of demand.
6. The price elasticity of demand generally is negative, indicating inverse relationship
between price and quantity demanded.
7. If income elasticity of demand is negative, then the product is an inferior good.
8. If cross-elasticity of demand is negative, then the products are complements.
9. Elasticity measures the extent of inter-dependence of two variables.
10. The income elasticity of demand is negative for inferior goods.
11. The cross-elasticity of demand is positive for substitutes.
12. In a hypothetical case of perfect price discrimination, producer surplus is completely eliminated.
13. In a hypothetical case of perfect price discrimination, deadweight loss is completely eliminated.
14. Monopolistic competition includes some characteristics of perfect competition and some
characteristics of monopoly.
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15. In a situation of monopolistic competition, no close substitutes are available.
16. Monopolistically competitive firms have higher unit costs than would be the case in a perfectly
competitive market.
Answers
1. True
2. True
3. True
4. True
5. True
6. True
7. True
8. True
9. True
10. True
11. False
12. False
13. True
14. True
15. False
16. True
Fill in the blanks:
1. Related goods are divided into two groups. These are ___________ and ______________.
2. The law of demand says that the demand of a commodity and its price are ______ related, other
things remaining constant.

3. Demand curve slopes downwards from __________ to _________.
4. The two methods of forecasts are ________ and _____________.
5. A monopoly that emerges because of economies of scale is called a ______monopoly.
6. A superstore prevents competitors from entering the market by temporarily pricing its
goods below cost, thus driving new entrants out of business. This practice is known as
_______ pricing.
7. Selling goods to another country at a price below the cost of production is known as
_______ .
8. The marginal revenue curve for a monopolist is (flat/downward-sloping/upwardsloping)___________ .
9. Market power in the form of a monopoly creates benefits for the __________ (buyer/
seller) at the expense of the ______ (buyer/seller).
Answers
1. substitutes and complementaries
2.
inversely
3. left, right
4.
qualitative and quantitative
5. natural
6.
predatory
7. dumping
8.
downward-sloping
9. seller, buyer
Choose the correct answer:
1. When economists speak of the utility of a certain good, they are referring to
(a) The demand for the good.
(b) The usefulness of the good in consumption.
(c) The satisfaction gained from consuming the good.
(d) The rate at which consumers are willing to exchange one good for another.
2. Economists use the term marginal utility to mean
(a) The additional satisfaction gained, divided by additional cost of the last unit.
(b) Total satisfaction gained when consuming a given number of units.
DEMAND ANALYSIS
147
(c) The additional satisfaction gained by the consumption of one more unit of a good.
(d) The process of comparing marginal units of all goods which could be purchased.
3. The highest price that buyers are willing and able to pay for a given quantity of a good is the
(a) Shortage price.
(b) Surplus price.
(c) Determinant price.
(d) Demand price.
(e) Supply price.
4. A demand schedule indicates that __________ corresponds with __________.
(a) Higher demand price, a smaller quantity demanded.
(b) Higher demand price, a larger quantity demanded.

(c) Larger income, a larger demand.
(d) Larger income, a smaller demand.
(e) The price of one good, the demand for another good.
5. Demand is a __________ and quantity demanded is a __________.
(a) Specific quantity at a specific price, range of quantities and prices.
(b) Specific quantity at a range of prices, range of quantities at a specific price.
(c) Specific quantity at a specific price, specific quantity at a specific price.
(d) Range of quantities at a specific price, specific quantity at a range of prices.
(e) Range of quantities at a range of prices, specific quantity at a specific price.
6. Market demand is most closely related to
(a) Human capital.
(b) Limited resources.
(c) Unlimited wants and needs.
(d) Seventh rule of complexity.
(e) Fifth rule of imperfection.
7. An item that would be classified as a determinant of demand is
(a) Preferences.
(b) Resource prices.
(c) Sellers expectations.
(d) Number of sellers in the market.
(e) Prices of goods using the same resources in production.
8. When a change in the price of a good causes a change in the quantity of the good
demanded because the real purchasing power of buyers incomes has changed, this is best
attributed to the
(a) Income effect.
(b) Substitution effect.
(c) Demand effect.
(d) Ceteris paribus effect.
(e) Determinant effect.
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9. Two goods that are used jointly to provide satisfaction are termed
(a) Inferior goods.
(b) Normal goods.
(c) Superior goods.
(d) Complement goods.
(e) Substitute goods.
10. A market demand curve
(a) May or may not show a positive relationship between price and quantity demanded.
(b) Is the horizontal sum of all individual demand curves.
(c) Is the vertical sum of all individual demand curves.
(d) Does not reflect the law of demand; however, an individual demand curve does.
11. What effect is working when the price of a good falls and consumers tend to buy it
instead of other goods?
(a) The income effect.
(b) The substitution effect.
(c) The diminishing marginal utility effect.
(d) The ceteris paribus effect.

12. The quantity demanded of a product increases when
(a) The consumers suddenly want more of the good.
(b) The consumers level of income falls.
(c) The price of the product falls.
(d) More buyers of the good enter the market.
13. Demand curve slopes downward because of:
(a) The law of diminishing marginal utility.
(b) The income effect.
(c) The substitution effect.
(d) All the above.
14. If the income and substitution effects of a price increase work in the same direction, the good
whose price has changed is an
(a) Giffen good.
(b) inferior good.
(c) normal good.
(d) superior good.
15. A rise in the relative price of bus transport will lead to
(a) A fall in the demand for taxi services.
(b) A fall in the demand for new cars.
(c) An expansion of supply of new cars.
(d) An expansion of new bus routes available for customers.
16. If the price of DVRs fell, and as a result, the demand for VHS recorders fell, we could conclude
that VHS recorders and DVRs are
(a) Normal goods.
(b) Substitutes.
DEMAND ANALYSIS
149
(c) Complements.
(d) Unrelated.
17. The percentage change in the quantity demanded of a product that results because of a percentage
change in income is called the
(a) Price elasticity of demand.
(b) Income elasticity of demand.
(c) Cross-elasticity of demand .
(d) Demand elasticity of different prices.
18. The percentage change in the quantity demanded of a product that results because of a percentage
change in the price of a different product is called the
(a) Price elasticity of demand.
(b) Income elasticity of demand.
(c) Cross-elasticity of demand.
(d) Demand elasticity of different prices.
19. The income elasticity of demand is negative for a
(a) Positive good.
(b) Normal good.
(c) Elastic good.
(d) Inferior good.
20. If the income elasticity of demand is greater than 1, the good is a
(a) Necessity.
(b) Luxury.
(c) Substitute.
(d) Complement.
21. To find the quantity people will buy, we move along the demand line if this changes
(a) Price of the product.
(b) Income.
(c) Price of a substitute.
(d) Price of a complement.
22. If peoples tastes change so that they like the product better, the demand for the product will
(a) Shift to the right.
(b) Shift to the left.
(c) Move along.
(d) None of the above.
23. If buyers expect the price of a product to rise greatly very soon, the demand for that product will
(a) Shift to the right.
(b) Shift to the left.
(c) Move along.
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24. All of the following are idealized types of market structure except
(a) Perfect competition
(b) Monopolistic competition
(c) Oligopolistic monopoly
(d) Pure monopoly
(e) Oligopoly
25. Which of the following is a condition of monopoly?
(a) Two or more sellers.
(b) Only one buyer.
(c) A good with several close substitutes.
(d) Barriers to entry.
(e) None of the above.
26. A natural monopoly is
(a) An oligopoly.
(b) A monopoly characterized by diseconomies of scale.
(c) A monopoly that emerges because of economies of scale.
(d) A monopoly on a scarce natural resource.
(e) A monopoly that solves the problem of diseconomies of scale.
27. In international trade, dumping refers to
(a) Exclusionary practices.
(b) Charging unfairly high prices.
(c) Providing unwanted goods free of charge.
(d) Selling goods at a price below the cost of production.
(e) Selling goods above market price.
28. Which of the following statements is false?
(a) Monopolistic firms maximize profits at the point where MC = MR.
(b) Monopolistic firms are price takers.
(c) Monopolistic firms face a downward sloping demand curve.
(d) Monopolistic firms face a downward sloping marginal revenue curve.
29. The demand curve for the output of a monopolistic firm is equal to
(a) The marginal revenue for the product in question.
(b) The market supply curve for the product in question.
(c) The market demand curve for the product in question.
(d) The demand curve for a firm in a perfectly competitive market.
(e) The concentration ratio of the firm.
30. A monopolistic firm can sell more by
(a) Advertising its product successfully.
(b) Competing effectively with other firms.
(c) Lowering the price of its product.
(d) Both (a) and (c) are true.
(e) Options (a), (b), and (c) are all true.
DEMAND ANALYSIS
151
31. Suppose a firm can sell five units of output at a price of Rs. 10 each. To sell six units of output,
the firm must lower its price to Rs. 9 per unit. To sell seven units, the firm must lower its price to Rs.
8 per unit. Which of the following statements is true?
(a) The firm can maximize profits at all of the production levels listed above.
(b) The firm faces an upward sloping demand curve.
(c) Based on the information given above, we can conclude that seven units is the profitmaximizing level of production.
(d) Based on the information given above, we can conclude that this firm faces net losses at the levels
of production considered here.
(e) The firm can be described as a price maker.
32. Suppose a firm can sell one unit of product for Rs. 50, two units for Rs. 45, three units for Rs. 40,
or four units for Rs. 35. When the firm sells four units, marginal revenues
is equal to
(a) Rs. 5.
(b) Rs. 20.
(c) Rs. 25.
(d) Rs. 30.
(e) Rs. 35.
33. Which of the following statements is true?
(a) Monopolistic firms face zero profits in the long run.
(b) Monopolistic situations do not involve any inefficiencies.
(c) The monopolistic firm always faces a downward sloping, marginal cost curve.
(d) The perfectly competitive firm faces a horizontal marginal revenue curve.
(e) The monopolistic firm faces a horizontal marginal revenue curve.
34. Which of the following statements is true of a monopolistically competitive firm?
(a) It faces a downward-sloping demand curve.
(b) It earns positive economic profits in the long run.
(c) It produces more than a perfectly competitive firm.
(d) It charges lower prices than a perfectly competitive firm.
(e) Its profits are protected by significant barriers to entry.
35. Under conditions of oligopoly, firms may collude in order to
(a) Avoid the outcome associated with the prisoners dilemma.
(b) Increase competition.
(c) Solve the concentration-ratio problem.
(d) Create a prisoners dilemma for buyers.
(e) Initiate a price war with one another.
36. Which of the following is a form of implicit collusion?

(a) Duopoly.
(b) Price wars.
(c) Non-price competition.
(d) Prisoners dilemma.
(e) Price leadership.
152
37. Which of the following statements about oligopoly is false?
(a) Under conditions of oligopoly, entry into the market is difficult.
(b) Each firm must consider how other firms will respond to its production decisions.
(c) Each firm in an oligopoly makes decisions without regard for the actions of other
firms.
(d) Game theory is used to analyze the behaviour of firms in an oligopoly.
(e) Firms in an oligopolistic market often have an incentive to collude.
38. A firm faces a small number of competitors. This firm is competing in
(a) A monopoly.
(b) Monopolistic competition.
(c) An oligopoly.
(d) Perfect competition.
39. Firms in an oligopoly
(a) Are independent of each others' actions.
(b) Can each influence the market price.
(c) Charge a price equal to marginal revenue.
(d) All of the above answers are correct.

40. How is a firm in an oligopoly similar to a monopoly?
(a) Both types of firms produce a standardized product.
(b) The behaviour of both types of firms can be analyzed using game theory.
(c) Both types of firms operate behind natural or legal barriers to entry.
(d) Both types of firms are price takers.
41. A group of firms acting together to limit output, raise price and increase economic profit is called
a
(a) Duopoly.
(b) Monopolistic oligopoly.
(c) Competitive oligopoly.
(d) Cartel.
42. A group of firms that has entered into an agreement to restrict output and increase prices and
profits is called
(a) A compliance.
(b) A cartel.
(c) An oligopoly.
(d) A duopoly.
43. Duopoly is
(a) Another name for monopoly.
(b) A special type of monopolistic competition.
(c) A two-firm oligopoly.
(d) A game with three players.
44. A market with two firms competing
(a) Is known as a duopoly.
(b) Is monopolistic competition.

DEMAND ANALYSIS
153
(c) Both (a) and (b) are correct
(d) None of the above answers are correct.
45. Which of the following statements is correct?
(a) A firm in an oligopoly will charge a price that is lower than the price charged in
perfect competition.
(b) If firms in an oligopoly look only at their own self-interest in deciding the output
they should produce, the total market output will exceed that of a monopoly.
(c) If one oligopolist reduces the price of its product, its demand curve shifts leftward.
(d) Because many producers join to form a cartel, the market becomes monopolistic
competition.
46. Firms operating in an oligopoly
(a) Always compete on price.
(b) Always compete on price, product quality and marketing.
(c) Can earn monopoly profits.
(d) Usually achieve a competitive outcome.
Answers:
1. (c)
2. (c)
3. (d)
4. (a)
5. (e)
6. (c)
7. (a)
8. (a)
9. (d)
10. (b)
11. (b)
12. (c)
13. (d)
14. (c)
15. (c)
16. (b)
17. (b)
18. (c)
19. (d)
20. (b)
21. (a)
22. (a)
23. (a)
24. (c)
25. (d)
26. (c)
27. (d)
28. (b)
29. (c)
30. (d)
31. (e)
32. (b)
33. (d)
34. (a)
35. (a)
36. (e)
37. (c)
38. (c)
39. (b)
40. (c)
41. (d)
42. (b)
43. (c)
44. (a)
45. (b)
46. (c)
1. Define the equilibrium of the firm in perfect competition.
2. What are the exceptions of the Law of Demand?
3. Explain the features of the Perfect Market.
4. Differentiate between demand function and demand schedule.
5. Derive demand schedule and demand curve.
6. Distinguish between monopoly and oligopoly.
7. What is demand? Mention its determinants.

8. Explain the terms monopoly and duopoly?
9. Note the techniques available for demand forecasting.
10. Distinguish income elasticity from price elasticity.
11. Explain the of Law of Demand.
12. What are internal economies?
154
13. What are fixed costs?
14. What do you understand by change in demand and elasticity of demand?
15. Explain the concept of demand.
16. What do you understand by cross-elasticity?
17. Explain shift in demand curve or change in demand.
18. What is movement along the demand curve or change in the quantity demanded?
19. Explain demand for producer goods and demand for consumer goods.
20. Differentiate between demand for durable and perishable goods.
21. Define price elasticity of demand.
22. Define cross-elasticity of demand.
23. Define point price elasticity of demand.
24. Define arc price elasticity of demand.
25. What are the business uses of price elasticity of demand?
26. Define monopoly.
27. Explain the demand function.
28. Describe the simultaneous equation method.

1. Define demand. What are the various determinants of demand? Explain.
2. What are the various types of demand? Explain.
3. What is an indifference curve? Explain its properties.
4. Explain the Law of Demand and exceptions to the Law of Demand.
5. Explain price elasticity of demand. How can it be measured? What are the business uses of price
elasticity of demand?
6. What are the features of perfect competition? How is price determined? Discuss.
7. State the factors determining the price elasticity of demand.
8. Describe the various types of price elasticity of demand.
9. What is demand forecasting? Explain the different methods of demand forecasting.
10. Define elasticity of demand and explain its types.
11. Discuss the methods of measuring elasticity of demand.
12. What is oligopoly? Explain price rigidity under oligopoly with the help of kinked demand curve
analysis.
13. What is perfect competition? Explain equilibrium of a firm under perfect competition.
14. What is price discrimination and how does the monopolist follow it for sales promotion?
DEMAND ANALYSIS
155
15. Define the term Demand and explain its law with reference to price and income.
16. What do you mean by arc elasticity of demand? How can you measure elasticity of
demand by arc method?
17. What is perfect market? Explain the features of perfect market.
18. What is meant by Law of Demand? Explain its characteristics and limitations.
19. Define a market. Explain different types of market structures.
20. Distinguish between monopoly and oligopoly. Discuss the equilibrium of a firm under
short and long run.
PROBLEMS
1. The annual sales of a company are as follows:
Year
1997
1999
2001
2003
2005
Sales (in lakhs)
75
84
92
98
88
Using the method of least squares, estimate sales for the years 2007 and 2009.
[ Ans. forecast sales for years 2007 and 2009 are 99.4 and 103.4 lakh units.]
2. Compute the 3-day moving average from the following sales data:
Period
January
February
March
April
May
40
55
68
53
35
CHAPT E R
3
Production and Cost Analysis
LEARNING OBJECTIVES
What is production?
The factors of production and the organisation.
Production function with one variable input, two variable inputs and three variable inputs.
The three stages of production
Cobb-Douglas production function
Economies of scaleexternal and internal
What is cost analysis
The relationship between the cost and output
Break-even analysis
INTRODUCTION
After discussing the demand side of price theory, we proceed to discuss the supply side. The supply
side relates to the production of goods and services. Production of goods depends on the cost of
production, which in turn depends on the prices of inputs or the factors of
production.
The cost which a firm incurs in the process of production of goods and services is an
important variable for decision-making. Total cost together with total revenue determines the profit
level of a business concern. In order to maximize profits, a firm endeavours to increase its revenue
and lower its cost. To achieve this, managers must try to produce optimum levels of output, use the
least cost combination of factors of production, increase factor productivities and improve
organizational efficiency.
156
PRODUCTION AND COST ANALYSIS
157
Production in economics is generally understood as the transformation of inputs into
outputs. The inputs are what a firm buys (i.e. productive resources) and outputs (i.e., goods and
services produced) what it sells. Apart from physical changes of the matter, production also includes
services like buying and selling, transporting and financing. But in economic analysis we restrict the
use of the term production to the production of goods only, because in the production of goods we can
precisely specify the inputs and also identify the quantity and quality of outputs.
In the theory of production, we study the factors of production and their organization. We also study
the laws of production, i.e. the generalizations governing the relations between the inputs and outputs.
We shall also study the production function, i.e. the relation between the inputs and outputs of a firm.
The theory of production occupies a very important place in economic analysis and it has
a great relevance to the study of various economic problems. Especially the theory of
production helps in the analysis of relations between costs and volume of output. It tells us how a
manufacturer combines various inputs in order to produce a given output in an economically efficient
manner, i.e. at the minimum unit cost. Theory of production also provides a base for the theory of the
demand of the firms productive resources. Thus, the theory of production has a great relevance to the
theory of the firm. Every firm tries to produce maximum output at minimum cost to maximize profits.
For this purpose, the firm has to consider the marginal cost and average cost of production besides
considering demand conditions, i.e. average and marginal revenues. The theory of production also
explains the forces which determine the
marginal productivity of factors and so the prices that have to be paid for the factors of production.
MEANING OF PRODUCTION
In economics, the term production means a process by which resources (men, material, time, etc.) are
transformed into a different and more useful commodity or service. In general,
production means transforming inputs (labour, machines, raw material, time, etc.) into an output. This
concept of production is however limited to manufacturing only.
In an economic sense, production is an organized activity of transforming inputs into
outputs to satisfy the demand for commodities and services of the community. Input refers to all those
things which a firm buys and employs to produce a particular product. Output means the quantity of
goods in the finished form produced by the firm for selling. Production also includes rendering of
various kinds of services such as transporting, banking, insurance, etc.
For example, transporting a commodity from one place to another where it can be consumed
or used in the process of production is production. Transporting men and material from one place to
another is a productive activity. It produces service. All productive activities are the examples of
service, All productive activities are the examples of production as manufacturing.
Production process does not necessarily involve physical conversion of raw materials into tangible
goods. Some kinds of production involves an intangible input to produce an intangible output. For
example, in the production of legal, social and other consultancy services, both input and output are
intangible.
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FACTORS OF PRODUCTION
Productive resources used in the production of a given product are called factors of production.
These productive resources may be raw material or services of the various categories of workers or
entrepreneurs or capitalists who supply capital. These resources used in the production of goods are
called inputs. The factors of production have been traditionally classified as land, labour, capital and
organization (or enterprise). The combination of these factors is essential in the production process.
Now we shall discuss these briefly one by one.
Land
The term land has been given a special meaning in economics. It does not mean soil as in the ordinary
speech, but it is used in a much wider sense. In the words of Marshall, land
means the materials and the forces which nature gives freely for mans aid, in land and
water, in air and light and heat. Land stands for all natural resources which gives an income or
which have exchange value. It represents those natural resources which are useful and scarce,
actually or potentially. The features of land are: (i) it is natures gift to man; (ii) it is fixed in quantity.
It is said that land has no supply price; (iii) it is permanent. There are inherent properties of the land
which Ricardo called Original and indestructible; (iv) land lacks mobility in the geographical sense;
(v) land provides infinite variation of degrees of fertility and situation so that no two places of land
are exactly alike. For using land as input in the production process, the entrepreneur has to pay rent to
the landlord. The remuneration for the land is called rent.
Labour
Labour is mans effort. Services offered for a price are alone considered labour in economics.
A housewife renders very important services, but the services are not offered for a monetary
remuneration. They do not carry market value, so they are not considered labour in economics.
Unless work is done for some consideration, e.g. payment in cash or kind, it cannot be called labour.
In ordinary language, by labour we mean the work done by labourershard manual
labour, generally unskilled. But in economics, the term Labour has a wider meaning. It does not
merely mean manual labour. It includes mental work too. It thus embraces the work of
engineers, clerks, typists, managers, government officials, lawyers, teachers, doctors, etc. All types of
work come under labour in economics, provided it is done for money.
Peculiarities of Labour
Labour is Inseparable from Labourer.
A worker cannot work in the factory while sitting
at home. A doctor has to attend to his patients in person. The farmer cannot work on the farm without
going to the farm.
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Labour Perishes.
Suppose the labour does not go to work today, he cannot store his labour
for tomorrow; it perishes. A good can be stored and sold tomorrow. So the labour looses the
remuneration for that day.
Labour has Weak Bargaining Power.
Labourers cannot store their labour and sell it later.
No work means no income; without income, they have to starve. So their bargaining power
is weak. In contrast to this, management has greater bargaining power. Workers organize
themselves into trade unions for collective action to get rid of this weakness.
Rise in Wage may not Lead to Increase in the Supply of Labour but Sometimes it may
even result in Decrease in Supply.
A rise in wage rate leads to increase in labourers
income. Due to this, they may opt for more leisure. Therefore they do not go to work for
longer hours or more days. On the other hand, when the wage rate falls, they may work for more hours
and days because their income may not be sufficient for their usual expenses.
Cost of Production of Labour cannot be Precisely Estimated.
The cost of production of
goods can be precisely calculated. But the cost of production of labour cannot be easily
estimated.
Labour Supply Chiefly Depends on Growth of Population.
If the population in the
country is large, labour supply will also be large. If it is small, labour will also be small. Thus,
labour supply mainly depends on population. If the price of any good rises up, its supply goes up. But
population does not increase just because wage rate rises. Increase or decrease of population is a
function of several non-economic factors.
Therefore, the supply of labour for the society as a whole will not be responsive to changes in wage
rate.
Capital
Capital is the man-made means of production like machinery, factory building, etc. Capital refers to
that part of a mans wealth which is used in producing further wealth or which yields an income. The
term capital is generally used for capital goods, e.g., plant and machinery, tools and accessories, etc.
Capital plays a vital role in the modern productive system. Production without capital is hard for us
even to imagine. Because of its strategic role in raising
productivity, capital occupies a central position in the process of production.
Capital is usually divided into (1) fixed capital and (2) variable capital. Fixed capital does not mean
capital that does not move. It is used in production for quite a long period of time, e.g. railroads,
factories, machines, buildings, etc. Variable capital goes on changing its form.
This may be initially in the form of money. Later, it may be convertible into raw material, and then it
may come into the form of finished goods. When they are sold, it again takes the form of money. So it
is also called circulating capital.
In each form, it will be used only once. Both types of capital are very important for the entrepreneur
in producing goods and services. For using capital in the production of goods, the firm must bear the
interest which is a cost to the firm. Therefore, capital is a form of
160
productive equipment, which the entrepreneur must use properly to maximize profits and
minimize its cost.
Organization or Enterprise
Organization or enterprise means to plan a business, start it and run it. It means to bring the factors of
production together, assign each its proper task and pay them remuneration when the work is done. It
implies not only the running of a business, but also shouldering the loss, if any. The man who
undertakes all this work is called an organizer or more commonly an
entrepreneur. Organising and risk-taking are the two main functions of the entrepreneur.
In modern times, business is a very complicated affair. National and international
influences act on it. Even a small happening in some remote corner of the world might bring it
disaster. Owing to such complexities, the work of an organization has become very
important.
The success of a business depends on sound organization. It must be carefully planned, and the plan
must be properly executed. This is a whole-time job. Somebody must devote all his time and energy
to it. Hence the work of an organizer is very important in the success of any business. The three
factorsland, labour and capitallie scattered. One person has land but no capital. Another has
capital but no land. The labour has neither; he has only his labour to offer. So all the factors of
production lie apart from one another. Somebody must bring them together if production is to go on.
This is what the entrepreneur does. Hence organization is a very important factor of production.
Unless business is properly organised, it cannot be a success. Other factors of production make their
best contribution in the production of goods through proper organization of business.
PRODUCTION FUNCTION
The term production function refers to the relationship between the inputs and the outputs produced
by them. Production function describes the technological relationship between inputs and output in
physical terms. The production function may be defined as the functional
relationship between physical inputs, (i.e. the factors of production) and physical outputs, (i.e.
the quantity of goods produced).
Traditional economic theory speaks of four factors of production, viz. land, labour, capital, and
organization or management. Technology also contributes to output growth and it is now regarded as
an additional determinant of output. Thus, the output of a firm or industry is a positive function of the
quantities of land, labour and capital, the quality of management, and the level of technology that is
employed in its production. Like demand, production function refers to a period of time. Accordingly,
it refers to a flow of inputs resulting in a flow of outputs over a period of time, leaving prices aside.
The production function shows the maximum output that can be produced from a given
set of inputs in the existing state of technology. The output will change when the quantity of any input
or the minimum quantities of various inputs required for producing a given quantity is changed.
The manufacturer wants to know how much of the various factors or inputs required to
produce a unit or given quantity of output during a given period of time. It is necessary for
161
him to know this so that he may be able not only to assess his requirements of inputs, but also roughly
to estimate the probable cost. The production function of course depends on quantities of resources
used, state of technical knowledge, possible processes, size of the firm, nature of the organization,
relative prices of the factors of production and the manner in which the factors of production are
combined. As these things change, the production function will
change too.
The production function changes with period of time. In the very long period, it changes
altogether because the same inputs produce different outputs. In the short run, the choices open to the
producer are restricted because some of the factors are fixed and cannot be changed in the short
period and only some can be varied. In this situation, the producer tries to find out the relation
between the variable inputs and the outputs.
Since production function is concerned with physical aspects of production, it is more a
concern of an engineer or technician rather than of an economist. Only a technician can say what
specific quantity of a good can be produced by the use of various productive resources and their
combinations.
Every management has to make a choice about the production function, depending not only
on industrial knowledge and the prices of the various factors of production but also on its own
capacity to manage. It has also to select the various factors and knit them together in
economical combinations to give the minimum average cost and maximum aggregate profit.
The production function may take the form of either a schedule or table, a graph line or
curve, an algebraic equation or a mathematical model. But each of these forms of the
production function can be converted into its other forms.
An empirical production function is generally very complex. It includes a wide range of
inputs, viz. (a) land, (b) labour, (c) capital, (d) raw material, (e) time and (f) technology. All these
variables enter the actual production function of a firm. Symbolically, the production function can be
denoted as follows:
Q = f ( X, Ld, L, K, M, T, t) where,
X = Output of a commodity
Ld = Land and buildings employed in the production of Q
L = Labour employed in the production of Q
K = Capital employed in the production of Q
M = Management employed in the production of Q
T = Technology employed in the production of Q
t = Time
f = Unspecified function.
The above equation describes a general production function. In a specific situation, one or the other
of these various factor inputs may not be important and the relative importance of a factor of
production varies from one type of product to another. Therefore, the economists have reduced the
number of variables used in a production function to only two, viz. capital ( K) and labour ( L), for
the sake of convenience and simplicity in the analysis of input-output relations. The production
function is expressed as
a = f ( K, L)
162

The reasons for ignoring other inputs are that land and buildings as inputs are constant for the
economy as a whole, and hence it does not enter into the aggregate production function.
However, land and buildings are not a constant variable for an individual firm or industry. In the case
of individual firms land and buildings are lumped with capital. In case of raw material, it has been
observed that this input bears a constant relation to output at all levels of production.
Similarly, for a given size of house, the quantity of bricks, cement, steel, etc. remains constant,
irrespective of number of houses constructed. This constancy of input-output relations leaves the
methods of production unaffected. That is whyin most production functions only two
inputslabour and capital are included.
The above algebraic or mathematical form of production function (i.e. X = f ( K, L)) has three
variablesoutput of commodity, units of labour and units of capital. For a given value of a, there will
be alternative combinations of L and K. These combinations of L and K will vary with variations in
X. Generally speaking, both labour and capital are necessary for the production of a commodity and
they are substitutes of each other. Thus, for any given level of output, an entrepreneur will need to hire
both capital and labour but he would have an option to employ any one combination. The alternative
combinations of factors for a given output level will be such that if the use of one factor input is
increased, that of another will decrease and vice versa. For example, in steel manufacturing the firm
employs only two inputscapital ( K) and labour ( L)into steel production activity.
The production function implies that quantity of steel produced depends on the quantity
of capital, K, and labour, L, employed to produce steel. Increasing steel production will require
increasing K and L. Whether, the firm can increase both K and L or only L depends on the time-period
it takes into account for increasing production, i.e., whether the firm considers a short run or a long
run. Supply of capital is inelastic in the short run and elastic in the long run.
In the short run, the firm can increase steel production by increasing labour only since the supply of
capital in the short run is fixed. In the long run, however, the firm can employ more of both capital and
labour because of supply of capital becomes elastic over time. Accordingly, there are two kinds of
production functions: (a) short-run production function and (b) long-run production function. The
short-run production function may also be termed single-variable production function. It can be
expressed as X = f (L). In the long-run production function, both K and L are included and the function
can be expressed as X = f (K,L).
Assumptions of Production Function
The production function is based on the following assumptions:
1. Technology is assumed to be constant. If technology changes it would result in
alteration of the input-output relationship, resulting in a production function.

2. It is assumed that firms utilize their inputs at maximum levels of efficiency. In other words, the
production function includes all the technically efficient methods of
production.
3. Production function is always related to a specified period of time.
4. There are only two factors of productionlabour ( L) and capital ( K).
163
5. Limited substitution of one factor for the other.
6. Inelastic supply of fixed factors in the short run.
7. It is possible to use various amounts of a variable factor on the fixed factors of
production.
If there is a change in these assumptions, the production function will have to be modified
accordingly.
Laws of Production
The laws of production state the relationship between inputs and outputs. The input-output
relationships can be studied under short-run and long-run conditions. In the short run, input-output
relations are studied with one variable input like labour, and all other inputs like plant, machinery,
floor space, etc. of a firm are fixed. The laws of production under short-term conditions are called
Laws of variable proportions or the Laws of Returns to a variable input.
In the long run, input-output relations are studied on the assumption of all the inputs to be variable.
The long-run input-output relations are studied under Laws of returns to scale.
In economic theory, the production function is of three types:
1. Production function with one variable input.
2. Production function with two variable inputs.
3. Production function with all variable inputs.
Production Function with One Variable Input
Some factors of production are available in unlimited supply even during the short period. Such
factors are called variable factors. Therefore, in the short run, the firm can employ an unlimited
quantity of the variable factor in varying quantities against a given quantity of fixed factors. This kind
of change in the input combination leads to variations in factor proportions.
The law which brings out the relationship between varying factor proportions and output are known
as the Law of returns to a variable input, or the Law of diminishing returns.
Law of Variable Proportions
The law of variable proportions shows the input-output relationship or production function with one
factor variable, while other factors of production are kept constant. Suppose that all inputs like plant,
machinery, floor space, etc. of a firm are fixed, while only the amount of labour services vary. This
means that any increase or decrease in output is achieved with the help of changes in the amount of
labour. When the firm changes in the amount of labour, it alters the proportion between the fixed input
and the variable input. As the firm keeps on altering this proportion by changing the amount of labour,
it inevitably experiences the law of diminishing marginal returns (which is the same thing as the law
of variable proportions). This law states that as more and more of one factor input is employed, with
all other input quantities held constant, a point will eventually be reached where additional quantities
of the varying input will yield diminishing marginal returns to total product.
164
Under this law, the effects of the changes in the variable input on the output can be studied under three
aspects, i.e., total product, average product and marginal product. Total product ( TP) is the total
output which increases at an increasing rate initially for an additional input, then increases at a
constant rate for every additional input and falls gradually for every further input. Average product (
AP) is the result of total product divided by the quantity of input, while marginal product ( MP) is the
additional product from every additional input. Average product increases rapidly and starts
declining, while marginal product increases and equals the AP at its maximum, declines rapidly and
becomes neutral even before AP, while the TP is at its maximum level.
Three Stages of Production
The short-run production function can be divided into three distinct stages of production. The three
stages showing the behaviour of output, when varying quantities of a factor of production are
combined with a fixed quantity of some other factor, are shown in the following
illustration:
Suppose that groundnut crop is raised on a one-acre plot of land. Land, tools and
equipment, seeds and fertilizer are kept constant; only the supply of labour is being increased.
The imaginary Table 3.1 shows how the output increases then.
Table 3.1 Three stages of production
No. of units of
Total product
Marginal product
Average product at
labour
(kg)
(kg)
first stage (kg)
1
100
100
100
2
220
120
110
3
300
80
100
4
360
60
90
5
400
40
80
6
420
20
70
7
420
0
60
8
400
20
50
First Stage.
The total product increases first at an increasing rate and then at a diminishing
rate. The average product continues to raise throughout this stage, while marginal product first raises
and then starts diminishing.
Second Stage.
In the second stage, the total product continues to increase at a diminishing
rate till it reaches its maximum value. During this stage, both the marginal and the average products of
the variable factor are decreasing but remain positive. The limit of the second stage is reached when
the marginal product of the variable factor becomes zero. This stage is the stage of diminishing
returns and is the stage where a rational producer seeks to produce.
165
Third Stage.
During the third stage, the total product declines and the marginal product starts
getting zero and negative values. Average product also diminishes.
The total, marginal and average product curves in Fig. 3.1(a) demonstrate the law of
variable proportions. The figure also shows the three stages of production associated with the law of
variable proportions.
Fig. 3.1(a) Three stages of production.
Law of Variable Proportions: Three Stages.
In Fig. 3.1(a), number of units of labour is
shown on the X-axis and product is shown on the Y-axis. When the average product ( AP) curve
begins to decline, the second stage begins. In the first stage itself, the marginal product curve ( MP)
declines. It begins to diminish. Total product curve ( TP) starts declining at the point of output where
the marginal product curve ( MP) cuts across the X-axis. Their marginal product becomes zero.
Hereafter, it becomes negative. Total output diminishes and third stage begins.
In the first stage MP and AP may increase, but after a point both of them will diminish.
The law of diminishing returns assumes a generalized form. Wherever all the factors except one are
kept constant and one is increased unit by unit, the behaviour of output will be like this in any field,
i.e. agriculture, industry or any other field of activity.
Assumptions.
The following assumptions are valid here:
1. It should be technically possible to increase the supply of one factor only while
keeping other factors constant.
166

2. All the units of the variable factor are homogenous. There should be no difference
between them.
3. It should not be necessary to increase the factors in the same proportion. It should
be possible to change the proportions of factors in which they are combined.
4. Technical knowledge and methods of production do not change.
Production Function with Two Variable Inputs
We have discussed in the preceding section the technical relationship between inputs and
outputs, assuming labour to be the only variable input, capital remaining constant. This is a short-run
phenomenon. In the long run, as all factors are variable, the firm has a wider choice of adopting
productive techniques and factor proportions in relation to employed technology.
In the long run, supply of both the inputs is supposed to be elastic and firms can hire longer quantities
of both labour and capital.
In this section, we shall discuss the relationship between input and output under the
condition that both the inputs are variable factors. This is a long-run phenomenon. The firm increases
its output by using more of two inputs that are substitutes for each other, say labour and capital. The
technical relationship between changing scale of inputs and output is explained under the laws of
returns to scale. This law of returns to scale can be explained through the production function and
iso-quant curve technique.
Iso-quant Curve
The term iso-quant has been derived from the Greek word iso meaning equal and latin word
quantus meaning quantity. Therefore, an isoquant curve is also known as iso-product curve, equal
product curve or production indifference curve. Iso-quant measures a quantum of production
resulting from alternative combination of two variable inputs. Iso-quant map
represents a set of iso-quants describing the production function of a firm. A higher iso-quant
represents a larger quantity of output than the lower one. Table 3.2 shows how different
combinations of labour and capital result in the same output.
Table 3.2 Labour, Capital combinations and Output
Combinations of
Labour
Capital
Volume of output
labour and capital
(units)
(units)
(units)
A
1
25
100
B
2
18
100
C
3
13
100
D
4
10
100
E
5
8
100
Table 3.2 is prepared on the basis of the assumption that only two factors, namely labour and capital,
are used in production. To produce 100 units we need 1 unit of labour and 25 units PRODUCTION
AND COST ANALYSIS
167
of capital (combination A). But the other combinations also give same output, i.e., 100 units.
Thus an iso-product table is a table of different combinations of factors of production giving same
volume of output.
In Fig. 3.1(b), an iso-quant is shown. We obtain this curve by combining the points A, B, C, D and E
which represent the different combinations of labour and capital giving same output.
Y
A
25
18
B
13
C
(units)
D
10
Capital
E
8
IQ
X
0
1
2
3
4
5
Labour (units)
Fig. 3.1(b) Iso-quant curve.
Iso-product Map
An iso-product map is similar to an indifference map. An iso-product map shows a set of iso-product
curves. For each level of output, there is a different iso-quant. When the whole arrays to iso-quant are
represented on a graph, it is called an iso-quant map (see Fig. 3.2).
Y
IQ IQ 2
1
IQ 3 IQ 4
(units)
400 units
Capital
300 units
200 units
100 units
X
Labour (units)
Fig. 3.2 Iso-quant map.

168
The map in Fig. 3.2 gives a typical iso-quant diagram in which the curves move upward
to the right as higher levels of outputs are obtained using larger quantities of inputs. In the above map
there are four iso-product curves. IQ 2 represents higher level of output than IQ 1.
Similarly IQ 3 represents still higher level of output than IQ 2.
Substitutability of Inputs. An important assumption in the iso-quant diagram is that the inputs can be
substituted for each other. Let us take a particular combination of X and Y resulting in an output of 100
units on IQ 1. By moving along the isoquant IQ 1, we find other quantities of the inputs resulting in the
same output. Various combinations of labour and capital yield output equal to 100 units of the
product. If the quantity of labour ( X) is reduced, the quantity of capital ( Y) must be increased in
order to produce the same output.
MARGINAL RATE OF TECHNICAL
SUBSTITUTION (MRTS)
Marginal rate of technical substitution (MRTS) of x for y is the number of units of factor y which can
be replaced by one unit of factor x, with the quantity of the output remaining unchanged. MRTS is a
technical name used for the slope of iso-quant. Marginal rate of
technical substitution is sometimes also called the marginal rate of substitution in production.
Thus, in terms of inputs of capital services K and labour L.
dK
MRTS = dL
(MRTS is similar to MRS, i.e., marginal rate of substitution, which is the slope of an
indifference curve.)
Types of iso-quants.
We have discussed above a convex iso-quant, which is most widely used
in traditional economic theory. The shape of an iso-quant, however, depends on the degree of
substitutability between the factors in the production function. The convex iso-quant assumes a
continuous substitutability between capital and labour but at a diminishing rate. But
economists have observed other degrees of substitutability between K and L and have demonstrated
the existence of three other kinds of iso-quants.
Linear Iso-quants.
A linear iso-quant implies perfect substitutability between the two
inputs K and L. For example, a given output, say 100 units, can be produced by using only capital or
only labour or by a number of combinations of labour and capital, say 1 unit of labour and 25 units of
capital, or 2 units of labour and 18 units of capital, and so on. This is possible only when the two
factors K and L, are perfect substitutes for one another. A linear iso-quant also implies that the MRTS
between K and L remains constant throughout. Hence the iso-quants are straight lines as indicated in
Fig. 3.3.
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Y
Q3
(units)
Q2
Q1
Capital
X
O
Labour (units)
Fig. 3.3 Linear iso-quant curves.
Right-angle Iso-quant or Input-Output Iso-quant. When a production function assumes a fixed
proportion between inputs of K and L, the iso-quant takes L shape, as shown by Q 1, Q 2 and Q 3 in
Fig. 3.4. This is also called fixed factor proportion or L-shaped iso-quants. In this production
function, the factors of production are used in definite fixed proportions. For instance, a fixed number
of workers may be required to produce a fixed number of units of the products, and this proportion
cannot be varied by substituting one factor for the other factors.
Fig. 3.4 L-shaped iso-quant.
Such an iso-quant implies zero substitutability between K and L. Instead, it assumes perfect
complementary between K and L. The perfect complementary assumption implies that a given quantity
of a commodity can be produced by one and only one combination of K and L and that the proportion
of the inputs is fixed. It also implies that if one input is increased and the 170
other input is held constant, there will be no change in output. The output can be increased only by
increasing both the inputs proportionately.
Kinked Iso-quant.
Kinked iso-quant assumes limited substitutability of the two variable
inputs. Since there are only a few processes available for producing any commodity (say A, B, C, D),
substitutability of factors is possible only at kinks. This kind of iso-quant is also called activity
analysis iso-quant or linear programming iso-quant, because it is basically used in linear
programming. Figure 3.5 shows the kinked iso-quants.
Fig. 3.5 Kinked iso-quant curve.
It may be noted that the kinked iso-quants are more realistic. Business executives consider production
processes as discrete rather than continuous because machinery, equipment, etc. are available in a
limited range. The possibilities of substitution between capital and labour are therefore limited.
However, we may consider the continuous iso-quant as an approximation to the kinked iso-quant; as
we increase the number of processes, the kinks come closer and closer until at the limit, the iso-quant
becomes a smooth curve. In our discussion we will consider only the smooth convex iso-quants as
they are easy to handle in practice.
Convex Iso-quant or Smooth Convex Iso-quant.
Convex iso-quant assumes continous
substitutability of the variable inputs over a certain range, beyond which the inputs cannot be
substituted by each other. The iso-quant appears as a smooth curve convex to the origin as given in
Fig. 3.6(a).
Fig. 3.6(a) Convex iso-quant curve.
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Production Function with All Variable Inputs
The proportionate increase in all the input factors will affect total production. Increasing inputs
proportionately and simultaneously is, in fact, an expansion of the scale of production. When a firm
expands its scale, i.e., it increases both the inputs proportionately. Then there are three technical
possibilities.
(a) Total output may increase more than proportionately.
(b) Total output may increase proportionately.
(c) Total output may increase less than proportionately.
Accordingly, there are three kinds of returns to scale: (a) increasing returns to scale;
(b) constant returns to scale; and (c) decreasing returns to scale. If the proportional increase in output
is more than the proportionate change in inputs, then we have increasing returns to scale. If the
proportional increase in all inputs is equal to the proportional increase in output, returns to scale are
constant. Doubling the inputs results in doubling the production. If output increases less than
proportionately with input increases, we have decreasing returns to scale.
Properties of Iso-quants.
The following properties are valid:
1. An iso-quant is downward sloping to the right, i.e., negatively inclined. This implies that if one
input increases, the other one reduces. Both the inputs need not be
increased to yield a given output. A degree of substitution is assumed between the
factors of production. It means that if one of the inputs is reduced, the other input
has to be so increased that the total output remains unaffected.
2. Higher iso-quant represents larger output, i.e., with the same quantity of one input
and larger quantity of the other input, larger output will be produced.
3. Iso-quants are convex to the origin. It is because the input factors are not perfect
substitutes. One input factor can be substituted by other input factor in a diminishing
marginal rate. If the input factors were perfect substitutes, the iso-quant would be a
falling straight line. When the inputs are used in fixed proportion and substitution of
one input for the other cannot take place, the iso-quant will be L-shaped.
4. Two iso-quants do not intersect each other because each of these denotes a particular
level of output. If the producer wants to operate at a higher level of output, he has
to switch over to another iso-quant with a higher level of output and vice versa. If
isoquants intersect each other, this would mean that there will be a common point on
the two curves, and this would imply that the same amount of two inputs can produce
two different levels of output which is rationally a meaningless situation.
5. The iso-quant touches neither X-axis nor Y-axis, as both inputs are required to produce a given
product.
Optimal Combination of Inputs
Every firm seeks to minimize its cost for a given output or to maximize its output for a given total
cost. The production function tells that a given output can be produced with different input
combinations. However, it does not tell which input combinations are optimal. The
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combination of factors with which a firm produces the product also depends on the prices of the
factors of production and the amount of money which a firm wants to spend.
Iso-cost Line
Iso-cost line represents different combinations of two factors which the producer can get for a certain
amount of money at given prices of the factors. Each iso-cost line will show various combinations of
two factors which can be purchased with a given amount of total money. For example, let us assume
that a producer having Rs. 500 with him. The price of units of labour is, say, Rs. 10. Then he can buy
50 units of labour. Similarly, when the price of a unit of capital is Rs. 5, he can buy 100 units of
capital. Figure 3.6(b) shows the resulting iso-cost curves (which are straight line under the
assumption made here), one iso-cost showing the quantities of labour and capital that can be
purchased for Rs. 500, another iso-cost curve showing the quantities of labour and capital which can
be purchased for an expenditure of Rs.
1000, and so on.
Y
C2
C1
C
(units)
Capital
L
L
2
L
1
X
Labour (units)
Fig. 3.6(b) Iso-cost curves.
Given the prices of capital as Rs. 5 per unit and labour as Rs. 10 per unit. If the producer spends Rs.
500, CL will be the iso-cost curve. If producer spends Rs. 1000, C 1 L 1 will be the iso-cost curve. If
producer spends Rs. 2,000, C 2 L 2 will be the iso-cost curve as shown in Fig. 3.6(b).
Producers Equilibrium
The map consisting many iso-product curves is called the iso-product curve map. Each curve
represents different combinations of the factors producing the same quantity of output.
Similarly, given the prices of the factors and the financial resources of the producer, we get the isocost line. The aim of any producer is to produce at minimum cost.
If a producer wants to produce 500 units, he must know which least-cost combination
would give him 500 units of output. A producer will be in equilibrium at least cost combination
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and maximum production. He will be in equilibrium at the point where the cost is least. We can
understand the same with the help of Fig. 3.7.
Fig. 3.7
Least-cost combination of inputs.
In Fig. 3.7, IQ is the iso-quant representing the level of 500 units output. Any point of IQ
represents the combinations of capital and labour that gives the same output. CL, C 1 L 1 and C 2 L 2
are the iso-cost curves. Given the resources and prices of factors of production, C 1 L 1 indicates the
possible cost situation. C 1 L 1the iso-cost lineis a tangent at E to the iso-quant IQ. Thus the
point E is the optimum point or equilibrium point because at this point the output of 500
units can be obtained at least cost. At other points, that is, at R and S the same 500 units could be
produced at higher cost. Hence E is the equilibrium point and the combination OM+ON at E is the
least cost combination of factors. The point E indicates MRTS of labour for capital.
Price of labour
MRTS of labour for capital = Price of capital
Thus, the producer will be at equilibrium at point E where iso-cost line becomes a tangent to the isoquant.
Several empirical studies are made to find out the actual production function at work. This is called
the statistical production function. The most well-known among them is the Cobb-Douglas
production function. The American ex-Senator and economist Paul H. Douglas and the mathematician
C.W. Cobb made a statistical study in the 1920s to find out the actual production function in the whole
of the American manufacturing industry. The output of this function is the American manufacturing
output. The inputs are capital and labour.
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Cobb-Douglas production function takes the form
Q = bLa C 1 a
where
Q = Total output
L = Index of employment of labour in manufacturing
C = Index of employment of fixed capital in manufacturing
The exponents a and 1 a are the elasticities of production, that is, a and 1 a measure the
percentage response of output to percentage changes in labour and capital respectively. The function
estimated for the USA by Cobb and Douglas is
Q = 1.01, L = 75, C.25, R2 = 0.9409
The production function shows that a 1 per cent change in labour input, capital remaining constant is
associated with a 0.75 per cent change in output. Similarly, a 1 per cent change in capital, labour
remaining constant, is associated with a 0.25 per cent change in output. The coefficient of
determination ( R2) means that 94 per cent of the variations on the dependent variable ( Q) were
accounted for by the variations in the independent variables ( L and C). It indicates constant returns to
scale, which means that there are no economies or diseconomies of large-scale production. On an
average, large- or small-scale plants are considered equally profitable in the US manufacturing
industry, on the assumption that the average and marginal production costs were constant.
Though the Cobb-Douglas production function was based on macro-level study, it has been
very useful for interpreting economic results. Later investigations revealed that the sum of the
exponents might be very slightly larger than unity, which implies decreasing costs. But the difference
was so marginal that constant costs would seem to be a safe assumption for all practical purposes.
ECONOMIES AND DISECONOMIES OF SCALE
The scale of production has an important bearing on the cost of production. The larger the scale of
production, the lower generally is the average cost of production. That is why the
manufacturer is tempted to enlarge the scale of production so that he may benefit from the resulting
economies of scale. The term economies refer to cost advantages, and sometimes, these economies
are over-exploited; the result may be cost disadvantages, i.e., diseconomies.
Economies of Scale
Marshall classified the economies of large-scale production into two types:
External economies
Internal economies
External Economies
External economies are those economies which accrue to each member firm as a result of the
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expansion of the industry as a whole. Expansion of an industry may lead to the availability of new and
cheaper raw materials, tools and machinery, and to the discovery and diffusion of a superior technical
knowledge. Some raw materials and tools may be available at reduced prices because, as the industry
grows, subsidiary and correlated firms may come into the existence to provide material at reduced
prices.
Further, as an industry expands, trade journals may appear which help in the discovery and diffusion
of the technical knowledge. With the expansion of an industry, certain specialized firms which work
its waste products may come into existence, and then the industry can sell their products at a good
price.
External economies also accrue to the large size firms in the form of discounts and
concessions on (a) large scale purchase of raw materials, (b) large-scale acquisition of external
finance, particularly from the commercial banks, (c) massive advertisement campaigns,
(d) large scale hiring of means of transport and warehouse, etc. These benefits are available to all the
firms of an industry. They are not specific to any one particular firm.
For example, the construction of a railway line in a certain region would reduce transport cost for all
the firms. The discovery of a new machine which can be purchased by all the firms, the emergence of
repair industries, rise of industries utilizing by-products, and the
establishment of special technical schools for training skilled labour and research institutes, etc.
Internal Economies
Internal economies are those economies in production, and those reductions in production costs,
which are available to the firm itself when it expands its output or enlarges its scale of production.
The internal economies arise within a firm as a result of its own expansion, not because of the size
and expansion of the industry. These economies are simply due to the
increase in the scale of production. They arise from the use of different methods which small firms do
not find it worthwhile to adapt. The internal economies may be classified as follows: Economies in
Production.
Economies in production arise from two sources:
(a) Technical economies and
(b) Division of labour and specialization.
Technical Economies.
These economies arise from the fact that it is easy to make a large
machine, and there is a mechanical advantage in the use of large machines. Modern technology is
highly specialized. The advanced technology makes it possible to conceive the whole process of
production of a commodity in one composite unit of production. For example, production of cloth in a
textile mill may comprise such plants as (a) spinning; (b) weaving; (c) printing and pressing; and (d)
packing, etc. Under small-scale production, the firm may not find it economical to have all the plants
under one roof. It would, therefore, not be in a position to have the full advantage of a composite
technology.
Economies arise only when large machines are used, e.g., a bigger boiler or a bigger
furnace. It has a bigger productive capacity but uses proportionately less energy. A bigger machine
does not require more staff to operate it. The cost of construction is also relatively less.
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Division of Labour and Specialization.
The firm with large-scale production can
employ more and more workers with varying skills and qualifications. With more skilled
workers, it is possible to divide the labour according to their qualifications and skills and to place
them in the process of production where they are best suited. This is known as division of labour.
This leads to specialization and increases production of labour and thereby reduces cost of
production. For instance, only in a big school can we have specialist teachers.
Managerial Economies.
Managerial economies arise from the creation of special departments
from functional specialization. For a large firm, it is possible to divide its management into
specialized departments under specialized personnel, such as production manager, sales
manager, personnel manager, labour officers, etc. This increases efficiency of management at all
levels of management because of decentralization of decision-making. In a small factory, a manager is
a worker, foreman and a manager all rolled in one. Much of his time is wasted on things having little
economic significance. In a big concern, such jobs confines himself to the jobs which bring more
profits. Moreover, large firms have the opportunity to use advanced techniques of communication,
telephones and telex machines, computers and their own means of transport. All these lead to quick
decision making, help in saving valuable time of the management, and thereby improve managerial
efficiency.
Marketing Economies.
These economies arise from the large-scale purchase of raw materials
and other material inputs as well as large-scale selling of the firms own products. Large businesses
have bargaining advantage and are accorded preferential treatment by the firms they deal with. A
large-scale purchase entitles the firm for certain discounts which are not available on small
purchases. The economies in marketing the firms own products are associated with economies in
advertisement, cost, economies in large-scale distribution through wholesalers, etc. The firms also
gain on large-scale distribution through better utilization of sales force, distribution of samples, etc.
Financial Economies.
These economies arise from the fact that a big firm has better credit
and can borrow on more favourable terms. Its share enjoys a wider market, which encourages a
prospective investor. A large firm can offer better security and is therefore in a position to secure
better and easier credit facilities both from its suppliers and its bankers.
Risk-bearing Economies.
A big firm can spread risk and can often eliminate them. This can
be done by diversifying the output. If there are many products, the loss in the sale of one product may
be covered by the profits from others. By diversification, the firm avoids what may be called putting
all eggs in the same basket. The larger producer is generally in a position to sell his goods in many
different places. Therefore, large firms can diversify its markets of sources of supply and of process
of manufacture.
Economies of Vertical Integration.
A large firm may decide to have vertical integration,
i.e., number of stages of production. This integration has the advantage that the flow of goods through
various stages in production processes is more readily controlled. Steady supplies of raw materials,
on the one hand, and study outlets for these raw material, on the other, make production planning more
certain and less subject to erratic and unpredictable changesvertical PRODUCTION AND COST
ANALYSIS
177
integration may also facilitate cost control as most of the costs become controllable costs for the
enterprise.
Economies in Transport and Storage. Transport costs are incurred both on production and sales.
Similarly, storage costs are incurred on both raw materials and finished products. The large firms
may acquire their own means of transport and they can, thereby, reduce the unit cost of transportation
compared to the market rate, atleast to the extent of profit margin of the transport companies. Some
large firms have their own railway tracks from the nearest railway point to the factory, and thus they
reduce the cost of transporting goods in and out. For example, the Bombay Port Trust has its own
railway tracks; oil companies have their own fleet of tankers. Similarly, large-scale firms can create
their own godowns in the various centres of product distribution and can save on cost of storage.
If the firm grows beyond a limit, internal economies may disappear. On the other hand, internal
diseconomies may appear. For example, after the division of labour has reached its most
efficient point, further increase in the number of workers will lead to a duplication of workers.
There will be too many workers per machine for really efficient production. These
diseconomies may be internal and external. Internal diseconomies are those which are exclusive and
internal to a firm. External diseconomies arise outside the firms, mainly in the input markets.
Internal Diseconomies
Economies of scale have a limit. This limit is reached when the advantages of division of labour and
management staff have been fully exploited; excess capacity of plant, warehouses, transport and
communication systems, etc. are fully used. The following are some of the
diseconomies of the firm.
Managerial Diseconomies. As a firm expands, complexities and problems of management increase.
After a certain point the manager finds it difficult to control the whole production in organization. The
entrepreneur and management will not be able to maintain contact with each other and check on all the
departments of a very large concern. The problem of
supervision becomes complex and intractable, thus leading to increasing possibilities of
mistakes and mismanagement. All these prove to be uneconomical, the defects in organization will
lead to waste and result in rising average costs.
Difficulties of Co-ordination. The task of organization and co-ordination become
progressively more and more difficult with the increasing size of the firm. The management of the
firm gradually faces numerous problems of decision-making and organization.
Difficulties in Decision-making. A large firm cannot take quick decisions and make quick changes as
and when they are needed, because it has to consult various departments for making any decisions and
so urgent matters requiring timely decisions are inevitably delayed.
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Increased Risks. As the scale of production increases, investment also increases. This involves more
risk of the business. To bear greater risks is an important limitation to the expansion of the size of a
firm from an error of judgment or misfortune in business. Therefore,
unwillingness to bear greater risks is an important limitation to the expansion of the size of the firm.
Labour Diseconomies. Extreme division of labour with growing scale of output results in lack of
initiative and drive in the executive personnel. Thus a large firm becomes more impersonal and
contact between management and workers become less. As such there are more chances of
occurrence of grievances and industrial disputes, which prove to be costly to the large firm.
Scarcity of Factor Supplies. Due to concentration of all firms in a particular place, each firm will
find scarcity of variable factors. Hence, competition among firms in purchasing raw
material, labour, etc, will result in increased factor prices. Thus extreme concentration of external
economies becomes a sort of diseconomy in the form of high factor prices.
Financial Difficulties. A big concern needs huge capital, which cannot always be easily obtainable.
Hence the difficulty in obtaining sufficient capital frequently prevents the further expansion of such
firms.
Marketing Diseconomies. When the industry expands and the firm grows, competition in the market
tends to become stiff. Thus, firms under monopolist competition will have to undertake extensive
advertising and sales promotion efforts and expenditure, which ultimately lead to higher costs.
External Diseconomies
External diseconomies are the disadvantages that originate outside the firm, in the input markets and
due to natural constraints, especially in agriculture and extractive industries. With the expansion of
the firm, particularly when all the firms of the industry are expanding, the discounts and concessions
that are available on bulk purchase of inputs and concessional finance come to an end. More than that,
increasing demand for inputs puts pressure on the input
markets and input prices begin to rise, causing a rise in the cost of production.
On the production side, the law of diminishing returns to scale come into force due to
excessive use of fixed factors, more so in agriculture and extractive industries.
COST ANALYSIS
The cost of production plays an important role in the decision-making process. The total cost
compared to the total revenue determines the margin of profit of a firm. The producers try to
maximize the revenue and minimize the cost in order to get maximum profit. Hence, they try to
produce at an optimum level, improving the operational efficiency of the firm and thereby increasing
the productivity of the firm as a whole. As long as cost is decreasing, the firm will benefit by
expanding its output. If the cost is increasing, the firm may decide not to produce at all, or try to
reduce the output.
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In producing a commodity (or service), a firm has to employ an aggregate of various
factors of production such as land, labour, capital and entrepreneurship. All these factors involve the
price, which the firm has to pay for them. Thus the cost of production of a
commodity is the aggregate of price paid for the factors of production used in producing the
commodity. Cost of production, therefore, denotes the value of the factors of production
employed. In short, the value of inputs required in the production of a good determines its cost of
output.
Business executives wish to make use of cost figures not only for the purpose of
determination of profits, but also for the determination of most profitable rate of operations of a given
plant or department. They need to know whether it would be profitable to buy a new machine, to
decide what sales channels to use and so on. So far as these calculations are related to costs, the
entrepreneur/businessman is interested in the cost that will be incurred, those which lie ahead, those
which are contingent on the particular proposal being considered, not those which have already been
incurred, and to which the business is already committed.
The distinction between the expenses, which have been incurred, and the expenses which are to be
incurred is important to the business executives in their managerial decision-making. For all these
purposes, the business executives may use cost figures obtained from his accounting records. But
costs relevant to decision-making can be found from these figures only by
reclassifications, deletions, additions, recombination of elements, and repricing of input factors.
One distinctive feature of cost analysis is that attention is focused on cost per unit, not on the
aggregate costs.
There are several types of costs that a firm may consider relevant under various
circumstances. The business executives must understand different cost concepts for significant
comparison of alternative plans and to select the most relevant one. Some important cost
concepts are discussed as follows:
Actual Cost and Opportunity Cost
Actual costs are also called as acquisition costs or outlay costs or absolute costs. Opportunity costs
are also called alternative costs. Actual costs are the costs which the firm incurs for acquiring or
producing a good or a service like the cost on raw material, labour, rent, interest, etc. These costs are
the costs that are generally recorded in the books of account.
Opportunity costs of a good or service is measured in terms of revenue which could have
been earned by employing that good or service in some other alternative use. Opportunity costs refer
to earnings/profits that are forgone from alternative ventures by using given limited facilities for a
particular purpose. They represent only the sacrificed alternatives. So the opportunity costs are never
recorded in the books of account. However, these costs must be considered for decision-making.
Resources are not only scarce but also have alternative uses. Where there is an alternative, there is an
opportunity to reinvest the resources. In other words, if there are no alternative, there are no
opportunity costs. We should always consider the cost of the next best alternative foregone before
committing the funds on a given option. For example, the firm chooses to
invest Rs. 1,00,000 in a residential plot instead of buying a government securities, the interest 180
that could have been earned on the securities must be added to the actual cost of Rs. 1,00,000.
In other words, the cost of the residential plot is not just Rs. 1,00,000 but Rs. 1,00,000 plus the
interest on the government securities that could have accrued if the amount was invested in
government securities. Some other examples are:
For example, suppose that a firm has two alternatives before it: (a) having a shop in the central
locality of the town after paying a pugree of Rs. 25,000 and (b) having a shop in any other locality
without any pugree. While comparing the two alternatives, the firm will have to take into
consideration the additional earnings that he can make by having a shop in the central locality and the
profits he can earn by investing the amount of pugree elsewhere. Thus the opportunity cost of having a
shop in the central locality is Rs. 25,000 plus interest foregone thereon.
The cost of getting a college education is not merely the amount spends on tuition fees,
books, etc., but it also includes the earnings foregone throughout the year by not doing any job.
The opportunity cost concept applies to all situations where a thing can have alternative uses. In the
absence of any alternative use, the opportunity cost is zero. The concept of opportunity cost is more
important and useful to the management in making a decision among alternatives.
Incremental Costs (Differential Costs) and Sunk Costs
Incremental cost is the additional cost due to a change in the level and nature of business activity, e.g.
change in product line or output level, adding or replacing a machine, changing distribution channels,
etc. These costs arise only when change is made in the existing business.
The question of incremental cost does not arise when a business is to be set up afresh. These costs
can be avoided by not bringing about any change in the existing business activity. That is why these
costs are also called avoidable costs or escapable costs. Since incremental costs may also be
regarded as the difference in total costs resulting from a contemplated change.
They are also called differential costs.
The sunk costs are those which cannot be altered, increased or decreased by changing the
rate of output. It will remain the same whatever the level of business activity, for example, all the past
costs are considered as sunk costs because any change in the activity and the resulting incremental
costs will have to take these preceding costs as given. The most important example of sunk cost is the
amortization of part expenses, e.g. depreciation. The distinction between sunk cost and incremental
cost assumes importance in evaluating alternatives.
Incremental costs would be different in the case of different alternatives. Hence incremental costs are
relevant to the management in the analysis for decision-making. Sunk costs will remain the same
irrespective of the alternative selected. Thus, it need not be considered by the management in
evaluating the alternatives as it is common to all of them.
Explicit (or paid-out) Costs and Implicit (or imputed) Costs
Explicit costs are those expenses which are actually paid by the firm (paid-out costs). These costs
appear in the accounting records of the firm. The payments for wages and salaries,
181
materials, licence fees, insurance premium, etc. are examples of explicit costs. These costs involve
cash payment and are recorded in normal accounting practices.
In contrast to explicit costs, there are certain other costs, which do not take the form of cash outlays.
They will not appear in accounting records. Such costs are known as implicit or imputed costs.
Opportunity cost is an important example of implicit cost. Suppose a
businessman does not utilize his services in his own business and works as a manager in some other
firm on a salary basis. If he sets up his own business, he foregoes his salary as a manager.
This loss of salary is the opportunity cost of income from his own business. This is an implicit cost of
his own business.
The interest payment on borrowed funds is an explicit cost and enters the accounting
record, but the amount of interest which the entrepreneur could have earned (and which he foregoes
when he uses his own capital in his firm) is his implicit cost. Similarly, the amount of rent, wages
etc., which are paid out are the explicit costs of the firm, while wages, rent, etc., which are due to the
entrepreneur for employing his own resources in the firm are the implicit costs. The explicit costs are
important for calculation of profits and losses, but for economic decision making the firms takes into
account both the explicit as well as the implicit costs.
Past Costs and Future Costs
Conventional financial records contain actual costs that are incurred in the past and they are known as
past costs. Through analysis of these costs, management may check and find out factors responsible
for excessive cost if any, though it cannot do anything to reduce them since they are already incurred.
Future costs are costs that are expected to be incurred in future. Their actual incurrence is a forecast
and their management is an estimate. Future costs are important for managerial decision-making
because they are the only costs subject to management control.

If the costs estimates show that the future costs are high, the firm may try to reduce them or it may find
ways of meeting them. Management needs to estimate the future costs for number of reasons like
expenses control, projection of future income statement, appraisal of capital expenditure, decisions
about new products, pricing, etc.
Short-run and Long-run Costs
The terms short-run and long-run costs are classifications of costs involving time. In
economics, the short run is defined as a period during which at least one element of factor input is in
fixed supply. The fixed factor input is plant and equipment. In the long run, all factor inputs are
variable. A short-run cost is that cost which varies with output when fixed plant and equipment
remain the same, while a long-run cost is that which varies with output when all factor inputs,
including plant and equipment, vary.
Both short-run and long-run costs are useful in decision-making. Short-run cost is relevant when a
firm has to decide whether or not to produce more or less with a given plant. If the firm is considering
an increase in plant size, it must examine the long-run cost of expansion.
Long-run cost analysis is useful in investment decisions. Long-run costs can help the
businessman in planning the best scale of plant, or the best size of the firm, for his purposes.
182
Thus long-run costs can be helpful both in the establishment of new enterprises as well as the
expansion of existing ones.
Fixed and Variable Costs
Economists divide the total cost into two groups: fixed costs and variable costs. Fixed costs remain
constant in total and does not change with the level of output, e.g. expenditure on depreciation, rent on
land and buildings, property taxes, etc. These costs will exist even if no output is produced. On the
other hand, variable costs vary directly as output changes. These costs include the cost of raw
materials, cost of casual labour, etc. They are incurred only when the factory is at work.
There are some difficulties in classifying the costs into fixed and variable categories. The difference
between the two is not as simple as it appears. There are some costs, which fall between the two
extremes. They are called semi-variable costs. They are not absolutely variable or absolutely fixed.
They change in the same direction as volume but not in direct proportion thereto. For example,
electricity bills often include both a fixed charge and a charge based on consumption. This is known
as two-part tariff. Again, a salesman may get both a monthly salary and a commission related to sales
volume. Supervisors may also be paid fixed salaries and bonuses related to output.
The distinction between fixed and variable costs is relevant only for a relatively short
period. It is only in the short period that the fixed equipment of a firm cannot be changed.
In the long run, there is no such limitation. If the output is to be increased to such an extent that the
existing machinery is not sufficient, more of it can be acquired, if sufficient time is allowed for. In
fact, everything is possible to change in the long run, that is why no cost item can be classified as
fixed cost. All costs are variable.
The distinction between fixed costs and variable costs is important in forecasting the effect of short
run changes in volume upon costs and profits. In the short run, the firm may continue to produce if all
its variable costs are recovered, but in the long run, it is very important to see that all costs (both
fixed and variable) must be recovered from the sales revenue.
Out-of-pocket and Book Costs
Out-of-pocket expenses refer to costs that involve current cash payments to outsiders when the firm
purchases an asset or disburses the salaries, etc. This causes an immediate outflow of cash.
On the other hand, book costs are the costs which do not require current cash payments. The salary of
the owner/manager is shown as a cost in the books but often it does not involve immediate cash
outflow. Similarly, interest on the owners capital is also another example of book costs. Depreciation
on machinery is also a book cost. For all practical purposes, the book costs are costs, which are to be
borne by the firm, but since they do not involve immediate cash outflow, they would not adversely
affect the cash portion. The out-of-pocket costs are also called explicit costs and book costs are
called implicit costs or imputed costs. Both implicit and explicit costs are important and should be
considered while making decisions. Negligence of PRODUCTION AND COST ANALYSIS
183
implicit costs leads to faulty business decisions. When they are ignored, to that extent profits are over
estimated, and a rosy picture will be painted, leading to wrong decisions.
Replacement Costs and Historical Costs
The historical cost means the cost of an asset at a price originally paid for it. In contrast to this,
replacement cost is the cost which will have to be incurred currently if that asset is purchased now.
The two concepts differ due to price variations overtime. If the price of the asset does not change
overtime, the historical costs will be the same as the replacement costs.
If the price rises the replacement cost will exceed the historical cost and vice versa. The assets are
usually shown in the conventional financial accounts at their historical costs. But during periods of
changing price levels, historical cost may not be the correct basis for projecting future costs.
Naturally historical costs must be adjusted to reflect current or future price levels.
Urgent and Postponable Costs

In order to continue the operations of the firm without break, certain costs such as raw material cost,
labour cost, etc. may be incurred. These costs are called urgent costs. There are certain costs which
can be postponed at least for sometime. These costs are called postponable costs, e.g. maintenance
relating to building and machinery, etc. They do not affect the operational efficiency of the firm. This
distinction of cost becomes quite obvious during the period of war or inflation when firms want to
produce the maximum and postpone the maintenance of their plants, buildings, etc.
Sunk, Shutdown and Abandonment Costs
Sunk costs are the costs that are not altered by a change in quantity and cannot be recovered, e.g.
depreciation. Sunk costs are a part of the outlay costs.
Shutdown costs are those which the firm incurs if it temporarily stops its operations. These costs
could be saved if the operations are allowed to continue. Examples of such costs are the costs of
sheltering the plant and equipment, and of construction of sheds for storing exposed property. Further,
additional expenses may have to be incurred when operations are restarted, e.g. reemployment of
workers may involve cost of recruitment.
Abandonment costs are the costs 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. For example, the plant installed during wartime may be so improvised that it may not be
required during peacetime. These costs become important when management is faced
with the alternatives of either continuing the existing plant or suspending its operations or abandoning
it altogether.
Escapable and Unavoidable Costs
Escapable costs refer to the costs that can be saved by reducing the scale of operations to a lower
level. It is the net effect on costs that is important, not just the costs directly avoidable by lowering
the scale of operations.
184
Unavoidable costs are those that are essential for the sustenance of the business activity and hence
they have to be incurred.
For example, nowadays most of the public sector banks have announced the voluntary
retirement scheme (VRS) to their employees to reduce the salary bills, because the private banks are
turning out equal amount of business with less manpower and thus continue to be profitable. The
public sector banks find that it can escape from huge salary bills every month in respect of each
employee in the long run, by paying him/her a lump sum of compensation at a time in case he/she opts
for the VRS. The bank has a clear policy not to extend VRS to its agriculture officers and other
specialists. For the sustenance of the bank, the cost to maintain such specialist officers and the
skeleton staff for each of its branch is an unavoidable cost.
Where it has excess staff, the likely saving in the salary bill because of the VRS scheme is the
escapable cost. Hence, escapable costs are highly correlated with controllable or discretionary costs,
but they are not the same.
COST-OUTPUT RELATIONSHIP
The cost of production of a commodity depends on many factors like the output level, prices of the
factors of production, productivity of the factors of production and the time scale. Of all these cost
determinants, the cost-output relationship is very important. The cost-output relationship significantly
differs in the short run and in the long run. It is because in the short run, the costs can be classified
into fixed and variable costs. The cost-output relationship in the short-run is governed by certain
restrictions in terms of fixed costs. Whereas in the long run, the cost-output relationship studies the
effect of varying the size of plants upon its cost. The study of cost-output relationship has two aspects.
(a) Cost-output relationship in the short run, and
(b) Cost-output relationship in the long run.
The short run is a period which does not permit alterations in the fixed equipment and in the size of
the organization. As such, if any increase in output is required, it is possible within the range
permitted by the restricting fixed factors of production.
The long run is a period in which there is sufficient time to alter the equipment and the size of the
organization. In the long run, output can be increased without any limits being placed by the fixed
factors of production.
Cost-Output Relationship in the Short Run
The cost-output relationship in the short run may be studied in terms of (a) average fixed costs (b)
average variable costs, and (c) average total cost.
Average Fixed Cost ( AFC) and Output
The fixed cost does not change with output. Thus, the larger the quantity produced, the lower will be
the fixed cost per unit. The reason is that total fixed costs remain the same and do not change with a
change in output. The relationship between output and fixed cost is a universal one for all types of
business. Thus average fixed cost falls continuously as output rises. The PRODUCTION AND COST
ANALYSIS
185
reason why total fixed cost remains the same and the average fixed cost falls is that certain factors are
indivisible. This means that if a small quantity is to be produced, the factor cannot be used in a
smaller quantity. It is to be used as a whole. Average fixed cost is obtained by dividing the total fixed
costs by the total output. As the output increases, average fixed cost decreases. It falls rapidly in the
beginning. But it declines slowly later.
Thus,
TFC
AFC Q
where Q stands for the number of units of output produced. AFC is the fixed cost per unit of output
and TFC is the total fixed cost.
Average Variable Cost ( AVC) and Output
The average variable costs will first fall and then rise as more and more units are produced in a given
plant. This is so because as we add more and more units of variable factors in a fixed plant; the
efficiency of inputs first increases and then decreases.
The variable factors tend to produce more efficiently at firms optimum output than at low level of
output. But beyond the optimum level of output, any further increase in output will lead to increase in
average variable cost. Suppose the units of the variable factor (e.g. labour) are increased while the
fixed factors remain constant; then the marginal and average products increase in the beginning.
Therefore the average variable cost declines for a few units of output.
However, this will be a short-lived phase. Sooner than later, the marginal and average products start
diminishing. Therefore the variable cost increases. For example, more and more workers are
employed; it may lead to overcrowding and bad organization. Moreover, workers may have to be
paid higher wages for overtime work. Average variable cost is obtained by dividing the total variable
cost by total output. Thus
TVC
AVC Q
where Q stands for the number of units of output produced, AVC is variable cost per unit of output and
TVC is total variable cost.
Average total Cost ( ATC) and Output
The average total cost is also called average cost, which first falls and then rises upward. But the
raising point in case of average cost would come a little later than in the case of average variable
cost. Average cost is the sum of average fixed cost and average variable cost. Average fixed cost
continues to fall with an increase in output.
Average variable cost first falls and then rises as output increases. So long as average
variable cost declines the average total cost will also decline. After certain level of output, the
average variable cost will rise. If the rise in variable cost is less than the decline in fixed cost, the
average total cost will still continue to decline. If the rise in average variable cost is more 186
than decline in average fixed cost, the total average cost starts rising. Thus, there will be a stage
where the AVC may have start rising, yet the ATC is still declining because the rise in AVC
is less than the decline in AFC; the net effect is decrease in average total cost. The least cost output
level is the level where the total average cost is the minimum and not the average variable cost. In
fact, at the least cost output level, the AVC will be more than its average cost.
The least cost output level is also the optimum level where the cost is minimum.
Table 3.3 given below illustrates the behaviour of total costs, average costs and marginal cost as the
output increases. All the costs shown in the table are in rupees.
Table 3.3 Cost-output relationship
(Rs.)
Output
TFC
TVC
TC
AFC
AVC
ATC
MC
1
100
50
150
100
50
150
2
100
90
190
50
45
95
40
3
100
150
250
33.3
50
83.3
60
4
100
220
320
25
55
80
70
5
100
300
400
20
60
80
80
6
100
400
500
16.6
66.6
83.3
100
( MCMarginal Cost, TFCTotal Fixed Cost, TVCTotal Variable Cost, TCTotal Cost, AFCAverage
Fixed Cost, AVCAverage Variable Cost, ATCAverage Total Cost)
In Table 3.3, there is no change in the total fixed cost ( TFC) as the output increases. Total variable
cost ( TVC) increases as the output increases. Total cost ( TC) also increases. In other words,
Total fixed cost + Total variable cost = Total cost
Average fixed cost ( AFC) declines continuously as output increases. Average variable cost ( AVC)
falls till the second unit and rises from there. Average total cost ( ATC) = Average fixed cost +
Average variable cost. ATC falls till the fourth unit is produced, remains constant for the fifth unit and
begins to rise up from the sixth unit. Average variable cost ( AVC) begins to rise up from the third
unit. Despite it, average total cost ( ATC) falls till the fourth unit because of the influence of the
declining AFC. It ( ATC) remains constant for the fifth unit and rises up from the sixth unit of output.
In Fig. 3.8, output is shown on the X-axis and cost on the Y-axis. TFC, TVC, and TC
curves are shown. TFC curve is parallel to the X-axis. Total fixed costs are measured by OF.
They do not change. TVC starts from the origin. Variable costs begin from zero. TVC rises up as
output increases. But after a stage, it rises up quickly or steeply. TC curve rises from F. For, it
includes the fixed cost also. Fixed costs will never be below OF. TC curve also rises up more steeply
after a stage. The vertical distance between TC and TVC will be the same. For, this distance indicates
the fixed costs.
187
Fig. 3.8 Linear cost functions.
Marginal Cost
Marginal cost is the increase in total cost by producing one more unit of output, or it is the decrease in
total cost when one less unit of output is produced. Marginal cost is obtained when the total cost for
n 1 units of output is deducted from n units of output. In Table 3.3, total cost is Rs. 190 when 2 units
of output is produced. Total cost is Rs. 250 when 3 units of output is produced. The different between
them is Rs. 60. It is marginal cost. Marginal cost may be defined as the change in total cost associated
with a one-unit change in output. It is also an
extra unit cost, or incremental cost, as it measures the amount by which total cost increases when
output is expanded by one unit. Marginal cost consists of variable cost only. It can be obtained either
from the total cost or the total variable cost.
It can also be calculated by dividing the change on total cost by the one unit change in
output.
Symbolically, thus
' ATC
MC
1
'Q
where D denotes change in output assumed to change by 1 unit only. Therefore, output change is
denoted by D1.
Relationship between Average Cost and Marginal Cost
Based on the average and marginal cost data, economists have observed a unique relationship
between the two. As output increases, average cost first declines. As long as average cost ( AC) is
declining, marginal cost ( MC) will be less than that. But marginal cost starts increasing even before
average cost starts increasing. It increases for a certain range of output, for example, from the 3rd unit
to 5th unit in Table 3.3. Average cost will be decreasing there. The marginal cost rises up and
becomes equal to average cost. In the table, AC and MC become equal for 188
the 5th unit. There the MC curve intersects the AC curve. That output ( OM) is the least cost output
(i.e the optimum output). Up to OM level of output average cost declines and then it starts rising. If
output increases even after that stage, average cost goes on increasing. Marginal cost also goes on
increasing. Marginal cost will be higher than the average cost when the average cost is increasing.
Short-run Output Cost Curves
The cost-output relationship can also be shown through the use of graphs shown in Fig. 3.9.
AFC is the average fixed cost curve. It will be seen that the average fixed cost curve ( AFC
curve) falls as output rises from the beginning to the end. The shape of the average fixed cost curve,
therefore, is a rectangular hyperbola. AVC is the average variable cost curve. AVC first falls and then
rises. So also the average total cost curve ( ATC curve). However, the AVC curve starts rising earlier
than the ATC curve. Further, the least cost output level corresponds to the point L 1 on the ATC curve
and not to the point L 2 which lies on the AVC curve as shown in Fig. 3.9.
Fig. 3.9 Shrot-run cost curves.
The marginal cost curve ( MC curve) intersects both AVC and ATC at their minimum points. If MC is
less than the average cost, it will pull AC down. If the MC is greater than AC, it will pull AC up.
Hence the MC curve tends to intersect the AC curve at its lowest point.
Similar is the position about the AVC curve. It will not make any difference whether MC is going up
or down. The inter-relationships between AVC, ATC and AFC can be summed up as follows:
1. If both AFC and AVC fall, ATC will fall.
2. If AFC falls but AVC rises:
(a) ATC will fall where the decrease in AFC is more than increase in AVC.
(b) ATC will not fall where the decrease in AFC is equal to the increase in AVC.
(c) ATC will rise where the decrease in AFC is less than the rise in AVC.
189
Cost-Output Relationship in the Long-Run
The long-run period differs from the short period. Output is produced within the existing plant
capacity in the short period. The factors like machines, buildings and tools remain fixed in supply.
The variable inputs like labour are increased to increase the output. Therefore, there is a little scope
for adjustments with a view to reducing the cost of production. On the other hand, the plant capacity
can be changed in the long period. The supply of factors like machines, buildings and other equipment
can also be increased or decreased. So any adjustment can be made with a view to reducing costs.
The long-run cost-output relationship can be made with a view to reducing costs. The long-run costoutput relationship can be shown graphically by the long-run cost curve, which shows how costs
would change when the scale of production
is changed.
The concept of long-run costs can be further elaborated with the help of an illustration.
Assume that at a particular time, a firm operates under average total cost curve S 2 and produces OQ
(see Fig. 3.10) output. Again, it is desired to produce OR amount of output. If the firm continues under
the old scale, its average cost will be RT. If the scale of the firm is changed, the new cost curve will
be S 3. The average cost of producing OR will then be RA. RA is less than RT. So the new scale will
be preferable to the old one and should be adopted. In the long run, the average cost of producing OR
output is RA. This may be called the long-run cost of producing OR output. We must be careful here to
note that we shall call RA as the long-run cost only. So long as the S 3 scale is in the planning stage,
and is not actually adopted. The moment the scale is adopted, the RA cost will be the short-run cost
producing OR output.
LAC
Y
S3
S2
S1
T
A
unit
per
Cost
X
O
Q
R
Quantity
Fig. 3.10 Long-run cost curve.
190
To draw the long-run cost curve, we have to commence with a number of short-run
average cost curves ( SAC curves), each curve representing a particular scale or size of the plant,
including the optimum scale. The long-run average cost curve is drawn by joining all the shortrun
average cost curves. LAC would be tangential to the entire family as SAC curves, that is, it would
touch each SAC curve at one point as shown in Fig. 3.11.
Fig. 3.11 Long-run cost curve.
The following points are to be noted:
1. The LAC curve is tangential to the various SAC curves at certain points of output.
It means that plant capacities indicated by tangency will be adopted to produce the
corresponding output levels in the long run. The short period cost and the long period
cost will be the same for such of output.
2. The LAC curve is referred to as the envelop curve because it is the envelop of all short-run
average cost curves appropriate to different levels of output since no point
on an SAC can ever be below the LAC curve.
3. The LAC curve is U-shaped or rather dish-shaped. This means that in the beginning lower and
lower the average cost until the optimum scale of the enterprise is reached,
and successively higher average cost thereafter, i.e., with plants larger than that of
the optimum scale.
The SAC curve is also of U shape but the difference is that the LAC curve is PRODUCTION AND
COST ANALYSIS
191
flatter, that is, U shape of the LAC curve will be less pronounced, because in the long run economies
of scale are possible as cannot be had in the short run.
4. The LAC curve can never cut SAC curves though they are tangential to each other.
This implies that for any given output, average cost cannot be higher in the long run
than in the short run.
5. LAC curve will touch the optimum scale curve at latters least cost point, i.e., M1.
6. LAC curve will touch SAC curves lying to the left of the optimum scale curve at the left of their
least cost points.
7. LAC curve will touch SAC curves lying at the right of the optimum scale curve at the right of their
least cost points.
Thus, we can find the LAC curve is tangential to the minimum cost point in case of optimum scale SAC
and not in case of other SAC curves.
In managerial decision-making, the LAC curve assists the management in the determination of the best
size of the plant to construct when a new one is being built or an old one is being expanded. As the
LAC curve can help the entrepreneur in planning the best scale of plant or the best size of the firm for
his purposes, it is also known as the planning curve.
BREAK-EVEN ANALYSIS
Generally it is believed in traditional theory of firm, the basic objective of the firm is to maximize
profit. Maximum profit does not necessarily coincide with the minimum cost, as far as the traditional
theory of firm is concerned. Besides, profit is maximum at a specific level of output, which is
difficult to know before hand. Even if it is known, it cannot be achieved at the outset of production. In
real life, firms begin their activity even at a loss, in anticipation of profit in the future. However, the
firm can plan their production better if they know the level of production where cost and revenue
break even, i.e., the profitable and non-profitable range of production.
Break-even analysis, which is also known as profit contribution analysis, is an important analytical
technique used to study, the relationship between the total costs, total revenue and total profits and
losses over the whole range of stipulated output. Break-even analysis is also called cost volume
profit (CVP) analysis. A break-even analysis indicates at what level of output costs and revenues are
equal. The break-even point ( BEP) is most important in breakeven analysis. It has been said that
The break-even point is that point of activity (Sales Volume) where total revenues and total costs are
equal, it is the point of Zero profit. In other words, break-even point is that specific level of activity
or volume of sales where the firm breaks even, i.e., the total cost equals the total revenue. Therefore,
it is a point where losses cease to occur while profits have not yet been earned. If the firm produces
and sells less than that of break-even level, it would incur losses; while if it produces and sells above
break-even level, it makes profits. The break-even point indicates the minimum level of production
which the firm has to undertake to become economically viable.
192
Determination of Break-Even Point
There are two ways of determining break-even point ( BEP) by means of a formula. It can be
determined either in terms of physical units of output or in terms of sales value of the output, i.e., in
money terms.
BEP in Terms of Physical Units
The break-even volume of output is determined in physical quantities (in units). The breakeven
volume is the number of units of a product that must be sold to get enough revenue just to cover all
expenditures both fixed and variable. The selling price of a unit should cover the average variable
cost ( AVC) in full as well as a part of the fixed cost. The excess of selling price over variable cost is
regarded as contribution margin per unit, which is contribution towards the fixed cost. Thus, the BEP
is spotted at a point where a sufficient number of units of output are produced, so that its total
contribution margin becomes equal to the total fixed cost. This method is convenient for the single
production firm. The formula for calculating the break-even point is as follows:
Total fixed cost
BEP Contribution margin per unit
where
Contribution margin = selling price minus variable cost per unit
(or BEP in units = PQ = F + VQ)
P = Selling price per unit
Q = Quantity in units
F = Fixed cost
V = Variable cost per unit

or
BEP (in Rs.) = Sales revenue Fixed cost + Variable cost.
Illustration 3.1:
Suppose the fixed expenses of a firm are Rs. 20,000 per year. The variable
cost per unit is Rs. 3, and selling price is Rs. 5 per unit. Calculate the break-even point in terms of
physical units.
Solution:
20, 000
20, 000
BEP
10, 000 units
53
2
It means that the company would not make any loss or profit of a sales volume of 10,000
units as shown below:
Sales
Rs. (10,000 5)
50,000
Cost of goods sold
Variable cost
30,000
@ Rs. 3
Fixed cost
20,000
50,000
Net profit
Nil
193
Break-Even Point in Terms of Sales Value
Where the firm is a multi-product firm, the BEP is to be measured in terms of sales value by
expressing the contribution margin as a ratio to sales. Multi-product firms are not in a position to
measure the BEP in terms of any common unit of product. The break-event point would be the point
where the contribution margin (sales value variable cost) would be equal to fixed cost.
The formula for calculating the break-even point is
Total fixed cost
BEP Contribution margin ratio
Illustration 3.2:
A firm incurs fixed cost of Rs. 8,000 and variable cost of Rs. 20,000 and
its total sales receipt are Rs. 30,000. Determine the break-even point.
Solution:
Sales
Variable
cost
Contribution margin ratio =
Sales
Thus, the contribution margin ratio is
30, 000 20, 000
10, 000
0.3
30, 000
30, 000
Fixed cost
8, 000
BEP
24, 000
Contribution margin ratio
0.3
The break-even point is reached when the firms sales value is Rs. 24,000. At Rs. 24,000 sales value,
there is no profit, no loss. This is because the variable cost at sales value of Rs. 24,000
2 24, 000
is
= 16,000.
3
Total cost = 16,000 + 8,000 = 24,000 is equal to total revenue of Rs. 24,000.
Contribution
Contribution is the difference between sales and variable cost or marginal cost of sales. It may also
be defined as the excess of selling price over variable cost per unit. Contribution is also known as
contribution margin or gross margin. A contribution is the amount that is contributed towards fixed
expenses and profit. If the selling price of a product is Rs. 20 per unit and its variable cost is Rs. 15
per unit, contribution per unit is Rs. 5 (i.e., Rs. 20 15).
Contribution = Sales Variable (marginal) cost
194
or
Contribution (per unit) = Selling price Variable (or marginal) cost per unit
or
Contribution = Fixed cost + Profit.

Break-Even Chart
In recent years, the break-even charts have been widely used by business managers; executives,
investment analysts, government agencies and even trade unions. A break-even chart is a group of the
short-run relationships of total cost and of total revenue to the rate of output and sales.
The break-even chart graphically shows cost revenue relationship to the volume of output. It helps the
management in visualizing the profit or loss implications at different levels of sales.
It shows the extent of profit or loss to the firm at different levels of the activity. Figure 3.12
illustrates a typical break-even chart. The units of output are shown on the horizontal axis OX
and costs and revenues are shown on the vertical axis of OY. A break-even chart prepared on the
basis of Illustration 3.1 is given in the figure.
Fig. 3.12 Break-even analysislinear functions.
The fixed cost of Rs. 20,000 is represented by a straight line parallel to the horizontal axis on the
chart. Variable costs are then plotted over and above the fixed costs. The resultant line is the total
cost line, combining both variable and fixed costs. There is no variable cost line in the graph.
Variable costs are represented by the vertical distance between the fixed cost and the total cost lines.
The total cost at any point is the sum of Rs. 20,000 plus Rs. 3 per unit of variable cost multiplied by
the number of units sold at that point. Total cost ( TC) curve is shown as linear on the assumption of
constant variable cost, i.e., variable cost changes linearly in a constant proportion to the change in
output rate. Total revenue ( TR) curve is also shown as linear as it is assumed that the price is
constant, irrespective of the output. This assumption is appropriate only if the firm is operating under
perfectly competitive conditions. Total revenue at any point is the unit price of Rs. 5 multiplied by the
number of units sold. The break-even point corresponds to the point of intersection of the total
revenue and the total cost lines. Projecting a perpendicular from BEP to the horizontal axis shows the
break-even point PRODUCTION AND COST ANALYSIS
195
in units of the product. Dropping a perpendicular from BEP to the vertical axis shows the break-even
sales value in rupees. Below the BEP or left of it, total cost is more than total revenue and the firm
would suffer a loss. Above BEP or right of it, total revenue is more than total cost and the firm would
be making profits. Since the profit or loss occurs between cost and revenue lines, the space between
them is known as the profit zone (to the right of BEP) and the loss zone (to the left of BEP).
Alternative Form of Break-Even Chart
Sometimes an alternative form of the break-even chart is drawn by starting with the variable cost
function from the horizontal axis and then adding total fixed cost to determine the total cost function or
curve. This type of break-even charts are used to measure the contribution made by the business
activity towards covering the fixed cost. The contribution is the difference between total revenue and
variable cost arising out of a business decision. For example, if a product sells at Rs. 20 per unit and
its variable expenses are Rs. 8, this implies that each unit of the product recovers Rs. 12 over and
above its variable expenses of Rs. 8. Thus Rs. 12, which is the contribution of the recovery of fixed
expenses and profit, is therefore the
contribution margin. This is also known as contribution profit. Figure 3.13 illustrates the concept of
contribution margin.
Y
TR
Profit
TC
BEP
FC
VC
Contribution
Loss
Cost/Revenue
Variable cost
O
X
Q
Output
Fig. 3.13 Contribution margin analysis.
As shown in Fig. 3.13, at the break-even level of output OQ contribution equals fixed costs. Below
the output OQ, the total contribution is less than the fixed cost. This amounts to loss. Beyond output
OQ, contribution exceeds fixed cost; the difference is a contribution towards profit resulting from a
business decision.
Profit-Volume (P/V) Analysis and P/V Ratio

The profit-volume ratio, which is also called the contribution sales ratio, expresses the relationship
between contribution and sales. It is the contribution per rupee of sales. Since the 196
fixed cost remains constant in the short run, the profit-volume ratio will also measure the rate of
change of profit due to change in volume of sales. In other words, it is the contribution expressed as a
proportion of selling price. P/V ratio is very important for studying the profitability of operations of
business. It reveals the effect on profit of changes in the volume.
Higher the P/V ratio, more will be the profit and lower the P/V ratio, lesser will be the profit.
Every management aims at increasing the P/V ratio. The ratio can be increased by increasing the
contribution, i.e., by increasing the selling price, or reducing the variable cost, or changing the sales
mixture and selling more profitable products for which the P/V ratio is higher. P/V
ratio can be the expressed as follows:
Contribution per unit
P/V ratio
100
Selling price per unit
or
Total contribution 100
Total sales
or
Change in profits or contribution
Change in sales
Since Contribution = Sales Variable cost = Fixed cost + Profit, P/V ratio can also be
expressed as
Sales Variable cost
P/V ratio
Sales
SV
S
In case of multi-product organizations, P/V ratio is very important for the management to find out
which product is more profitable. Management tries to increase the value of this ratio by reducing the
variable cost or by increasing the selling price.
The ratio is useful for the determination of the desired level of output or profit and for the calculation
of variable costs for any volume of sales. The variable costs can be expressed as follows:
VC = S(1 P/V Ratio)
Illustration 3.3:
Sales
Rs. 1,00, 000
Variable cost
Rs. 60,000
Fixed cost
Rs. 20,000
Rs. 1,00,00 Rs. 60,000
P/V ratio
0.4 or 40%
Rs. 1,00,000
197
If we know P/V ratio and sales beforehand, the variable cost can be calculated as follows: Variable
cost = 1 0.04 = 0.06, i.e., 60% of sales
= Rs 60,000 (60% of Rs 1,00,000)
Alternatively, by the formula
SV
P/V ratio =
S
or
S V = S P/V ratio
or
V = S S P/V ratio
= S (1 P/V ratio)
or
Fixed cost Profit
FP
P/V ratio =
Sales
S
This ratio can also be shown in the form of percentage by multiplying by 100. Thus, if selling price of
a product is Rs. 40 and variable cost is Rs. 30 per unit, then:
40 30
P/V ratio =
100
40
10
=
100 25%
40
Contribution = P/V Ratio Sales
and
Contribution
Sales =
P / V ratio
The P/V ratio can also be calculated by the formula
Profit
P/V Ratio = Margin of safety ratio
Features of P/V Ratio
1. It helps the management in ascertaining the total amount of contribution for a given
level of sales.
2. It remains constant so long as the selling price and variable cost per unit remain
constant or so long as they fluctuate in the same proportion.
3. It would not be affected by any change in the level of activity. P/V ratio remains the same whether
the volume of activity is 100 units or 1,000 units.
4. The P/V ratio would also not affect by any variation in the fixed cost since fixed cost are not at all
considered while calculating the P/V ratio.
198
Margin of Safety
The concept of margin of safety is very important in the break-even analysis. According to Horngren,
the Margin of safety is the excess of budgeted or actual sales over the break-even sales volume.
Margin of safety represents the difference between the actual sales volume and the sales volume at
break-even point. A large margin of safety indicates the soundness of the business. Margin of safety
can be improved by lowering fixed and variable costs or by
increasing volume of sales or by increasing sales or selling price or by changing the product mix to
improve contribution and overall P/V ratio. Therefore,
Margin of safety = Actual sales at selected activity Sales at BEP
or
Profit
P/V ratio
As at break-even point, there is no profit no loss, sales beyond the break-even point represent margin
of safety because any sales above the break-even point will give some profit.
Suppose, the actual sales are Rs. 2,50,000 and the break-even sales are Rs. 2,00,000, then margin of
safety is Rs. 50,000, i.e., 2,50,000 2,00,000.
Margin of safety can also be computed according to the following formula:
Net profit
Margin of safety = P/V ratio
Margin of safety can also be expressed as a percentage of sales. For the above example, margin of
safety in percentage can be calculated as
50,000 100 20%
2,50,000
Margin of safety calculated in percentage is also known as margin of safety ratio and can be
expressed as
MS
MS ratio =
100
Sales
Actual sales Sales at BEP
= 100
Sales
Illustration 3.4:
Total sales
Rs. 3,00,000
Variable costs
Rs. 1,50,000
Fixed costs
Rs. 1,00,000
199
The margin of safety can be computed as follows:
Fixed cost
1, 00, 000
Break-even sales =
= Rs. 2,00,000
P/V ratio
50%
SV
3,00,000 1,50,000
(P/V ratio =
, i.e.,
= 50%)
S
3,00,000
Net profit = Contribution Fixed cost
= Rs. 1,50,000 1,00,000 = Rs. 50,000
Margin of Safety = 3,00,000 2,00,000 = Rs. 1,00,000
Net profit
50, 000
=
Rs. 1, 00, 000
P/V Ratio
50%
Angle of Incidence
The angle of incidence is the angle between the sales line and the total cost line formed at the breakeven point where the sales line and the total cost line intersect each other. The angle of incidence
indicates the profit-earning capacity of a business. A large angle of incidence indicates a high rate of
profits and vice versa. Usually, the angle of incidence and margin of safety are considered together to
indicate the soundness of business. A large angle of incidence with a high margin of safety indicates
the most favourable position of business.
Assumptions in Break-Even Analysis
1. The total revenue of the enterprise change in direct proportion to changes in unit sales volumes.
This is the same as assuming that the average selling price is constant.
2. The total expenses can be separated into variable and fixed expenses.
3. The total variable expenses vary in direct proportion to changes in sales volume. This is the same
as assuming the variable expenses per unit is constant.
4. The total fixed expenses, within a relevant range of volume, do not change as sales
volume changes.
5. For a multi-product firm, the sales mix remains constant for all volume levels under
consideration.
6. Production volume and sales volume are equal. In other words, inventory changes do
not affect profit. Everything produced is sold and there is no change in the closing
inventory.
7. Average and marginal productivity of factors are constant.
8. The volume of output or production is the only factor which influences the cost.
200
Managerial Uses of Break-Even Analysis
1. The break-even analysis provides microscopic view of the profit structure of a
business enterprise.
2. The break-even analysis highlights the areas of economic strength and weaknesses of
the firm.
3. Through break-even analysis, it is possible for the management to examine the profit
vulnerability of a business firm to the possible changes in business conditions.
4. The break-even chart helps the management to know at a glance the profits generated
at the various levels of sales.
5. Break-even analysis is useful for the purpose of determining the volume of sales
necessary to achieve a targeted profit.
6. Break-even analysis can be used for determining the safety margin regarding the
extent to which the firm can permit a decline in sales without causing losses.
7. Sometimes the management may face the problem of whether to reduce prices. If the
price is reduced, the volume of sales will have to be increased even to maintain the
previous level of profit. Break-even analysis will help the management to know the
required volume of sales to maintain the previous level of profit.
8. Impact of increase or decrease in fixed and variable costs can be highlighted through
break-even analysis.
9. Break-even analysis is useful in arriving at make or buy decisions by the firms,
when these are often have the option of making certain components which are part
of their finished products or purchasing them from outside supplies. In short, break-
even analysis is highly significant in business decision-making pertaining to pricing

policy, sales projection, capital budgeting, etc.
Limitations of Break-Even Analysis
Break-even analysis is not a remedy for all problems faced by a business firm. It cannot be used
usefully without a thorough understanding of its concept and limitations. The break-even analysis has
certain limitations as follows:
1. Break-even analysis is usually based on past accounting data. Accounting data has
certain limitations such as neglect of imputed costs, arbitrary calculation of
depreciation, etc. Break-even analysis is useful only if the firm maintains a good
accounting system. If break-even analysis is based on past data, the same should be
adjusted for changes in input prices such as raw material prices, wages, etc. Such
adjustments are generally avoided because of their complexity in analysis.
2. Break-even analysis is static in character. In break-even analysis, everything is
assumed to be constant. This implies static conditions. It assumes a constant
relationship between costs and revenues on the one hand and inputs on the other.
Costs and revenues, however, may change over time, which makes the projection
based on past data wrong.
201
3. A basic assumption in break-even analysis is that cost-revenue-volume relationship is
linear. Linearity of cost and revenue function are true only for limited range of
output.
4. Break-even analysis is not an effective tool for a long-run analysis and its use should be restricted
to the short run only, i.e., to the budget period of the firm which is
usually the calendar year.
5. Break-even analysis assumes that profit as a function of output only. It fails to
consider the impact of technological change, better management, division of labour,

improved productivity and such other factors influencing profits. Therefore, breakeven analysis gives us only a partial view of the situation.
6. Handling selling costs in break-even analysis is difficult because selling costs do not vary with
output and sales. They manipulate sales and affect the volume of output.
7. The break-even charts are drawn on the basis of given product prices. The product
prices change frequently, and the non-inclusion of the changes in prices is basically
due to difficulty of precisely estimating the sales volume at various prices. But this
non-inclusion of product prices imparts its share of unrealism to the results.
8. The area included in the break-even analysis should be limited. If too many products,
too many departments or too many plants are clubbed together and graphed on a
single break-even chart, both good and bad performances can easily be buried in the
total picture of the group. Getting data by product or by brand is very difficult.
9. A straight-line total revenue curve presumes that any quantity might be sold at that
one price. This implies a horizontal demand curve and can be true only under
conditions of perfect competition. To be realistic, calculations are often made at
several price levels. Several total revenue curves are required instead of one revenue
curve, because in real world, perfect competition is not realistic.
10. Perfect matching of output and costs to the particular time period is difficult. Costs in a particular
period may not be caused entirely by the output in that period. Some
costs like maintenance expenses may be the result of previous output or a preparation
for future output. Therefore, it is difficult to match the output and costs to a timeperiod, resulting in unreliable estimates of profit.
Despite the above limitations, break-even analysis serves some useful purpose in business decisions.
It provides guidelines for alternative possibilities and arriving at better decisions.
Illustration 3.5:
From the following information, you are required to calculate break-even

point in units and sales value.
Output = 1500 units
Variable cost per unit = Rs. 10
Total fixed cost = Rs. 10,000
Selling price per unit = Rs. 15
202
Solution:
Fixed cost
Break-even point (in units) = Selling price per unit Variable cost per unit
10,000
10,000
=
=
=2,000 units
15 10
5
Fixed cost sales
Break-even point (in sales value) Sales Variable cost
Fixed cost
= P/V ratio
Contribution
P/V Ratio =
100
Sales
15 10
500
100
33.33%
15
15
10,000
Hence, BEP (in sales value) =
= 30,000
33.33%
Otherwise, as the BEP is 2,000 units, break-even sales would be
2,000 15 = 30,000
TR = TC at 2,000 units
i.e.
Fixed cost
= 10,000
Variable cost (2,000 s. 10) = 20,000
30,000
TR = 2,000 units s. 15
= 30,000
Illustration 3.6: Calculate the profit-volume ratio and the break-even point from the following
information:
Fixed cost = Rs. 3,00,000
Variable cost per unit = Rs. 20

Solution:
Contribution
1. Profit volume ratio =
Sales
= Selling price per unit
Selling price per unit Variable cost per unit
=
Rs. 30 20
10
=
= Rs.
= 0.66
30
15
203
Profit volume ratio of 0.66 indicates that for every one rupee of sales, 66 paise is available as
contribution.
Total fixed cost
2 (a) Break-even point (in terms of units) = Contribution per unit
Total fixed cost
= Selling price Variable cost

3,00,000
3,00,000
=
=
= 30,000 units
30-20
10
If one unit is sold, Rs. 30 will be received and if one unit is produced a variable cost
Rs. 20 will be incurred. A contribution of Rs. 10 per unit will be left to cover the total fixed cost and
30,000 such units should be produced and sold (30,000 @ Rs. 10 have to be earned) to cover the
total fixed cost of Rs. 3,00,000.
(b) Break-even point (in terms of rupees or value):
(i) Break-even units elling price
= 30,000 units s. 30
= Rs. 9,00,000
Total fixed cost
(ii)
Selling price
Total fixed cost Selling price per unit
=
Selling price Variable cost
3,00,000 30
90,00,000
=
= Rs. 9,00,000
30 20
10
Total fixed cost
3,00,000
(iii)
= Rs. 9,00,000
Profit volume ratio
0.666
Illustration 3.7:
From the given data below, calculate (a) P/V ratio, (b) fixed cost, and
(c) sales volume to earn a profit of Rs. 80,000.
Sales = Rs. 2,00,000
Profit = Rs. 20,000
Variable cost = 70%
Solution:
Sales = Rs. 2,00,000
70
Variable cost = 70% =
2,00,000 = Rs. 1,40,000
100
Sales Variable cost
(1) P/V ratio =
100
Sales
2,00,000 1,40,000
60,000
=
100
100 30%
2,00,000
2,00,000
204
(2) Contribution = Fixed cost + Profit
or Rs. 60,000 = Fixed cost + Rs. 20,000
or Fixed cost = 60,000 20,000 = 40,000
Fixed cost + Profit
40,000 + 80,000
(3) Sales =
=
P/V Ratio
30%
1,20,000
=
100 Rs. 4,00,000.
30
Illustration 3.8:
From the following information, calculate (a) P/V ratio, (b) sales required
to earn a profit of Rs. 20,000, (c) profit when sales are Rs. 60,000.
Year
Sales (Rs.)
Profit (Rs.)
2004
70,000
7,500
2005
80,000
10,000
Solution:
Change in profit
2,500
(a) P/V ratio =
100
100 25%
Change in sales
10,000
(b) Sales required to earn a profit of Rs. 20,000
Fixed cost + Profit
P/V ratio =
Sales
25
Fixed cost + 7,500
or
=
100
70,000
25
or
70,000
17,500 FC 7,500
100
or
17,500 7,500 = 10,000
Fixed cost = Rs. 10,000
Fixed cost + Profit
10,000 + 20,000
Desired sales =
=
P/V ratio
25
100
100
= 30,000
Rs. 1,20,000
25
(c) Profit when sales are Rs. 60,000
FC P
S P/V ratio
or
S P/V Ratio = F + P
25
or
60,000
= 15,000 + P
100
205
or
15,000 = 10,000 + P
or
P = 15,000 10,000 = 5,000
Illustration 3.9:
From the following data, you are required to calculate (a) BEP in units and
sales value, and (b) number of units to be sold to earn a profit of Rs. 50,000.
Fixed factory overheads cost = Rs. 35,000
Fixed selling overheads cost = Rs. 5,000
Variable manufacturing cost per unit = Rs. 6
Variable selling cost per unit = Rs. 2
Selling price per unit = Rs. 12.

Solution:
Fixed cost
(a)
Break-even point = Selling price per unit Variable cost per unit
Variable cost per unit = 6 + 2 = 8
Total fixed cost = 35,000 + 5,000 = 40,000
40,000
40,000
BEP
=
10,000 units
28
4
BEP in sales value = 10,000 12 = 1,20,000
(b) Number of units that must be sold to earn a profit of Rs. 50,000
Fixed cost + Profit
= Selling price per unit Variable cost per unit
40,000 + 50,000
90,000
22,500 units
12 8
4
Illustration 3.10:
From the following data, you are required to calculate: (a) P/V ratio,
(b) break-even sales with the help of P/V ratio, and (c) sales required to earn a profit of Rs.
2,25,000.
Variable costs: Direct material = Rs. 3
Direct labour = Rs. 1
Direct overheads = 100% of direct labour
Solution:
Less: Variable cost per unit
Direct material
3
Direct labour
1
Direct overheads
1
5
206
Contribution = Selling price Variable cost = Rs. 6 5 = Re. 1.
Contribution
1
P/V ratio
100 100 16.66%
Sales
6
Fixed expenses
45,000
45,000 100
Break-even sales
Rs. 2,70,108
P/V ratio
16.66
16.66
100
(c) Sales required to earn a profit of Rs. 2,25,000
Fixed expenses + Desired profit
45,000 + 2,25,000
P/V ratio
16.66%
2,70,000
2,70,000 100
Rs. 16,20,648
16.66
16.66
100
Illustration 3.11:
From the following data of a company, calculate: (a) P/V ratio, (b) break-
even point, (c) profit or loss when the sales amount to Rs. 40,000, and (d) sales required to earn a
profit of Rs. 20,000.
1st year: Sales Rs. 75,000, Profit Rs. 10,000
2nd year: Sales Rs. 80,000, Profit Rs. 15,000
Solution:
Difference in profit
(a) P/V ratio =
100
Difference in sales
' Profit
=
100
' Sales
15,000 10,000
5,000
=
=
100 100%
80,000 75,000
5,000
Fixed expenses
(b) Break-even point =
P/V ratio
(c) Fixed expenses:
Sales
Rs. 75,000
80,000
Contribution @100%
75,000
80,000
Less: Profit
10,000
15,000
Fixed expenses
65,000
65,000
Fixed expenses
65,000
BEP
= 65,000
P/V ratio
100%
207
(d) Profit when sales are Rs. 40,000
Sales
40,000
Contribution @ 100%
40,000
Less: Fixed expenses

65,000
Loss
25,000
Alternatively,
F + Profit
Required sales = P/V ratio
65,000 + P
40,000 =
100%
40,000 = 65,000 + P; 40,000 65,000 = P
P = () 25,000 (showing loss of Rs. 25,000)
(e) Sales required to earn a profit of Rs. 20,000
FP
65,000 + 20,000
Required sales
P/V ratio
100%
85,000
85,000
100 85,000
100%
100
Illustration 3.12:
From the given data, calculate the number of units to be produced and sold
in order to (a) achieve break-even, and (b) to earn a profit of Rs. 10,000.
Fixed expenses = Rs. 10,00,000
Variable expenses = Rs. 10 per unit
Selling price = Rs. 15 per unit.
Solution:
Fixed cost
(a) Break-even in units = Contribution per unit
10,00,000
10,00,000
=
20,00,000 units
15 10
5
(b) Number of units to be sold to earn a profit of Rs. 10,000 can be found from
Fixed cost + Profit
Sales =
P/V ratio
Contribution
P/V ratio =
100
Sales
5
100 33.33%
15
10,00,000 + 10,000
10,10,000
30,30,303
33.33%
33.33%
Sales
30,30,303
Number of units =
2,02,020 units
15
208
Illustration 3.13:
A company has supplied the following information. You are required to
find the break-even point.
Total fixed cost = Rs. 20,000
Total variable cost = Rs. 30,000
Total sales = Rs. 65,000
Units sold = 20,000
Solution:
Break-even point = Fixed cost/Selling price Variable cost per unit
Selling price = 65,000
Selling price per unit = 65,000/20,000 = Rs. 3.25

Variable cost per unit = 30,000/20,000 = 3/2 = Rs. 1.50
20,000
20,000
BEP =
=
= 11,428 units
3.25 1.50
1.75
Illustration 3.14:
Calculate the P/V ratio, break-even point and margin of safety from the
following data:
Sales
Rs. 4,00,000
Fixed expenses
Rs. 1,00,000
Variable expenses:
Direct material
Rs. 1,50,000
Direct labour
Rs. 80,000
Other variable expenses
Rs. 60,000
2,90,000
Solution:
1. P/V ratio = Contribution/Sales
Sales Variable cost/Sales = 40,000 2,90,000/4,00,000 = 0.275
2. Break-even point = Fixed cost/P/V ratio = 1,00,000/0.275 = 3,63,636
3. Margin of safety = Profit/P/V ratio = [Sales (Variable cost + Fixed cost)]/P/V ratio
= 4,00,000 (2,90,000 + 1,00,000)/0.275 = 10,000/0.275 = 36,363
Margin of safety can also be verified with
Actual sales Break-even sales
= 4,00,000 3,63,636 = Rs. 36,364.
Illustration 3.15:
From the following information, (a) Calculate P/V ratio, (b) Fixed cost,
(c) Break-even point, and (d) Sales required to earn a profit of Rs. 10,000.
Year
Sales
Profit
1
40,000
2,000
2
20,000
800
209
Solution:
Change in profit
1. P/V ratio
=
100
Change in sales
1200
1,20,000
=
100 =
= 6%
20,000
20,000
Fixed cost = 1 P/V ratio = V/C ratio
1 6% = 94%
VC = 40,000 94% = 37,600
Contribution = 40,000 37,600 = 2,400
Fixed cost = Contribution Profit
= 2,400 2,000 = Rs. 400.
(c) Break-even point = Fixed cost/P/V ratio = 400/6% = 0.666
(d) Sales required to earn a profit of Rs. 10,000
Profit
400 + 10,000
= Sales = Fixed cost +
=
= 10,400/6% = 1,73,333.
P/V ratio
6%
SUMMARY
Production is a process by which resources are transformed into different and more useful
commodities or services. The factors of production have been traditionally classified as land, labour,
capital and organization (or enterprise). The term production function refers to the relationship
between the inputs and the outputs in physical terms. The law of production states the relationship
between inputs and outputs. The input-output relationships can be studied under short-run and longrun conditions. The laws of production under short-term conditions are called the laws of variable
proportions or the laws of returns to a variable input. The long-run input-output relations are studied
under laws of returns to scale.
In economic theory, the production function is of three types: production function with one variable
input, production function with two variable inputs and production function with all variable inputs.
Production function with one variable input shows the input-output relationship or production function
with one factor variable. In production function with two variable inputs, the firm increases its output
by using more of two inputs that are substitutes for each other, say labour and capital. The
proportionate increase in all the input factors will affect total production. Production function with all
variables shows how output increases due to change in all input variables. Iso-quant measures a
quantum of production resulting from alternative combination of two variable inputs. Types of isoquants are: linear iso-quant, right-angled isoquant, input-output iso-quant, and kinked iso-quant. A
linear iso-quant implies perfect
substitutability between the two inputs K and L. When a production function assumes a fixed
proportion between inputs of K and L, the iso-quant takes L shape and is called a right-angled isoquant. Kinked iso-quant assumes limited substitutability of the two variable inputs. Cobb-Douglas
production function takes the form, Q = bLa C 1 a, where Q is the total output, L is 210
the index of employment of labour in manufacturing and C is the index of employment of fixed capital
in manufacturing. The production function shows that a 1 per cent change in labour input, capital
remaining constant, is associated with a 0.75 per cent change in output.
The term economies refers to cost advantages, and sometimes these economies are over-exploited;
the result may be cost disadvantages, i.e., diseconomies. Economies of large-scale production are
categorised into two types: external economies and internal economies. External economies are those
economies which accrue to each member firm as a result of the expansion of the industry as a whole.
Internal economies are those economies in production or those reductions in production costs which
are available to the firm itself when it expands its output or enlarges its scale of production. If the
firm grows beyond a limit, internal economies may disappear. On the other hand, internal
diseconomies may appear. These diseconomies may be internal and external. Internal diseconomies
are those which are exclusive and internal to a firm. External diseconomies arise outside the firms,
mainly in the input markets. The cost of production plays an important role in the decision-making
process. The total cost compared to the total revenue determines the margin of profit of a firm.
Break-even analysis is also called Cost Volume Profit (CVP) analysis. A break-even
analysis indicates at what level of output costs and revenues are equal. Contribution is the difference
between sales and variable cost or marginal cost of sales. It may also be defined as the excess of
selling price over variable cost per unit. The profit-volume ratio, which is also called the
contribution sales ratio, expresses the relationship between contribution and sales.
Margin of safety represents the difference between the actual sales volume and the sales volume at
break-even point. The angle of incidence is the angle between the sales line and the total cost line
formed at the break-even point where the sales line and the total cost line intersect each other.
EXERCISES
1. Break-even chart depicts cost-volume-profit relationship.
2. Profit-volume ratio indicates the relationship between profit and sales.
3. The angle formed at the intersection of the sales line and the total cost line is called angle of
incidence.
4. All future costs are not relevant costs.
Answers:
1. True
2. False
3. True
4. True
Choose the most appropriate answer:
1. Variable cost per unit
(a) Remains fixed
(b) Fluctuates with the volume of production
(c) Varies with the volume of sales

211
2. Fixed cost per unit increases when
(a) Production volume decreases
(b) Production volume increases
(c) Variable cost per unit decreases.
3. Opportunity cost helps in
(a) Ascertainment of cost
(b) Controlling cost
(c) Making managerial decisions
4. Contribution margin is also known as
(a) Net income
(b) Gross profit
(c) Marginal income
5. When fixed cost is Rs. 10,000 and P/V ratio is 50%, the break-even point will be
(a) Rs. 20,000
(b) Rs. 40,000
(c) Rs. 50,000
6. When P/V ratio is 40% and sales value Rs. 10,000, the variable cost will be
(a) Rs. 4,000
(b) Rs. 6,000
(c) Rs. 10,000

Answers:
1. (b)
2. (a)
3. (c)
4. (c)
5. (c)
6. (a)
7. (b)
1. What is break-even analysis? Discuss its assumptions and uses.
2. Differentiate between fixed cost and variable cost.
3. Write briefly about Cost Volume Profit Analysis.
4. What do you mean by opportunity cost?
5. Explain the features of iso-quant curves.
6. Explain explicit costs and implicit costs.
7. Explain the features of LAC (Long-run Average Cost Curve).
8. Explain the Cobb-Douglas production function.
9. What is the production function? What are its assumptions?
10. What are the iso-quant curves?
11. Define cost. Give examples of fixed costs.
212
12. List the steps followed for achieving a reasonable margin of safety in break-even analysis.
13. What are internal economies?

14. Briefly explain the Consumption Function.
15. List the properties of Iso-quants.
16. Define Future, Incremental and Imputed costs.
17. Explain cost-benefit analysis.
18. What is margin of safety?
19. Explain the term Firm.
20. What do you understand by variable costs?
21. Define the following terms:
(a) Opportunity cost
(b) Sunk cost
(c) Relevant cost
(d) Differential cost.
22. Break-even analysis is a useful device of profit planning. Do you agree? Discuss.
23. What is a break-even chart? How is it constructed? Explain its utility.
24. Explain the assumptions, utility and limitations of cost-volume-profit analysis.
1. What is the production function?
2. Explain as to how break-even analysis is useful for managerial decisions.
3. What do you understand by break-even analysis? Explain its managerial uses and
limitations.
4. Explain the internal and external economies of scale.
5. What is meant by the production function? Explain the firms equilibrium output by using iso-quants
and iso-cost curves.
6. Explain in detail the Law of Diminishing Marginal Returns.
7. Diagrammatically represent the cost-output relationships at different situations.

8. State the assumptions and limitations of break-even analysis.
9. Explain the concept of production function and the laws of returns to scale.
10. Enlist any five concepts of cost and explain them.
11. From the following data, determine the break-even point:
Variable cost = Rs. 10 per unit.
Selling price = Rs. 15 per unit.
What should be the sales volume to make a profit of Rs. 25,000?
213
12. (a) A firm has a fixed cost of Rs. 10,000, the selling price per unit is Rs. 5 and variable cost per
unit is Rs. 3.
(i) Determine the break-even point in terms of volume and also sales value.
(ii) Calculate the margin of safety, considering that the actual production is 8,000 units.
13. What is break-even point? Calculate the break-even point from the following data:
Variable cost per unit = Rs. 30.
CHAPT E R
4
Capital Management and
Investment Decisions
LEARNING OBJECTIVES
the concept of capital

the significance of capital
the types of capital: fixed capital and working capital
The sources of capital
working capitalconcepts, need, requirements, etc.
Capital budgetingdecisions, concept, process, significance, factors affecting investment decisions,
techniques, etc.
INTRODUCTION
The term capital generally refers to the amount invested in an enterprise by its owners. It refers to
money as well as moneys worth. Capital may be in the form of property, cash or titles to wealth.
From the economists point of view, capital is the value of total assets available with the business.
Capital has been defined as that part of a persons wealth, other than land, which yields an income or
which aids in the production of further wealth. If wealth is not used or if it is stored, it cannot be
considered as capital. Capital serves as an instrument of production.
Anything which is used in production is capital. Capital consists of those physical goods which are
produced for use in future production. Machines, tools and instruments, factories, canals, dams,
transport equipment, stocks of raw materials, etc. are some of the examples of capital.
But from the accountants point of view, it is the difference between assets and liabilities. Thus, it is
the total amount of finances required by the business to conduct its business operations both in the
short run and in the long run.
214
CAPITAL MANAGEMENT AND INVESTMENT DECISIONS
215
SIGNIFICANCE OF CAPITAL
Capital plays a vital role in the modern business operations and productive system. It is required
from the process of procuring raw materials till the sale of finished products. Capital is needed in a
business to start and promote it, to run the day-to-day operations of the business, to replace old
assets, to expand the business and diversify its activities, to pay taxes, dividend and interest, to meet
unforeseen contingencies and to wind up the business.
CAPITAL MANAGEMENT
The capital requirements of a firm can broadly be divided into two main categories. They are: (i)
Fixed capital requirements

(ii) Working capital requirements.
Fixed capital is the capital which is meant for meeting the permanent or long-term needs
of the business. In other words, fixed capital is required for the acquisition of those assets that are to
be used over a long period. Fixed capital stands for the durable-use produced goods which are used
in production again and again till they wear out. Machinery, tools, railways, tractors, factories, etc.
are all fixed capital. Fixed capital does not mean fixed in location.
Capital like plant, tractors and factories are called fixed because if money is spent on these durableuse goods it becomes fixed for a long period, in contrast with the money spent in purchasing raw
materials which is released as soon as the goods made with them are sold out.
It is therefore necessary that sufficient funds should be raised for acquisition of fixed assets.
These funds are required not only while establishing a new enterprise but also for expanding,
diversifying and maintaining intact the existing enterprise.
The assessment of fixed capital requirements for a business can be made by preparing a
list of the fixed assets needed by the business. Once a list of the fixed assets required for the business
is compiled, it will not be difficult to ascertain the total funds required for purchase of fixed assets.
The term working capital refers to the capital required for day-to-day operations of a firm.
It includes the single-use producer goods like raw materials, goods in process and fuel. They are used
up in a single act of consumption. Moreover, money spent on them is fully recovered when goods
made with them are sold in the market.
Working Capital
In any organization, we find that most of the time managers are concerned with working capital
management to ensure that enough cash exists to pay bills, ensuring that enough inventory exists to
make and sell products; ensuring that any excess cash is invested in interest-bearing securities;
ensuring that accounts receivables are at a level that maximizes earnings, ensuring that short-term
borrowings such as salaries payable and trade credit are used efficiently and at the lowest cost
possible.
Working capital management involves the relationship between a firms short-term assets
and its short-term liabilities. Working capital management, also known as short-term financial 216
management, largely deals with the management and control of current assets and current liabilities.
Short-term financial management involves cash flows within the operating cycle of the company,
usually not exceeding the period of one year. The basic goal of working capital management is to
ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both
maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing inventories, accounts receivable, accounts payable
and cash.
Need for Working Capital
The need for working capital to run the day-to-day business activities cannot be
overemphasized. We will hardly find a business firm which does not require any amount of
working capital. Indeed, firms differ in their requirements of working capital.
We know that a firm should aim at maximizing the wealth of its shareholders. In its
endeavour to do so, a firm should earn sufficient return from its operations. Earning a steady amount
of profit requires successful sales activities. The firm has to invest enough funds in current assets for
generating sales. Current assets are needed because sales do not convert into cash instantaneously.
There is always an operating cycle involved in the conversion of sales into cash.
Concepts of Working Capital
Working capital can be understood in two different but interlinked senses. In the first sense, working
capital refers to gross working capital and in second sense it is understood in terms of net working
capital (see Fig. 4.1).
There are two concepts of working capital:
Concepts of working capital
Gross working capital (broad view)
Net working capital (narrow view)
(Current assets)
(Current assets Current liabilities)
Fig. 4.1 Concepts of working capital.
Gross working capital, simply called working capital, refers to the firms investment in total current
or circulating assets. Current assets are the assets which can be converted into cash within an
accounting year (or operating cycle). These include cash, debtors, bills receivables, inventory and
short-term securities.
Net working capital is an accounting concept and has been defined in two different ways: (i) It is the
difference between current assets and current liabilities.
(ii) It is that portion of a firms current assets which is financed with long-term funds.
Current liabilities are debts which are due to be paid within one year, such as accounts payable,
accrued liabilities, and the portion of long-term debt which is due within one year. Net working
217
capital can be either positive or negative. A positive net working capital will arise when current
assets exceed current liabilities. Positive working capital means that the company is able to pay off
its short-term liabilities. A negative working capital arises when current assets are less than current
liabilities. Negative working capital means that a company currently is unable to meet its short-term
liabilities with its current assets (cash, accounts receivable, inventory, etc.). These two concepts of
working capital are not exclusive; rather, they have equal significance from the managements point of
view.
The gross working capital concept focusses attention on two aspects of current assets
management:
Optimum Investment in Current Assets.
The level of investment in current assets should
neither be excessive nor be inadequate. The planning should be done keeping in mind two
danger points, i.e., excessive and inadequate investment in current assets. Investment in current assets
needs to be adequate to the needs of the business firm as it affects the profitability, solvency and
liquidity, as shown in Table 4.1.
Table 4.1 Adequacy of working capital
Excessive investment (profitability)
Inadequate investment (liquidity)
It results in unnecessary accumulation of
It stagnates growth.
inventories. Thus, chances of inventory
It becomes difficult to implement operating
mishandling, waste, theft and losses

plans and achieve the firm's operating profit
increase.
target.
It is an indication of defective credit policy and
Operating inefficiencies creep in when it
slack collection period.
becomes difficult even to meet day-to-day
Excessive working capital makes managecommitments.
ment complacent, which degenerates into
Fixed assets are not efficiently utilised for
managerial inefficiency.
the lack of working capital funds. Thus, the
Tendencies of accumulating inventories tend
firm's profitability would deteriorate.
to make speculative profits grow.
Lack of working capital funds render the firm
unable to avail attractive credit opportunities.
The firm loses its reputation when it is not
in a position to honour its short-term
obligations.
Financing of Current Assets.
Many businesses operate in industries that have seasonal
changes in demand. The working capital needs of the firm may be fluctuating with changing business
activity. This may cause excess or shortage of working capital. The management
should take an appropriate step to correct imbalance to run the business efficiently.
Arrangement should be made in case of requirement of working capital and on the other hand should
be invested when surplus funds arise.
The net working capital concept focusses attention on two aspects:
Liquidity Position of Firm.
Current assets should be sufficiently in excess of current
liabilities. If a companys current assets do not exceed its current liabilities, then it may run 218
into trouble while paying back creditors in the short term. Working capital also gives investors an
idea of the companys underlying operational efficiency. Hence current assets should exceed current
liabilities to avoid insolvency of the company.
Financing Working Capital Requirements Partly Out of Permanent Sources of
Funds.
For every firm, there is a minimum amount of net working capital which is
permanent. There, a portion of the working capital should be financed with permanent sources of
funds. Thus the management should decide the extent to which current assets should be
financed from the permanent sources of funds.
The firm should maintain a sound working capital position. It should have adequate
working capital to run its business operations. Both excessive as well as inadequate working capital
positions are dangerous from the firms point of view. Excessive working capital means idle funds
which earn no profits for the firm. Lack of working capital not only impairs the firms profitability but
also results in production interruptions and inefficiencies.
To conclude, both the concepts of working capitalgross and nethave their relative
importance and are equally important for the efficient management of working capital.
Composition of Working Capital
The two components of working capital are Current Assets (CA) and Current Liabilities (CL) as
shown in Table 4.2.

Table 4.2 Composition of working capital
Current assets
Current liabilities
Inventories
Sundry creditors
Trade debtors
Bank overdrafts
Prepaid expenses
Short-term loans
Loans and advances
Provisions
Investment
Cash and bank balance
Current assets comprise items that would get converted into cash in the short term, within a year,
through the business operations. Current assets constitute the following:
Inventories.
These represent raw materials and components, work-in-progress and finished
goods.
Trade Debtors.
These comprise credit sales to customers.
Prepaid Expenses.
These are expenses which have been paid for goods and services whose
benefits are yet to be received.
Loans and Advances.
They represent loans and advances given by the firm to other firms
for a short period of time.
219
Investment.
These assets comprise short-term surplus funds invested in government
securities, shares and short-term bonds.
Cash and Bank Balance.
These assets represent cash in hand and at bank, and are used for
meeting operational requirements.
Current liabilities form part of working capital that represent obligations which the firm has to clear
to the outside parties in a short period, generally within a year. Current liabilities comprise the
following:
Sundry Creditors.
These liabilities stem out of purchase of raw materials on credit terms

usually for a period less than one year.
Bank Overdrafts.
These include withdrawals in excess of credit balance held in the firms
current account with banks.
Short-term Loans.
Short-term borrowings by the firm from banks and others form part of
current liabilities as short-term loans.
Provisions.
These include provisions for taxation, proposed dividends and contingencies.
Types of Working Capital
The amount of funds tied up in working capital would not typically be a constant figure
throughout the year. Only in the most unusual of businesses would there be a constant need for
working capital funding. For most businesses there would be weekly fluctuations. Many businesses
operate in industries that have seasonal changes in demand. This means that sales, stocks, debtors,
etc. would be at higher levels at some predictable times of the year than at others.
In principle, the working capital need can be separated into two parts on the basis of time (see Fig.
4.2):
Fig. 4.2 Types of working capital.
Permanent Working Capital.
This component represents the value of the current assets
required on a continuing basis over the entire year, and for several years. Permanent working 220
capital is the minimum amount of current assets, which is needed to conduct a business even during
the dullest season of the year. The minimum level of current assets is called permanent or fixed
working capital as this part is permanently blocked in current assets. For example, every firm has to
maintain a minimum level of raw materials, work in process, finished goods and cash balance to run
the business operations. This amount varies from year to year,
depending upon the growth of the company and the stage of the business cycle in which it
operates.
The permanent working capital can further be classified into regular working capital and
reserve working capital. Regular working capital is the minimum amount of working capital required
to ensure circulation of current assets from cash to inventories, from inventories to receivables and
from receivables to cash and so on. Reserve working capital is the excess amount over the
requirement for regular working capital which may be provided for
contingencies that may arise at unstated periods such as strikes, inflation, depression, etc.
Characteristics of permanent working capital
It is classified on the basis of the time-period
It constantly changes from one asset to another and continues to remain in the business process.
Its size increases with the growth of business operations.
Temporary or Variable Working Capital.
It is the investment in current assets that varies
with seasonal requirements. The amount of such working capital keeps on fluctuating from time to
time on the basis of business activities. In other words, it is the amount of additional current asset that
are required to meet the seasonal needs of a firm, and so is also called the seasonal working capital.
For example, additional inventory will be required for meeting the demand during the period of high
sales. When the peak period is over, variable working capital starts decreasing or becomes very little
during the normal period. It is temporarily invested in current assets.
The variable working capital can be further classified into seasonal working capital and
special working capital. Seasonal working capital is required to meet certain seasonal demands,
while special working capital is required to meet special exigencies like market research, campaigns,
etc.
Characteristics of Temporary Working Capital
It is not always gainfully employed, though it may change from one asset to another
asset, as permanent working capital does.
It is particularly suited to business of a seasonal or cyclical nature.
The diagrams given below illustrate the firms changing needs for working capital over time while
highlighting both the temporary and permanent nature of those needs. In Fig. 4.3(a), permanent
working capital is fixed over a period of time, while temporary working capital is fluctuating. It
shows that permanent working capital is stable overtime, while temporary
working is fluctuatingsometimes increasing and sometimes decreasing. However, the
permanent working capital line need not be horizontal if the firms requirement for permanent
221
working capital is increasing (or decreasing) over a period. For a growing firm, the difference
between permanent and temporary working capital can be depicted through Fig. 4.3(b).
Temporary or
capital
fluctuating WC
working
of
mountA
Permanent
Time
WC
Fig. 4.3(a) Permanent or temporary working capital in case of stable firm.
Temporary or
fluctuating WC
Permanent
WC
capital
working
of
mountA
Time
Fig. 4.3(b) Permanent or temporary working capital in case of growing firm.
Permanent working capital is similar to the firms fixed assets in two important respects.
First, the investment in both of these asset groups is long term. Second, for a growing firm the level of
permanent working capital needed will increase over time in the same way that a firms fixed assets
will need to increase over time. However, permanent working capital is different from fixed assets in
one very important respectit is constantly changing. Thus, permanent working capital does not
consist of particular current assets staying permanently in place, but is a permanent level of
investment in current assets whose individual items are constantly turning over.
The more permanent needs (fixed assets and the fixed element of working capital) should
be financed from fairly permanent sources (e.g. equity and loan stocks); the fluctuating element 222
should be financed from a short-term source (e.g. a bank overdraft), which can be drawn on and
repaid easily and at short notice.
Determinants of Working Capital
A firm should plan its operations in such a way that it should have neither too much nor too little
working capital. A large number of factors influence the total working capital
requirements of a firm. All factors are of different importance and change from time to time.
The following are the factors which influence the working capital requirements of firms:
Nature of Business.
The working capital requirements of an enterprise are closely related to
the nature of its business, which in turn is related to the operating cycle. For example, public utility
undertakings like electricity, water supply, railways, etc. need very limited working capital as the
operating cycle will be much shorter, because they offer cash sales only, and supply services, not
products, and as such no funds are tied up in inventories and receivables.
But at the same time, they have to invest fewer amounts in fixed assets. As against this, the
manufacturing concerns on the other hand will be having a much longer operating cycle as it would be
selling mostly on credit, and consequently would require sizable working capital along with fixed
investments as they have to build up the inventories.
Supply Conditions of Materials.

If the required raw materials and consumable stores and
spares are in short and scarce supply, the working capital needs may be higher due to high level of
inventory of materials to ensure uninterrupted production. On the other hand, if these materials are in
ample supply the working capital needs may be lower.
Terms of Sales and Purchases.
Credit sales granted by the concerns to its customers as well
as credit terms granted by the suppliers also affect the working capital. If the credit terms of the
purchases are more favourable and at the same time those of sales less liberal, less cash will be
invested in the inventory. With more favourable credit terms, working capital requirements can be
reduced.
Manufacturing Cycle.
The length of manufacturing cycle influences the quantum of
working capital needed. Manufacturing process always involves a time lag between the time when
raw materials are fed into the production line and finished goods are finally turned out by it. The
length of the period of manufacture in turn depends on the nature of product as well as production
technology used by a concern. Shorter the manufacturing cycle, lesser the
working capital required and vice versa.
Production Policy.
Production policies followed by the management of the business concern
will have an important bearing upon the working capital requirements. In certain firms, the demand
for products is seasonal. There are two alternatives available to such enterprises: either they confine
their production only during seasons or they keep manufacturing goods in the off-season so as to keep
in working above the break-even point (BEP), to meet at least the fixed costs, on a continuous basis.
They may as well offer some short-term incentives, so as to yield some amount by way of
contributions. This may add to the profitability of the company. This CAPITAL MANAGEMENT
AND INVESTMENT DECISIONS
223
way, the working capital requirements even of seasonal industries may remain almost stable and
uniform throughout the year. As against the seasonal industries, the firms producing
unseasonable products would be having stable and uniform sales throughout the year.
Therefore, for such firms, the working capital requirements may be almost uniform throughout.
Thus, production policies will differ from firm to firm, depending on the nature of the product and the
business.
Rapidity of Turnover.
If the inventory turnover is high, the working capital requirements
will be low. With better inventory control, a firm is able to reduce its working capital
requirements. When a firm has to carry on a large slow-moving stock, it needs larger working capital
as against another whose turnover is rapid. A firm should determine the minimum level of stock
which it will have to maintain throughout the period of its operation.
Business Cycle.
Cyclical changes in the economy also influence the quantum of working
capital. In a period of boom, i.e., when the business is prosperous, there is a need of larger amount of
working capital due to increases in sales, rise in price, etc. and vice versa during the period of
depression.
Changes in Technology.
Changes in technology may lead to improvement in processing of
raw materials, savings in wastage, greater productivity, and more speedy in production. All these
improvements may enable the firm to reduce investments in inventory.
Seasonal Variation.
The inventory of raw materials, spares and stores depends on the
conditions of supply. If the supply is prompt and adequate the firm can manage with small inventory.
However, if the supply were unpredictable and scant then the firm, to ensure the continuity of
production, would have to acquire stocks as and when they are available and carry larger inventory
on an average. For example, manufacturing of fans, coolers, air-conditioners, fridges, room heaters,
geysers, woollen clothes, etc. may require a much higher level of
working capital requirements in peak seasons, and much lower requirements during the offseasons. Thus the working capital requirements will be fluctuating for such companies during peak
and slack seasons.
Operating Efficiency.
A business concern can minimize its need for working capital by

efficiently controlling its operating costs, i.e., utilising the resources optimally. Such efficiency in
operations will ensure improvement in the use of working capital and also acceleration in the pace of
cash cycle. Profitability will also improve which will help in relieving the pressure on working
capital.
Market Conditions.
The degree of competition prevailing in the marketplace has an
important bearing on working capital needs. When competition is keen, a larger inventory of finished
goods is required to promptly serve customers who may not be inclined to wait because other
manufacturers are ready to meet their needs. Besides, with a view to pushing up the sales and to
withstand stiff competition a company may have to offer credit terms, whereby larger amounts of
money may get blocked by sundry debtors for quite a long time. Thus, the
additional inventory of finished goods and the larger amount of sundry debtors may
proportionately increase the quantum of working capital requirements.
224
As against this, if the products of a company have a marked edge in the market as
compared to their competitors, it may not be required to have huge stocks of finished goods, as the
customers may prefer to wait for sometime for a better quality of goods rather than shifting to the
competitors product. A company may also insist that the customers pay cash in advance in full or a
part. These advantages will well reduce the level of working capital requirements of such companies.
Price Level Changes.
When the prices are rising, higher investment in working capital is
required, because the same level of current assets would need increased investment due to rises in
prices. However, companies which can immediately revise their product prices with rising price
levels will not face serious working capital problem. The effects of rising price levels may not affect
all the companies. Thus, the effect of changing price levels on working capital position differs from
company to company depending on circumstances of the firms.
Growth and Expansion.
Growing concerns require more working capital than those which
are static. As a concern grows, larger amount of working capital will be required.
Dividend Policy.
It has a dominant influence on the working capital position of a firm. If
the firm is following a conservative dividend policy, the need for working capital can be met with
retained earnings. In planning working capital requirements, a firm should decide whether profits will
be retained or paid out to shareholders. Thus, a dividend policy is a significant element in
determining the level of working capital in an organization.
Working Capital Cycle.
Another factor which has a bearing on the requirements of working
capital is working capital cycle. Larger the working capital cycle, more is the requirement of working
capital. Working capital cycle is the length of time for a company to acquire the materials, produce it,
sell the product and collect the cash from customers.
Thus, there are several factors affecting the working capital requirements. However, as a general
rule, it can be concluded that in most cases the period, which elapses between the purchase of
materials and the receipt of sale, proceeds of the finished goods will determine the level of working
capital required in the firm. Efficient working capital management requires efficient planning and
constant effort.
Working Capital Cycle
Working capital is vital to a business. They have to have funds available to pay their day-today bills,
wages and so on. The working capital is made up of the current assets net of the current liabilities. It
is very important to a company to manage its working capital carefully.
This is particularly true where there is a substantial time lag between making the product and
receiving the money for it. In this situation the company has paid out all the costs associated with
making the product (labour, raw materials and so on) but not yet got any money for it.
They must therefore ensure they have enough cash to do this.
Investment in working capital is influenced by four key events in the production and sales cycle.
These events are: purchase of raw materials, payment for their purchase, the sale of CAPITAL
MANAGEMENT AND INVESTMENT DECISIONS
225
finished goods, and collection of cash for the sales made. The time lag between the purchase of raw
materials and the collection of cash for sales is referred to as the operating cycle for the company.
The time lag between the payment for raw materials purchases and the collection of cash from sales
is referred to as the cash cycle.
Working capital is required because of the time gap between the sales and their actual
realization in cash. This time gap is technically termed as the operating cycle of the business.
Operating cycle is defined as the average time between purchasing or acquiring inventory and
receiving cash proceeds from its sale. In other words, it is the length of time for a company to acquire
materials, produce the product, sell the product, and collect the proceeds from customers.
Figure 4.4 shows in a simplified form the chain of events in a manufacturing firm. Each
of the boxes in the diagram can be seen as a tank through which funds flow. These tanks, which are
concerned with day-to-day activities, have funds constantly flowing into and out of them.
In case of a manufacturing firm, the operating cycle is the length of time necessary to complete the
cycle of events. The chain starts with the firm buying raw materials. In due course, this stock will be
used in production, work will be carried out on the stock, and it will become part of the firms workin-progress (WIP). Work will continue on the WIP until it eventually emerges as the finished product.
As production progresses, labour costs and overheads will need to be met. Of course, at some stage,
sundry creditors will need to be paid. When the finished goods are sold on credit, debtors are
increased. They will eventually pay, so that cash will be injected into the firm. Each of the areas
stocks (raw materials, work-in-progress and finished goods), trade debtors, cash and trade creditors
can be viewed as events into and from which funds flow. This cycle will be repeated again and
again.
Cash
Sundry
Creditors
Bills
Cash
Receivable
Sales
and
Raw
verheads
Materials
Wages
O
Finished
Goods
Work-inProgress
Fig. 4.4 Operating cycle of a manufacturing firm.
226
In case of a trading firm the operating cycle will include the length of time required to convert cash
into inventories, inventories into accounts receivables and accounts receivables into cash.
In the case of a financing firm, the operating cycle includes the length of time taken for conversion of
cash into debtors and conversion of debtors into cash.
Estimating Working Capital Requirements
In order to determine the amount of working capital needed by a firm, a number of factors are to be
considered by the firm. Besides these factors a firm can apply a number of methods for assessing the
working capital requirements of a firm in addition to the operating cycle concept. The following are
the various methods for assessment of a firms working capital requirements.
Estimation of Components of Working Capital Method.
Since working capital is the
excess of current assets over current liabilities, an assessment of the working capital
requirements can be made by estimating the amounts of different constituents of working
capital, e.g., inventories, accounts receivables, cash, accounts payable, etc.
The assessment of working capital requirements can be made on the basis of the current
assets required for the business and the credit facilities available for the acquisition of current assets,
i.e., current liabilities.
Since working capital is excess of current assets over current liabilities, the forecast for working
capital requirements can be made only after estimating the amount of different
constituents of working capital. The steps involved in estimating the different items of current assets
(CA) and current liabilities (CL) are as follows:
Estimation of Current Assets.

1. Inventories can be estimated. The term Inventories
includes stock of raw material, work-in-progress and finished goods. The estimation of each of them
will be made as follows:
(a) The average amount of raw materials to be kept in stock will depend upon the
quantity of raw material required for production during a particular period and the
average time taken in acquiring a fresh delivery. The investment in raw materials
inventory is estimated as
Budgeted production (in units) Cost of raw material (s)
Average inventory holding period (months/weeks/days)
12 months/52 weeks/365 days
(b) Work-in-progress cost can be estimated. The cost of work-in-progress includes raw
materials, wages and overheads. The amount of working capital locked up in workin-progress will be computed as
227
Budgeted production (in units) Estimated work-in-progress cost per unit
Average time span of work-in-progress inventory (months/weeks/days)
(c) Finished goods costs can be estimated. The period for which the finished goods have
to remain in the warehouse before sales is an important factor for determining the
amount locked up in finished goods. Working capital required to finance the finished
goods inventory is computed as:
Budgeted production (in units) Cost of goods produced per unit
(excluding depreciation) Finished goods holding period (months/weeks/days)

2. The amount of funds locked up in sundry debtors will be computed on the basis of credit sales and
the time lag in collecting payment. The working capital tied up in sundry debtors should be computed
as:
Budgeted credit sales (in units) Cost of sales per unit (excluding depreciation)
Average debt collection period (months/weeks/days)
3. A firm needs to keep some cash in hand and cash at bank to meet day-to-day payments. The cash
and bank balances to be maintained is based on many factors like firms past experience, attitude,
objectives, sources of borrowing cash in case of need, etc.
Estimation of Current Liabilities.
Current liabilities form part of working capital that
represent obligations which the firm has to clear to the outside parties in a short period, generally
within a year. The important current liabilities (CL) are trade creditors, wages and overheads.
1. The lag in payment to suppliers of raw materials, goods, etc., and the likely credit purchases to be
made during the period will help in estimating the amount of creditors. It will be
computed as:
Budgeted production (in units) Raw material requirement per unit
Credit period allowed by creditors (months/weeks/days)
2. The average credit period for the payment of wages is computed as
Budgeted production (in units) Direct labour cost per unit
Average time lag in payment of wages (months/weeks/days)
228
3. The amount of overhead expenses is computed as
Budgeted production (in units) Overhead cost per unit

Average time lag in payment of overheads (months/weeks/days)
Format for Computation of Working Capital
Statement showing the working capital requirements of a
manufacturing firm for a future year
Particulars
Amount (Rs.)
Amount (Rs.)
I. Estimation of Current Assets
1. Inventories
(a) Raw Materials
xxx
(b) Work-in-progress
Raw Materials
xxx
Labour
xxx
Overhead
xxx
xxx
(c) Finished Goods
Raw Materials
xxx
xxx
Labour
xxx
xxx
Overhead
xxx
xxx
xxx
2. Sundry Debtors
xxx
3. Cash and Bank Balance
xxx
Gross Working Capital/Total Current Assets
xxx
I . Estimation of Current Liabilities
1. Trade Creditors
xxx
2. Outstanding Wages
xxx
3. Overhead Expenses
xxx
Total Current Liabilities
xxx
III. Net Working Capital (III)
xxx
Add: Margin for contingency
IV. Net Working Capital Required
xxx
Illustration 4.1:
From the following information prepare a statement showing the working
capital requirements of the business:
(a) Budgeted sales = 26,000 units during the future year.
(b) Selling price = Rs. 10.
(c) Raw material cost per unit = Rs. 3.
(d) Labour cost per unit = Rs. 2.
(e) Overhead cost per unit = Rs. 4.
(f) 6 weeks stocks of raw materials and 4 weeks stocks of finished goods are to be
maintained.
(g) Factory processing will take 4 weeks.
229
(h) Customers are required to be given 6 weeks credit while suppliers offer 4 weeks
credit.
(i) A minimum cash balance of Rs. 5,000 to be maintained.
(j) Time lag in payment of wages is 3 weeks, and in case of expenses 5 weeks.
Solution:
Statement showing the working capital requirements of a
manufacturing firm for a future year
Particulars
Amount (Rs.)
Amount (Rs.)
I. Current Assets
1. Investment in Inventories:
26,000 3 6
(a) Investment in raw materials:
9,000
52 weeks
(b) Investment in work-in-progress
26,000 3 4
Raw materials =
= 6,000
52
26,000 2 4
Labour =
= 4,000
52
26,000 4 4
Overhead =
8,000
18,000
52
(c) Investment in finished goods

26,000 3 4
Raw materials =
6,000
52
26,000 2 4
Labour =
4,000
52
Overhead = 26,000 4 4 8,000
18,000
52
45,000
26,000 9 6
2. Investment in Debtors:
27,000
52
3. Cash Balance
5,000
Gross Working Capital
77,000
Less: Current Liabilities
26,000 3 4
1. Trade Credit =
6,000
52
26,000 2 3
2. Outstanding Wages =
52
3,000
26,000 4 5
3. Overhead Expenses =
52
10,000
19,000
Net Working Capital/Working Capital Requirements
58,000
230
Percent of Sales Method.
This method is based on past experience between sales and
working capital requirements. A ratio can be determined for estimating the working capital
requirements in future. For example, if the past experience shows that working capital has been 40
percent of sales and it is estimated that the sales for the next year would amount to
Rs. 2,00,000, the amount of working capital requirement can be assessed as Rs. 50,000.
Operating Cycle Approach.
According to this method, the requirement of working capital
depends upon the operating cycle of the business. The operating cycle begins with the
acquisition of raw materials and ends with the collection of receivables. It may be broadly classified
into the following four stages:
(i) Raw materials and stores storage stage ( R);
(ii) Work-in-progress stage ( W);
(iii) Finished goods inventory stage ( F); and
(iv) Receivables collection stage ( D).
The duration of the operating cycle for the purpose of estimating working capital
requirements is equivalent to the sum of the durations of each of these stages minus the credit period
allowed by the suppliers of the firm.
Symbolically, the duration of the working capital cycle can be put as follows:
O=R+W+F+DC
where
O = Duration of operating cycle
R = Raw materials and stores storage period
W = Work-in-progress period
F = Finished stock storage period
D = Debtors collection period
C = Creditors payment period.
Each of the component of the operating cycle can be calculated as follows:
Average stock of raw materials and stores
R = Average raw materials and stores consumption per day
Average work-in-progress inventory
W = Average cost of production per day
Average finished stock inventory
F = Average cost of goods sold per day

Average book debts
D = Average credit sales per day
Average trade creditors
C = Average credit purchases per day
After computing the period of one operating cycle, the total number of operating cycles
that can be completed during a year can be computed by dividing 365 days with the number
231
of operating days in a cycle. The total operating expenditure in the year when divided by the number
of operating cycles in a year will give the average amount of the working capital
requirements.
Illustration 4.2:
From the following information extracted from the books of a
manufacturing company, compute the operating cycle in days and the amount of working
capital required:
Period covered
365 days
Average period of credit allowed by suppliers
15 days
(Rs. in 000)
Average total of debtors outstanding
360
Raw material consumption
2,800
Total production cost

8,000
Total cost of sales
9,000
Sales for the year
12,000
Value of average stock maintained
Raw material
200
Work-in-progress
240
Finished goods
180
Solution:
Computation of Operational Cycle
1. Raw materials held in stock:
Average stocks of raw materials held
200
200 365
=
=
= 26 days
Average consumption per day
2,800/365
2,800
Less: Average credit period granted by suppliers = 15 days
11 days
2. Work-in-progress:
Average work-in-progress maintained
240
240 365
=
=
= 11 days
Average cost of production per day
8,000/365
8,000
3. Finished goods held in stock:
Average finished goods maintained
180
180365
=
=
= 7 days
Average cost of goods sold per day
9000/365
9,000
4. Credit period allowed to debtors:
Average total of outstanding debtors

360
360 365
=
=
= 11 days
Average credit sales per day
12,000/365
12,000
Total operating cycle period: (1) + (2) + (3) + (4)
40 days
Number of operating cycles in a year = 365/40 = 9.13
232
Total operating cost
Amount of Working capital required = Number of operating cycles in a year
= 9,000/9.13 = Rs. 986
CAPITAL BUDGETING
The mobilization and investment of funds are the two major tasks that the management has to perform
in any organization. The source mix, the size of the capital expenditure budget and the pattern of
investments made will decide, to a considerable extent, what an organization is and what it will be. It
is therefore not surprising that these problems have received considerable attention.
The planning of capital structure (source mix) and the relative allocation of funds to
different projects are interrelated problems in the long run. The source mix determines the cost of
raising the funds and the obligations towards repayment thereby determining the type of projects that
can be considered for investment.
Investment is the economic activity of committing a set of resources with the expectation of receiving
a stream of benefits in the future. In current managerial practice, if the time horizon over which
benefits accrue is longer than one year, then the resources committed are called investment and the
money spent is termed as capital expenditures.
Capital expenditure can be of two types:
(i) Expenditure increasing revenue. Such expenditure brings more revenue to the firm either by
expansion of present operations or development of a new product line.
(ii) Expenditure reducing cost. Such a capital expenditure reduces the total cost and thereby adds to
the total earnings of the firm.
Capital Budgeting Decisions
A business concern has to face the problem of capital investment decisions. Capital investment refers
to the investment in projects whose results would be available only after a year. The following are
some of the cases where heavy capital investment may be necessary:
Replacement.
Replacement of fixed assets may become necessary either on account of their
being worn out or becoming outdated on account of new technology.
Expansion.
A firm may have to expand its production capacity on account of more demand
for its product and inadequate production capacity.
Diversification.
Firm may decide to produce more than one line of products or to operate
in several markets rather than in a single market with the purpose of reducing risk or earning higher
contribution and sustained growth. In such a case, capital investment may become
necessary for purchase of new machinery and other resources to handle the new products.
233
Research and Development.
In some industries, technology changes rapidly, while in other
industries, the change in technology takes some time. Huge amount is required for those
organizations where technology is rapidly changing.
Miscellaneous.
A firm may have to invest money in projects which do not directly help in
achieving profit-oriented goals. For example, these projects help in improving working
conditions, pollution control, and provision of safety. Though such projects do not directly help in
earning profit, these become desirable for their long-term impact on the goodwill of the firm.
Meaning of Capital Budgeting
Capital budgeting is the most important and complicated problem of managerial decisions. It is
concerned with designing and carrying out through a systematic investment programme. It involves the
planning of such expenditures which provide yields over a number of years. Under capital budgeting,
proposed capital expenditures and their financing are considered and projects assuring the most
profitable use of given resources are undertaken.
Capital budgeting may be defined as the rational allocation of a firms scarce resources
among the competing investment opportunities with a view to maximize the market value of
the firm in the long run.
Importance of Capital Budgeting
Capital budgeting decisions are the most crucial and critical business decisions. Investment decisions
require special attention because of the following reasons:
Involvement of Heavy Funds.
Capital budgeting decisions require large capital outlays
which make it imperative for the firm to plan its investment programmes very carefully so that it may
get the finances at the right time and they are put to most profitable use. A correct decision can give
progressive results while incorrect decision can affect the survival of the firm.
Long-term Implications.
The effect of capital budgeting decisions will be felt by the firm
over a long period, and therefore they have a decisive influence on the rate and direction of the
growth of the firm.
Irreversible Decisions.
In most cases, capital budgeting decisions are irreversible. This is
because it is very difficult to find a market for the capital assets. The only alternative will be to scrap
the capital assets so purchased or sell them at a substantial loss in the event of the decision being
proved wrong.
Most Difficult to Make.
The capital budgeting decisions are among the firms most difficult
decisions. It requires an assessment of future events which are uncertain. It is really a complex task to
correctly estimate future cash flows of an investment. The cash flow uncertainty is caused by
economic, political, social and technological factors.
234
The importance of need of capital budgeting lies in the fact that its absence may lead to considerable
losses. If we do not consider the rate of return and undertake long-term investment we may involve
ourselves in losing projects or less returns from the projects at high cost.
Capital budgeting is essential as far as the firm should make long-term commitment. Therefore, it has
become one of the most important areas of managerial decision-making.
Kinds of Capital Investment Proposals
A firm may have several investment proposals for its consideration. It may adopt one of them, some
of them or all of them, depending upon whether they are independent, contingent or
dependent, or mutually exclusive.
Independent Proposals.
It pertains to independent projects which do not compete with
each other. All those proposals which give a higher return than a certain desired rate of return are
accepted and the rest are rejected.
Contingent or Dependent Proposals.
These are proposals whose acceptance depends on the
acceptance of one or more other proposals. For example, a new machine may have to be
purchased on account of substantial expansion of plant. In this case investment in the machine is
dependent upon expansion of plant.
Mutually Exclusive Proposals.
These exist where the investments are mutually exclusive,
implying that the selection of one project automatically excludes the selection of the others.
Consider for instance a replacement decision as follows. Two new machines with different cost, life
and scrap value may arrive into the market, that of the machine the company is having.
On the basis of evaluation of cost savings the management can select any one but not both the
machines.
Cash Flows and Accounting Flows
It is useful to make a distinction between the cash flows and the accounting flows. The
accounting profit shown in the Profit and Loss Account is the result of the adoption of certain
accounting concepts and conventions. For instance, any advance payment for expenditure
involves actual cash outflows during the year. But the accountant takes into consideration only the
expenditure related to the current year, in arriving at the current years profit. Similarly a production
unit within the organization may supply its finished product to the same company at a notional price.
This notional revenue generated by the unit is credited to the profit and loss account. But there is no
additional inflow of cash into the business on account of this credit. As such a debit to the profit and
loss account in respect of depreciation does not involve any cash outflows but the accounting profit is
affected by this debit. Since different methods of depreciation lead to varying debits to the revenue
account, the accounting profit also changes depending on the method adopted. Thus there is a
difference in the accounting and cash flows.
In the context of capital budgeting we are concerned with the actual flows irrespective of the year to
which they belong. Ultimately what is important for a company is the monetary inflow and not
accounting flows.
235
Factors Affecting Capital Investment Decisions
The following are the important factors which are considered while making a capital investment
decision:
Amount of Investment.
In case a firm has unlimited funds for investment it can accept all
capital investment proposals which gives a higher rate of return. While the firms, which have limited
funds, can take only such projects, which are within their capacity.
Minimum Rate of Return on Investment.
A firm expects a minimum rate of return on the
capital investment. The minimum rate of return is usually decided on the basis of the cost of capital.
For example, if the cost of capital is 15 percent, the management will not prefer to accept a proposal
which yields a rate of return less than 15 percent. Hence it is rejected.
Return Expected from the Investment.
Capital investment decisions are made in
anticipation of increased return in the future. It is therefore very necessary to estimate the future return
or benefits accruing from the investment proposals.
Ranking of the Investment Proposals.
When a number of projects appear to be acceptable
on the basis of their profitability, the projects will be ranked in order of their profitability in order to
determine the most profitable project.
Risk and Uncertainty.
Different capital investment proposals have different degrees of risk
and uncertainty. Risk involves situation in which the probabilities of a particular event occurring are
known, whereas in uncertainty these probabilities are not known. While
evaluating capital investment proposals, a proper adjustment should therefore be made for risk and
uncertainty.
Capital Budgeting Process
Capital budgeting is a complex process, which may be divided into the following phases (see Fig.
4.5):
Step 1: Identification of potential investment opportunities
Step 2: Assembling of proposed investments
Step 3: Decision making
Step 4: Preparation of capital budget and appropriations

Step 5: Implementation
Step 6: Performance review
Fig. 4.5 Capital budgeting process.
236
Identification of Project
A project is an investment proposal. At a given point of time, while the investible funds are limited, a
firm may come across with mutually competing projects and mutually exclusive
projects as well. These surface when the environmental factors (such as product scarcity) are
monitored and analysed by the management. The expected level of sales and the required
production capacity will help in arriving at the amount of investment. Project identification may
emerge from a department or a committee in charge of the responsibility.
Assembling of Proposed Investments
Investment proposals identified by the production department and other departments are
submitted in a standardized capital investment proposal form. Generally, most of the proposals are
routed through several persons before they reach the planning body to ensure that the proposal is
viewed from different angles. This not only enables the groups to have a sense of involvement in the
decision-making process, but also brings abut coordination.
Investment proposals are classified into various categories for facilitating decision making,
budgeting, and control:
(a) Replacement investments
(b) Expansion investments
(c) New product investments
(d) Obligatory and welfare investment.
Decision-making
Executives are vested with the power to approve investment proposals keeping in mind certain
constraints. Depending on the financial power, the executive decision-maker may range from a plant
engineer to the Managing Director or a Capital Budgeting Committee.

Preparation of Capital Budget and Appropriations
The decisions to invest is followed by financing alternatives. Projects involving smaller outlays and
which can be decided by executives at lower levels are often covered by a blanket
appropriation for expeditious action. Projects involving larger outlays are included in the capital
budget after necessary approvals. Before undertaking such projects, an appropriation order is usually
required. The purpose of this check is mainly to ensure the funds position of the firm is satisfactory at
the time of implementation.
Implementation
In this stage, an investment proposal is translated into a concrete project, which is a complex, timeconsuming and risk-involved task. Undue delays in implementation may result in cost
escalations. This may render a profitable project into an unprofitable one. To avoid this it is
necessary that those in charge of implementation are assigned specific responsibilities for CAPITAL
MANAGEMENT AND INVESTMENT DECISIONS
237
completion within the time-frame. The use of mathematical techniques like Programme
Evaluation, Review Technique and Critical Path Method are useful in this regard.
Performance Review
Performance Review is a feedback device. It is a means for comparing actual performance with
projected performance. It may be conducted, most appropriately, when the operations of the project
have stabilized. This is helpful in future decisions.
Problems and Difficulties in Capital Budgeting
Capital budgeting decisions are not only critical in nature, but also involve various difficulties which
a finance manager may come across. The problems in capital budgeting decisions may
be as follows:
Future Uncertainty
All capital budgeting decisions involve long term, which is uncertain. Inspite of efforts and special
care cent percent correct forecast is not possible. The uncertainty exists with reference to the cost of
the project, returns from the project, demand in the future, competition,
environmental changes etc.
Time Element
The cost and benefit of a decision may occur at different point of time. These are not
comparable unless adjusted for time value of money. The longer the time period involved, the greater
would be the uncertainty.
Measurement
Sometimes it is difficult to measure the cost and benefits of a project in quantitative terms.
Methods of Capital Budgeting
Capital expenditure represents long-term commitment in the sense that current investment
yields benefits beyond one year in future. As such, the decisions in respect of such expenditure have
far reaching effect upon concerns future earnings and growth. Thus, capital expenditure decisions
assume great importance for the future development of the concern. The essence of capital investment
analysis is in comparing the benefits that accrue over a period of time with the amount invested. This
comparison is made with a view to judging whether or not the
benefits are at least as high as the amount invested.
Three steps are involved in the evaluation of an investment:
Estimation of cash flows
238
Estimation of the required rate of return
Application of a decision rule for making the choice.
A sound appraisal technique should be used to measure the economic worth of an
investment project. A sound technique is one which maximizes the shareholders wealth.
Any appraisal method should satisfy at least the following conditions:
(i) It should consider all cash flows to determine the true profitability of the project.
(ii) It should serve as basis for distinguishing between acceptable and rejectable proposals.
(iii) It should provide a basis for ranking the various proposals in order of their
desirability.
(iv) It should also help in choosing among alternative proposals.
(v) It should equally be applicable to any conceivable proposals.
(vi) It should recognize the motto that larger benefits are preferable to smaller ones and early
benefits are preferable to later benefits.
(vii) It should relate the stream of future savings to the cost of obtaining these benefits.
Considering the above conditions, a number of appraisal methods may be recommended for
evaluating the capital expenditure proposals. There are broadly two methods of capital
budgeting: firstly, the non-discounted methods comprising (a) Payback Period and
(b) Average Rate of Return; and secondly, the discounted methods comprising (a) Net Present Value,
(b) Internal Rate of Return and (c) Profitability Index. These are shown in
Fig. 4.6.
Capital Budgeting Techniques
Traditional methods/
Discounted Cash Flow (
)
DCF methods
Non-discounted cash flow methods
(a) Net Present Value (
)
NPV method
(a) Average Rate of Return (
)
ARR method
(b) Internal Rate of Return (
)
IRR method
(b) Payback (
)
PB method
(c) Profitability Index (
)
PI
Fig. 4.6 Methods of capital budgeting.
The Payback Period and Average Rate of Return are considered traditional methods of
investment appraisal as they are very commonly used. The Net Present Value, Internal Rate of Return
and Profitability Index are the modern techniques as the development and use of
discounting methods are relatively new.
Payback Period Method
The most commonly used and simple technique for taking decisions on capital expenditure is the
payback period method. It is also sometimes called pay-out method. The payback period is the
number of years required to return the original investment from the net cash flows (net operating
income after taxes plus depreciation). It indicates only the number of years it will take to recover the
initial investment and does not measure the rate of return.
239
Computation.
There are two ways of calculating the payback period. The first method can
be applied when the project generates even annual cash flows. The second method can be
applied when the project generates uneven annual cash flows.
Even Cash Inflows.
If the cash inflows are even, the pay-back period is calculated as follows:
Initial investment
C
Payback period =
0
=
Annual cash inflows
C
Accept/Reject criterion.
This is as follows:
Accept if PB < Standard payback
Reject if PB > Standard payback.
Illustration 4.3:
A project requires Rs. 20,000 as initial investment and it will generate an
annual cash inflow of Rs. 5,000 for ten years. Calculate payback period.
Solution:
Initial investment Scrap or salvage value
Payback period =
Annual cash inflow
Rs. 20,000
=
= 4 years
Rs. 5,000
Decision: As the payback period of the project is lesser than the expected life of the project, it is
acceptable.
The annual cash inflows are calculated by taking into account the amount of net income
on account of the asset (or project) before depreciation but after taxation.
Uneven/Non-uniform Cash Inflows.
In the above example, we have presumed that the
annual cash inflows are uniform. However, it may not always be so. The cash inflow in each year
may be different. The second method is used when projects cash inflows are not uniform but differ
from year to year. In such case cumulative cash inflows will be calculated and by interpolation, the
exact payback period can be calculated. When the cumulative cash flow is equal to the initial
investment, we get the payback period.
Illustration 4.4:
A machine costs Rs. 40,000 and is expected to generate the following
benefits over its 10-year life. Compute the payback method.
Y
ear
1
2
3
4
5
6
7
8
9
10
Cash inflows 6,000 6,000 4,000 4,000 10,000 10,000 8,000 12,000 12,000 8,000
240

Solution:
The payback period will be calculated as follows:
Statement of Cumulative Cash Inflows
Year
Cash inflows (Rs.)
Cumulative cash inflows (Rs.)
1
6,000
6,000
2
6,000
12,000
3
4,000
16,000
4
4,000
20,000
5
10,000
30,000
6
10,000
40,000
7
8,000
48,000
8
12,000
60,000
9
12,000
72,000
10
8,000
80,000
When the cumulative cash inflow is equal to the cash outflow/investment, we get the payback period.
The above statement of cumulative cash inflows shows that in 6 years investment of Rs. 40,000 has
been recovered.
Decision: As the payback period of the project (i.e. 6 years) is lesser than the expected life (i.e. 10
years) of the project, it is acceptable.
Mutually Exclusive Projects.
The payback period can also be used as a method of ranking
in case of mutually exclusive projects. The projects can be arranged in an ascending order according
to the length of their payback period. The project having the shortest payback period will be
preferred. Thus, if the firm has to choose among two mutually exclusive projects, the project with
shorter payback period will be selected.
Illustration 4.5:
Calculate the payback periods of the following projects each requiring a cash
outlay of Rs. 1,00,000. Suggest which of the projects would be chosen.
Year
Cash Flow
Project A (Rs.)
Project B (Rs.)
1
20,000
10,000
2
20,000
30,000
3
20,000
40,000
4
20,000
60,000
5
20,000
40,000
241
Solution:
Project A
Since the annual cash inflows are uniform, the payback period can be calculated
with the help of the formula

Payback period =
Annual cash inflow
1,00,000 0
=
= 5 years
20,000
Therefore, the payback period of the project A is 5 years.
Project B
As the annual cash inflows are uneven, the payback period of the project can be
calculated by the process of cumulative cash inflows:
Year
Annual cash inflows
Cumulative annual cash inflows
1
10,000
10,000
2
30,000
40,000
3
40,000
80,000
4
60,000
1,40,000
5
40,000
1,80,000
The above statement shows that the payback period is lying in between 3rd year and 4th year.
At the end of 3rd year the cumulative cash inflows are Rs. 80,000, requiring Rs. 20,000 to be
recovered during the 4th year. During the 4th year
If Rs. 60,000 in 12 months
Rs. 20,000 in ? months
Solution:
20,000 12 = 4 months
60,000
Therefore, the payback period of the Project B is 3 years and 4 months.
Decision: As the payback period of Project B is shorter than that of Project A, project B is
acceptable.
Recovery.
Sometimes two or more projects are equally desirable when they yield total cash
inflows over equal time periods. But project should be preferable as larger cash inflows come earlier
in its life.
Illustration 4.6:
There are three projects A, B and C. The cost of the project is Rs. 20,000
in each case. The cash inflows are as follows:
242
Year
Project A
Project B
Project A
1
5,000
8,000
6,000
2
5,000
6,000
4,000
3
5,000
4,000
5,000
4
5,000
2,000
5,000
5
5,000
1,000
2,000
Solution:
Project A
Since the annual cash inflows are even, the payback period can be calculated with
the help of the following formula
Cash outlay (Investment) Scrap value
20,000 0
Payback period =
=
= 4 years
Annual cash inflows
5,000
Therefore, the payback period of the project A is 4 years.
Project B
prepared with the help of statement showing cumulative cash inflows.
Year
Annual cash inflows
1
8,000
8,000
2
6,000
14,000
3
4,000
18,000
4
2,000
20,000
5
1,000
21,000
The above statement of cumulative cash inflows shows that in 4 years Rs. 20,000 has been
recovered. Therefore, the payback period of Project B is 4 years.
Project C
prepared with the help of statement showing cumulative cash inflows.
Year
Annual cash inflows
1
6,000
6,000
2
4,000
10,000
3
5,000
15,000
4
5,000
20,000
5
2,000
22,000
243
The above statement of cumulative cash inflows shows that in 4 years Rs. 20,000 has been
recovered. Therefore, the payback period of Project C is 4 years.
Decision: As the payback period of all the three Projects (Project A, project B and Project C) is
same, from the profitability angle, all the projects are acceptable. When the profitability of alternative
projects are same, their riskiness should be considered for making decision. From the riskiness point
of view, the project B is preferable as major portion of its investment is returning in the earlier year
of life.
Illustration 4.7:
There are five alternative proposals under consideration. The details about
the proposals are given in the table below.
Proposals
Initial investment/cash outlay (Rs.)
Annual cash flow (Rs.)
Life in years
1
60,000
12,000
15
2
88,000
22,500
22
3
2,150
1,500
3
4
20,500
4,500
10
5
4,25,000
2,25,000
20
The relevant cost of capital is 10 percent.
Solution:
If the cash inflows are uniform, the formula for calculating the payback period is
Initial investment
Payback period = Annual cash flow

The payback period of the various proposals would be
Proposal
Calculation of PB
Payback period
Proposal 1
60,000/12,000
5 years
Proposal 2
88,000/22,500
3.9 years
Proposal 3
2,150/1,500
1.4 years
Proposal 4
20,500/4,500
4.6 years
Proposal 5
4,25,000/2,25,000
1.9 years
Decision: As the payback period of proposal 3 is 1.4 years, it is acceptable.
Illustration 4.8:
XYZ is considering the purchase of a new machine which would carry out
some operations at present being performed by hands. The two alternative models under
consideration are A and B.

244
The following information is available in respect of both models:
A (Rs.)
B (Rs.)
Cost of machines
6,00,000
10,00,000
Estimated life (in years)
10
12
Estimated savings in scrap p.a.
40,000
60,000
Additional cost of supervision p.a.
48,000
64,000
Additional cost of maintenance p.a.
28,000
44,000
Cost of indirect material p.a.
24,000
32,000
Estimated savings in wages:

(i) Wages per worker p.a.
2,400
2,400
(ii) No. of workers required
150
200
Using the method of payback period, suggest as which model should be purchased. Ignore tax.
Solution:
A (Rs.)
B (Rs.)
Estimated savings p.a.
(i) Scrap
40,000
60,000
(ii) Wages
3,60,000
4,80,000
4,00,000
5,40,000
Less: Estimated additional cost:
(i) Cost of supervision
(ii) Cost of maintenance
48,000
64,000
(iii) Indirect material
28,000
44,000
24,000
32,000
1,00,000
1,40,000
Operating saving p.a. (Cash flows)
3,00,000
4,00,000
Payback period =
Annual cash inflow
6,00,000
Project A =
= 2 years
3,00,000
10, 00, 000
Project B =
2.5 years
4, 00, 000
Decision: It may be recommended that Machine A should be purchased because it has comparatively
lower payback period.
245
Merits of Payback Period Method.
The following are the major advantages of the payback
period criterion:
1. It is simple and easy to calculate, communicate and understand.
2. It is useful for ranking the projects which are equally desirable under the other
methods of capital budgeting. The project with the shortest payback period gets first
priority in selection.
3. It eases the problem of liquidity of the firm by stressing quick recovery.
4. It favours less risky projects which generate higher rates of returns in the earlier years than those
which have high gestation period. This is useful when technological
progress is too fast or where there is political and economic uncertainty. In such a
case the risk of obsolescence is minimized through selection of projects with shorter
payback periods.
5. The company can judge the length of time its funds will be tied up and the risk
involved in the various projects.
6. It takes care of the fact that investment decisions are made under conditions of high
uncertainty.
7. This method seeks to favour a short-term project against a long-term one.
Demerits of Payback Period Method.
The following are the major limitations of the
payback period criterion:
1. It does not consider profitability of the project. For instance, it does not measure
either return on equity or return on investment.
2. It ignores changes in cash flows.
3. Fastness of recovery of investment amounts to over-emphasis on liquidity. There are

other ways of providing liquidity to the organization.
4. Time value of money is not considered by the method.
Suppose there are two projects A and B each having a 4-year life and each
requiring an investment of Rs. 55,000. Assume that A is expected to generate benefits
of Rs. 25,000, 15,000, 10,000 and 5,000. Suppose the inflows of B are in the reverse
order (Rs. 5,000, Rs. 10,000, Rs. 15,000 and Rs. 25,000). Clearly A is more
preferable since it generates larger inflows during the earlier years of its life.
5. It does little justice to a project with a long gestation period.
6. It does not consider other objectives of the firm.
7. It does not pay attention to cash inflows after the payback period. There may be a
project generating better rates of returns after the payback period, which might have
been rejected under this criterion.
For example, the payback period of A and B is identical at, say, 4 years. But A
has a 10-year life and B has a 5-year life. Clearly A generates more inflows which
are ignored.
8. It also ignores long-term prospects of growth.
246
Despite such drawbacks, the payback method is widely adopted in practice for ranking
investment proposals due to the following reasons:
1. It is a most suitable criterion when the firm is in urgent need of cash and wants
immediate liquidity.
2. It is a quasi-break-even point analysis.
3. The payback period is somewhat reciprocal for the internal rate of return when a
project is of long duration and yielding a constant annuity.
4. It reveals information regarding the rate at which the risks and uncertainty associated with a project
can be resolved.
Discounted Payback Period
In spite of many weaknesses, payback period method is very popular. On account of this greater use
of this method, some authorities on Accountancy have ventured to bring some
improvements in traditional approach to remove some of its defects or weaknesses, like one of
serious limitations to payback method is that it does not discount the cash flows for calculating the
payback period. These improvements are discussed here.
As discussed earlier, discounting aspect or interest factor or time value of money has been ignored in
the method of payback period. This method can be improved or modified to
consider the time value of money. When payback period is calculated by taking into account the
discounting or interest factor, it is known as discounted payback period.
The discounted payback period is the number of years/periods taken in recovering the
investment the outlay on the present value basis. The discounted payback period still fails to consider
the cash flows occurring after the payback period.
Average Rate of Return Method
This is also called the Return on Investment ( ROI) or the Average Rate of Return ( ARR), since the
return is measured in accounting terms and concepts. It is a mere expression of the expected return as
a percentage to investment. The average return on investment is defined as the ratio of the net average
annual income from the project to the initial investment. The net income is defined as the different
between the net cash inflows generated by the project and the cash outflows resulting from the initial
investment. The net average annual income is defined as the income divided by the life of the project
measured in years.
Average income
ARR =
100
Average investment
The average profits after tax are determined by adding up the after-tax profits expected for each year
of the projects life and dividing the result by the number of years. The average
investment is determined by dividing the net investment by two.

247
Statement showing the calculation of Average Rate of Return
Period
Year 1 Year 2 Year 3 Year 4 Year 5 Average
Earnings before depreciation, interest
and taxes (EBDIT)
xxx
xxx
xxx
xxx
xxx
xxx
Less: Depreciation
xxx
xxx
xxx
xxx
xxx
xxx
Earnings before interest and taxes ( EBIT)
xxx
xxx
xxx
xxx
xxx
xxx
Less: Taxes
xxx
xxx
xxx
xxx
xxx
xxx
Earnings before interest and after
taxes [ EBIT (1 T)]
xxx
xxx
xxx
xxx
xxx
xxx
Book value of investment:
Beginning
xxx
xxx
xxx
xxx
xxx
xxx
Less: Depreciation
xxx
xxx
xxx
xxx
xxx
xxx
Ending
xxx
xxx
xxx
xxx
xxx
xxx
Average
xxx
xxx
xxx
xxx
xxx
xxx
Accept or Reject Criterion.

All those projects whose ARR is higher than the minimum rate
established by the management are accepted and those projects which have ARR less than the
minimum rate is rejected. In case of mutually exclusive projects, this method would rank a project as
number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.
Illustration 4.9:
Determine the average rate of return from the following data of two
machines A and B.
Machine A
Machine B
Cost
Rs. 60,000
Rs. 60,000
Annual estimated income after depreciation and income tax:
Year 1
3,500
11,500
3
5,500
9,000
3
7,500
7,500
4
9,000
5,500
5
11,500
3,500
37,000
37,000
Estimated life (years)
5
5
Estimated salvage value
3,000
3,000
Depreciation has been charged on straight-line basis.
248
Solution:
Cost Scrap value
Depreciation under straight-line method =
Estimated life
60,000 0
=
12,000
5
Average income
ARR =
100
Average investment
Rs. 37,000
Average income of machines A and B =
= Rs. 7,400
5
1
Average investment = Salvage value +
(Cost of machine Salvage value)
2
1
= Rs. 3,000 +
(Rs. 60,000 Rs. 3,000)
2
= Rs. 31,500
Rs. 7,400
ARR (for machines A and B) =
100 = 23.5%
31,500
Decision: ARR in case of both machines A and B is same, although Machine B should be preferred
since its returns in the early years of its life are greater.
Illustration 4.10:
A project will cost Rs. 40,000. Its stream of income before depreciation,
interest and taxes ( EBDIT) during first year through five years is expected to be Rs. 10,000, Rs.
12,000, Rs. 14,000, Rs. 16,000 and Rs. 20,000 respectively. Assume a 50 per cent tax rate and
depreciation on straight-line basis. The minimum rate is 13%.
Solution:
Calculation of Accounting Rate of Return
Period
Year 1 Year 2
Year 3
Year 4
Year 5 Average
Earnings before depreciation,
interest and taxes ( EBDIT)
10,000 12,000
14,000
16,000
20,000
14,400
Less: Depreciation
8,000
8,000
8,000
8,000
8,000
8,000
Earnings before interest and taxes
( EBIT)
2,000
4,000
6,000
8,000
12,000
6,400
Less: Taxes at 50%
1,000
2,000
3,000
4,000
6,000
3,200
Earnings before interest and after
taxes [ EBIT (1 T)]
1,000
2,000
3,000
4,000
6,000
3,200
Book value of Investment:
Beginning
40,000 32,000
24,000
16,000
8,000
Less: Depreciation
8,000
8,000
8,000
8,000
8,000
Ending
32,000 24,000
16,000
8,000
0
Average
36,000 28,000
20,000
12,000
4,000
20,000
249
Cost Scrap value
Depreciation under straight-line method =
Estimated life
40,000 0
=
5
= 8,000
Average income
ARR =
100
Average investment
3,200
=
100 = 16 percent
20,000
Decision: As the project ARR is higher than the minimum rate established by the management, the
project is acceptable.
Illustration 4.11:
Calculate the average rate of return for the projects X and Y.
Investment
Year
Project X
Project Y
0
50,000
80,000
Net profit after tax
1
4,500
9,000
2
3,000
6,000
3
4,100
7,200
4
2,800
3,600
5
1,200
Salvage value
5
5,000
6,000
Cost Scrap value
Depreciation under straight-line method (Project X) =
Estimated life
50,000 5,000
45,000
=
= 9,000
5
5
Cost Scrap value
Depreciation under straight-line method (Project Y) =
Estimated life
80,000 6,000
=
= 14,800
5
250
Calculation of Accounting Rate of Return
Rs.
Period
Year 1 Year 2
Year 3
Year 4
Year 5 Average
Project X
Net Profit after Tax
4,500
3,000
4,100
2,800
2,880
Book Value of Investment:
Beginning
50,000 41,000
32,000
23,000
14,000
Less: Depreciation
9,000
9,000
9,000
9,000
9,000
Ending
41,000 32,000
23,000
14,000
5,000
Average
45,500 36,500
27,500
18,500
9,500
27,500
Project Y
Net Profit after Tax
9,000
6,000
7,200
3,600
1,200
5,400
Book Value of Investment:
Beginning
80,000 65,200
50,400
35,400
20,600
Less: Depreciation
14,800 14,800
14,800
14,800
14,800
Ending
65,200 50,400
35,400
20,600
5,800
Average
72,600 57,800
42,900
28,000
13,200
42,900
Average income
ARR =
100
Average investment
Project X
2, 880
ARR =
100 10.47%
27, 500
Project Y
5,400
ARR =
100 = 12.59%
42,900
Decision: As Project Y has the highest ARR than project X, Project Y would be preferred.
Merits of ARR Method.

The ARR method has the following merits:
1. It is easy to understand and compute.
2. It does not take into account the time value of money.
3. It arrives at a unique number to represent the benefits resulting from the investment, and so be used
for comparing and ranking the projects.
4. It takes into account the entire cash flow spread over the life of the project.
5. It is based on accounting information, which is readily available.
6. Is a method commonly understood by accountants, and frequently used as a
performance measure.
251
Demerits of ARR Method.
ARR method has the following drawbacks:
1. It is based upon accounting profit and not cash flows.
2. It ignores the time value of money.
3. A firm employing the ARR rule uses an arbitrary cut-off yardstick. The yardstick is the firms
current return on its assets. Because of this, the growth companies earning
very high rates on their existing assets may reject profitable projects (i.e. with
positive NPVs) and the less profitable companies may accept bad projects (i.e. with negative NPVs).
4. It is not suitable for comparing projects of different durations.
In spite of the above limitations, this method is used as a performance evaluation and
control measure because of its simplicity.
Discounted Cash Flow Methods
We now turn to the more sophisticated methods of capital budgetingthe discounted methods.
The basic difference between the two methods (i.e discounted and non-discounted) pertains to
time value of money; a rupee in hand today is more valuable than a rupee to be received tomorrow
and this fact is not recognized by the non-discounted methods of evaluation. The discounted cash flow
technique is an improvement on the payback period method. It takes into account both the interest
factor as well as the return after the payback period.
The method involves the following stages:
(i) Calculation of cash inflows and outflows (preferably after tax) over the entire life of the asset.
(ii) Discounting the cash flows so calculated by a discount factor.
(iii) Aggregating of discounted cash inflows and comparing the total with the discounted
cash outflows.
(iv) Discounted cash flow technique thus recognizes that Re.1 of today (the cash outflow) is worth
more than Re.1 received at a future date (cash inflow).
Discounted cash flow methods for evaluating capital investment proposals are of three
types:
(i) Net Present Value ( NPV)
(ii) Internal Rate of Return ( IRR)
(iii) Profitability Index ( PI)
Net Present Value Method
The Net Present Value ( NPV) method is the classic economic method of evaluating the investment
proposals. It is one of the discounted cash flow ( DCF) techniques explicitly recognizing the time
value of money. The net present value method is considered to be the best method for evaluating the
capital investment proposals. NPV method of project evaluation consists of comparing the present
value of all net cash inflows to the initial investment cost.
It is described as the aggregation of the present values of cash inflows in each year minus the
aggregation of present values of the net cash outflows in each year.
252
Computation.
The following steps are involved in the calculation of NPV:

(i) Determination of cash outflows and cash inflows for different periods.
(ii) Determination of discounting rate.
(iii) Present value of cash flows should be calculated using opportunity cost of capital as the discount
rate.
(iv) Present value of all cash inflows for different periods are added together. Thus:
Present Value ( PV) = Cash inflow PVF (Present Value Factor)
(v) The present values (total of cash inflows) should be compared with the present values of cash
outflows. If the present value of cash inflows are greater than (or equal to)
the present value of cash outflows (cash outlay), the project would be accepted. If
it is less, then proposal will be rejected.
The equation for the Net Present Value can be written as follows:
C
C
C
C
1
2
3
n
NPV
"
C0
2
3
(1 k)
(1
k)
(1 k)
(1 k) n
or
n
Ct
NPV =
C0
(1 k) t
t1
where C 1, C 2, . . . represent net cash inflows in years 1, 2, . . ., n, k is the opportunity cost of
capital, C 0 is the initial cost of the investment and n is the expected life of the investment.
It should be noted that the cost of capital, k, is assumed to be known and is constant.
Accept or Reject Criterion.
In case the NPV is positive, i.e., NPV > 0 (in other words, the
present value of cash inflows > present value of cash outflows) the project should be accepted.
However, if the NPV is negative, or NPV < 0 (i.e. present value of cash inflows < present value of
cash outflows), the project should be rejected. A project may be accepted if NPV = 0. A zero NPV
implies that project generates cash flows at a rate just equal to the opportunity cost of capital.
Symbolically, the accept/reject criterion can be put as follows:
Accept the project: if NPV is positive
Reject the project: if NPV is negative
or
Accept NPV > 0
Reject NPV < 0
May accept NPV = 0
If two projects with positive NPVs are mutually exclusive, the one with the higher NPV
should be chosen.
253
Even Cash Inflows
Illustration 4.12:
A company is considering a project A which would cost Rs. 30,000 and
generate cash flows after taxes of Rs. 10,000 for five years. The required rate of return is assumed to
be 10%. Compute the net present value.
Solution:
As the cash inflows after tax of this project are uniform, the present value of cash
inflows can be found out by multiplying the annual cash inflows with the present value of an annuity.
At 10% the present value of an annuity for five years will be 3.791.
Present value of cash inflows Rs. 10,000 3.791
Rs. 37,910
Less: Present value of cash outflows
Rs. 30,000
Net present value
Rs. 7,910
Project Xs present value of cash inflows (Rs. 37,910) is greater than that of cash outflow (Rs.
30,000). Thus it generates a positive net present value ( NPV = Rs. 7,910), and therefore it should be
accepted.
Uneven Cash Inflows

Illustration 4.13:
An investment proposal would initially cost Rs. 25,000 and would generate
year-end cash inflows of Rs. 9,000, Rs. 8,000, Rs. 7,000, Rs. 6,000 and Rs. 5,000 in one
through five years. The required rate of return is assumed to be 10%. Calculate net present values.
Solution:
The net present value for Project X can be calculated by the following equation.
The calculations are shown below:
Rs. 9,000
Rs. 8,000
Rs. 7,000
Rs. 6,000
Rs. 5,000
NPV =
+
+
+
+
Rs. 25,000
2
3
4
5
(1 + 0.10)
(1 + 0.10)
(1
0. 10)
(1 + 0.10)
(1 + 0.10)
NPV = [Rs. 9,000(PVF1, 0.10) + Rs. 8,000 (PVF2, 0.10) + Rs. 7,000 (PVF3, 0.10) + Rs. 6,000
(PVF4, 0.10) + Rs. 5,000 (PVF5, 0.10)] Rs. 25,000
The present value factors can be taken by referring to present value table given at the end of the book.
NPV = [Rs. 9,000 0.909 + Rs. 8,000 0.826 + Rs.7,000 0.751 +
Rs. 6,000 0.683 + Rs. 500 0.620] Rs. 25,000
NPV = [Rs. 8,181 + 6,608 + 5,257 + 4,098 + 3,100] Rs. 25,000
NPV = Rs. 27,244 Rs. 25,000 = Rs. 2,244
Projects present value of cash inflows (Rs. 27,244) is greater than that of cash outflow (Rs.
25,000). Thus it generates a positive net present value ( NPV = Rs. 2,244). Therefore it should be
accepted or alternatively, NPV can be calculated as follows:
254
Calculation of Net Present Value
Year
Cash inflows (Rs.)
PVF at 10%
Present value (Rs.)
1
9,000
0.909
8,181
2
8,000
0.826
6,608
3
7,000
0.751
5,257
4
6,000
0.683
4,098
5
5,000
0.62
3,100
Total
27,244
Less: PV of Cash Outflows
25,000
Net Present Value

2,244
Thus, NPV is positive and proposal is acceptable.
Illustration 4.14:
A choice is to be made between two competing projects which require an
equal investment of Rs. 60,000 and are expected to generate net cash flows as under:
Year
Project X
Project Y
1
30,000
14,000
2
20,000
16,000
3
15,000
22,000
4
29,000
5
17,000
12,000
6
11,000
8,000
The cost of capital of the company is 10%. Using Net Present Value method, recommend
which proposal is to be preferred.
Solution:
Calculation of Net Present Value
Year
PVF at 10%
Project X
Project Y
Cash inflows
PV
Cash inflows
PV
Rs.
Rs.
Rs.
Rs.
Rs.
1
0.909
30,000
27,270
14,000
12,726
2
0.826
20,000
16,520
16,000
13,216
3
0.751
15,000
11,265
22,000
16,522
4
0.683
29,000
19,807
5
0.621
17,000
10,557
12,000
7,452
6
0.564
11,000
6,204
8,000
4,512
Total
71,816
74,235
Less: PV of Cash Outflows
60,000
60,000
Net Present Value
11,816
14,235
255
Decision: Under the net present value method, the project with higher net present value will be
preferred. As the net present value of the Project Y is greater than that of the Project X, Project Y is
preferable.
Merits of NPV Method.
This method has the following advantages:
1. It takes into account all cash flows occurring over the entire life of the project in
calculating its worth.

2. It incorporates the time value of money.
3. It relies on estimated cash flows and the discount rate rather than any arbitrary
assumption or subjective consideration.
4. It is possible to estimate and compare the combined NPV of two or more projects
associated in packages of investment proposals.
5. It is consistent with the objective of maximizing the shareholders wealth.
Demerits of NPV Method.
Following are its major limitations:
1. It involves difficult calculations for an ordinary businessman.
2. In practice, it is quite difficult to obtain the estimates of cash flows due to uncertainty and to
precisely measure the discount rate.
3. It is grossly affected by the different discount rates. Thus, in one situation if a project is preferred
on account of positive NPV, it may be rejected if higher discount rate
is taken and NPV turns out to be negative.
4. It is an absolute measure. It may therefore be not very meaningful to those
entrepreneurs who want to consider the rate of return on their investments.
Internal Rate of Return
This method is also called Time Adjusted Return on Investment of Discounted Rate of Return.
Internal Rate of Return is that rate at which the sum of discounted cash inflows equals the sum of
discounted cash outflows. The IRR is defined as that discount rate which equates the present value of
a projects expected cash inflows to the present value of the projects costs. It is called internal rate
because it depends solely on the outlay and proceeds associated with the investment and not on any
rate determined outside the investment. PV (Inflows) = PV
(Investment Costs).
Computation.
Internal Rate of Return is calculated in two ways:
Where cash inflows are even

(i) Determine the payback period of the proposed investment.
(ii) In the present value table showing the present value of an annuity of Re. 1, look for the payback
period that is equal to or closest to the life of the project.
(iii) In the year, find two values or discount factors closest to payback period (one higher and one
lower than it).
(iv) Note interest rate ( r) corresponding to these present values.
256
(v) Determine actual IRR by interpolation. The interpolation will be done by the
following formula:
PB DF
r
IRR r DF
DF
rL
rH
where,
PB = Payback period
DFr = Discount factor for interest rate r
DFrL = Discount factor for lower interest rate
DFrH = Discount factor for higher interest rate
r = Either of the two interest rates used in the formula
Alternatively,
PV
PV
CO
CFAT
IRR r
'r
PV
'
where,
PVCO = Present value of cash outlay
PVCFAT = Present value of cash inflows
r = Either of the two interest rates used in the fomula
D r = Difference in interest rates
D PV = Difference in calculated present values of inflows
Illustration 4.15:
A firm with a required rate of return of 10 per cent is considering a project
that involves an investment of Rs. 16,000 and is expected to generate cash inflows of Rs. 4,000
each for 5 years. Calculate the Internal Rate of Return.
Solution:
Initial outlay
16,000
(1)
The payback period is:
=
=4
Annual cash inflow
4,000
(2) The rate which gives a PVAF (Present Value of an Annuity) of 4 for 5 years is the projects
internal rate of return. Looking up PVAF in the annuity Table A.4 (given in the Appendix) across the 5
years row, we find it approximately under the 8 per
cent column.
(3) In order to calculate the actual IRR, we need to find two values closest to payback
period, one higher and one smaller than it.
(4) According to the annuity table, the discount factors closest to payback period 4 for
5 years are 3.993 (8 percent rate of interest) and 4.100 (7 per cent rate of interest).
The actual value of IRR which lies between 7% and 8% can be determined by
interpolation:
PB DF
r
IRR r DF
DF
rL
rH
257
Substituting the values in the above equation, we get
4 4.100
IRR 7
7
>0.93@ 7.9 per cent

4.100
3.993
Alternatively (starting with the higher rate), we get
4 3.993
IRR 8
8
>0.07@ 7.9 per cent

4.100
3.993
The internal rate of return for the investment is 7.9 percent. As the 7.9 percent is lesser than the 10
percent required return, the project should be rejected.
Uneven Cash Flows: Calculating IRR by Trial and Error Method.
When the cash
inflows are uneven, the internal rate of return for such projects is calculated by a process of trial and
error method. To do this, first we determine the present value of the future free cash flows using an
arbitrary discount. The approach is to select any discount rate to compute the present value of cash
inflows. If the calculated present value of the expected cash inflow is lower than the present value of
cash outflows a lower rate should be tried. On the other hand, a higher value should be tried if the
present value of inflows is higher than the present value of outflows. This process will be repeated
until the net present value becomes zero. The steps to calculate IRR are:
Step 1
Pick an arbitrary discount rate and use it to determine the present value of the free
cash flows.
Step 2
Compare the present value of the free cash flows with the initial outlay; if they are
equal you have determined the IRR.
Step 3
If the present value of the free cash flows is more than (less than) the initial outlay,
raise (lower) the discount rate.
Step 4
When the cash inflows are not equal to the cash outlay, determine two consecutive
discount rates that give positive and negative NPV values.
Step 5
The actual value can be ascertained by the method of interpolation.
IRR can also be determined by solving the following equation for r:
C
C
C
C
1
2
3
n
C
"
0
2
3
(1 r)
(1 r)
(1 r)
(1 r) n
n
Ct
C
0
(1 r) t
t1
or
n
Ct
C0
0
(1 r) t
t1
258
Illustration 4.16:
A firm with a required rate of return of 10 per cent is considering a project
that requires an initial outlay of Rs. 15,500 and the cash inflows are given as follows:
Year
1
2
3
4
5
Cash flow (Rs.)
3,000
4,000
6,000
5,000
4,000
Calculate the internal rate of return and suggest whether the project is acceptable or not.
Solution:
1. The sum of cash inflows of a project is Rs. 22,000, which, when divided by the life
of the project (5 years), results in a fake annuity of Rs. 4,400.
2. Dividing the initial outlay of Rs. 15,500 by Rs. 4,400, we have fake average payback
period of 3.523 years.
3. In the annuity table, the factor closest to 3.523 for 5 years is 3.517 for a rate of 13
percent.
4. Taking the IRR found approximately in Step 3 (i.e. 13%), the present value of cash
inflows are calculated and compared with cash outlay as follows:
Year
Cash inflows after tax (Rs.)
PV factor (13%)
Total PV (Rs.)
1
3,000
0.885
2655
2
4,000
0.783
3132
3
6,000
0.693
4158
4
5,000
0.613
3065
5
4,000
0.543
2172
Total Present Value of Cash Inflows
15,182
Less: Initial Outlay
15,500
Net Present Value (NPV)
318
Since the NPV is negative for both the machines, the discount rate should be subsequently lowered as
follows:
Year
Cash inflows after tax (Rs.)
PV factor (12%)
Total PV (Rs.)
1
3,000
0.893
2,679
2
4,000
0.797
3188
3
6,000
0.712
4272
4
5,000
0.636
3180
5
4,000
0.567
2268
Total Present Value of Cash Inflows
15,587
15,500
+87
259
Since 13% and 12% are consecutive discount rates that give positive and negative net present values,
interpolation method can be applied to find the actual IRR which will be between 12
and 13 percent.
PV PV
IRR
CO
CFAT
r
'r
PV
'
Rs. 15, 500

.
Rs 15, 587
12
1 12.21%
Rs. 15,587 Rs. 15,182
Merits of IRR Method
1. It recognizes the time value of money.

2. It deals with the whole range of the annual returns earned during the lifetime of the
project.
3. It provides a meaningful consideration to the entrepreneurs in their decision making
process.
4. It is consistent with the shareholders wealth maximization objective.
Demerits of IRR Method
1. The computation of IRR is quite cumbersome.
2. It makes no distinction between lending and borrowing.
3. There may not be a unique IRR in a project. There may be multiple rates of return.
Then it becomes a very complex phenomenon.
4. It is not a suitable method for ranking projects having substantially different
investment costs.
Comparison of IRR with NPV.
Though both NPV and IRR are the species of the discounted
cash flow method, yet they are different from each other due to the following points:
(a) The net present value method takes the interest rate as a known factor while internal rate of return
method takes it as an unknown factor.
(b) The net present value method seeks to find out the amount that can be invested in
a given project so that its anticipated earnings will exactly suffice to repay this
amount with interest at the market rate. On the other hand, internal rate of return
method seeks to find the maximum rate of interest at which the funds invested in the
project could be repaid out the cash inflows arising out of that project.
(c) Both the net present value method and internal rate of return method proceed on this
presumption that cash inflows can be reinvested at the discounting rate in the new
projects. However, reinvestment of funds at the cut-off rate is more possible than at
the internal rate of return. Hence, net present value method is more reliable than the
internal rate of return method for ranking two or more capital investment projects.
Similarities in Results under NPV and IRR.
Both NPV and IRR will give the same result
(i.e. acceptance or rejection) regarding an investment proposal in the following cases:
(i) Projects involving conventional cash flows, i.e., when an initial outflow is followed by a series of
inflows.
(ii) Independent investment proposals, i.e., proposals the acceptance of which does not
preclude the acceptance of others.
260
The reason for similarity in results in the above cases is simple. In case of NPV method, a proposal is
acceptable if its NPV is positive. NPV will be positive only when the actual return on investment is
more than the cut-off rate. In case of IRR method a proposal is acceptable only when the IRR is
higher than the cut-off rate. Thus, both methods will give consistent results since the acceptance or
rejection of the proposal under both of them is based on the actual return being higher than the cut-off
rate.
Conflict in Results under NPV and IRR.
Though NPV and IRR are based on the same data
and often give similar results, it is significant to note that they may give conflicting results in case of
mutually exclusive project, i.e., projects where acceptance of one would result in non-acceptance of
the other. This point may be well understood with the help of the illustration.
NPV and IRR Methods
Illustration 4.17:
The following are the details of two mutually exclusive projects having
equal lives and cost of outlays but with different cash inflows pattern:
Year
Project A (Rs.)
Project B (Rs.)
0
1,20,000
1,20,000
1
65,000
20,000
2
50,000
35,000
3
35,000
50,000
4
20,000
80,000
Cost of capital may be assumed to be 8%. Compare the projects using NPV and IRR methods.
Solution:
Calculation of NPV
Year
PVF at 8%
Project A
Project B
Cash inflows
PV
Cash inflows
PV
Rs.
Rs.
Rs.
Rs.
Rs.
1
0.926
65,000
60,190
20,000
18,520
2
0.857
50,000
42,850
35,000
29,995
3
0.794
35,000
27,790
50,000
39,700
4
0.735
20,000
14,700
80,000
58,800
Total Present Value
1,45,530
1,47,015
Cash Inflows
1,20,000
1,20,000
Less: Cash Outlay
NPV
+25,530
+27,015
261
Calculation of IRR
Project A
Year
Cash inflows
PVF at 19%
PV inflows
PVF at 20%
PV inflows
1
65,000
0.84
54,600
0.833
54,145
2
50,000
0.706
35,300
0.694
34,700
3
35,000
0.593
20,755
0.579
20,265
4
20,000
0.499
9,980
0.482
9,640
Total Present Value Cash Inflows
1,20,635
1,18,750
1,20,000
1,20,000
+635
1250
Project B
Year
Cash inflows
PVF at 15%
PV inflows
PVF at 16%
PV inflows
1
20,000
0.87
17,400
0.862
17,240
2
35,000
0.756
26,460
0.743
26,005
3
50,000
0.658
32,900
0.641
32,050
4
80,000
0.572
45,760
0.552
44,160
1,22,520
1,19,455

1,20,000
1,20,000
+2520
545
The rankings under the two methods would be as follows:
Proposal
IRR
NPV
Proposal A
Between 19% and 20%
Select
25,530
Reject
Proposal B
Between 15% and 16%
Reject
27,015
Select
According to rankings under the two methods of NPV and IRR, Project A is acceptable
according to IRR method due to higher rate of return, while Project B is acceptable according to NPV
method due to high positive value. Hence conflict arises as a result of both NPV and IRR.
Such conflict of result may be due to any one or more of the following reasons:
(a) The projects require different cash outlays.
(b) The projects have unequal lives.

(c) The projects have different patterns of cash flows.
When there is a conflict the net present value method gives the correct ranking. It is more realistic to
assume that reinvestment is made at rates currently available in the market.
262
Profitability Index (PI) Method
It is also known as Cost-Benefit Ratio. It is the ratio of the present value of cash inflows, at the
required rate of return, to the initial cash outflow of the investment. The formula to calculate
profitability index is as follows:
PV of cash inflows
PV ( C )
PI =
=
t
Initial cash outlay
C0
n
Ct
C
0
(1 k) t
t1
Accept or Reject Criterion
Accept if PI > 1.0
Reject if PI < 1.0

Project may be accepted if PI = 1.0
Illustration 4.18:
The initial cash outlay of a project is Rs. 10,000 and it can generate cash
inflow of Rs. 4,000, Rs. 3,000, Rs. 5,000 and Rs. 2,000 in year 1 through 4. Assume a 10
percent discount rate.
Solution:
Statement Showing Net Present Value
Year
Cash inflows (Rs)
Present value factor
Present Value of
@ 10%
Cash Inflows (Rs)
1
Rs. 4,000
0.909
3,636
2
3,000
0.826
2,478
3
5,000
0.751
3,755
4
2,000
0.683
1,366
Present Value of Cash Inflows
11,235
11, 235
Profitability Index =
=
1.124
Initial Cash Outlay
10, 000
Decision: As the profitability index is greater than 1, the project is acceptable.
Illustration 4.19:
Compute the Profitability Index for the projects A and B and choose the
best. The firms cost of capital is 10%. The cash flows are as follows:
Year
Project A
Project B
0
70,000
70,000
1
10,000
50,000
2
20,000
40,000
3
30,000
20,000
4
45,000
10,000
5
60,000
10,000
263
Solution:
Year
PVF at 10%
Project A
Project B
Cash inflows
PV
Cash inflows
PV
(Rs.)
(Rs.)
(Rs.)
(Rs.)
1
0.909
10,000
9,090
50,000
45,450
2
0.826
20,000
16,520
40,000
33,040
3
0.751
30,000
22,530
20,000
15,020
4
0.683
45,000
30,735
10,000
6,830
5
0.621
60,000
37,260
10,000
6,210
1,16,135
1,06,550
1,16,135
1,06,550
Present Value of Cash Flows
70,000
70,000
Profitability Index =
Initial Cash Outlay
= 1.66
= 1.52
Decision: Under this method, a project with higher profitability index is preferred. As the
profitability index of Project A is higher than that of Project B, Project A is preferable.
Illustration 4.20:
A firm has suggested three investment proposals. The after-tax cash flows
for each are tabulated below. If the companys cost of capital is 12%, rank them in order of
profitability.
Year
Project X (Rs.)
Project Y (Rs.)
Project Z (Rs.)
0
20,000
60,000
36,000
1
5,600
12,000
13,000
2
6,000
20,000
13,000
3
8,000
24,000
13,000
4
8,000
32,000
13,000
Solution:
Calculation of Present Value Cash Inflows
Year
PVF at 12% Project X
Project Y Project Z
Cash inflows
PV
Cash inflows
PV
Cash inflows PV
1
0.893
5,600
5,001
12,000
10,716
13,000
11,609
2
0.797
6,000
4,782
20,000
15,940
13,000
10,361
3
0.712
8,000
5,696
24,000
17,088
13,000
9,256
4
0.636
8,000
5,088
32,000
20,352
13,000
8,268

20,567
64,096
39,494
Cost
20,000
60,000
36,000
20,567
64,096
39,494
=
=
20,000
60,000
36,000
P.I.
= 1.028
= 1.068
= 1.097
Ranking
II
I
I
264
Decision: As the profitability index of Project Z is higher than that of Projects X and Y, Project Z is
preferable.
NPV, PI and IRR
Illustration 4.21:
A firm whose cost of capital is 10% is considering two mutually exclusive
Projects A and B, the details of which are:
Project A
Project B
Investment
Rs. 70,000
Rs. 70,000
Cash flow year 1
Rs. 10,000
Rs. 50,000
2
20,000
40,000
3
30,000
20,000
4
45,000
10,000
5
60,000
10,000
1,65,000
1,30,000
Compute Net Present Value at 10%, Profitability Index and Internal Rate of Return for the two
projects.
[Ans. NPV: A 46,135, B 36,550; PI: A 1.659, B 1.522 and IRR: A 27.326%,
B 37.56%]
Solution:
1. Net Present Value:
Year
PV factor
Project A
Project B
(10%)
Cash inflows
Total PV
Cash inflows
Total PV
1
0.909
10,000
9,090
50,000
45,450
2
0.826
20,000
16,520
40,000
33,040
3
0.751
30,000
22,530
20,000
15,020
4
0.683
45,000
30,735
10,000
6,830
5
0.621
60,000
37,260
10,000
6,210
Total Present Values
1,16,135
1,06,550
70,000
70,000
Net Present Value
46,135
36,550
Decision: Under NPV method the project with the higher NPV should be chosen. As Project A NPV
(i.e. Rs. 46,135) is higher than the Project B NPV (i.e. Rs. 36,550), Project A would be selected.
2. Profitability Index:
Project A
Project B
Present Values of Cash Inflows
1,16,135
1,06,550
Initial Cash Outlay
70,000
70,000
1,16,135
1,06,550
Profitability Index
=
=
70,000
70,000
= 1.659
= 1.522
265
Decision: Under Profitability Index method, the project with the higher PI should be chosen.
As Project A PI is higher than that of Project B, Project A would be chosen.
3. Internal Rate of Return:
Project A
Year
Cash inflows
PVF at 27%
PV inflows
PVF at 28%
PV inflows
1
10,000
0.787
7,870
0.781
7,810
2
20,000
0.62
12,400
0.61
12,200
3
30,000
0.488
14,640
0.477
14,310
4
45,000
0.384
17,280
0.373
16,785
5
60,000
0.303
18,180
0.291
17,460
70,370
68,565
70,000
70,000
+370
1435
PV PV
CO
CFAT
IRR = r
'r
PV
'
70,000 70,370
= 27
1 = 27.204%
70,370 68,565
Project B
Year
Cash inflows
PVF at 37%
PV inflows
PVF at 38%
PV inflows
1
50,000
0.73
36,500
0.725
36,250
2
40,000
0.533
21,320
0.525
21,000
3
20,000
0.389
7,780
0.381
7,620
4
10,000
0.284
2,840
0.276
2,760
5
10,000
0.207
2,070
0.2
2,000
70,510
69,630
70,000
70,000
+510
370
PV PV
CO
CFAT
IRR = r
'r
PV
'
70,000 70,510
= 37
1 = 37.58%
70,510 69,630
266
Decision: Under IRR method, the project with the higher rate of return should be chosen. As Project
B IRR is higher than that of Project A, Project B would be chosen.
SOURCES OF CAPITAL
Capital is the wealth which includes land, buildings, equipment, cash, stocks and bondsall of
which have a monetary value. Capital is, in essence, the savings of individuals, corporations,
governments and many other forms of organizations. It is quite often scarce and considered by many
as the most valuable of all commodities.

A firm cannot run efficiently if it does not have adequate finance to meet its requirements.
Not having enough capital is the cause of many business failures. Adequate capital is needed to start
up the business, operate through hard times, and provide a good chance to become a profitable
enterprise. The financial requirements of business can be categorized into two: 1. Short-term
financial requirements
2. Long-term financial requirements.
Short-term funds are required for meeting the working capital requirements. They are
required for a short period (i.e. less than one year) and raised from sources which can provide at
reasonable cost for a short period only within the required time. The requirements of these funds are
usually met by taking short-term loans or getting the bill discounted from the
commercial banks.
The long-term funds are required for financing fixed assets. They are required for more
than one-year period. The funds required for a period of more than one year and less than five years
is called intermediate or medium term funds and the funds required for more than 5 years is called
long-term funds. These are generally raised from the sources which provide the use of funds for a
long period, viz. shares, debentures, loans from specialized financial institutions, etc.
Since 1999, the other financial institutions like IDBI (Industrial Development Bank of
India), ICICI (Industrial Credit and Investment Corporation of India) and IFCI (Industrial Finance
Corporation of India) have also chosen to finance the working capital requirements, besides granting
term loans. And commercial banks too, in turn, have started granting term loans, along with financing
the working capital requirements.
Shares
This is the most common method of raising long-term funds. Every company in India generally uses
this method.
Meaning of Shares
A share may be defined as one of the units into which the share capital of a company has been
divided. According to Section 2 (46) of the Companies Act, 1956, a share is the share in the capital
of a company and includes stock except where a distinction between stock and share is expressed or
implied.
267
The person holding the share is known as a shareholder. He receives dividend from the company as a
consideration for investing his money into the company. However, payment of
dividend is not legally compulsory. The power to recommend dividend vests in the Board of
Directors of the company. The recommendation of the Directors is put before the Annual
General Meeting of the shareholders who may reduce the rate of dividend as recommended by the
Board but cannot increase it.
Types of Shares
A public company can issue only two types of shares. They are:
(i) Preference shares
(ii) Equity shares.
Preference Shares.
Preference shares are those which carry the following preferential rights
over other classes of shares:
(a) A preferential right in respect of a fixed dividend. It may consist of a fixed amount at a fixed rate.
(b) A preferential right to repayment of capital in the case of winding up of the company in priority to
other classes of shares.
Types of Preference Shares
(a) In case of cumulative preference shares the dividend goes on accumulating unless paid. The
accumulated arrears of dividend shall be paid before anything is paid out
of the profits to the holders of any other class of shares.
(b) In case of non-cumulative preference shares the right to claim dividend lapses if there are no
profits in a particular year. In other words, they are not entitled to claim
arrears of dividend (i.e., the dividend which could not be paid on account of
inadequacy of profits in earlier years).
(c) In case of participating preference shares their holders also get a share out of the
surplus profits remaining after paying dividend to the equity shareholders at a fixed
rate as determined by the companys Articles. In other words, besides getting

dividend at fixed rate in priority to other shareholders, they get a share out of the
surplus profits too.
(d) Non-participating preference shareholders do not have rights unlike participating ones.
(e) Redeemable preference shares are those which can be redeemed during the lifetime of the
company.
(f) Irredeemable preference shares can be redeemed only when the company goes for liquidation.
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Merits
Demerits
1. Dividend postponability
1. Non-deductibility of dividends as an expense
2. Riskless leverage advantage
for taxation purpose out of the profits of the
company.
3. Fixed rate of dividend
2. Dilute the claim of the equity shareholders
4. Does not disturb the existing pattern of
over the assets of the company.
control of the company
3. Commitment to pay dividend.
5. Financing through preference shares is
cheaper
6. Useful for those investors who expect
higher rate of return with comparatively

lower risk.
7. Limited voting rights.
Equity Shares.
Unlike preference shares, equity shares do not carry any preferential right.
For the purpose of dividend and repayment of capital in the event of winding up of a company, equity
shares are ranked after preference shares. The rate of the dividend is not fixed, and it depends on the
availability of divisible profits and the intention of the Directors. The equity shareholders have voting
rights and also a say in the management of the company.
Merits
Demerits
1. Dividend payment discretion of the 1. Shares are costly as dividends are not tax Directors.
deductible.
2. Increases the company's financial base 2. Risk due to uncertainty regarding dividend and through
borrowing on the security of its
capital gains.
assets.
3. Issue of additional equity shares dilutes the
3. Company does not face the risk of
ownership and control of the existing
magnifying its losses in periods of
shareholders.
adversity.
4. Issue of new shares dilutes the existing
4. Flexibility in the utilization of its profits
shareholder's earnings per share if the profits
and funds since neither the payment of

do not increase immediately in proportion to
dividend is compulsory nor any provision
the increase in the number of shares.
is to be made for repayment of capital.
Debentures
A debenture is a document issued by a company as an evidence of a debt due from the company with
or without a charge on the assets of the company. It is a certificate issued by a company under its seal
acknowledging a debt due by it to its holders. In other words, debentures are instruments for raising
long-term debt capital. Debentureholders are the creditors of the company. The obligation of the
company towards its debentureholders is similar to that of a borrower who promises to pay interest
and capital at specified times.
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Definition
According to the Companies Act, 1956, the term debenture includes debenture stock, bonds and any
other securities of a company whether constituting a charge of the assets of the
company or not.
Merits
Demerits
1. Provide funds to the company for a specific
1. Raising funds through debentures is risky.
period.
2. Not suitable for companies whose earnings
2. Does not result in dilution of control since
fluctuate considerably.
debentureholders are not entitled to vote.
3. Do not carry the right to vote.

3. Suitable for investors who expect a stable
4. Every additional issue of debentures becomes
rate of return.
more risky and costly on account of higher
4. Specific cost of debt capital is lower
expectation of debentureholders.
because the interest on debentures is
tax-deductible and hence the effective
post-tax cost of debentures is lower.
Difference between Shares and Debentures
Shares
Debentures
1. Shares are a part of the capital of the
1. Debentures constitutes loan to the company.
company.
2. Shareholders are owners of the company.
2. Debentureholders are creditors of the
company.
3. Shareholders have right to vote and can
3. Debenture holders do not carry the right to
exercise control over the management of
vote and not in a position to exercise any
the company.
control over the affairs of the company.

4. Shares do not have charge on the assets
4. Debentures have a charge on the assets of
of the company.
the company.
5. Shareholders dividend may fluctuate from
5. Debentures carry a fixed rate of interest.
year to year depending upon the profits.
6. Dividend on shares is paid only if company
6. Interest on debentures payable irrespective of
has earned profits. It can never be paid out
profits or not. It is a debt and may be paid
of capital.
even out of capital.
7. As regards return of principal, share capital
7. Debenture will have a prior claim over share
is ranked after debenture.
capital in case of return of principal.
8. Shares can't be issued at a discount, un8. Debentures can be issued at a discount.
less the company satisfied the conditions
of Section 79 of the Companies Act, 1956.
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Retained Earnings
Retained earnings represent the internal sources of finance available to the company. It refers to
retaining a major portion of the net profit, to be ploughed back in the business so as to result in an
overall growth of the shareholders wealth, instead of just the annual income, by way of dividend
paid. It is also known as Internal financing or Ploughing back of profits.
Companies normally retain 30 percent to 80 percent of profits after tax to finance its
developmental activities or repay loans. Hence, retained earnings can be an important source of longterm financing.
Merits
Demerits
1. Readily available internally.
1. The amount raised may be limited.
2. It enhances business reputation and 2. The opportunity cost of retained earnings is increases the
capacity of the business to
quite high.
meet
unexpected
and
emergency 3. Can be misused by the management to
expenditure.
manipulate the value of the company's shares
3. No dilution of control.
in the stock exchange and also to cover their
4. Help the company to avoid issuance of
inefficiency in managing the affairs of the
fresh equity shares.
company.
5. Less costly.
4. It may prove harmful to society for not giving an
opportunity to invest in such a firm.
6. It is useful since it carries no fixed
obligation regarding payment of dividend or 5. Shareholders may object as it affects their interest.
income.
Loans
A firm may meet its financial requirements by taking both short-term loans or credits and long-term
loans.
Short-term Loans or Credit
These are obtained for working capital requirements. Some of the important loans are:
Trade Credit.
It is a form of short-term financing common to almost all types of firms. Most
of the buyers are not required to pay for goods on delivery. This credit is in two forms: (i) an open
Account Credit Arrangement, in which the buyer does not sign a formal debt
instrument as an evidence of the amount due by him to the seller; (ii) Acceptance Credit
Arrangement in which the buyer accepts a bill of exchange or gives a promissory note for the amount
due by him to the seller.
Trade credit arrangement is generally made available to the buyer on an informal basis
without creating any change on assets. It means allowing a cash discount to the buyer for prompt
payments.
Commercial Banks.
Commercial banks provide only short-term credit to the business. They
have also started providing medium-term loans, but only marginally. These banks make
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advances to the customers in the form of loans, cash credits, pledge, overdraft, bills discounted and
purchased.
Public Deposits.
Most of the firms accept deposits for short periods from their members,
directors and the general public.
Business Finance Companies.
These are companies established primarily for providing
short-term and medium-term loans to firms known to them. Money lended by these companies
to medium- and small-size firms will be limited due to their limited financial resources. These firms
raise the resources mostly from their owners, relatives, friends, etc.
Accrual Accounts.
Accrual accounts are a spontaneous source of financing since they are
self-generating. The most common accrual accounts are wages and taxes. The time lag between
receipt of income and making payment for the expenditure incurred in earning that income
helps the business in meeting some of its short-term financial requirements.
Indigeneous Bankers.
Indigeneous bankers are private individuals engaged in the business
units. They provide short-term or medium-term finance. However, they charge exorbitant rates of
interest and are therefore considered only as a last resort of finance.
Advances from Customers.
Manufacturers who are engaged in producing goods involving
long manufacturing processes demand advance money from their customers at the time of
accepting their orders for executing their contracts or supplying the goods.
Miscellaneous Sources.
A firm may depend on miscellaneous sources of finance in
emergency needs. Such sources may include loan from directors or sister business units,
specialized financial institutions, etc.

Long-term or Term Loans
Term loans, also referred to as term finance, represent a source of debt finance which is generally
repayable in more than one year but less than 10 years. The term Term Loans is used for both
medium-term (15 years) as well as long-term (515 years) loans.
These loans are granted for establishment, renovation, expansion and modernization of
industrial units, or for meeting the requirements of the core working capital, or for reducing bonds in
order to reduce interest costs or to redeem preference shares, so as to substitute tax-deductible
interest payment for non-deductible dividends. These loans are usually secured and granted on the
basis of a formal agreement for a period ranging from 1 to 15 years. There are two major sources of
term loans: (a) specialized financial institutions or development banks and (b) commercial banks.
SUMMARY
Capital is the amount invested in an enterprise by its owners. The capital requirements of a firm can
broadly be divided into two main categories. They are fixed capital requirements and
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working capital requirements. Fixed capital is the capital which is meant for meeting the permanent
or long-term needs of the business. The term working capital refers to the capital required for day-today operations of a firm. Working capital management involves the
relationship between a firms short-term assets and its short-term liabilities. There are two concepts
of working capitalgross working capital (current assets) and net working capital (current assets
minus current liabilities). Composition of working capital constitutes current assets and current
liabilities.
Working capital can be classified into permanent or temporary forms. Permanent working
capital is the amount of current assets required to meet a firms long-term minimum needs.
Temporary working capital is the amount of current assets that varies with seasonal needs. The
factors which influence the working capital are: nature of business, supply conditions of materials,
terms of sales and purchases, manufacturing cycle, production policy, rapidity of turnover, business
cycle, changes in technology, seasonal variation, operating efficiency, market conditions, seasonality
of operation, price level changes, growth and expansion, dividend policy and working capital cycle.
The time lag between the purchase of raw materials and the
collection of cash for sales is referred to as the operating cycle for the company. The time lag
between the payment for raw materials purchases and the collection of cash from sales is
referred to as the cash cycle. Estimation of Components of Working Capital Method, Percent of Sales
Method and Operating Cycle Approach are the techniques for assessing the working capital
requirements of a firm.
Investment is the economic activity of committing a set of resources with the expectation of receiving
a stream of benefits in the future. Capital investment refers to the investment in projects whose results
would be available only after a year. Capital budgeting is defined as the rational allocation of a
firms scarce resources among the competing investment opportunities with a view to maximize the
market value of the firm in the long run. Contingent or dependent proposals, mutually exclusive
decisions and independent proposals are the kinds of capital investment proposals. The important
factors which are considered while making a capital
investment decision are: the amount of investment, the minimum rate of return on investment, the
return expected from the investment, the ranking of the investment proposals, and risk and uncertainty.
A number of appraisal methods may be recommended for evaluating the capital
expenditure proposals. There are broadly two methods of capital budgeting: (1) The
undiscounted methods comprising (a) Payback (PB) Period and (b) Accounting Rate of Return
(ARR), and (2) The Discounted Methods comprising (a) Net Present Value (NPV), (b) Internal Rate
of Return (IRR) and (c) Profitability Index (PI). The Payback Period is the number of years required
to return the original investment from the net cash flows (net operating income after taxes plus
depreciation). Accept if PB < Standard Payback and Reject if PB > Standard Payback. Accounting
Rate of Return is a mere expression of the expected return as a percentage to investment. All those
projects whose ARR is higher than the minimum rate established by the management are accepted and
those projects which have ARR less than the minimum rate
is rejected. In case of mutually exclusive projects, this method would rank a project as number one if
it has the highest ARR and the lowest rank would be assigned to the project with lowest ARR.
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Net Present Value method of project evaluation consists of comparing the present value of all net cash
inflows to the initial investment cost. The decisions involve accepting the project if NPV is positive
and rejecting the project if NPV is negative. Internal Rate of Return is that rate at which the sum of
discounted cash inflows equals the sum of discounted cash outflows.
This involves accepting the project if the IRR > opportunity rate of interest and rejecting the project if
the IRR < opportunity rate of interest. Profitability Index is the ratio of the present value of cash
inflows, at the required rate of return, to the initial cash outflow of the investment. Here the decisions
involve accepting the project if PI > 1.0, rejecting the project if PI < 1.0 and possibly accepting it if
PI = 1.0.
A firm cannot run efficiently if it does not have adequate finance to meet its requirements.
The financial requirements of business can be categorized into two: short-term financial
requirements and long-term financial requirements. Shares, debentures, loans and retained earnings
are some of the sources to raise capital. A share may be defined as one of the units into which the
share capital of a company has been divided. The two major types of shares are preference shares
and equity shares. Preference shares are those which carry the preferential rights over other classes
of shares. Equity shares do not carry any preferential right. The equity shareholders have a voting
right and also a say in the management of the company.
A debenture is a document issued by a company as an evidence of a debt due from the
company with or without a charge on the assets of the company. Retained earnings refers to retaining
a major portion of the net profit, to be ploughed back in the business, so as to result in an overall
growth of the shareholders wealth, instead of just the annual income, by way of dividend paid. A firm
may meet its financial requirements by taking both short-term loans or credits and long-term loans.
Term loans, also referred to as term finance, represent a source of debt finance which is generally
repayable in more than 1 year but less than 10 years.
EXERCISES
Fill in the blanks:
1. A unit of capital is called ___________.
2. A shareholder is an owner of the company whereas a ___________ is a creditor.
3. ___________ shares have voting rights.
Answers:
1. Share
2. Debentureholder
3. Equity
1. It is necessary for firms to devise systematic strategies for generating capital budgeting projects
because of the competitive nature of most industries.
2. NPV has no disadvantages because it is considered the most theoretically correct capital budgeting
method.
3. All investment projects will have only one IRR.
4. In the real world, most firms use NPV and IRR as their primary capital budgeting
decision techniques.
274
5. The discount rate used to calculate NPV must equal the projects IRR if NPV equals zero.
6. Capital investment is not necessarily an investment in tangible assets.
7. The Payback Period method takes into account the cash flows in the Payback Period.
8. Depreciation is considered while calculating the return on a project according to the
Accounting Rate of Return method.
9. Discounted cash flow technique takes into account the time value of money.
10. Net working capital is that portion of a firms current assets which is financed by long-term funds.
Answers:
1. True
2. False
3. False
4. True
5. True
6. True
7. False
8. True
9. True
10. True
1. Cash inflow each year is equal to:
(a) Accounting profit minus tax

(b) Accounting profit minus tax plus depreciation
(c) Accounting profit only
2. The return after the pay-off period is not considered in case of
(a) Payback Period Method
(b) Accounting Rate of Return Method
(c) Present Value Method
(d) None of these.
3. While evaluating capital investment proposals, the time value of money is considered in case of
(b) Discounted Cash Flow Method
(c) Accounting Rate of Return Method
(d) None of these.
4. Depreciation is included in costs in case of
(b) Accounting Rate of Return Method
(c) Discounted Cash Flow Method
(d) None of these.
5. A machine would cost Rs. 50,000 and would fetch Rs. 10,000 in 1st year, Rs. 20,000
in 2nd year and Rs. 20,000 in 3rd year. Hence Payback Period would be:
(a) 21/2 years
(b) 5 years
(c) 3 years
(d) None of these.

275
6. Total cash flow after tax before depreciation for 5 years is Rs. 45,800 and total
depreciation amounts to Rs. 32,000. Initial investment is Rs. 30,000. Thus Average Rate
of Return would be
(a) 20%
(b) 9.2%
(c) 18.4%
(d) 152.6%.
7. Profitability Index is also known as
(a) Cost-Benefit ratio
(b) Desirability Factor
(c) Both (a) and (b)
(d) None of these.
Answers
1. (b)
2. (a)
3. (b)
4. (b)
5. (c)
6. (c)
7. (a)
1. What is meant by cash flow?

2. State the sources of fixed capital.
3. What is meant by NPV?
4. What is IRR method?
5. Distinguish between Operating Cycle and Cash Cycle.
6. Distinguish between gross working capital and net working capital.
7. Distinguish between temporary and permanent working capital.
8. List the sources of capital.
9. What are the types of investment decisions?
10. What do you understand by time value of money?
11. What is capital budgeting? Why is it needed?
1. What is meant by working capital management? What are the determinants of working
capital needs of an enterprise?
2. Define working capital. Distinguish between permanent and temporary working capital.
3. For a growing firm, the level of total assets keep on changing over a period of time.
Do you agree? Explain with examples.
4. Explain the importance of working capital in attaining the profit objective of an
organization. Explain how working capital needs are assessed.
5. Explain various determinants of working capital of a concern.
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6. What is capital budgeting? Explain the methods of capital budgeting.
7. Define payback period and discuss its merits and demerits as a tool of capital budgeting.
8. Compare the accounting rate of return and net present value methods of project
evaluation.
9. Explain the method of calculating (a) NPV and (b) IRR. What are the decision rules in
the two methods?
10. Explain the reasons for NPV and IRR giving conflicting results. Which of the two
methods should be preferred in a such a case? Discuss.
11. How do you calculate the Accounting Rate of Return? What are its limitations?
12. Compare and contrast the Net Present Value and Internal Rate of Return techniques.
Which method will you recommend for evaluating investment? Explain.
13. Define working capital. Explain the various sources of meeting working capital needs.
14. Explain the different steps that are involved in capital budgeting.
PROBLEMS
Payback Period
1. If a project requires Rs. 60,000 as initial investment and it will generate an annual cash inflow of
Rs. 15,000 for six years. Calculate the payback period.
[ Answer: 4 years. As the payback period is less than the expected life of the project, it is
acceptable.]
2. ABC Co. has upto Rs. 20,000 to invest. The following proposals are under consideration: Project
Initial outlay (Rs.)
Annual cash flow (Rs.)
Life (Years)
A
10,000
2,500
5
B
8,000
2,600
7
C4,000
1,000
15
D
10,000
2,400
15
E
5,000
1,125
15
F
6,000
2,400
6
(a) Rank these projects in the order of their desirability under the Payback Period
method.
(b) Which projects would you recommend?
[ Answer: (a) Payback periods of the various projects A4 yrs; B3.1 yrs; C 4 yrs; D 4.7
yrs; E 4.4 yrs and F 2.5 yrs; (b) As the payback period of Project F is 2.5
yrs (i.e., shorter than other projects), it is recommended.]

277
3. If the project requires an initial investment of Rs. 20,000 and the annual cash inflows for 5 years
are Rs. 6,000, Rs. 8,000, Rs. 5,000, Rs. 4,000 and Rs. 4,000 respectively.
Calculate the payback period.
[ Anwer: 3.25 years.]
4. A firm is considering the purchase of a machine. Two machines X and Y, each costing
Rs. 50,000, are available. Cash inflows are expected to be as follows. Calculate payback
period.
Year
Machine X (Rs.)
Machine Y (Rs.)
1
15,000
5,000
2
20,000
15,000
3
25,000
20,000
4
15,000
30,000
5
10,000
20,000
[ Anwer: Payback Period is 2.6 years for Machine X and 3 years 4 months for Machine Y; therefore
machine X is preferred.]
5. There are two projects A and B. The cost of the project is Rs. 30,000 in each case. The cash
inflows are as follows:
Year
Project A
Project B
1
10,000
2,000
2
10,000
4,000
3
10,000
24,000
[ Answer: The payback period is 3 years in both the cases. However, Project A should be preferred
as compared to Project B because of speedy recovery of the initial investment.]
6. There are three projects A, B and C. Each requires a cash outlay of Rs. 10,000. You are required to
suggest which project should be acceptable if the standard payback period is
5 years:
Year
Cash inflows (Rs.)
Project A
Project B
Project C
1
2,500
4,000
1,000
2
2,500
3,000
2,000
3
2,500
2,000
3,000
4
2,500
1,000
4,000
5
2,500
[ Anwer: Payback period in each case is 4 years. However, Project B is the best of all, since in this
case the cash inflows are higher in initial years.]
278

7. There are six projects A, B, C, D, E and F. Each requires an initial investment of
Rs. 10,000. The cash inflows are as under:
Year
Cash inflows (Rs.)
Project A
Project B
Project C
Project D
Project E
Project F
1
10,000
5,000
2,000
10,000
6,000
8,000
2
500
5,000
4,000
3,000
4,000
8,000
3
500
5,000
12,000
3,000
5,000
2,000
[ Anwer: Payback period for Project A is 1 year, B is 2 years, C is 2 years and 4 months, D is 1 year,
E is 2 years and F is 1 year and 3 months. Since the payback period is 1
year for both projects A and F, hence both the projects are ranked as first or preferable over other
projects.]
8. The following are the details relating to two projects A and B:
Project A (Rs.)
Project B (Rs.)
Cost of the project
1,60,000
2,00,000
Estimated scrap
16,000
25,000
Estimated savings:
Year 1
20,000
40,000
Year 2
30,000
60,000
Year 3
50,000
60,000
Year 4
50,000
60,000
Year 5
40,000
30,000
Year 6
30,000
20,000
Year 7
10,000
Calculate payback period and consider which project is better.

[ Anwer: Payback period for Project A is 4 years 3 months and of Project B is 3 years 8 months.]
9. Neelima Industries Ltd. is considering the purchase of a new machine which will carry
out operations performed by labour. Machines A and B are alternative models. From the
following information, you are required to prepare a profitability statement and work out the payback
period in respect of each machine:
Machine A
Machine B
Estimated life of machine (years)
5
6
Cost of machine
Rs. 1,50,000
Rs. 2,50,000
Cost of indirect materials
6,000
8,000
Estimated savings in scrap
10,000
15,000
Additional cost of maintenance
19000
27,000
Estimated savings in direct wages:
Employees not required (number)
150
200
Wages per employee
600
600
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Taxation is to be regarded as 50% of profit (ignore depreciation for calculation of tax).
Which project would you recommend? Why?
[ Answer: Payback period in case of Machine A is 4 years and in case of Machine B it is 5 years.
Hence Machine A is preferable.]
Traditional and Discounted Payback Method
10. Using the information given below, compute the payback period under (a) traditional payback
method and (b) discounted payback method. Comment on the results.
Initial outlay
Rs. 80,000
Estimated life
5 years
Profit after tax:
End of Year
1
Rs. 6,000
2
14,000
3
24,000
4
16,000
5
Depreciation has been calculated under straight-line method. The cost of capital may be
taken at 20% p.a. The P.V. of Re. 1 at 20% p.a. is given below.
Y
ear
1
2
3
4
5
PV Factor
0.833
0.694
0.579
0.482
0.402
[ Answer: (a) 2.7 yrs; (b) 4.39 yrs.]
Hint: (i) Add depreciation of Rs. 16,000 to net profit each year for determining cash
flows; (ii) Discount the cash flows for determining the present values for calculating
payback period according to method (b).]
Accounting Rate of Return
11. A company has to choose between two projects A and B. A requires an investment of
Rs. 80,000 and B requires Rs. 2,00,000. Each has a life of 5 years. Working capital
blocked up in the two for their respective lives is: A Rs. 20,000 and B Rs. 60,000.
At the end of the 5th year the salvage value of A and B are estimated at Rs. 10,000 and
Rs. 40,000. Find out the average rate of return if the annual net earnings from each is
Rs. 20,000.
12. Ram Co. Ltd is proposing to take up a project which will need an investment of Rs.
40,000. The net income before depreciation and tax is estimated as follows:
Y
ear
1
2
3
4
5
Income (Rs.)
10,000
12,000
14,000
16,000
20,000
Depreciation is to be charged according to the straight-line method. Tax rate is 50%.
280
Calculate the Accounting Rate of Return.
[ Anwer: Rs. 3,200/Rs.20,000 = 16%.]
13. A project requires an investment of Rs. 10,00,000. The plant and machinery required
under the project will have a scrap value of Rs. 80,000 at the end of its useful life of
5 years. The profits after tax and depreciation are estimated to be as follows:
Y
ear
1
2
3
4
5
Profits (Rs.)
50,000
75,000
1,25,000
1,30,000
80,000
Calculate the Accounting Rate of Return.
[ Answer: Rs. 92,000/Rs. 9,20,000 = 10%.]
Payback and Accounting Rate of Return
14. Ram and Co. is considering the purchase of a machine. Two machines X and Y are
available, each costing Rs. 50,000. Earnings after tax are expected to be as follows:
Year
Machine A
Machine B
1
15,000
5,000
2
20,000
15,000
3
25,000
20,000
4
15,000
30,000
5
10,000
20,000
Evaluate the following alternatives:
(a) Payback period method
(b) Return on investment method.
[ Answer: Payback Period: A 2 yrs 71/8 months, B 3 yrs 4 months; Return on Investment: A
28% and B 32%]
Internal Rate of Return
A. Even cash flows
15. A project requires an initial investment of Rs. 9,00,000 at a cost of 16%. The annual cash inflows
generated by the project during its 14 years of economic life are estimated at
Rs.1,50,000. Do you accept the project under the IRR method?
[ Answer: IRR is 14%; We reject the project since the IRR is less than the cost of capital (16%).]
B. Uneven cash flows
16. The Finance Manager of a company estimated the following cash inflows: Rs. 60,000,
1,00,000, 65,000 and 45,000. The cost of the project and the cut-off rate were estimated
at Rs. 1,80,000 and 10%. Should the project be accepted under the IRR method?
[ Answer: 20.13%. Since the IRR of the project is greater than the cost of capital (10%), it should be
accepted.]
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17. A project needs an investment of Rs. 1,38,500. The cost of capital is 12%. The net cash inflows
are as follows:
Y
ear
1
2
3
4
5
Cash inflows (Rs.)
30,000
40,000
60,000
30,000
20,000
Calculate the Internal Rate of Return and suggest whether the project should be accepted
or not.
[ Answer: 10%, The project should not be accepted.]
18. A company has to select one of the following two projects:
Project A (Rs.)
Project B (Rs.)
Cost
11,000
10,000
Cash Inflows:
Year 1
6,000
1,000
Year 2
2,000
1,000
Year 3
1,000
2,000
Year 4
5,000
10,000
Using the Internal Rate of Return method, suggest which project is preferable.
[ Answer: The IRR of Project A is 11.27% and Project B is 10.23%.]
Net Present Value
19. Project A initially costs Rs. 30,000. It generates the following cash flows:
Year
Cash inflows (Rs.)
Present value at 10%

1
10,000
0.909
2
9,000
0.826
3
8,000
0.751
4
8,000
0.683
5
7,000
0.621
Taking the cut-off rate as 10%, suggest whether the project should be accepted or not.
20. The following details relate to two mutually exclusive projects A and B having uneven lives:
Project A (Rs.)
Project B (Rs.)
Initial outlay
20,000
40,000
Cash Inflows After Taxes:
Year 1
16,000
16,000
Year 2
14,000
18,000
Year 3
14,000
Year 4
12,000
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The required Rate of Return is 10%. Which project should be preferred by NPV method?
[ Answer: The NPV of Project A is +11,166 and of Project B is +8,122.]
21. Which of the following two projects must be accepted under the NPV method?
Project A (Rs.)
Project B (Rs.)
Initial Outlay
1,00,000
1,40,000
Salvage Value
Nil
20,000
Economic Life (years)
5
5
Earning before Tax and Depreciation:
25,000
40,000
25,000
40,000
20,000
40,000
20,000
40,000
25,000
40,000
Assume a tax rate of 50% and required rate of return of 10%. Depreciation is charged
on a straight-line basis.
22. Consider the following proposed investment with the following cash inflows:
Project
Initial outlay
Year-end cash inflows
Year 1
Year 2
Year 3
A
2,00,000
2,00,000
B
2,00,000
1,00,000
1,00,000
1,00,000
C2,00,000
20,000
1,00,000
3,00,000
D
2,00,000
2,00,000
20,000
20,000
E
2,00,000
1,40,000
60,000
1,00,000
F
2,00,000
1,60,000
1,60,000
80,000
Rank the investment according to Net Present Value (NPV), using a discount rate of
10 per cent, and comment.
Year
1
2
3
Present value of Re. 1 at the end of the year
0.909
0.826
0.751
Payback and Net Present Value
23. The management of a company is considering for purchase of two new machines X and
Y, each costing Rs. 5,00,000 and having a life of 5 years. Cash flows after tax are
expected to be as follows:
283
Y
ear
1
2
3
4
5
Cash Inflows
X
1,50,000
2,00,000
2,50,000
1,50,000
1,00,000
Y
50,000
1,50,000
2,00,000
3,00,000
2,00,000
A discount rate of 10% is to be used. You are asked to advise as to which machine would
be more profitable under the
(a) Payback period method
(b) Net Present Value method.
Profitability Index
24. The initial cash outlay of a project is Rs. 1,00,000 and it can generate cash inflow of Rs.
40,000, Rs. 30,000, Rs. 50,000 and Rs. 20,000 in Years 1 through 4. Assume a 10% rate
of discount. Compute the Profitability Index.

[ Answer: 1.12. As the Profitability Index is greater than 1, the project is acceptable.]
Net Present value and Profitability Index
25. M/s. XYZ Ltd. is considering two investment proposals each of which requires an initial
investment of Rs. 1,80,000. The profits after taxes and depreciation charges for each
project are as follows:
Year
A
B
1
30,000
60,000
2
50,000
1,00,000
3
60,000
65,000
4
65,000
45,000
5
40,000
30,000
7
16,000
The firms cost of capital is 8%. Evaluate the projects under NPV and PI methods.
[ Answer: NPV: A 1,75,350; B1,90,125; PI: A 1.97, B2.06.]
Payback, Net Present Value and Profitablility Index
26. A company has an investment opportunity costing Rs. 35,000 with the following expected net cash
flow (i.e. after tax but before depreciation):
Y
ear
1
2
3
4
5
6
7
8
9
10
Net Cash Inflow
5,000 5,000 5,000 5,000 5,000 6,000 8,000 13,000 8,000 2,000
Using 10% as the rate of discount, determine the following:
(a) Payback Period

(b) Net Present Value
(c) Profitability Index.
284
Payback, Accounting Rate of Return, Net Present Value and Internal Rate of
Return
27. The following data pertain to give independent investment projects:
Project
Initial outlay
Annual inflows
Life in years
A
5,00,000
1,25,000
8
B
1,20,000
12,000
15
C92,000
15,000
20
D
5,750
2,000
5
E
40,000
6,000
10
Assume a 10% required rate of return and a 50% tax rate. Rank these projects according
to each of the following:
(a) Payback Period
(b) Accounting Rate of Return
(c) Net Present Value
(d) Internal Rate of Return.
CHAPT E R
5
Accountancy
LEARNING OBJECTIVES
book-keeping
the principles and significance of double entry book-keeping
Journal
subsidiary books
Ledger accounts
the Trial Balance concept
the preparation of Final Accounts with simple adjustments

the meaning and preparation of Bank Reconciliation Statement
INTRODUCTION
In this modern era, people carry on a variety of activities to satisfy human wants. In all activities and
organizations which require money and other economic resources, accounting is required to Account
for the resources. In other words, wherever money is involved, Accounting is required to account for
it. Accounting is very often called the language of business. The basic function of any language is to
serve as a means of communication. The task of learning Accounting is principally the same as the
task of learning a new language.
If you know Accounting, you will understand how a business operates and how decisions
are taken. Even if you do not take part in Accounting activities, you will find this knowledge helpful
in order to know what Accounting information means, how it is complied and how it can be used for
practical purposes.
285
286
MEANING OF ACCOUNTING
Accounting, as an information system, is the process of identifying, measuring and
communicating the economic information of an organization to its users who need the
information for decision-making.
DEFINITION OF ACCOUNTING
Accounting has been defined in different ways by different authorities. Accounting is a
comprehensive discipline which cannot be satisfactorily explained through any single definition.
Indeed, there is no precise and universally acceptable definition of accounting.
According to the American Accounting Association, Accounting is the process of
identifying, measuring and communicating economic information to permit informed
judgments and decisions by users of the information.
The definition given by the American Institute of Certified Public Accountants clearly
brings out the meaning and functions of Accounting. According to it, Accounting is the art of
recording, classifying and summarizing in a significant manner and in terms of money,
transactions and events which are, in part at least, of a financial character and interpreting the results
thereof.
An analysis of the definition brings out the following functions of Accounting:
Recording.
This is the basic function of Accounting. It is essentially concerned with not only
ensuring that all business transactions of financial character are in fact recorded but also that they are
recorded in an ordinary manner, soon after their occurrence in the proper books of accounts.
Recording is done in the book Journal.
Classifying.
It is concerned with the classification of the recorded transactions so as to group
the transactions of similar type at one place. This function is performed by maintaining the book
Ledger in which different accounts are opened to which related transactions are brought to one
place by posting. For example, all purchases of goods made for cash or on credit on different dates
are brought to purchases account.
Summarising.
It is concerned with the summarization of the classified transactions in a
manner useful to the users. This function involves the preparation of financial statements such as
income statement, balance sheet, statement of changes in financial position, statement of cash flow,
etc.
Deals with Financial Transactions.
Accounting records only those transactions and events,
which are of a financial (money) character. Transactions which are not of a financial character are not
recorded in the books of accounts. For example, if a company has a team of dedicated and trusted
employees, it is of great use to the business; but since it is not of a financial character and capable of
being expressed in terms of money, it will not be recorded in the books of accounts.
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287
Analysing.
It is concerned with the establishment of relationship between the various items
or group of items taken from income statement or balance sheet or both. Its purpose is to identify the
financial strengths and weaknesses of the enterprise. It provides the basis for interpretation.
Interpreting.
It is concerned with explaining the meaning and significance of the relationship
so established by the analysis. Nowadays, the above five functions are performed by electronic data
processing devices and the accountant has to concentrate mainly on the interpretation aspects of
accounting. The accountant should interpret the statements in a manner useful to the users, so as to
enable the users to make reasoned decisions out of alternative courses of action.
The accountant should explain not only what has happened but also (a) why it happened? and (b) what
is likely to happen under specified conditions?.
Communicating.
It is concerned with the transmission (or reporting) of summarized,
analysed and interpreted information to the users to enable them to make reasoned decisions.
NEED FOR ACCOUNTING
Consider yourself a businessman. Will it be possible for you to remember hundreds, even
thousands of transactions that have taken place in your business that too, over a period of time, say
in a year. It is not humanly possible to remember all the financial transactions which have taken place
in a business during a considerable period of time. Even if some one does really remember all the
transactions, he would find it impossible to calculate the net effect of all such transactions. Hence the
need for accounting.
As the business grows in size, it becomes necessary to employ outsiders to assist the
businessman. Since outsides are involved, it is necessary to maintain accounting records for the
purpose of control.
Again if the business is a partnership firm having more than one owner, all of them might or might not
be actively participating in the day-to-day management of the firm. Therefore, it is necessary to
record all the financial transactions in order to satisfy all the partners.
In the case of impersonal organizations like joint stock companies and other corporate
bodies, there is a division between ownership and management. The owners viz. the company
shareholders, who have actually invested their money in the company and who may be living in
different places, will find it convenient to entrust the management to their elected
representatives and paid managers. Hence the need for recording all financial transactions.
However, whether you are an owner or manager of a business you would like to have
information about:
(a) The nature and amount of expenditure;
(b) The nature, source and amount of earnings;
(c) The amount and cause of losses, if any;
(d) The size of capital and causes for its increase or decrease;
(e) The nature and the value of assets possessed; and
(f) The nature and value of liabilities.
288
Further, business requires various types of information for both external and internal use.
For example, information is required for filing sales tax, income tax and other tax returns, and for
preparing statements for decisions to be taken by managers. The question is: How to get this
information? A systematic accounting record is the only answer. Thus, the need for
accounting arises on account of practical needs and legal requirements.
Accounting is absolutely necessary for commercially run (i.e. profit-minded) organizations.
Even in the case of non-profit organizations like co-operative societies, educational institutions, etc.,
and governments and quasi-governmental institutions such as municipalities and zilla Parishads, it is
necessary to maintain accounting records of funds received from various sources and expenditure on
various activities, as they are accountable.
ACCOUNTANCY, ACCOUNTING AND BOOK-KEEPING
Accountancy refers to a systematic knowledge consisting of principles, concepts, conventions and
policies governing recording, classifying, summarising, analysing and interpreting financial
transactions, whereas the practice (i.e. art) of that knowledge is accounting. In other words,
Accountancy is the science, Accounting is the art. Accountancy explains the why to do and how to do
of various aspects of accounting. It tells us why and how to prepare the books of accounts and how to
summarise the accounting information and communicate it to the interested parties.

The actual practice (doing) of that is accounting.
Some people take book-keeping and Accounting as synonymous terms, but they are different from
each other. Book-keeping is mainly concerned with recording of financial data relating to the business
operations in a significant and orderly manner. A book-keeper is responsible for keeping all the
records of a business in such a way that a correct picture can emerge whenever needed. Much of the
work of a book-keeper is clerical in nature and can be accomplished through the use of mechanical
and electronic devices. On the other hand,
Accounting is primarily concerned with the design of the system of records, summarising the recorded
data, the preparation of reports based on the recorded data, the interpretation of the reports and
finally communicating the results to the persons who are interested in such results.
Accountants often direct and review the work of book-keepers. The work of accountants at the
beginning may include some booking but accountants must possess a much higher level of
knowledge, conceptual understanding and analytical skill than is required from the bookkeepers.
OBJECTIVES OF ACCOUNTING
The main objectives of Accounting are as follows:
To Keep Systematic Records.
Accounting is done to keep a systematic record of financial
transactions. Written records are always better than oral records, since written records can be used
by different persons for different decision-making purposes and serve as evidence of transactions.
Nowadays, the volume of transactions is so large that human memory cannot
absorb each and every transaction.
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289
To Protect Business Properties.
Accounting provides protection to business properties from
unjustified and unwarranted use. This is possible on account of Accounting supplying the
information to the manager or proprietor on business information such as: (a) The amount of the
proprietors funds invested in the business; (b) How much the business has to pay to others?
(c) How much the business has to recover from others? (d) How much the business has in the form of
various assets? etc.
To Ascertain the Results of Operations.
Accounting helps in ascertaining the profit earned
or loss suffered on account of carrying the business. This is done by keeping a proper record of
revenues and expenses of a particular period. The profit and loss account (also called income
statement) is prepared at the end of each financial year. A systematic record of income and expenses
facilitates the preparation of the income statement.
To Ascertain the Financial Position of the Business.
To evaluate the financial strengths and
weaknesses of the enterprise, the financial position is ascertained by preparing a position statement
(also called balance sheet), which shows resources (assets) owned by an enterprise and the sources
of financing the same. A businessman wants to know what the business owes to others and what it
owns, and what happened to his capital whether the capital has increased, decreased or remained
constant. A systematic record of various assets and liabilities facilitates the preparation of a position
statement. It serves as a barometer for ascertaining the financial health of the business.
To Communicate the Information to the Users.
Accounting communicates information to
internal users and external users. The internal users include all the organizational participants at all
levels of management (i.e. top, middle and lower). Top-level management requires
information for planning, while middle-level management requires information for controlling the
operations. For internal use, the information is usually provided in the form of reports, for instance,
cash budget report, production report, idle time report, feedback reports, project appraisal reports,
etc.
Since the external users (e.g. banks and creditors) do not have direct access to all the
records of an enterprise, they have to rely on financial statements as the source of the
information. External users are basically interested in the solvency and profitability of an enterprise.
PARTIES INTERESTED IN ACCOUNTING INFORMATION
The accounting information is of primary importance to the proprietors and the managers.
However, other persons such as creditors, prospective employees, etc. are also interested in
accounting information. Some of the users and their needs for information are given below:
Proprietors/Owners.
A business is done with the objective of making profit. Its profitability
and financial soundness are therefore very important to the proprietors who have invested their
money in the business. Naturally, they are interested in obtaining information about the
operations of their business, how much it has earned and the position regarding their capital.
290
They also use the accounting information to evaluate the managements performance and to
compare their enterprise with others.
Managers.
In a sole proprietor concern, usually the proprietor is the manager. In case of a
partnership business either some or all the partners participate in the management of the business.
Therefore, they act both as managers as well as owners. In case of joint stock
companies, the relationship between ownership and management becomes all the more remote.
In most cases the shareholders act merely as renters of capital and the management of the company
passes into the hands of professional managers. The accounting information greatly helps them in
knowing about what has happened and what should be done to improve the
profitability and financial position of the enterprise. Accounting reports are important to managers for
having their decisions, or for evaluating the results of their decisions, or for controlling the activities
of the business. In addition to external financial statements, managers need detailed internal reports
either branch-wise, division or department-wise or product-wise for taking further decisions on
business activities.
Creditors.
Creditors are the persons who have extended credit to the company/business unit.
They are also interested in the financial statements in order to know the efficiency of the firm to meet
its commitments towards the payment of interest and principal in time and satisfy themselves that their
money will be safe.
Prospective Investors.
Persons who are interested to invest in a business would like to know

about its profitability and financial position. They also require information to judge. The prospects of
an enterprise and to determine whether they should invest or not. Prior to
committing their money to a business either in the form of ownership capital or loan capital, need to
make a careful analysis of the financial statements of that business, so as to know how safe and
rewarding the proposed investment will be.
Government.
The government is interested in the financial statements of business enterprise
on account of taxation, labour and corporate laws, for exercising control and regulation such as
directing the flow of capital, for granting licences or loans for determining whether welfare measures
and social security benefits to their employees are observed or not, etc. Further, as a central
statistical agency, the government collects various types of information from business entities and
publishers statistical data about different aspects of business.
Employees.
The employees are interested in the financial statements to know the stability and
profitability of the employers. They are also interested in information, which enables them to assess
the ability of the enterprise to pay remuneration, retirement benefits and to provide employment
opportunities.
Customers.
Customers have an interest in information about the continuation of an
enterprise, especially when they have established a long term involvement with, or are
dependent on the enterprise.
Citizens.
An ordinary citizen may be interested in the accounting records of the institutions
with which he comes in contact in his daily life e.g. bank, temple, public utilities such as gas,
ACCOUNTANCY
291
transport and electricity companies. As a voter and a taxpayer, he is also interested in the accounts of
a government companies, a public utility concern, etc.
Financial Analysts.
Many investment decisions are made on the advise of financial analysts
who are experts in analysing accounting reports. Security analysis employed by stock exchange
dealers advise their clients on the buying and selling of shares of companies. Many institutions like
banks, companies, trusts, pension or provident fund trusts maintain their own staff who can analyse
financial statements.
Researchers.
Financial statements are of immense use to research scholars who want to make
a study of financial operations.
The users of accounting information are therefore many and diverse, and hence it is
impossible to provide information suited to the requirements of each one of them. While
internal management can have access to all the detailed information contained in the entities records,
the external users have to rely heavily on the abridged, periodically published financial statements
prepared on the basis of generally accepted accounting principles and practices.
Accounting reports are therefore general purpose statements intended to serve the various needs of
the above-mentioned groups. However, these reports should possess relevant, timely,
accurate and adequate information as far as possible.
BRANCHES OF ACCOUNTING
Due to economic development and technological improvement, scale of operations of business has
increased. These increased scale of operations and social awareness have made the
management functions more and more complex. These factors have given rise to specialized
branches of accounting such as Financial Accounting, Cost Accounting, and Management
Accounting (see Fig. 5.1)
Branches of Accounting
Cost Accounting
Fig. 5.1 Branches of accounting

It is the process of identifying, measuring, recording, classifying, summarising the financial
transactions and events. The purpose of this branch of accounting is to keep systematic records to
ascertain financial performance and financial position and to provide other relevant
information to the management for decision-making and to satisfy the statutory requirements.
Cost Accounting
It is the process of accounting and controlling the cost of a product, operation or function. The
purpose of this branch of accounting is to ascertain the cost of a product, operation, venture 292
or project and the cost incurred for carrying out various activities and also assist the
management in controlling the costs. The necessary data and information are gathered from financial
accounts and other sources.
It is the application of accounting techniques for providing information designed to help all levels of
management in planning and controlling the activities of business enterprise and in decision making.
The purpose of this branch of accounting is to supply any and all information that management may
need in taking decision and to evaluate the impact of its decisions and actions. The data required for
this purpose are drawn, generally, from the above mentioned two branches, viz., financial accounting
and cost accounting.
ADVANTAGES OF ACCOUNTING
There are many advantages to be obtained from accounting information. The following are the
advantages of a properly maintained accounting system:
1. Accounting attempts to replace human memory by maintaining complete record of
financial transactions. Human memory is limited by its very nature. Accounting helps
to overcome this limitation.
2. Accounting facilitates compliance with legal requirements, which require an
enterprise to maintain books of accounts.
3. Accounting facilitates the ascertainment of the net results of operations by preparing income
statements.
4. Accounting helps to ascertain financial position by preparing position statement or
balance sheet.
5. Accounting helps short-term creditors, long-term creditors, potential investors,
employees, management and the general public to take decisions by communicating
accounting information to them.
6. Accounting assists management in planning and controlling business activities and in
taking decisions.
7. Accounting helps the management in settling tax liability with the authorities by
maintaining proper books of accounts in a systematic manner.
8. Accounting facilitates the ascertainment of value of business in case of transfer of
business to another business enterprise.
9. Accounting helps to raise loans from lenders by providing them historical and
projected financial statements.
10. Proper books of accounts maintained in systematic manner act as legal evidence in
case of disputes.
LIMITATIONS OF FINANCIAL ACCOUNTING
In spite of many advantages from accounting records, there are some limitations of financial
accounting.
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293
Records only Monetary Transactions.
Accounting records only those transactions which can
be measured in monetary terms. Non-monetary transactions, though they are very important
and have strong effects on business results, are not recorded in the books of business. Example:
Conflict between production manager and marketing manager, efficient management, etc.
Effects of Price Level Changes are not Considered.
Business transactions are recorded at
cost in the books. The effect of price-level changes is not brought into the books, with the result that
comparisons of the various years become difficult.
No Realistic Information.
Accounting information may not be realistic as accounting
statements are prepared on the basis of basic concepts and conventions.
Not Free from Bias.
Accounting statements are influenced by the personal judgment of the
accountant. He may select any method of depreciation, valuation of stock, amortization of fixed
assets, treatment of deferred revenue expenditure, etc. Since the subjectivity is inherent in personal
judgment, the financial statements are therefore not free from bias. As a result, the analysis of
financial statements also cannot be said to be free from bias.
Estimated Position and Not Real Position.
Since the financial statements are prepared on
a going concern basis as against liquidation basis, they report only the estimated periodic results
and not the true results since the true results can be ascertained only on liquidation of an enterprise.
No Real test of Managerial Performance.
Profit earned during an accounting period is the
true test of managerial performance. Profit may be shown in excess by manipulation of
accounts by suppressing such costs as depreciation, advertisement, research and development, and
taking excess value of closing stock. Consequently, the real idea of managerial performance may not
be available by manipulated profit.
Historical in Nature.
Usually accounting supplies information in the form of profit and loss
account and balance sheet at the end of the year. So, the information provided is of historical interest
and only gives post-mortem analysis of the past accounting information. For control and planning
purposes management is interested in quick and timely information, which is not provided by
financial accounting.
Danger of Window Dressing.
When the management decides to enter wrong figures to
artificially inflate or deflate the figure of profits, assets and liabilities, the income statement fails to
provide true and fair view of the result of operations and balance sheet fails to provide true and fair
view of the financial position of the enterprise.
THE ACCOUNTING PROCESS
The business activity may be broadly divided into two categories, viz., manufacturing and nonmanufacturing. In the case of manufacturing activity, the business has to purchase either on cash or
credit basis the various inputs required for production and produce the output. The 294
produced output may be sold on cash or credit basis. All credit transactions are finally
converted into cash transactions. In the case of non-manufacturing activity, goods are purchased and
sold at price either on cash or on credit basis. In the case of service organizations services are
offered for sale.
The accounting process, therefore, begins when a financial transaction takes place. As proof of the
transaction, a business document receipt, voucher, bill or invoice is obtained. Based on this
evidence, the transaction is recorded first in a book called Journal and later posted in separate
accounts maintained for the purpose in a Ledger. After sometime, generally at the end of the
accounting year, whether the actual figures are entered accurately or not in the accounts, are tested by
preparing a Trial Balance. With the help of this Trial Balance and other information the Final
Accounts are prepared to find out the financial results of the operations (Profit and Loss Account)
and the financial position (Balance Sheet) of the
accounting entity. In the subsequent year, accounting books are opened with the previous years
closing balances to start with, and then only the current years transactions are recorded. This process
thus repeats itself like a cycle. The accounting cycle may therefore be presented in the form of a
diagram as given in Fig. 5.2.
Transactions
Balance
Profit
Sheet
and
Loss
Journal
Manufacturing
Entry
and Trading
Trial
Ledger
Posting
Balance
Fig. 5.2 Accounting cycle.
An accounting cycle is a complete sequence beginning with the recording of the transactions and
ending with the preparation of the final accounts. After identifying and measuring the financial
transactions, the accounting cycle begins.
SYSTEMS OF ACCOUNTING
Broadly there are two systems of accounting, viz., the Double Entry System and the Single Entry
System.
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295
Double Entry System.
Every transaction has two aspects, giving and receiving. For example,
when you pay money there is somebody to receive it. Thus, for every transaction two accounts are
realised at the same time and with the same amount one account giving the benefit and the other
receiving the benefit. Double Entry is a system which recognizes and records both the aspects of a
transaction. This system has many advantages, for example, (a) the accuracy of the accounts can be
verified and (b) final accounts can be prepared with ease. Since there is check and counter-check in
the form of Double Entry, it is difficult to commit fraud or misappropriation.
Single Entry System.
It is a combination of double entry, single entry and no entry. The

accounts maintained under this system are incomplete and unsystematic. This style of account-keeping
is often called accounts from incomplete records. Generally, what is not double entry accounting is
termed single entry accounting, thereby implying that the accounts are
incomplete.
Big organizations or all the enterprises in the organized sector maintain accounts on double entry
system. Inspite of many defects in single entry system, small business adopts this system.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
Accounting is the language of business. To make the language convey the same meaning to all people,
accountants have developed certain rules, procedures and conventions, which represent a consensus
view by the profession of good accounting practices and procedures, and are
generally referred to as Generally Accepted Accounting Principles (GAAP).
Generally Accepted Accounting Principles may be defined as those rules of action or
conduct which are derived from experience and practice, and when they prove useful they
become accepted as principles of accounting. According to the American Institute of Certified Public
Accountants (AICPA) the principles, which have substantial authoritative support,
become a part of the generally accepted accounting principles.
The principles which constitute the ground rules or guidelines for financial recordkeeping and reporting are usually called generally accepted accounting principles. Accounting
principles are also referred to as standards, assumptions, concepts, conventions, doctrines, axioms,
etc. The various terms, which have to come to be used to describe accounting
principles, indicate the prevailing confusion and lack of clarity in accounting theory. However,
serious efforts to construct a satisfactory body of accounting theory are still being made, the results of
which may be available in the near future.
In an effort to make accounting practices more uniform than it would be otherwise, the
accounting profession, industry and government have created specific organizations to set forth
accounting principles or standards. They are, for example, the Financial Accounting Standards of the
Board of America, the Accounting Standards Steering Committee of Britain, the
Accounting Standard Board of India, and the International Accounting Standards Committee.
It is important for financial statements to be prepared in a manner that permits them to
be compared fairly with the statements of earlier years and with that of other organizations.
We therefore need a well-defined body of accounting principles or standards to guide managers and
accountants in preparing financial statements which will achieve the objectives of
understandability, reliability and comparability in addition to being informative.
296
At the present juncture, it is difficult to codify the accounting principles, as there is no authoritative
list. Further, they are subject to a change with the passage of time. However, the
principles/concepts/conventions which are generally found in accountancy books are classified into
two groups and presented below:
1. Accounting concepts
2. Accounting conventions.
ACCOUNTING CONCEPTS
Accounting concepts may be considered as postulates, i.e., basic assumptions or conditions upon
which the science of accounting is based. These concepts are briefly discussed below.
Business Entity Concept.
According to this concept, business is treated as a separate entity
from its owners. In other words, the proprietor or owner of an enterprise is always considered to be
separate and distinct from the business which he or she controls. Business is kept separate from the
proprietor so that transactions of the business may also be recorded with him. If this concept is not
followed, the transactions of the business will be mixed up with the private transactions of the
proprietor and the true picture of the business will not be available.
Money Measurement Concept.
Accounting records only monetary transactions. Money is
the only practical unit of measurement that can be employed to achieve homogeneity of
financial data. Events or transactions, which cannot be expressed in terms of money, do not find place
in the books of accounts. Measurement of business transactions in money helps to understand the state
of affairs of the business in a much better way. For example, if a business owns Rs. 10,000 of cash,
500 kg of raw materials, two motor cars, 1,000 sq. ft. of building space, etc. These amounts cannot be
added together to produce a meaningful total of what the business owns. However, if these items are
expressed in monetary terms such as Rs. 10,000 of cash, Rs. 12,000 of raw materials, Rs. 2,00,000
worth of cars and Rs. 1,00,000 worth of

buildings, all such items can be added and much more intelligible and precise estimate about the
assets of the business will be available.
Going Concern Concept.
According to this concept it is assumed that the business will
continue for a fairly long time to come. There is neither the intention nor the necessity to liquidate the
business venture in the foreseeable future. A business unit is deemed to be a going concern and not a
gone concern. It is because of this concept that suppliers supply goods and services and other
business firms enter into business transactions with the business unit.
Supplier will not supply goods or services and others will not enter into business agreement if they
have the feeling that the concern will be liquidated. This assumption provides much of the
justification for recording fixed assets at original cost (i.e. acquisition cost) and depreciating them in
a systematic manner without reference to their current realisable value.
Cost Concept.
This concept is closely related to going concern concept. According to this
concept an asset is recorded in the books at the price paid to acquire it and this cost is the basis of all
subsequent accounting for the asset. For example, if a business buys a piece of land for
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Rs. 1,00,000, the asset would be recorded in the books at Rs. 1,00,000 even if its market value at that
time happens to be Rs. 1,50,000. In case a year later the market value of the asset comes down to Rs.
50,000, it will ordinarily continue to be shown at Rs. 1,00,000 and not at Rs. 50,000.
Dual Aspect Concept.
This is the basic concept of accounting. According to this concept
every business transaction has a dual effect. For example, if X starts a business with a capital of Rs.
50,000, there are two aspects of the transaction. On the one hand, the business has an asset (cash) of
Rs. 50,000 while on the other hand, the business has to pay to the proprietor a sum of Rs. 50,000
which is taken as proprietors capital. This expression can be shown in the form of the following
equation:
Capital (Equities) = Cash (Assets)
or
50,000 = 50,000
The term assets denotes the resources owned by a business while the term equities denotes the claims
of various parties against the assets. The total assets will be equal to total of liabilities.
Thus
Equities = Assets
or
Liabilities + Capital = Assets
In the example given above, if the business purchases furniture worth Rs. 10,000 out of the money
provided by X, the situation will be as follows:
Equities = Assets
Capital = Cash + Furniture
Rs. 50,000 = Rs. 40,000 + Rs. 10,000
Subsequently, if the business borrows Rs. 20,000 from a bank, the new position would be as follows:
Equities = Assets
Capital + Bank Loan = Cash + Furniture
Rs. 50,000 + Rs. 20,000 = Rs. 60,000 + Rs. 10,000
The term accounting equation is also used to denote the relationship of equities to assets. The
equation can be technically stated as For every debit, there is an equivalent credit. As a matter of
fact, the entire system of double entry book-keeping is based on this concept.
Accounting Period Concept.
According to this concept, the life of the business is divided
into appropriate segments for studying the results shown by the business after each segment.
Though the life of the business is considered to be indefinite (according to going concern concept),
the measurement of income and the financial position of the business after a very long period would
not be helpful in taking proper corrective steps at the appropriate time. Therefore, it is necessary that
after each segment or time interval the business must stop and see back, 298
how things are going on. In accounting, such a segment or time interval is called accounting period,
it is usually a year.
At the end of each accounting period, an income statement and a balance sheet is prepared.
To know the profit or loss made by the business during the accounting period a profit and loss account
is prepared, whereas balance sheet is prepared to show the financial position of the business as on
the last day of the accounting period.
Matching Concept.
This concept is based on the accounting period concept. The main
objective of running a business is to ascertain profit periodically. The determination of profit of a
particular accounting period is essentially a process of matching the revenues of the period with the
costs (expenses) of that period. The term matching means appropriate association of related
revenues and expenses. In other words, income made by the business during a period can be
measured only when the revenue earned during a period is compared with the
expenditure incurred for earning that revenue. The question, when the payment was received or made
is irrelevant. For example, if a salesman is paid commission in January 2003 for sales made by him
in December 2002, the commission paid to the salesman in January 2003, should be taken as the cost
for sales made by him in December 2002. This means that revenues of
December 2002 (i.e. sales) should be matched with the costs incurred for earning that revenue (i.e.
salesmans commission) in December 2002, (though paid in January 2003). On account
of this concept, adjustments are made for all outstanding expenses, accrued incomes, prepaid
expenses and unearned incomes, etc., while preparing the final accounts at the end of the accounting
period.
Realisation Concept.
According to this concept, revenue is recognized when a sale is made.
Sales are considered to be made at the point when the property in goods passes to the buyer and he
becomes legally liable to pay. This can be made clear with the folowing example:
A customer at Hyderabad places an order with a manufacturer at Delhi on 1st January. On
receipt of order, the manufacturer manufactures goods and delivers them to the customer at Hyderabad
on 1st February who makes payment of goods on March 1st after enjoying credit
period of one month. In this case, revenue was realized not on January 1st, when order was received,
nor on March 1st, when cash was received but on February 1st when goods were
delivered to the customer. However, there are certain exceptions to this concept:
(a) In case of hire purchase the ownership of the goods passes to the buyer only when
the last instalment is paid, but sales are presumed to have been made to the extent
of instalments received and instal ments outstanding (i.e. instalment due but not
received).
(b) In case of contract account though the contractor is liable to pay only when the whole contract is
completed as per terms of the contract, the profit is calculated on the basis of work certified year
after year as per certain accepted accounting norms.
Objective Evidence Concept.
Objectivity connotes reliability, trust worthiness and
verifiability, which means that there is some evidence in ascertaining the correctness of the
information reported. Entries in accounting records and data reported in financial statements must be
based on objectively determined evidence. Invoices, vouchers for purchases and sales,
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299
bank statements for amount of cash at bank, physical checking of stock in hand, etc. are
examples of objective evidence which are capable of verification. As far as possible, every entry in
accounting records should be supported by some objective evidence. Evidence should be such that it
will minimize the possibility of error and intentional bias or fraud.
Accrual Concept.
The essence of the accrual concept is that revenue is recognized when it
is realized, that is, when sale is complete or services are given and it is immaterial whether cash is
received or not. Similarly, according to this concept, expenses are recognized in the accounting
period in which they help in earning the revenue whether cash is paid or not. Thus, to ascertain
correct profit or loss for an accounting period and to show the true and fair financial position of the
business at the end of accounting period, we make record of all expenses and incomes relating to the
accounting period whether actual cash has been paid or received or not. Therefore, as a result of the
accrual concept, outstanding expenses and incomes are taken into consideration while preparing final
accounts of a business entity.
ACCOUNTING CONVENTIONS
The term conventions denotes customs and traditions which guide the accountant while
preparing the accounting statements. Some of the important accounting conventions are:
Convention of Consistency.
According to this convention, accounting practices should
remain unchanged from one period to another. The results of different years will be comparable only
when accounting rules are continuously adhered to from year to year. For example, stock is valued at
cost or market prices, whichever is less, this principle should be followed year after year. Similarly
if depreciation is charged on fixed assets according to diminishing balancing method, it should be
done year after year. This is necessary for the purpose of comparison.
However, consistency does not mean inflexibility. It does not forbid introduction of improved
accounting techniques. However, if adoption of such a technique results in inflating or deflating the
figures of profit as compared to the previous period, a note to that effect should be given in the
financial statements.
Convention of Materiality.
According to this convention, the accountant should attach
importance to material details and ignore insignificant details. Materiality depends on the amount
involved in the transaction. For example, a minor expenditure of Rs. 10 for the
purchase of a waste basket may be treated as an expense of the period rather than an asset.
Custom also influences materiality. For example, only round figures (to the nearest rupee) may be
shown in the financial statements to make the figures manageable without affecting the accuracy of the
accounting data. Similarly, for income tax purposes the income has to be
rounded to nearest rupee.
The question what constitutes a material detail is left to the discretion of the accountant.
Moreover, an item may be material for one purpose while immaterial for another. For example, while
sending each debtor a statement of his account, complete details up to the paise level have to be
given. However, when a statement of outstanding debtors is prepared for sending to top management,
figures may be rounded to the nearest ten or hundred.
300
The term materiality is a subjective term. The accountant should record an item as
material even though it is of small amount and its knowledge seems to influence the decision of the
proprietors or auditors or investors. For example, commission paid to sole selling agents should be
disclosed separately in the profit and loss account.
Convention of Full Disclosure.

According to this, accounting records/reports should disclose
fully and fairly the information they purport to represent. They should be honestly prepared and
sufficiently disclose information, which is of material interest to proprietors, creditors and investors.
This is most important for big business like joint stock companies where ownership is divorced from
management. The Companies Act, 1956, not only requires that income
statement and balance sheet of a company must give a true and fair view of the state of affairs of the
company but it also gives the prescribed forms in which these statements are to be prepared. This is
necessary for having full information of material nature without missing.
Convention of Conservatism or Prudence.
Conservatism means taking the gloomy view of
a situation. It is a policy of caution or playing safe and had its origin as a safeguard against possible
losses in a world of uncertainty. It compels the businessman to wear a risk proof
jacket, for the working rule is: anticipate no profits, but provide for all possible losses. For
example, closing stock is valued at cost or market price whichever is lower. Similarly a
provision is made for possible bad and doubtful debts out of current years profits. This concept
affects principally the category of current assets.
This convention of conservatism has become target for great criticism now a days
especially on the ground that it goes against the concept of full disclosure. It encourages the
accountant to create secret reserves (e.g. by creating excess provision for bad and doubtful debts,
depreciation, etc.) and financial statements do not depict a true and fair view of state of affairs of the
business.
Research studies conducted by the American Institute of Certified Public Accountants have indicated
that conservation concept needs to be applied with much more caution and care if the results reported
are not to be distorted.
DOUBLE ENTRY SYSTEM
In every business, there will be a number of transactions. The business has to enter into business
dealings with a number of persons or firms. So an account of each person or firm with whom the
business has business dealings is opened. Such accounts are known as personal accounts.
The business must necessarily have some assets such as stock, cash, furniture, etc., with the help of
which the business may be carried on. Therefore, an account of each asset in the
business is opened. Such accounts are classified as Real or Property Accounts.
There must be certain sources from which the income of the business is derived. Similarly, certain
expenses must be incurred to earn the income. Therefore, an account of each expense and income is
opened in the books. Such accounts are known as Nominal or Fictitious
Accounts. Thus accounts are of three types, viz., personal accounts, real accounts and nominal
accounts.
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All these business transactions result in the transfer of money or moneys worth, i.e., goods or
services. As every transaction involves a transfer of money or moneys worth, it consists of two
aspects. The receipt of a benefit in the form of money, goods or services and the giving of a benefit.
These two aspects are inseparable and it is impossible to think of one without the other. Giving
necessarily implies receiving and vice versa. Thus there will be two parties to every business
transaction, and the benefit of the transaction is exchanged between them. There cannot be a receiver
without a giver and a giver without a receiver. To record transaction completely, these two aspects
are to be entered in two accounts. The account which receives the benefit is debited and the account
which gives the benefit is credited. Thus we can conclude that every debit must have a corresponding
credit and vice versa. Every business transaction has a double aspect. As two entries are made for
every transaction, the principle is known as
Double Entry.
The terms Debit and Credit are used in Accountancy to represent the receiving and giving
aspects. Debit denotes the receiving aspect and Credit denotes the giving aspect. It is necessary to
record both these aspects to get complete record of any business transaction. This system of recording
the two-fold effect of each transaction is called the Double Entry System.
For recording two aspects of each transaction, two separate accounts are opened in the
books and the entry will be made in both of them, i.e. on the debit side in one of them and on the
credit side in the other. In other words, for every debit there must be a corresponding credit involving
an equal amount. This is called the principle of double entry. Let us consider an example, suppose
goods are purchased for cash. To record this transaction, goods account is debited and cash account is
credited. If goods are sold for cash; cash account is debited and goods account is credited. Thus
transfer is effected between accounts and not between persons.
Whenever there is a transaction in the business, it effects two accounts and entries are made in those
two accounts. This method of recording a transaction gives rise to the term Double Entry.
Now, let us see why every account is divided into two sides. In every transaction, there
will be the receipt of the benefit and the giving of a benefit. One account receives the benefit and
other account gives the benefit.

MEANING OF ACCOUNT
An account is a summarized record of transaction relating to a particular person or thing. An account
is vertically divided into two halves. It resembles in shape the English alphabet T
as here under:
Dr.
Name of the Account
Cr.
The left hand side is called the Debit side and the right hand side is called the Credit side.
The word Dr (abbreviation for debit) is written on the left-hand top corner of the account 302
and the Cr (abbreviation as credit) is written on the right-hand top corner of the account to
indicate the debit side and credit side respectively. The name of the account is written at the top in the
centre. The word Account or its abbreviation A/c is added to the name of the account.
To indicate this information clearly, it becomes necessary to divide every account into two sections.
The left hand side is used to record transactions in respect of which the benefit has been received by
that account and the right hand side is used to record the benefits given by that account. Thus, in every
account, all the benefits received are entered on the debit side and all the benefits given are recorded
on the credit side. This is done with a definite purpose. We can find out the total benefits received
and given by every account by seeing the two sides of that account.
Further we can know whether every account has received more benefits than it has given
or vice versa. For this purpose, the two sides must be added and the balance is found out. The
difference between the two sides is called balance. If the debit side is more than the credit side, the
difference is called a debit balance. On the other hand, if the credit side is more than the debit side,
the account shows a credit balance.
RULES OF DEBIT AND CREDIT
We have seen that every business transaction affects two accounts, and for a complete record of each
such transaction it would be necessary to debit one account and credit another account.
In order to decide which of the two accounts is to be debited and which are to be credited, the first
thing is to find out which type of accounts is affected by the transaction. Then the rules of debit and
credit will have to be applied. For this purpose, accounts are classified into three types: Personal
accounts, Real accounts, and Nominal accounts (see Fig. 5.3).

Types of Accounts
Personal
Real
Nominal
Accounts
Accounts
Accounts
Natural
Tangible
Expenses
and Losses
Artificial
Intangible
Incomes
Representative
and Gains
Fig. 5.3 Types of accounts.
Personal Accounts.
Personal accounts are those which are concerned with the individual
persons, partnership firms, companies or other organizations. Example, As A/c, Ramas A/c,
Muralis A/c, Andhra Bank A/c. ABC & Co. A/c, Delhi Cloth and General Mills Ltd. A/c, etc.
From business point of view, these would be only two persons, one who receives the benefit and one
who gives the benefit, i.e., either the receiver or the giver of the benefit.
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The rule for debit and credit for personal accounts is:
Debit the Receiver and Credit the Giver
According to this rule, all the benefits received by the person or firm are entered on the debit side and
all the benefits given are recorded on the credit side.
A personal account is debited when that person becomes debtor in a transaction and it is
credited when he becomes a creditor. In other words, the receiver of anything is debited and the giver
of anything is credited. These accounts can be classified into three categories: Natural Personal
Accounts.
Natural persons means persons who are created through
natural means. Example: Mohans Account, Ramus Account, etc.
Artificial Personal Accounts.
These accounts include the accounts of corporate bodies
or institutions, which are recognized as persons in business dealings. Example, the account of a
limited company, the account of a co-operative society, the account of a club, government, insurance
company, etc.
Representative Personal Accounts.
These accounts represent a certain person or group
of persons. For example, if rent is due to the landlord, an outstanding rent account will be opened in
the books. Similarly, for salaries due to the employees (not paid), an outstanding salaries account will
be opened. The outstanding rent account represents the account of the landlord to whom the rent is to
be paid, while the outstanding salaries account represents the accounts of the persons to whom the
salaries have to be paid. All such accounts are therefore termed as Representative Personal
Accounts.
Real Accounts.
Real accounts are those which relate to those assets of the firm which are real
and tangible in nature. Example: Land and Buildings Account, Plant and Machinery Account, Cash
Account, Furniture Account, etc.
The rule for debit and credit for real accounts is:
Debit what comes In and Credit what goes Out

As per this rule, when any property purchased and comes into the business, the account
of that property is debited and when any property is sold and goes out of the business, the account of
that property is credited. A separate account is opened for each asset or property and the entry is
made on both sides based on the debit aspect and credit aspect.
Example: Purchased Machinery for cash Rs. 25,000
In this case, Machinery account and Cash account are affected. Both are real accounts. As Machinery
has come in and cash has gone out, Machinery account will be debited (debit what comes in) and cash
account credited (credit what goes out) to record this transaction.
Real accounts are generally classified into two types:
Tangible Real Accounts.
These accounts related to things which can be touched, felt,
measured, etc. Examples are Cash account, Buildings account, Furniture account, Stock
account, etc.,
304
Intangible Real Accounts.
These accounts represent things which cannot be touched. Of
course, they can be measured in terms of money. Example, Patents account, Goodwill account, etc.
For example, if building has been purchased for cash, building accounts should be debited and a cash
account should be credited, because of building is coming into the business and cash is going out from
the business.
Nominal Accounts.
These accounts are opened in the books to explain the nature of the
transactions. They do not really exist. For example, salary paid to the manager, rent paid to landlord,
commissions paid to salesmen, etc. cash goes out of the business and it is something real, while
salary, rent or commission as such do not exist. Nominal accounts include accounts of all expenses,
losses, incomes and gains. Examples are, rent, rates, lighting, insurance, dividends, loss by fire, etc.,
The rule is
Debit all Expenses and Losses and Credit all Gains and Incomes
It should be noted that when some prefix or suffix is added to a nominal account, it becomes a
personal account. Example, Rent account is a nominal account whereas rent prepaid account,
outstanding rent account, etc. are personal accounts.
A separate account is maintained for each item of expenses or incomes. If any expense is
incurred or loss suffered, that transaction is recorded on the debit side of that account and if any
income or gain is made that is recorded on the credit side.
Some more examples:
1. Brought goods for Rs. 4,000 from A on credit
In this transaction goods have come in and A has given them and has become creditor.
Here the two accounts are Goods account and As account.
Goods account is a real account and applying the rule for debit, goods account will have
to be debited.
As account is a personal account and hence on applying the rule A is the giver, As
account is credited.
2. Sold goods to B on credit for Rs. 5000
In this case, the two accounts affected are goods account and Bs account
Goods have gone out, and hence goods account must be credited.
As B has become a debtor, Bs account must be debited.
3. Bought goods for cash Rs. 3000
This transaction affects goods account and cash account. Both are real accounts.
As goods are coming into business, goods account is debited and as cash is going out, cash account is
credited.
4. Sold goods for cash Rs. 10,000
In this case also goods account and cash account are affected. As cash comes into the business, cash
account is debited and goods account is credited as goods go out from the business.
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5. Sold goods to B for cash Rs. 2000
This is an example of cash transaction. The goods account and cash account are affected by it. Cash
account is debited as cash comes in, while goods account is credited as goods go out.
Bs account is not affected because he is not a debtor.
6. Paid office rent to the landlord Rs. 2000
As a result of this transaction, office rent account and cash account are affected.
Rent is an expense and cash is paid.
Hence rent account will be debited and cash account will be credited as cash is going out.
The account of the landlord should not be debited because he need not refund the cash received by
him.
7. Received commission from X Rs. 500
Here the personal account of X is not affected. Cash account is debited and commission
account is credited, wherein in a cash transaction a nominal account is affected, the account of the
person receiving the benefit or giving the benefit is not affected. Hence the record is made in the
nominal account and not in the personal account.
8. Purchased office furniture from Mr. Mukesh on credit for Rs. 10,000.
The two-fold effect is office furniture comes in and Mukesh is the giver. Therefore Furniture account
is debited and Mukesh account is credited. However, goods account should not be
debited as furniture represents an asset.
Advantages of Double Entry System
The following are the advantages of Double Entry System of Accounting:
1. It provides a proper, complete and reliable record of all business transactions.
2. It supplies full information regarding expenses, losses, incomes, assets and liabilities of the
business.
3. The arithmetical accuracy of the books of account can be known through the Trial
Balance.
4. The trading result, i.e., profit made or loss suffered, for any given period can be
found out.
5. The financial state of affairs of the business can be known.
6. It helps the management in taking suitable decisions.
7. It is helpful in comparing the business performance of the current year with the
preceding years so as to know the progress of the business.
JOURNAL
The word Journal means a daily record. A firm may first record its transactions in what is known as
Journal. This is also called a day book, because day-to-day transactions are recorded in this book
in a chronological order as they occur. A Journal may therefore be defined as a book containing a
chronological record of transactions. It is the book in which the transactions are recorded first of all
under the double entry system before further entries are made in other 306
books of account. Thus, Journal is the book of original entry or record. The process of
recording transaction in the Journal is termed Journalising and the various entries made in the
journal are called Journal Entries. The ruling of the Journal is as follows:
Format of the Journal
Date
Particulars
L.F.
Dr.
Cr.
Amount
Amount
(Rs.)
(Rs.)
Year
Name of Account to be debited
Month
Date
To Name of Account to be
credited (Narration)
The columns of the Journal are explained below:
Column 1 Date.
The date of the transaction on which it takes place is written in this
column. This column is divided into two parts. The first part is used for writing the month and the
second part is used for writing the date. The year is written at the top.
Column 2 Particulars.
The two aspects of the transaction are recorded in this column, i.e.
the details regarding accounts which have to be debited and credited. The name of the account to be
debited is written close to the left-hand margin line (i.e. near the date line). The word
Dr is written on the same line against the name of the account towards the end of the column (i.e.
closer to the third column). The name of the account to be credited preceded by the word
To is written on the next line, after leaving a little space. (Please note that the words Dr
and To are being gradually dropped in modern practice.) Then in that next line, a brief description
of the nature of the transaction is given. This is called Narration. It is customary to prefix the word
Being, or For to the narration. Narration should be written in the particulars column only. It should
not extend to other columns. After writing the narration, a line (called dividing line) should be
drawn across the second column in order to separate the transaction from one another.
Column 3 L.F.
L.F. stands for Ledger Folio, which means page number of the ledger.
In this column, the page numbers on which the various accounts appear in the Ledger are noted.
Column 4 Dr. Amount.
In this column, the amount to be debited against the Dr. account

is written along with the nature of currency.
Column 5 Cr. Amount.
In this column the amount to be credited against the Cr. account
is written along with the nature of currency.
If two or more transactions of the same nature occur on the same day and either the debit account or
credit account is common, such transactions can be conveniently entered in the
Journal in the form of a combined Journal entry instead of making a separate entry for each
transaction. Such type of entry is known as Compound Journal Entry.
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307
In a going concern, the balances of the previous year appearing in various accounts are
brought forward at the beginning of the new accounting year by means of a Journal Entry
known as opening entry to incorporate the previous balances in a new set of accounts. All the assets
accounts are debited and liabilities accounts are credited. The difference between the assets and
liabilities is credited to capital account.
Advantages of Journal
The main advantages of Journal are as follows:
Chronological Record.
Journal is a chronological record in the sense that it records the
transactions in the order in which they occur.
Explanation of Transaction.
Each Journal entry in the journal carries narration, which gives
a brief explanation of the transaction.
Recording Both the Aspects.
Both the aspects (i.e. Debit and Credit) of a transaction are
recorded in the Journal. Since the amounts are recorded in both the amount columns, the debit and
credit amount must be equal. The possibility of committing error is reduced and the
detection of errors, if any, committed becomes easy.
Limitations of Journal
When the number of transactions are large, it is practically impossible to record all the transactions in
one Journal because of the following reasons:
(i) The system of recording all the transactions in a Journal requires: (a) The writing
down of the name of the account involved as many times as the transactions occur
and (2) an individual posting of each account debited and credited and hence involves
the repetitive Journalising and posting.
(ii) Such a system does not provide the information on prompt basis.
(iii) Such a system does not facilitate the installation of an internal check system since the Journal can
be handled by only one person.
(iv) The Journal becomes bulky and voluminous.
Illustration 5.1:
From the following transactions find out the nature of account and also state
which account should be debited and which account should be credited
1. Rent Paid
2. Salaries Paid
3. Interest Received
4. Dividends Received
5. Furniture Purchased for Cash
6. Machinery Sold
7. Salaries Outstanding
8. Telephone Charges Paid
9. Paid to Nagesh
10. Received from Ganesh (The Proprietor)

11. Lighting
308
Solution
Transaction
Accounts Involved
Nature of Accounts
Debit/Credit
Rent Paid
Rent A/c
Nominal A/c
Debit
Cash A/c
Real A/c
Credit
Salaries Paid
Salaries A/c
Nominal A/c
Debit
Cash A/c
Real A/c
Credit
Interest Received
Cash A/c
Real A/c
Debit
Interest A/c
Nominal A/c
Credit
Dividends Received
Cash A/c
Real A/c
Debit
Dividends A/c
Nominal A/c
Credit
Furniture Purchased for Cash
Furniture A/c
Real A/c
Debit
Cash A/c
Real A/c
Credit
Machinery Sold
Cash A/c
Real A/c
Debit
Machinery A/c
Real A/c
Credit
Salaries Outstanding
Salaries A/c
Nominal A/c
Debit
Outstanding
Personal A/c
Credit
Salaries A/c
Telephone Charges Paid
Telephone Charges A/c
Nominal A/c
Debit
Cash A/c
Real A/c
Credit
Paid to Nagesh
Nagesh A/c
Personal A/c
Debit
Cash A/c
Real A/c
Credit
Received from Ganesh
Cash A/c
Real A/c
Debit
(Proprietor)
Capital A/c
Personal A/c
Credit
Lighting
Lighting A/c
Nominal A/c
Debit
Cash A/c
Real A/c
Credit
The journalising of the various transactions are explained below:
1. Mr. Vinod starts a business with capital of Rs. 10,000 on January 1, 2004.
In this example, there are two accounts involved, i.e. Vinod account and Cash account.
Mr. Vinod is a natural person and therefore his account is a personal account. Cash account is a
tangible asset and therefore it is real account. As per the rules of debit and credit applicable to
personal accounts, Vinod is the giver and therefore, his account, i.e. Vinods Capital account or
simply Capital account should be credited. Cash is coming into the business and therefore as per rules
applicable to real accounts, it should be debited. The transaction will be entered in the Journal as
follows:
Journal
Date
Particulars
L.F. Dr. (Rs.) Cr. (Rs.)
2004
Cash Account
Dr
10,000
Jan. 1
To Capital Account
10,000
(Being Commencement of Business)
ACCOUNTANCY
309
The words being commencement of Business put within brackets constitute the narration
for the entry passed.
2. Mr. Vinod purchased furniture for cash Rs. 2,000 on January 10, 2004.
The two accounts involved are furniture account and cash account. Both are real accounts.
Furniture is coming in and therefore it should be debited and cash is going out and therefore cash
account should be credited.
3. Mr. Vinod paid rent for business premises Rs. 1,000 on January 15, 2004.
In this transaction, two accounts involved are the rent account and the cash account. Rent account is a
nominal account, it is an expense and therefore it should be debited. Cash account is a real account. It
is going out of the business and therefore it should be credited.
4. Mr. Vinod purchased goods on credit for Rs. 5,000 from Mr. Vijay on January 25, 2004.
The two accounts involved are Vijay account and Goods account. The account of Vijay is a
personal account while that of goods is a real account. Vijay is the giver of goods and therefore his
account should be credited while goods are coming into the business and therefore goods account
should be debited.
The term goods includes articles purchased by the business for sale. These goods may be returned by
the business to the supplier due to certain reasons. Similarly, goods sold by the business to its
customers can also be returned by the customers back to the business due to certain reasons.
Therefore, in business, a separate record is maintained for sale, purchase and return of goods. Hence
goods account can be classified into: (i) purchases account; (ii) sales account; (iii) purchases returns
account and (iv) sales returns account. This classification is necessary to record transactions
separately in their respective accounts.
Compound Journal Entry
Sometimes there are number of transactions on the same date relating to one particular account or of
one particular nature. Such transactions may be recorded by means of a single Journal Entry instead
of passing several separate Entries. Such Entry regarding recording a number of transactions is
termed Compound Journal Entry. It may be recorded as follows:
1. One particular account may be debited while several accounts may be credited.
2. One particular account may be credited while several accounts may be debited.
3. Several accounts may be debited and several accounts may also be credited.
Illustration 5.2:
Pass a compound journal entry for the following transactions:
1. Cash paid to Mr. Ramu Rs. 2,000. Ramu allowed a cash discount of Rs. 100.
2. Cash received from Mr. Naresh Rs. 1000. Naresh was allowed a discount of Rs. 50.
3. An existing business was purchased by Mr. Murthy with the following assets and
liabilities: Cash Rs. 1,000, Land Rs. 20,000, Furniture Rs. 15,000, Stock Rs. 2,000,
Creditors Rs. 2,500, Bank Overdraft Rs. 2,000.
310
Solution
Model journal entries in the books of Mr. Murthy
Date
Particulars

Ramu A/c
Dr
2,100
To Cash A/c
2,000
To Discount A/c
100
(Being payment made to Ramu Rs. 2000 and he
allowed Rs. 100 as discount)
Cash A/c
Dr
1,000
Discount A/c
Dr
50
To Naresh A/c
1,050
(Being cash received from Naresh Rs. 1,000 and
he allowed Rs. 50 as discount)
Cash A/c
Dr
1,000
Land A/c
Dr
20,000
Furniture A/c
Dr
15,000
Stock A/c
Dr
2,000
To Creditors
2,500
To Bank Overdraft
2,000
To Capital A/c
33,500
(Being commencement of business by Mr. Murthy
by taking over an existing business)
Illustration 5.3:
Journalise the following transactions in the books of Akash & Co.
2004
January 1st, Akash started business with cash Rs. 50,000
January 5th, he paid into the Bank Rs. 10,000
January 8th, he purchased goods for cash Rs. 5,000
January 10th, he sold goods for cash Rs. 8,000
January 12th, he purchased machinery and paid by cheque Rs. 15,000
January 15th, he sold goods to Ankush for Rs. 5,000

January 18th, he purchased goods from Anand for Rs .5,000
January 20th, he returned goods to Anand Rs. 1,000.
January 22nd, he received from Ankush Rs. 4,800 in full settlement of his account
January 24th, he withdrew goods for personal use Rs. 1,000
January 25th, he withdrew cash from business for personal use Rs. 1,500
January 26th, he paid telephone charges Rs. 500
January 27th, cash paid to Anand Rs. 3,900 in full settlement of his account.
January 30th, paid for stationery Rs. 1,500, Rent Rs. 1,000 and Salaries for staff Rs. 5,000
January 31st, Goods distributed by way of free samples Rs. 2,000.
ACCOUNTANCY
311
Solution
Journal entries in the books of Mr. Akash & Co.
Date
Particulars
2004
Jan 1
Cash A/c
Dr
50,000
To Capital A/c
50,000
(Being cash brought into business to commence)

Jan 5
Bank A/c
Dr
10,000
To Cash A/c
10,000
(Being cash deposited in the bank)
Jan 8
Purchases A/c
Dr
5000
To Cash A/c
5000
(Being purchase of goods for cash)
Jan 10
Cash A/c
Dr
8,000
To Sales A/c
8,000
(Being goods sold for cash)
Jan 12
Machinery A/c Dr
15,000
To Bank A/c
15,000
(Being machinery purchased and paid by cheque)
Jan 15
Ankush A/c
Dr
5,000
To Sales A/c
5,000
(Being sale of goods to Ankush on credit)
Jan 18
Purchases A/c
Dr
5,000
To Anand A/c
5,000
(Being goods purchased from Anand on credit)
Jan 20
Anand A/c
Dr
1,000
To Purchase returns A/c
1,000
(Being goods returned to Anand)

Jan 22
Cash A/c
Dr
4,800
Discount A/c
Dr
200
To Ankush A/c
5,000
(Being cash received from Ankush in full settlement and
allowed him Rs. 200 as discount)
Jan 24
Drawings A/c
Dr
1,000
To Purchases A/c
1,000
(Being withdrawal of goods for personal use)
Jan 25
Drawings A/c
Dr
1,500
To Cash A/c
1,500
(Being cash drawn from business for personal use)
Jan 26
Telephone Charges A/c
Dr
500
To Cash A/c
500
(Being telephone charges paid in cash)
(Contd.)
312
Journal entries in the books of Mr. Akash & Co. (Contd.)
Date
Particulars
Jan 27
Anand A/c
Dr
4,000
To Cash A/c
3,900
To Discount A/c
100
(Being cash paid to Anand and he allowed Rs. 100 as

discount)
Jan 30
Stationery expenses A/c
Dr
1,500
Rent A/c
Dr
1,000
Salaries A/c
Dr
5,000
To Cash A/c
7,500
(Being expenses paid)
Jan 31
Advertisement expenses A/c
Dr
2,000
To Purchases A/c
2,000
(Being goods distributed by way of free samples)
Total
1,20,500 1,20,500
OPENING AND CLOSING ENTRIES

Any business concern will be started with an intention to continue in the future indefinitely, but it
closes its business operations at the end of an accounting period by closing the books of accounts and
recommencing the same by opening a new set of books of accounts from the
next day. In this process of closing and opening the books of accounts, it is required to pass a closing
entry to close the books of accounts and an opening entry to open the books of
accounts of the next accounting period.
A journal entry, by means of which the balances of various assets, liabilities and capital appearing in
the balance sheet of previous accounting period are brought forward in the books of current
accounting period, is known as Opening Entry.
While passing an opening entry, all asset accounts are debited and all liabilities accounts are
credited. The excess of assets over liabilities is the proprietors capital and is credited to his capital
account (in case of a proprietary concern) or partners capital accounts (in case of a partnership
concern).
Illustration 5.4:
Pass the Opening Entry on January 1, 2004 with the following information
about a business:
Cash in hand
Rs.
1,000
Sundry Debtors
Rs.
3,000
Stock of goods
Rs.
2,000
Plant
Rs. 10,000
Land and Buildings

Rs. 20,000
Sundry Creditors
Rs. 10,000
ACCOUNTANCY
313
Solution
Journal
Date
Particulars
2004
Cash A/c
Dr
1,000
Jan 1
Sundry Debtors A/c
Dr
3,000
Stock A/c
Dr
2,000
Plant A/c
Dr
10,000
Land and Buildings A/c
Dr
20,000
To Sundry Creditors A/c
10,000
To Capital A/c (Balancing figure )
26,000
(Being balances brought forward from the last year)
Total
36,000 36,000
Illustration 5.5:
Journalise the following transactions in the books of Suryam & Co.:
January 1, 2004
Assets in hand: Cash in hand Rs. 10,000, Cash at bank Rs 25,000, Stock of goods Rs. 25,000,
Furniture Rs. 5,000, Building Rs. 50,000, Sundry Debtors Arun Rs. 5,000, Anil Rs. 2000.
Liabilities: Sundry creditors Akash Rs. 10,000, Loan from bank Rs. 25,000
Following is the further information in the month of January 2004:
Jan 1:
Purchased goods worth Rs. 10,000 for cash less 20% trade discount and 5% cash
discount
Jan 4:
Received Rs. 4,800 from Arun and allowed him discount Rs. 200
Jan 6:
Purchased goods from Bhanu Rs. 5,000
Jan 8:
Purchased plant from Mukesh for Rs. 10,000 and paid Rs. 200 as cartage for bringing
the plant to the factory and another Rs. 200 as installation charges.
Jan 12:
Sold goods to Ramu on credit Rs. 1,200
Jan 15:
Ramu became an insolvent and could pay only 50 paise in a rupee.
Jan 18:
Sold goods to Krishna for cash Rs. 2,000
Jan 20:
Paid salary to Ratnam Rs. 5,000
Jan 21:
Paid Akash Rs. 9,600 in full settlement of his account.
Jan 28:
Paid interest on bank loan Rs. 1,000
Jan 30:
Sold goods for cash Rs. 5,000
Jan 31:
Withdrew goods from business for personal use Rs. 500
Jan 31:
Interest received from Anil Rs. 500
314
Solution
Journal entries in the Books of Suryam & Co.

Date
Particulars
2004
Jan 1
Cash A/c
Dr
10,000
Bank A/c
Dr
25,000
Stock A/c
Dr
25,000
Furniture A/c
Dr
5,000
Building A/c
Dr
50,000
Arun A/c
Dr
5,000
Anil A/c
Dr
2,000
To Akash A/c
10,000
To Bank Loan A/c
25,000
To Capital A/c
87,000
(Being business brought forward from last year)
Jan 1
Purchases A/c
Dr
8,000
To Cash A/c
7,600
To Discount A/c
400
(Being purchase of goods for cash worth Rs. 10,000
allowed 20% trade discount and 5% cash discount on
Rs. 8,000)
Jan 4
Cash A/c
Dr
4,800
Discount A/c
Dr
200
To Arun A/c
5,000
(Being cash received from Arun, allowed Rs. 200 as
discount)
Jan 6
Purchases A/c
Dr
5,000
To Bhanu A/c
5,000
(Being purchase of goods from Bhanu)
Jan 8
Plant A/c
Dr
10,400
To Mukesh A/c
10,000
To Cash A/c
400
(Being purchase of plant for Rs. 10,000 and paid
Rs. 200 as cartage and installation charges Rs. 200)

Jan 12
Ramu A/c
Dr
1,200
To Sales A/c
1,200
(Being goods sold to Ramu on credit)
Jan 15
Cash A/c
Dr
600
Bad Debts A/c
Dr
600
To Ramu A/c
1,200
(Being cash received from Ramu @ 50% of the amount
due from him and the rest has been taken as bad debt)
Jan 18
Cash A/c
Dr
2,000
To Sales A/c
2,000
(Being cash sales)
(Contd.)
ACCOUNTANCY
315
Journal entries in the Books of Suryam & Co. (Contd.)
Date
Particulars
Jan 20
Salary A/c
Dr
5,000
To Cash A/c
5,000
(Being salary paid)
Jan 21
Akash A/c
Dr
10,000
To Cash A/c
9,600
To Discount A/c
400
(Being cash paid to Akash and he allowed Rs. 400 as

discount)
Jan 28
Interest on Loan A/c
Dr
1,000
To Cash A/c
1,000
(Being interest paid on bank loan)
Jan 30
Cash A/c
Dr
5,000
To Sales A/c
5,000
(Being cash sales)
Jan 31
Drawing A/c
Dr
500
To Purchases A/c
500
(Being goods withdrawn for personal use)
Jan 31
Cash A/c
Dr
500
To Interest A/c
500
(Being interest received)
Total
1,76,800 1,76,800
SOME IMPORTANT POINTS IN JOURNALISING
The student is advised to note the following points in connection with the Journal Entries: 1. In case
of credit transaction, the person with whom we are dealing becomes either
a debtor or a creditor as the cash settlement is postponed. Consequently, it becomes
necessary to record the transaction through the account of the person concerned. In
the case of a cash transaction, no further obligation remains to be fulfilled by the
parties to the transaction. Therefore, we are not concerned with the account of the
person with whom we are dealing while recording the transaction.
Similarly, transactions relating to payment of expenses and receipts of incomes
are recorded through the expense account or the income account concerned and
not through the account of the person involved, since no debtor/creditor relationship
is created.
The following are the examples of some of the transactions in which the personal
accounts are not considered while recording:
(a) Purchased goods for cash from Hari
Rs. 3,500
(b) Sold goods to Kiran for cash
Rs. 1,000
(c) Rent paid to landlord Raghuram
Rs. 1,500
(d) Received commission from Mehta
Rs. 600
316
2. When the name of the person is given in a transaction and when the word cash does
not appear, it is implied that it is a credit transaction, e.g., purchased furniture from Rao & Company:
Rs. 4000.
When the name of the party does not appear, it is always a cash transaction even
if the word cash is not mentioned in the transaction. Example: purchased machinery:
Rs. 25,000.
3. While recording transactions involving the taking or giving of loans, the word loan
is added to the name of the related party. E.g., Ramlals Loan Account.
4. In the illustrations given above, Goods Account may also be used while recording
the dealings in Goods, viz. purchases, sales and return of goods. In the practical
system of book-keeping, the goods account is not maintained. It is divided into four
accounts as follows:
1. Purchases Account
For recording cash and credit purchases of
goods
2. Sales Account
For recording cash and credit sales of goods
3. Purchases Returns Account
For recording goods returned to suppliers

(also called Returns Outward
Account)
4. Sales Returns Account
For recording goods returned by customers
(also called Returns Inward
Account)
5. In respect of certain items like rent, commission, etc., where both payments (i.e.
expenses) and receipts (i.e. incomes) take place, two separate accounts may be
maintained, one for recording payments and the other for receipts, e.g. Commission
Allowed Account and Commission Received Account. Alternatively, only one
account may be maintained, in which case the account is debited with payments and
credited with receipts.
LEDGER
We have learnt that Accounting involves recording, classifying and summarising the financial
transactions. The Journal is a daily record in which all transactions are entered as and when they
occur. The transactions pertaining to a particular person, asset, expense or incomes are recorded at
different places in the Journal as they occur on different dates. Journal fails to bring the similar
transactions together at one place.
Suppose one wants to know the amount due to a particular supplier or the amount due from
a particular customer on any given date. As transactions are recorded in the Journal date-wise the
required information is not found at one place and one has to search through all the pages of the
Journal to find it. With a view to overcoming this limitation, transactions relating to particular
account are brought together and recorded at one place in another book called the
Ledger.
Ledger is a book which contains various accounts. In other words, ledger is a set of
accounts. It contains all accounts of the business whether real, nominal or personal . Thus, a ledger
account may be defined as a summary statement of all the transactions relating to a ACCOUNTANCY
317
person, asset, expense or income which have taken place during a given period of time and shows
their net effect. Journal is maintained only to facilitate the passing of entries in the ledger. So every
entry recorded in the Journal must be posted into the Ledger. Ledger is a register having a number of
pages which numbered consecutively. One page is assigned for one account in the Ledger. It is the
principal book of accounts because it helps us in achieving the objectives of accounting.
Ledger Posting
The process of entering the transactions (which have already been recorded in the journal) in the
Ledger is technically called Posting. The posting is usually made immediately after Journalising.
Every transaction is first recorded in the journal in the form of Journal Entry. From the Journal it is
transferred to the concerned accounts in the ledger. It should be noted that the exact names of the
accounts used in the Journal should be carried to the Ledger. Posting may be done at any time.
However, it should be completed before the financial statements are prepared. The Ledger Folio
(L.F.) column in the Journal is used at the time when debits and credits are posted to the Ledger. The
page number of ledger on which the posting has been done is mentioned
in the L.F. column of the Journal. Similarly, a folio column in the Ledger can also be kept where the
page from which posting has been from the Journal may be mentioned. Thus, there are crossreferences in both the Journal and the Ledger. The form of a ledger account is as follows:
Name of the Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
Journal
Each account in the Ledger is divided into two equal parts by a vertical line. The left hand side of the
account is called the debit side and the right hand side is called credit side. Each of the two sides is
further divided into four columns for date, particulars, folio and amount.
Folio stands for page number of the Journal.
An alternative rule, which is usually followed by the banks, is that the account is to be divided into
six columns as follows:
Name of the Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
318
The main advantage of the alternative ruling of the account is that the balance of the
account can be known after every transaction.
While posting the transactions into the Ledger certain rules should be followed:
1. The date of each transaction is entered in the date column. The method adopted is
similar to that adopted in the case of the Journal.
2. Separate accounts should be opened in the Ledger, for posting transactions relating
to different accounts recorded in the Journal.
3. The concerned account which has been debited in the Journal should also be debited
in the Ledger, but a reference should be made of the other accounts which has been
credited in the Journal.
4. The concerned account, which has been credited in the Journal, should also be
credited in the Ledger. But reference should be given of the account which has been
debited in the Journal.
For example, as Salaries of Rs. 5,000 have been paid in cash, the following entry will be passed in
the Journal:
Salaries Account
Dr
5,000
To Cash Account
5,000
(Being salaries paid in cash)
In the Ledger, two accounts will be opened: Salaries account and Cash account. Since salaries
account has been debited in the Journal, it will also be debited in the Ledger. Similarly, cash account
has been credited in the Journal, and therefore it will also be credited in the Ledger, but reference
will be given of the other account involved. Thus, the accounts will appear as follows in the Ledger.
Salaries Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
To Cash A/c
5,000
Cash Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
By Salaries A/c
5,000
Use of the words To and By: It is customary to use words To and By while making
posting in the Ledger. The word To is used with the accounts which appear on the debit side of a
ledger account. For example, in the salaries account, instead of writing only Cash, the words To
Cash will appear on the debit side of the account. Similarly the word By is used with the accounts
which appear on the credit side of the Ledger accounts. For example, in the ACCOUNTANCY
319
above case, the words By salaries A/c will appear on the credit side of the cash account instead of
only Salaries Account. The words To and By do not have any specific
meanings. Therefore modern accountants ignore the use of these words.
BALANCING OF ACCOUNT
All the accounts appear in the Ledger are balanced with a view to preparing the final accounts.
In Journal, transactions appear on different pages date-wise, while they appear in a classified form
under a particular account in the Ledger. At the end of a period (say one month, a year), the
businessman will be interested to know the position of a particular account. For this purpose, he
should total the debits and credits of the accounts separately and find out the net balance. This
technique of finding out the net balance of an account is known as Balancing the Account. The
procedure for balancing an account is:
1. Take the totals of the two sides of the account.
2. Ascertain the difference between the totals of the two sides.
3. Enter the difference in the amount column of the side showing less total, writing
against the difference in the particulars column To Balance c/d (c/d means carried
down) on the debit side of the account and By Balance c/d on the credit side of
the account. In this way, the totals of two sides will agree.
4. The balance is brought forward at the beginning of the next period. If To Balance
c/d is written on the debit side before balancing, it is brought forward on the credit
side as By Balance b/d (b/d means brought down) is written against the balance in
the particulars column and vice versa.
5. An account is said to have a debit balance if the total of its debit side is more than the total of its
credit side. On the other hand, an account is considered to have a credit balance if the total of its
credit side is more than the total of its debit side.
Notes:
1.
We have seen that the abbreviation, c/d is used when closing an account and b/d when
opening of the account on the next date. These abbreviations are used when the balance
is carried down on the same page. In case the balance is carried forward to the next page or some
other page, the abbreviations c/f (carried forward) and b/f (brought forward) are used in place of
c/d and b/d.
2.
Sometimes, the balance of an account may be nil when the totals of both sides are the same.
In such cases we will only enter the totals on both sides of the account.
Interpretation of Ledger Accounts
Personal Accounts.
These are more frequently balanced than others so as to know the
amounts owed and owing. When the account of a person shows a debit balance, it indicates
that he is a debtor. If, on the other hand, the account of a person shows a credit balance, it means that
he is a creditor.
Real Accounts.
Real accounts are normally balanced at the end of each accounting period,
i.e., before preparing the final accounts. They generally show a debit balances, and are asset
accounts.
320
Nominal Accounts.
When nominal accounts are balanced, debit balances in such accounts
indicate expenses or losses and credit balances, incomes and gains. Nominal accounts are closed by
transfer to profit and loss account at the end of the accounting period.
Advantages of Ledger
The main advantages of a Ledger are summarized as under:
1. It provides complete information about all accounts in one book.
2. It enables to ascertain what are the main items of revenues and expenses.
3. It enables to ascertain what the assets are and of what amount and what the liabilities are and of
what amount.
4. It facilities the preparation of Final Accounts.
Differences between Journal and Ledger
There are certain differences between Journal and Ledger. They are:
Journal
Ledger
1. It is a book of original (i.e. first) entry.
1. It is a book of final entry.
2. Transactions recorded in the chronological 2. All transactions relating to a particular order as
order as and when they occur.
account appears at one place in the Ledger.
3. If any disputes arise in trade, the Journal
3. For accounting purposes, Ledger is the main
as a book of primary source has greater

source of information.
weight as legal evidence.
4. It is a subsidiary book.
4. It is a principal book.
5. The process of recording financial trans5. The process of recording transactions in
action in the Journal is called Journalising.
the Ledger is called Posting.
Illustration 5.6:
Pass necessary Journal entries and post them in the Ledger accounts of
Mr. Prabhu for the month of December 2003.
Dec 1:
Started business with Rs. 1,00,000 in the Bank and Rs. 50,000 in Cash
Dec 1:
Bought furniture for shop Rs. 25,000 and motorcycle Rs. 60,000, both paid by
cheque.
Dec 2:
Paid rent by cheque Rs. 2,000
Dec 3:
Bought goods for resale on credit from Madhavan Rs. 50,000
Dec 5:
Cash Sales Rs. 10,000
Dec 8:
Paid wages to assistant in cash Rs. 1,000

Dec 10: Paid insurance by cheque Rs. 1,000
Dec 12: Cash Sales Rs. 10,000
Dec 15: Goods returned to Madhavan Rs. 5,000
Dec 17: Paid Madhavan by cheque Rs. 20,000
Dec 19: Bought goods for resale on credit from Rao & Co. Rs. 35,000
ACCOUNTANCY
321
Dec 22: Bought stationery, paid in cash Rs. 1,000
Dec 27: Paid Rao & Co Rs. 15,000 by cheque
Dec 29: Paid wages to assistant in cash Rs. 1,000
Dec 31: Paid into Bank Rs. 25,000.
Solution
Journal entries in the books of Mr. Prabhu
Date
Particulars
L.F.
Dr. (Rs.) Cr. (Rs.)
2003
Dec 1
Bank A/c
Dr
1,00,000
Cash A/c
Dr
50,000
To Capital A/c
1,50,000
(Being Capital invested)
Dec 1
Furniture A/c
Dr
25,000
Motorcycle A/c
Dr
60,000
To Bank A/c
85,000
(Being the purchase of furniture and motorcycle for
business)
Dec 2
Rent A/c
Dr
2,000
To Bank A/c
2,00
(Being rent paid by cheque)

Dec 3
Purchases A/c
Dr
50,000
To Madhavan A/c
50,000
(Being goods purchased on credit)
Dec 5
Cash A/c
Dr
10,000
To Sales A/c
10,000
Dec 8
Wages A/c
Dr
1,000
To Cash A/c
1,000
(Being wages paid to assistant)
Dec 10 Insurance A/c
Dr
1,000
To Bank A/c
1,000
(Being insurance paid by cheque)
Dec 12 Cash A/c
Dr
10,000
To Sales A/c
10,000
Dec 15 Madhavan A/c
Dr
5,000
To Returns outwards A/c
5,000
(Being goods returned to Madhavan)
Dec 17 Madhavan A/c
Dr
20,000
To Bank A/c
20,000
(Being paid by cheque)
(Contd.)
322

Journal entries in the books of Mr. Prabhu (Contd.)
Date
Particulars
L.F.
Dr. (Rs.) Cr. (Rs.)
Dec 19 Purchases A/c
Dr
35,000
To Rao & Co A/c
35,000
(Being goods purchased on credit)
Dec 20 Cash A/c
Dr
5,000
To Sales A/c
5,000
(Being goods sold for Cash)
Dec 22 Stationery A/c
Dr
1,000
To Cash A/c
1,000
(Being purchase of stationery)
Dec 25 Cash A/c

Dr
10,000
To Sales A/c
10,000
Dec 27 Rao & Co A/c
Dr
15,000
To Bank A/c
15,000
(Being paid by cheque)
Dec 29 Wages A/c
Dr
1,000
To Cash A/c
1,000
(Being wages paid to assistant in cash)
Dec 31
Bank A/c
Dr
25,000
To Cash A/c
25,000
(Being cash paid in bank)

Total
4,26,000 4,26,000
Bank Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 12 To Capital A/c
1,00,000 Dec 1 By Furniture A/c
25,000
Dec 31 To Cash A/c
25,000 Dec 1 By Motorcycle A/c
60,000
Dec 2 By Rent A/c
2,000
Dec 10 By Insurance A/c
1,000
Dec 17 By Madhavan A/c
20,000
Dec 27 By Rao & Co. A/c
15,000
Dec 31 By Balance c/d
2,000
1,25,000
1,25,000
2004
Jan 1
To Balance b/d
2,000
ACCOUNTANCY
323
Cash Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 1
To Capital A/c
50,000 Dec 8 By Wages A/c
1,000
Dec 5
To Sales A/c
10,000 Dec 22 By Stationery A/c
1,000
Dec 12 To Sales A/c
10,000 Dec 29 By Wages A/c
1,000
Dec 20 To Sales A/c
5,000 Dec 31 By Bank A/c
25,000
Dec 25 To Sales A/c
10,000 Dec 31 By Balance c/d
57,000
85,000
85,000
2004
Jan 1
To Balance b/d
57,000
Capital Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 31 To Balance b/d
1,50,000 Dec 1
By Bank A/c
1,00,000
Dec 1 By Cash A/c
50,000
1,50,000
1,50,000
2004
Jan 1 By Balance b/d
1,50,000
Furniture Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 1
To Bank A/c
25,000
2004
Jan 1
To Balance b/d
25,000
Motor cycle Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 1
To Bank A/c
60,000
2004
Jan 1
To Balance b/d
60,000
324
Rent Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
Dec 2
To Bank A/c
2,000
2004
Jan 1
To Balance b/d
2,000
Purchases Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 3
To Madhavan A/c
85,000
Dec 19 To Rao & Co. A/c
35,000
85,000
85,000
2004
Jan 1
To Balance b/d
85,000
Madhavan Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 15 To Returns
5,000 Dec 3
By Purchases A/c
50,000
Outwards A/c
Dec 17 To Bank A/c
20,000
Dec 31 To Balance c/d
25,000
50,000
50,000
2004
Jan 1
By Balance b/d
25,000
Sales Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 31 To Balance b/d
35,000 Dec 5
By Cash A/c
10,000
Dec 12 By Cash A/c
10,000
Dec 20 By Cash A/c
5,000
Dec 25 By Cash A/c
10,000
35,000
35,000
2004
Jan 1
By Balance b/d
35,000
ACCOUNTANCY
325
Wages Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 8
To Cash A/c
2,000
Dec 29 To Cash A/c
1,000
2,000
2,000
2004
Jan 1
To Balance b/d
2,000
Insurance Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 10 To Bank A/c
1,000
2004
Jan 1
To Balance b/d
1,000
Rao & Co. Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 27 To Bank A/c
15,000 Dec 19 By Purchases A/c
35,000
20,000
35,000
35,000
2004
Jan 1
By Balance b/d
20,000
Stationery Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
Dec 22 To Cash A/c
1,000
2004
Jan 1
To Balance b/d
1,000
326
Returns Outward Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
2003
5,000 Dec-15 By Madhavan A/c
5,000
2004
Jan 1
By Balance b/d
5,000
SUBSIDIARY BOOKS
We have already learnt that Journal is the book of prime entry. We have seen that all
transactions are first entered in the Journal in a chronological order and from the Journal they are
posted to their respective accounts in the Ledger. However, in a big business organization the
recording of all transactions in one Journal will not only be inconvenient but also cause for delay in
collecting information required. The system of having one Journal and one Ledger may work in a
small business where the number of transactions are usually small. But where the number of
transactions are very large, it is practically impossible to record all the transactions in one Journal.
Moreover, the Journal can be handled by only one person and the work becomes too heavy for him.
The day-to-day transactions may not be recorded promptly
in it. In order to overcome this difficulty and to facilitate speedy recording of a large volume of
transactions, the Journal is divided into a number of separate journals. These are called subsidiary
books.
Advantages of Subsidiary Books
1.
Maintenance of one Journal will make it quite bulky and difficult to handle. Sub-division of Journal
will reduce the size of Journal and make it convenient to handle.
2.
Sub-division of Journal helps in division of Labour since different persons can write
different Journals.
3.
Each Journal provides information relating to a particular aspect of the business. For
example, a Purchases Journal gives information about the total credit purchases made by
the business. Thus, the businessman gets the information relating to different aspects of the business in
a classified form in the shortest possible time. These subsidiary books are also known as books of
original entry because transactions are first recorded in these books and subsequently transferred to
their respective accounts in the Ledger.
In any business many of the transactions are usually repetitive in nature. Broadly, the
transactions can be grouped into two categories: cash and non-cash transactions. Cash
transactions are those which involve cash inflows (receipts) and cash outflows (payments). Non-cash
transactions are those which do not directly or immediately involve cash flows. Many of the non-cash
transactions are credit transactions of purchase and sale of goods. Credit purchases and sales, other
than goods, are few in number and not repetitive, i.e., may occur occasionally.
The cash receipts and payments may be grouped into one category, credit purchases of goods
ACCOUNTANCY
327
into another category and credit sale of goods into yet another category and recorded in special
journals. Thus, in practice, the main Journal is subdivided in such a way that a separate journal or
book is used for each category or group of transactions which are sufficiently large in number and
also repetitive in nature. By and large, in any large scale business, the following special journals are
found, viz.,
1. Cash book
2. Purchases book
3. Sales book
4. Purchases returns book
5. Sales returns book
6. Bills receivable book
7. Bills payable book
8. Journal proper
CASH JOURNAL OR CASH BOOK
A cash book is a special Journal which is used for recording all cash receipts and cash
payments. Cash book plays a dual role, i.e., it serves both as Journal and Ledger. The cash book is a
book of original entry (or prime entry) since transactions are recorded for the first time without taking
in any other books. The cash book is a ledger in the sense that it is designed in the form of cash
account and records cash receipts on the debit side and cash payments on the credit side. Thus the
cash book is both a Journal and a Ledger.
PURCHASES JOURNAL OR PURCHASES BOOK
Purchases book (also known as invoice book/ bought book) is used for the purpose of recording all
credit purchases of goods in which business enterprise deals. Cash purchases will not be entered in
this book because entries in respect of cash purchases must have been made in the cashbook. Credit
purchases of things other than goods and materials which the enterprise deals must not be recorded in
this book. These transactions are to be recorded in the General Journal.
For example, purchase of furniture by a book seller will not be entered in the purchases book but
purchase of furniture by a furniture dealer will be recorded in the purchases book. At the end of each
month, the purchases book is totalled. The total shows the total amount of goods or materials
purchased on credit. The purchases book is also called Purchases Day Book,
Purchases Register, Bought Book or Invoice Book.
INVOICE
According to the objective evidence concept, as seen earlier, there should be evidence for the fact
that a transaction has taken place. Without evidence, transactions are not recorded in the books of
accounts. Invoice is a business document or bill or statement giving details of the goods such as
their quantity, quality, price and total value given by the seller to the purchaser.
It is popularly known as bill. It is Purchase Invoice also called Inward Invoice for the purchaser
and Sales Invoice or Outward Invoice for the seller.
328
Nowadays, you might have observed, the price of the article is mentioned on the article
(e.g., Retail price not to exceed Rs.) . The price mentioned on the article or at which it is to be
sold is called the Catalogue or List Price. When a purchase is made, the invoice is prepared first
on the basis of its catalogue price and then certain percentage of that price is allowed as rebate or
reduction, which is called trade discount. The purchaser pays only the net amount. i.e. what remains
after allowing the trade discount to the seller.
Trade discount thus is an allowance given by the seller to the buyer and the catalogue price of the
article at the time of selling. This is generally given by the manufacturers and
wholesalers to their customers. Since the trade discount is deducted from the catalogue price and only
the net amount is received or paid, it is this net amount that is actually recorded in the books. The
trade discount, therefore, does not appear in the books of account.
Proforma Ruling of Purchases Book
Date
Name and Address of
Inward invoice
L.F.
Details
Amount
Remarks
the Supplier
Number
(Rs.)
1
2
3
4
5
6
7
Recording in the Purchases Book
The credit purchases of goods are recorded in the purchases book in the following manner: 1. In the
first column, i.e., Date Column, the year and month of purchase is recorded
on the left hand side sub-column and the day of purchase is recorded on the right
hand side sub-column.
2. In the second column, the name and address of the party or supplier of goods are
recorded.
3. In the third column, inward invoice number is to be entered. When goods are
purchased on credit the businessman receives from the supplier a written statement
(invoice/credit memo/bill) giving the details of the goods supplied. It is an inward
invoice for the businessman. The invoices so received are consequently numbered and
filed. Consecutive numbers given to inward invoices are to be entered in the inward
invoice column of the purchases book.
4. In the fourth column, the Ledger Folio or page number of the account in ledger is
to be entered. This is done while posting the amounts to the individual ledger
accounts of the suppliers.
5. In the Details Column, the value of the goods purchased and details of various items
purchased, amount of trade discount received are entered.
6. In the amount column, the net amount payable is to be recorded. If any sales tax is
levied, and in some cases any packing and forwarding charges are charged, such
amounts is to be added to the net amount payable after deducting trade discount.
After adjusting these amounts in the details column, the final amount is to be
recorded in the amount column.
7. In the Remarks column, any other relevant information is recorded; for example, the
date on which the amount of the bill is to be payable (if there is a due date), the date
of actual payments etc.
ACCOUNTANCY
329
Posting of Purchases Book
The periodical total of the purchases book is posted to the debit side of purchases account with the
words To sundries as per purchases book. Each suppliers account is individually credited in the
ledger with the amount of goods purchased from him because he is the giver of goods.
The total debit placed in the purchases account equals the total of various credits given to suppliers
account. Thus the double entry will be completed.
Illustration 5.7: From the following transactions prepare the purchases book of Mr. Ram for July,
2003 and prepare Ledger Accounts concerned with this book:
Jul 5 Purchased on credit from Kiran & Co.
50 Textbooks @ Rs. 100
10 Notebooks @ Rs. 25
Jul 6 Purchased for cash from John & Brothers
Jul 10 Purchased from Rao & Sons on credit
100 Gum bottles @ Rs. 25
50 Staplers @ Rs. 20
Jul 15 Purchased on credit from Murthy & Co.
25 Boxes of chalks @ Rs. 50
Jul 20 Purchased one typewriter on credit from Remington Rand for Rs. 5,000
Solution
Purchases Book of Mr. Ram
Date Name and Address of the Supplier
Inward
L.F.
Details
Amount Remarks
Invoice
(Rs.)
No.
2003
July
5 Kiran & Co.
1
5,000
10 Notebooks @ Rs. 25
250
Goods purchased vide their
Bill No.. Dated
5,250
10 Rao & Sons
2
100 Gum bottles @ Rs. 25

2,500
50 Staplers @ Rs. 20
1,000
Goods purchased vide
Bill No. .. Dated .
3,500
15 Murthy & Co.
3
25 Boxes of chalks @ Rs. 50
1,250
Goods purchased vide
Bill No Dated .
July 31 Total
10,000
330
Note: Transaction on July 6th will be entered in the cash book and that on July 20th will be
journalized in the general Journal. The inward invoice numbers are imaginary.
LEDGER ACCOUNTS
Purchases Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
Jul 31
To Sundries as
per purchases
book
10,000
Kiran & Co. Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
Jul 5
By Purchases A/c
5,250
Rao & Sons Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
Jul 10
By Purchases A/c
3,500
Murthy & Co. Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2003
Jul 15
By Purchases A/c
1,250
SALES JOURNAL OR SALES BOOK
The book used to record all credit sale of goods is called sales book, sales day book or sales
journal. Only credit sale of goods dealt in or produced by the firm are recorded in the sales book.
Cash sales are recorded in the cash book and credit sale of things other than goods dealt
ACCOUNTANCY
331
in are recorded in the Journal proper. The total of the sales book shows the total credit sale of goods
during the period concerned. Usually, the sales book is totalled every month. The ruling of the sales
journal is as follows:
Proforma of Sales Book
Date
Name and Address of
Inward Invoice
L.F.
Details
Amount
Remarks
the Customer
Number
(Rs.)
1
2
3
4
5
6
7
Recording in the Sales Book
The entries in the Sales Journal are made in the following manner:
1. In the Date column, the date of credit sale is recorded.
2. In the second column, the name and address of the customer to whom goods are sold
on credit are recorded.
3. When goods are sold a bill or invoice is given to the customer. For the customer it
is an inward invoice and for the seller it is an outward invoice. Such invoices are to
be consecutively numbered and their copies filed. The number of the outward
invoices is to be entered in the third column for further reference.
4. In the fourth column, the Ledger Folio or page number of the customers account in
the ledger is to be entered while posting the transactions.
5. In the Details column, the details of the various items and the amounts, and the
amount of trade discount is written.
6. In the Amount column, the amount actually receivable by the businessman, i.e.,
catalogue price minus trade discount should be entered.
7. In the Remarks column, any other relevant information is recorded, for example, the
actual date of receipt of the bill, etc.
Ledger Posting
The total of the sales book is credited to sales account (goods account, if that is maintained).
Customers whose names appear in the sales book are debited with the amount appearing against their
names. Double entry is thus completed. The total of the debits placed in the accounts of customers
will be equal to the amount credited to the sales account.
Illustration 5.8:
From the transactions given below, prepare the sales book of Gopichand, a
furniture dealer:
2004
March 5th sold on credit to Sreeram College
10 Tables @ Rs. 500 each, 10 chairs @ Rs. 250 each at 10% Discount
March 8th sold to Mohan Brothers

5 Stools @ Rs. 100 each
10 chairs @ Rs. 300 each
332
March 10th, sold on credit to M/s Ramji & Co.
3 Tables @ Rs. 400 each
5 Chairs @ Rs. 1,000 each
March 20th, sold to M/s Ramlal & Sons for cash
5 Tables @ Rs. 500 each
March 25th, sold on credit to Anath Pal & Co. old typewriter for Rs. 1,000
Solution
Sales Book of Gopichand
Date Particulars
Inward
L.F.
Details
Amount Remarks
Invoice
(Rs.)
No.
2004
Sreeram College
March 5 10 Tables @ Rs. 500
5,000
10 Chairs @ Rs. 250
2,500
7,500
Less 10% Discount
750
Sales to Sreeram College, Invoice
No.
6,750
8 Mohan Brothers
5 Stools @ Rs. 100
500
10 Chairs @ Rs. 300
3,000
Sales as per Invoice No
3,500
10 Ramji & Co.
3 tables @ Rs. 400
1,200
5 Chairs @ Rs. 1,000
5,000
Sales as per Invoice No
6,200
March 31 Total
16,450
The Transaction on 20th March and on 25th March have not been entered in the sales book
because the transaction on 20th is a cash transaction and the transaction on 25th is other than goods
which the enterprise deals.
Ledger Accounts of Gopichand
Sales Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Mar 31 By Sundries as
per sales book
16,450
ACCOUNTANCY
333
Sreeram College Account

Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Mar 5
To Sales A/c
6,750
Mohan Brothers Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Mar 8
To Sales A/c
3,500
Ramji & Co. Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Mar 10
To Sales A/c
6,200
PURCHASES RETURNS BOOK
This book is used to record the return of goods purchased on credit. The person returning the goods
sends a debit note to the supplier informing him that he is debiting the latters account with the amount
of goods returned. This book is also known as Returns Outwards Book. This book is also used to
allowances for damages claimed in respect of goods purchased. Sometimes instead of returning the
goods to the supplier, the purchaser may retain the goods but claim some allowance (damages or
compensation) to which the supplier may agree.
DEBIT NOTE
When goods are returned to a supplier or some allowance is claimed from him, a statement
called Debit Note is sent to him. It informs him that his account is debited to the extent of the value
of goods returned or allowance claimed. The debit note also contains the name and address of the
supplier, description of the goods returned or nature of allowances claimed and reasons for the same.
The debit notes are consequently numbered and their duplicate copies carefully filed. The ruling of
the purchase returns book is as follows:
334
Date
Name and Address of
Ledger Folio
Debit
Details
Amount
Remarks
the Supplier
Note No.
(Rs.)
1
2
3
4
5
6
7
Recordings in the Purchases Returns Book
1.
The year, month and day on which the goods are returned or claim is made is entered in
the first column.
2.
The name and address of the supplier to whom goods are returned or from whom some
allowance is claimed are entered.
3.
The ledger page number of the suppliers account is to be entered in the L.F. column at
the time of posting.
4.
The serial number of debit note is to be entered in the debit note column.
5.
The details of the amount of goods returned are entered in the 5th column.
6.
The net value of the goods returned or the amount of claim made is to be entered in the
amount column.
7.
In the remarks column, any other relevant information, may be recorded.
Posting the Purchases Returns Book
The total of the returns outwards book is credited to Return Outwards Account (being the total of
goods sent out). Individual suppliers to whom goods are returned are debited because they receive
goods.
Illustration 5.9:
Prepare Purchase Returns Book from the following particulars:
2004
March 1
Returned to Prakash Bhatt 50 metres of shirt cloth @ Rs. 150
March 15
Returned to Bharath & Sons 10 Sarees @ Rs. 500
March 20
Returned to Premchand 200 metres of cloth @ Rs. 100
March 31
Returned to Ashok Brothers 100 metres of cloth @ Rs. 150
Solution
Purchases Returns Book
Date
Name and Address of the
Debit
L.F.
Details
Amount
Remarks
Supplier
Note No.
(Rs.)
(Rs.)
2004
Mar 1
Prakash Bhatt
50 m of shirt cloth @ Rs. 150
50 150
7,500
Mar 15 Bharath & Sons
10 Sarees @ Rs. 500
10 500
5,000
Mar 20 Premchand
200 m of cloth @ Rs. 100
200 100
20,000
Mar 31 Ashok Brothers
10 m of cloth @ Rs. 150

10 150
1,500
Mar 31 Total
34,000
ACCOUNTANCY
335
LEDGER ACCOUNTS
Prakash Bhatt Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Mar 1
To Returns
Outward A/c
7,500
Bharath & Sons Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Mar 15
To Returns
Outward A/c
5,000
Premchand Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Mar 20
To Returns
Outward A/c
20,000
Ashok Brothers Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Mar 31
To Returns
Outward A/c
1,500
Purchases Returns Account
Dr.
Cr.
Date
Particulars
Folio of
Amount Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Mar 31 By Sundries as
per purchases
returns book
34,000
336
SALES RETURNS BOOK
The sales returns book is used for recording goods returned by the customers. It is also used for
recording allowances granted to the customers on account of damages, breakages, short weight, etc. In
the case of purchase returns books, where a businessman may return goods
purchased owing to various reasons, similarly the customers of the businessman may return the goods
to him. They constitute Sales Returns. They are also called Returns Inwards as goods are coming in.
Likewise the allowances claimed by the customers, if agreed to by the
businessman, are recorded in the journal. The sales returns journal is also called Returns Inward
Journal or Book.
CREDIT NOTE
When a customer returns goods or is given an allowance, a credit note is prepared and sent to the
customer. It has the name and address of the customer, description of the goods received, etc. It
informs the customer that his account is credited to the extent of value of the goods returned or
allowance granted to him. The credit note is the basis for recording in the Sales Returns Book. Credit
notes are consecutively numbered and their copies filed. The ruling of the Sales Returns Book is as
shown below:
Proforma of Returns Inward Book
Date
Name and Address of
Credit Note
L.F.
Details
Amount
Remarks
the Customer
No.
(Rs.)
1
2
3
4
5
6
7
Recording in the Sales Returns Book
Enter the date of the credit note in the first column, name and address of the customer who has
returned good or to whom some allowance is granted in the second column, credit note
number in the third column, ledger page number of the customers in the L.F. column, details of the
goods returned in the details column, and net value of goods returned or amount of allowance granted
in the amount column.
Posting in the Sales Returns Book
1. Debit the Sales Returns or Inward Returns Account with the periodical total, by writing To
Sundries as per the Sales Returns Book.
2. Credit the customers account (already opened in connection with the sales) who has
returned the goods or to whom some allowance is granted by writing By Sales Returns
Account.
ACCOUNTANCY
337
Illustration 5.10:
From the following information prepare returns inward book:
2006
Feb. 1
Mr. Harish Gupta returned 200 rice bags @ Rs. 500 to us
Feb. 15
Returned by Bhupal & Co. 300 wheat bags @ Rs. 200
Feb. 28
Returned by Bhagavandas 50 tins of oil @ Rs. 1,000
Solution
Sales Returns Book
Date
Name and Address of the Customer
Credit Note
L.F.
Details
Amount
No.
(Rs. )
2006
Feb 1
Harish Gupta
200 500
1,00,000
200 bags of rice @ Rs. 500
Feb 15
Bhupal & Co.
300 bags of wheat @ Rs. 200
300 200
60,000
Feb 28
Bhagavandas
50 tins of oil @ Rs. 1000
50 1000
50,000
Total
2,10,000
LEDGER ACCOUNTS
Harish Gupta Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
Feb 1 By Sales Returns A/c
1,00,000
Bhupal & Co. Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
60,000
Bhagavandas Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
50,000
338
Sales Returns Account

Dr.
Cr.
Date
Particulars
Folio of
Amount
Date Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
Feb 28
To Sundries as per
sales returns book
2,10,000
BILLS OF EXCHANGE
Credit purchases and credit sales are very common in every business to promote sales, when a
purchaser makes the purchases on credit; he undertakes to make the payment of the goods purchased
to the seller at a future date. It is possible that the oral promise of making the payment in future may
not be fulfilled by the purchaser, so the seller of the goods asks the purchaser to give the undertaking
of future payment on a written paper known as a bill of exchange or a promissory note. In case of nonpayment by the purchaser in future, the seller can go to the court for the recovery of the amount of
goods sold on credit, because the proof of the amount due from the purchaser is in writing in the form
of a bill of exchange or a promissory note. These are also called Negotiable Instruments because the
title can be
transferred to a third party for valuable consideration. These instruments are mostly used in payment
against purchase of goods or assets and in the settlement of debts.
Definition of a Bills of Exchange
A bill of exchange has been defined by Section 5 of the Indian Negotiable instruments Act, 1881 as
an instrument in writing containing an unconditional order signed by the maker,
directing a certain person to pay a certain sum of money only to, or to the order of a certain person or
to the bearer of the instrument. There are three parties to a Bill of Exchange.
Drawer: One who draws a bill (generally a creditor)
Drawee: One on whom the bill is drawn
Payee: One who is entitled to receive the amount of the bill (generally a drawer himself, or the
endorsee).
BILLS RECEIVABLE AND BILLS PAYABLE BOOKS
If the number of acceptances received or given is large, it is better to record them in separate
subsidiary books, instead of Journalising each receipt of bill or issue of bill. For this purpose two
books known as Bills Receivable book and Bills Payable book are used. Bills receivable book is
used to record full particulars of bills receivable drawn by us and accepted by the drawees and those
endorsed to us by our debtors. Bills payable book is used for recording all bills accepted by us.
Posting.
The total of the bills receivable book shows the total amount of bills received. This
total is debited to bills receivable account. The parties from whom the bills have been received will
be credited with the amount shown against their names. The total of the bills payable books
ACCOUNTANCY
339
credited to bills payable account. The parties at whose request the bills were accepted will be
debited. If a firm maintained bills receivable and bills payable books the use of the Journal will be
much curtailed in respect of bill transactions. The ruling of bills receivable and bills payable books
are given below.
Proforma of Bills Receivable Book
S. No. Date of
From
Name
Where
Date of Term When LF Amount Remarks
Receipt Whom
and
Payable
Bill
Due
(Rs.)
Received Address
of the
Accepter
Proforma of Bills Payable Book
S. No. Date of
Name and
Name and Address Term
When LF Amount Remarks
Bill
Address of
of Payee
Due
(Rs.)
Drawer
Illustration 5.11:
From the following particulars of M/s Roy & Co., prepare the bills
receivable book and bills payable book and post them into the Ledger:
2006
Mar 1
Acceptance received from Ashok payable three months after due date for Rs. 7,500
Mar 5
Accepted Suhasinis draft for Rs. 5,000 for two months
Mar 15
Drew a bill on Yahu for Rs. 2,500 for 3 months
Mar 20
Gave Rajesh our acceptance for Rs. 6000 payable four months after date
Mar 22
Ashoks acceptance for Rs. 7,500 was retired under a rebate of Rs. 500
Mar 25
Received a bill from Nagesh for Rs. 2,000 for two months
Mar 28
Accepted bill of Patel for Rs. 5,500 for 2 months
Mar 30
Accepted Suhasinis draft for Rs. 2,000 for one month
Mar 30
Drew a bill on Yahu for Rs. 2,000 for 2 months and accepted by him payable at
Bank of India, Chennai.
Solution
Bills Receivable Book

S. No. Date
From
Name
Where
Date of Term When LF Amount Remarks
of
Whom
of
Payable
Bill
in
Due
(Rs.)
Receipt Received Accepter
Months
2006
2006
2006
1
Mar 1 Ashok
Self
Mar 1
3
Jun 4
7,500
Retired
2
Mar 15 Yahu
Self
Mar 15
3
Jun 15
2,500
3
Mar 25 Nagesh
Self
Mar 25
2
May 28
2,000
4
Mar 30 Yahu
Self
Bank of Mar 30
2
Jun 02
2,000
India,
Chennai
14,000
340
Bills Payable Book
S. No. Date
Name
Name
Term
When
LF
Amount
How
Remarks
of
of
of
Due
(Rs.)
Met
Bill
Drawer
Payee
2006
2006
1
Mar 5
Suhasini
Suhasini
2 Months May 8
5,000
2
Mar 20
Rajesh
Rajesh
4 Months Jul 23
6,000
3
Mar 28
Patel
Patel
2 Months May 31
5,500
4
Mar 30
Suhasini
Suhasini
1 Month
May 3
2,000
18,500
LEDGER ACCOUNTS
Ashok Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
Mar 1
By Bills receivable A/c
7,500
Yahu Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
Mar 15 By Bills receivable A/c
2,500
2,000
Nagesh Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
2,000
Bills Receivable Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
Mar 31
To Sundries as per
bills receivable book
14,000
ACCOUNTANCY
341
Suhasini Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
Mar 15
To Bills payable A/c
5,000
Mar 30
2,000
Patel Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
Mar 28

5,500
Rajesh Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
Mar 20
6,000
Bills Payable Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2006
Mar 31 By Sundries as per
bills payable book
18,500
JOURNAL PROPER
In addition to seven books so far discussed, the original Journal, now called Journal Proper
is also used to record all other transactions which cannot be recorded in any of the aforesaid books.
The Journal Proper is similar to the Journal in ruling and form.
Sometimes, as some transactions are not numerous, a particular sub-division of the journal may not be
maintained. For example, if the businessman is not in a habit of accepting bills payable, then he
would not maintain a bills payable book. However, if occasionally a bill is accepted, then such a
transaction has to be passed through some journal before the ledger posting is done. Thus, when any
one or more sub-divisions are not maintained by the
businessman, he would pass all such transactions in the Journal Proper.
342
Types of Transactions Recorded in Journal Proper

The following types of transactions are usually recorded through Journal proper:
Opening Entries.
An opening entry is passed in the Journal for bringing the balances of
various assets, liabilities, and capital appearing in the balance sheet of the previous accounting
period, in the books of current accounting period.
Closing Entries.
Closing entries are passed in the Journal for closing the nominal accounts
by transferring them to the trading and profit and loss account. These are needed at the end of the
accounting year, when the final accounts are prepared.
Transfer Entries.
Transfer entries are passed in the Journal for transferring an amount from
one account to another account, i.e, Transfer of total drawings from Drawings account to
Capital account.
Adjusting Entries.
Adjusting entries are passed in the Journal to bring into the books of
accounts certain unrecorded items like closing stock, depreciation on fixed assets, outstanding and
prepaid items. These are needed at the time of preparing the final accounts.
Rectification Entries.
Rectifying entries are passed in the Journal to rectify the various errors
committed while posting, totalling, balancing, etc.
Other Entries.
Those which are included in the Journal are:
(a) Capital brought in kind other than cash
(b) Purchase of assets other than stock-in-trade on credit
(c) Sale of assets other than stock-in-trade on credit

(d) Return of assets other than stock-in-trade which are sold on credit
(e) Return of assets other than stock in Trade which were bought on credit
(f) Endorsement of bills receivable to a creditor
(g) Dishonour of bills receivable (not discounted with bank)
(h) Cancellation of bills payable
(i) Abnormal loss of stock-in-trade/other assets by theft, accident, fire etc.
(j) Writing-off bad debts.
TRIAL BALANCE
We know that the fundamental principle of double entry system of Accounting is that for every debit,
there must be a corresponding credit. Thus, for every debit or a series of debits given to one or
several accounts, there is a corresponding credit or series of credits of an equal amount given to some
other account or accounts and vice versa. It follows, therefore, that the sum total of debit amounts
should equal the credit amounts of the ledger at any date. But if the various accounts in the Ledger are
balanced, then the total of all debit balances of ledger ACCOUNTANCY
343
accounts must be equal to the total of all credit balances if the books of accounts are
arithmetically accurate.
Thus, at the end of the financial year or at any other time, the balances of all the ledger accounts are
extracted and are written up in a statement known as Trial Balance and finally totalled up to see if the
total of debit balances is equal to the total of credit balances. Thus, a Trial Balance may be defined as
a statement of debit and credit totals or balances extracted from the various accounts in the Ledger
with a view to test the arithmetical accuracy of the books.
The agreement of the Trial Balance reveals that both the aspects of each transaction have been
recorded and that the books are arithmetically accurate. If the Trial Balance does not agree, it shows
that there are some errors which must be detected and rectified to prepare final accounts to ascertain
real performance and financial position of the business. It is necessary to note that even when it does
tally, it does not conclusively prove that there are no errors. Thus, though it does not disclose all the
errors, it serves the purpose of detecting certain types of errors. Thus, Trial Balance forms a
connecting link between the Ledger accounts and the final accounts.
The main objectives of preparing Trial Balance are:
1. It ensures that all transactions have been recorded with identical debit and credit
amounts and the balance of each account has been computed correctly.
2. It facilitates the preparation of the Trading, Profit and Loss accounts and the Balance Sheet of the
business by making available the balances of all the accounts at one
place.
3. It also ensures that the balances of each account, whether debit or credit, has been
transferred properly to the respective columns of the Trial Balance and that the Trial
Balance has been correctly added.
4. Some of the errors in the books of accounts can be detected by the Trial Balance and
they can be rectified before the preparation of the final accounts.
Preparation of Trial Balance
The Trial Balance is a statement and that is why no journal entries are passed to prepare it.
All the ledger accounts, whenever they appear, i.e., in one book or in many books are balanced and
included in the Trial Balance. Thus all the personal, real and nominal accounts will appear in the
Trial Balance provided they have some balance, i.e., either a debit balance or a credit balance.
Earlier, we have seen that in addition to the Cash Book (which must be regarded as cash account and
thus considered a part of the Ledger), a general ledger is maintained with all personal, real and
nominal accounts, or that the general ledger is sub-divided into debtors ledger, creditors ledger and
general ledger. A list of all accounts of customers appearing in the debtors ledger and showing debit
balances will be prepared and totalled. This total will be referred to as Sundry Debtors. Similarly,
the total of credit balances appearing in various suppliers account in the creditors ledger will be
called Sundry Creditors. Cash and Bank accounts, contained in the cash book, will be balanced and
included in Trial Balance. Other personal accounts like Capital account of the proprietor, Drawings
account and various real and 344
nominal accounts contained in the general ledger will also be balanced and included in the Trial
Balance. Thus any account, wherever it might appear, will be included in the Trial Balance, provided
it shows some balance. A Trial Balance is prepared in the following proforma:
Proforma of Trial Balance
Trial balance of ..as on ..
Serial No.
Name of Account
L.F.
Dr. Balance
Cr. Balance
(Rs.)
(Rs.)
Balance in various accounts will be shown in the appropriate column and the two amount
columns will be totalled. When the two totals tally, i.e., when the total of debit balances equals the
total of credit balances, it is proved that a debit exists for every credit and that it can reasonably be
said that the ledgers arithmetical accuracy is established. However, it does not conclusively prove
that the postings are accurate in all respects, as there are certain types of errors which could take
place in the Ledger inspite of the agreement of the Trial Balance.
Trial Balance can be prepared by the following two methods:
Total Method.
In this method, the debit and credit totals of each account are shown in the
two amount columns (one for the debit total and the other for the credit total) against it.
Balances method.
In this method, the difference of each account is extracted. If the debit
side of an account is bigger in amount than the credit side, the difference is put in the debit column of
the Trial Balance and if the credit side is bigger, the difference is put in the credit column of the Trial
Balance. Trial Balance can be prepared on a loose sheet having four
columns. Of the two methods of preparation, the second method is usually in practice because it
facilitates the preparation of the final accounts.
Limitations of Trial Balance
1. Trial Balance can be prepared only in those concerns where double entry system of
accounting is adopted.
2. Though the Trial Balance is agreed, there are certain errors which are not disclosed
by the Trial Balance. That is why Trial Balance is not a conclusive proof of the
accuracy of the books of accounts.
3. If the Trial Balance is not prepared correctly, then the final accounts prepared will
not reflect the true and fair view of the state of affairs of the business.
Illustration 5.12:
From the following ledger balances, prepare a Trial Balance as on 31st
December, 2005.
ACCOUNTANCY
345
S. No.
Name of Account
Rs.
1
Bank Account
2,000
2
Cash Account
57,000
3
Capital Account
1,50,000
4
Furniture Account
25,000
5
Motorcycle account
60,000
6
Rent Account
2,000
7
Purchases Account
85,000
8
Madhavan Account
25,000
9
Sales Account
35,000
10
Wages Account
2,000
11
Insurance Account
1,000
12
Rao & Co. Account
20,000
13
Stationery Account
1,000
14
5,000
Solution
Trial Balance of Mr. Prabhu as on 31st December, 2005
S. No.
Name of Account
Dr. (Rs.)
Cr. (Rs.)
1
Bank Account
2,000
2
Cash Account
57,000
3
Capital Account
1,50,000
4
Furniture Account
25,000
5
Motorcycle account
60,000
6
Rent Account
2,000
7
Purchases Account
85,000
8
Madhavan Account
25,000
9
Sales Account
35,000
10
Wages Account
2,000
11
Insurance Account
1,000
12
Rao & Co. Account
20,000
13
Stationery Account
1,000
14
5,000
Total
2,35,000
2,35,000
Errors
The Trial Balance sometimes does not tally because of the errors in the accounting records. The
accounting errors are the mistakes committed by the book-keeper or accountant. The agreement of a
Trial Balance is not a conclusive proof as to the absolute accuracy of the books. It only gives an
indication of the arithmetical accuracy. The Trial Balance may agree and yet there may be some
errors. Therefore the errors are classified into two types:
1. Errors not disclosed by Trial Balance and
2. Errors disclosed by Trial Balance.
346
Errors Not Disclosed by Trial Balance
1.
Omission of an entry in a subsidiary book: If an entry is completely omitted to record in a subsidiary
book both of debit and credit aspects of the transactions, Trial Balance will not be affected in any
way.
2.
A wrong entry in a subsidiary book: If a wrong amount is written in subsidiary books, then entries on
both debit and credit sides will be on the basis of the wrong amount and the
Trial Balance will naturally agree. Example, if a credit purchase of Rs. 565 is wrongly
written as Rs. 655 in the purchases book.
3.
Posting an amount on the correct side but in the wrong account: If a purchase of
Rs. 1000 from Arvind has been credited to Akash instead of Aravind, it will not affect the agreement
of the Trial Balance.
4.
Compensating errors: These errors compensate themselves in the net result, i.e. over-debits or underdebits of various accounts being neutralized by the over-credits or under-credits to the same extent of
some other accounts.
5.
Errors of principle: These errors will not affect the agreement of the Trial Balance as they arise from
the debiting or crediting of wrong heads of accounts as would be inconsistent

with the fundamental principles of double entry accounting. An error of principle takes
place in the following cases:
(a) Treating an expense as an asset
(b) Treating an asset as an expense
(c) Treating an income as a liability or vice versa.
Errors Disclosed by Trial Balance
There are a number of errors which, if committed, will lead to the disagreement of Trial
Balance. These are:
1. Wrong totalling or casting of the subsidiary books.
2. Posting of wrong amount to a Ledger account. Example, a credit sale of Rs. 5,000
to X wrongly posted to his account as Rs. 500.
3. Posting an amount to the wrong side of the Ledger Account. Suppose Rs. 100
discount allowed to a customer is wrongly posted to the credit instead of the debit
side of the discount account.
4. Wrong additions or balancing of Ledger accounts.
5. An item in the subsidiary book posted twice to a Ledger account.
6. Omission of a balance of an account in the Trial Balance.
7. Balance of some account wrongly entered in the Trial Balance.
8. Balance of some account written to the wrong side of the trial Balance.
An error in the totalling of the Trial Balance will bring the disagreement into the Trial Balance.
CASH BOOK
The cash book is a special Journal which is used for recording all cash receipts and cash payments.
In any business, there will be numerous transactions relating to cash-receipts and ACCOUNTANCY
347
payments of cash. Since cash transactions will be numerous, it is justifiable to have a separate book
to record them. Proper maintenance of cash book helps preventing theft of cash.
Generally, there will be a separate book called cash book to record cash receipts and cash payments
including payments into and withdrawals from the bank account.
Dual Role of the Cash Book
Credit purchases, credit sales and returns of goods as indicated in the previous topics are first
recorded in separate subsidiary books meant for them. A separate account is maintained in the ledger
for each of these items and postings are made with periodical totals. But this is not the case with the
cash book. The cash book unlike other subsidiary books is both a book of prime entry i.e., subsidiary
journal and a book of final entry, i.e. ledger which plays the dual role of a journal as well as a ledger.
It is a book of original entry or prime entry because cash receipts or payments are not normally
entered in any other subsidiary books. They are entered in the cash book. It is also a book of final
entry, i.e., Ledger, because cash transactions once entered in the cash book need not again be posted
to a separate cash account in the Ledger.
The cash book itself serves as both a journal and a ledger account. Thus, it plays the dual role of a
journal and a ledger, and its ruling is similar to that of a ledger account.
Kinds of Cash Books
Cash books are of various kinds. The following are the most common ones:
1. Simple cash book or single column cash book or cash book with cash column only.
2. Double column cash book or cash book with cash and discount columns.
3. Three-column cashbook or cashbook with cash, bank and discount columns.
4. Petty cash book.
Simple Cash Book or Single Column Cash Book
Simple cash book has one amount column for cash on each side. All the receipts and payments of cash
transactions will be recorded in this cash book. All cash received in the form of coins, notes,
cheques, postal orders, bank drafts and treasury notes will be recorded on the debit side and
payments on the credit side. In fact, this book is nothing but a cash account. Hence, there is no need to
open cash account in the Ledger. The format of a Simple Cash Book is given
below:
Simple Cash Book
Dr.
Cr.
Receipts
Payments
Date Particulars
VR LF
Amount Date Particulars
VR LF Amount
No.
(Rs.)
No.
(Rs.)
To (Write the name
By (Write the name
of the account to be
of the account to be
credited)
debited)
348
When cash is received, it is entered on the debit side of the cash book in the amount
column along with the name of the party paying the cash in the particulars column. Similarly, cash
paid is entered on the credit side of the cash book. When cash is received a voucher (receipt) is
generally given and when cash is paid a voucher is obtained and if it is so desired a separate column
may be provided in the cash book to record the voucher number. At regular periodic intervals,
preferably daily or weekly, cash book should be balanced like other ledger accounts and the balance
shown by it should be equal to cash in hand, if no mistake or fraud has been committed. The cash
book should always show a debit balance because total cash
payments never exceed the cash receipts and opening balance of cash.
Posting of Simple Cash Book
Opening balance appearing on the debit side of the cash book is not posted to any account in the
ledger as it comes in the cash book from the opening entry recorded in the journal proper.
The other transactions recorded on the debit side of the cash book are posted to the credit side of the
respective accounts in the ledger to complete the second aspect of the entry as the first aspect of the
transaction has been covered by giving debit to cash account in the cash book itself. Similarly, the
entries appearing on the credit side of the cash book are posted to the debit side of the respective
accounts in the ledger.
Balancing of Simple Cash Book
The cash book is balanced just like any other ledger account. It should be kept in mind that the cash
book debit side total will always be more than or atleast equal to the credit side total.
This is so because the cash payments can never exceed the amount of cash available. The cash book
therefore generally shows a debit balance, and occasionally a nil balance, but it will never show a
credit balance. The balance is entered on the credit side by writing By balance c/d.
The amount columns are then totalled. After closing the cash book the balance is shown on the debit
side by writing To balance b/d. It becomes the opening balance of cash for the next period.
Illustration 5.13:
Enter the following transactions of Mr. Ashok in simple cash book and
balance the same.
2006
Jan 1
Commenced business with cash Rs. 20,000
Jan 2
Paid into Bank Rs. 15,000
Jan 3
Purchased goods for cash Rs. 2,000
Jan 4
Sold goods for Cash Rs. 5,000

Jan 5
Paid for stationery Rs. 500
Jan 6
Received from Naresh Rs. 2,000
Jan 7
Paid to Giri Rs. 1,000
Jan 7
Purchased office furniture Rs. 2,000
ACCOUNTANCY
349
Solution
Cash Book of Mr. Ashok
Dr.
Receipts
Payments
Cr.
Date
Particulars
LF
Amount
Date
Particulars
LF
Amount
(Rs.)
(Rs.)
2006
2006
Jan 1
To Capital A/c
20,000
Jan 2
By Bank A/c
15,000
Jan 4
To Goods A/c
5,000
Jan 3
By Goods A/c
2,000
Jan 6
To Naresh A/c
2,000
Jan 5
By Stationery A/c
500
Jan 7
By Giri A/c
1,000
Jan 7
By Office furniture A/c
2,000
Jan 7
By Balance c/d
6,500
27,000
27,000
Jan 8
To Balance b/d
6,500
Cash Discount
Cash discount is a rebate or an allowance or a deduction made usually by the receiver of cash
(creditor) to the payer of cash (debtor) for prompt payment. When credit sales are made, the seller
makes an offer to the buyer that he will be prepared to grant an allowance to him if he pays the
amount on or before the due date. It is allowed only when cash is paid promptly. It, therefore, occurs
only on and along with cash receipt or payment. Hence, it is called cash discount. It is a loss to the
receiver and a gain to the payer of cash.
Cash discounts must be clearly distinguished form trade discounts. Trade discount is not
shown in the books of account, since it is deducted in the invoice itself and the net amount alone is
taken into account. The payment will be only for the net amount. But in the case of cash discount, there
is uncertainty. The debtor may make use of this facility by paying
promptly or not. Therefore, the full amount has to be recorded in the books when the sale is made.
When the buyer pays promptly this deduction is allowed and recorded in the books of accounts.
Since cash discount is allowed only when cash is received and cash discount is received
only when cash is paid. It will be convenient to record a cash discount in the cash book itself by
adding an extra amount column for discount, in addition to the existing cash column on either side of
the cash book.
Sometimes, in order to encourage early payments due from customers, a company may offer
a certain percentage of the amount as a discount. Usually cash discount is allowed to customers who
pay promptly. There will be no question of cash discount unless payment is received from the
customer. Similarly, no cash discount is received unless payment is made to suppliers. Cash discounts
accompany cash receipts from customers and payments to suppliers. Therefore, it is convenient to
record discount allowed or received along with cash receipt or cash payment. To record discount
allowed and discount received along with cash column one more amount
350
column is added on each side to record discount. Discount allowed column is maintained on debit
side to record discount allowed to customers and discount received column is maintained on credit
side to record discount received from suppliers. The cash book which contains
columns for discount in addition to cash columns is known as a double column cash book or cash
book with discount and cash columns. The ruling of the Double column cash book is as follows:
Double column cash book
Dr.
Receipts
Payments
Cr.
Date Particulars LF
Discount
Amount
Date
Particulars
LF
Discount
Amount
Allowed
(Rs.)
Received
(Rs.)
(Rs.)
(Rs.)
Recording.
All cash receipts and discounts allowed, if any, are recorded on the debit side.
All cash payments and discounts received, if any, are recorded on the credit side.
Posting.
The entries in the cash column of this cash book are posted to the respective
accounts in the ledger in the same way as in the case of simple cash book. But as regards the discount
column, the entries in the discount allowed column will be posted to the credit side of the respective
personal accounts as By discount allowed and the entries in the discount received column will be
posted to the debit side of the respective personal accounts as To discount received.
While balancing the double column cash book, only cash columns are to be balanced as
usual and discount columns are not to be balanced but are to be merely totalled. The total of discount
allowed column on the debit side of the cash book is to be posted on the debit side of the discount
allowed account in the ledger as To Sundries. Similarly, the total of the discount received column
on the credit side of the cash book is to be posted on the credit side of the discount received account
in the Ledger as By Sundries.
Illustration 5.14:
Enter the following Transactions of Mr. Praveen in Double Column Cash
Book
2006
Rs.
Jan 1
Balance of cash in hand
2,000
Jan 2
Paid to Madan (discount allowed Rs. 50)
950
Jan 3
Cash sales
1,000
Jan 4
Sale of old packing cases
50
Jan 5
Paid for duplicator
2,500
Jan 5
Withdrawn from Bank
1,000
Jan 6
Received from Mr. Arvind (in full settlement of his debt of Rs. 1,500)
1,400
Jan 6
Sale of old furniture
4,000
Jan 7
Received from Raju (discount allowed Rs. 200)
800
Jan 7
Paid wages
400
Jan 7
Received from Keerthy against debt previously written off
200
ACCOUNTANCY
351
Solution
Double Column Cash Book of Mr. Praveen
Dr.
Receipts
Payments
Cr.
Date
Particulars
LF Discount Amount Date
Particulars
LF
Discount
Amount
Allowed
(Rs.)
Received
(Rs.)
(Rs.)
(Rs.)
2006
2006
Jan 1 To Balance b/d
2,000 Jan 2 By Madan A/c
50
950
Jan 3 To Sales A/c
1,000 Jan 5 By Duplicator A/c
2,500
Jan 4 To Miscellaneous
50 Jan 7 By Wages A/c
400
Sales A/c (Sale of
old packing cases)
Jan 5 To Bank A/c
1,000
Jan 6 To Arvind A/c
100
1,400
Jan 6 To Furniture A/c
4,000
Jan 7 To Raju A/c
200
800
Jan 7 To Bad Debts A/c
200 Jan 7 By Balance c/d
6,600
(Amount received
against debt
previously written
off)
300 10,450
50
10,450
Jan 8 To Balance b/d
6,600
Note: The cash in hand Rs. 2000 on 1st Jan is not a transaction but a mere statement of fact.
It is a balance brought down from the previous period just as the balance on Jan 8th. It will be shown
on the debit side of the cash column and no further posting to any other account is necessary.
Illustration 5.15:
Record the following in a two-column cash book and post them into
Ledger
2004
Rs.
Apr 1
Cash in hand
5,000
Apr 4
Received from Krishna
980
Discount allowed
20
Apr 8
Cash Sales
1,000
Apr 12
Paid to Ramachandra
1,960
Discount received
40
Apr 15
Received from Narasimha
490
in full settlement of his account for
500
Apr 18
Purchased an old typewriter for

1,000
Apr 22
Received for cash sales
600
Apr 25
Settle the account of Venkatesh by paying the necessary amount
after receiving a discount of 5%
600
Apr 30
Paid wages to employees
600
352
Solution
Cash Book with Discount and Cash Columns
Dr.
Receipts
Payments
Cr.
Date
Particulars
LF Discount Amount Date
Particulars
LF Discount Amount
Allowed
(Rs.)
Received
(Rs.)
(Rs.)
(Rs.)
2004
2004
Apr 1 To Balance b/d
5,000 Apr 17 By Ramachandras A/c
40
1,960
Apr 4 To Krishnas A/c
20
980 Apr 18 By Typewriters A/c
1,000
Apr 4 To Sales A/c
1,000 Apr 25 By Venkateshs A/c
30
570
Apr 15 To Narasimhas A/c
10
490 Apr 30 By Wages A/c
600
Apr 22 To Sales A/c
600 Apr 30 By Balance c/d
3,940
30
8,070
70
8,070
May 1 To Balance b/d
3,940
LEDGER ACCOUNTS
Krishnas Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Apr 4
By Cash A/c
980
Apr 4
By Discount
allowed A/c
20
Sales Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Apr 8 By Cash A/c
1,000
Apr 22 By Cash A/c
600
Narasimhas Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Apr 15 By Cash A/c
490
Apr 15 By Discount
allowed A/c
10
ACCOUNTANCY
353
Discount Allowed Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Apr 30
To Sundries as per
cash book
30
Ramachandras Account
Dr.
Cr.
Date
Particulars
Folio of Amount
Date Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Apr 12
To Cash A/c
1,960
To Discount Received A/c
40
Typewriter Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Apr 18
To Cash A/c
1,000
Venkateshs Account
Dr.
Cr.
Date
Particulars
Folio of Amount
Date Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Apr 25
To Cash A/c
570
Apr 25
To Discount A/c
30
Wages Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Apr 30
To Cash A/c
600
354
Discount Received Account
Dr.
Cr.
Date
Particulars
Folio of
Amount
Date
Particulars
Folio of
Amount
Journal
(Rs.)
Journal
(Rs.)
2004
Apr 4
By Sundries as per
Cash Book
70
THREE-COLUMN CASH BOOK
Business firms generally deposit the bulk of their funds in the current account of a bank.
Practically, there is no difference between cash in hand and cash with bank, just as cash is received
from various parties, so also are cheques received from parties. Just as cash is used for making
payments, so also are cheques issued for making payments. Thus, in a modern
business, deposits into the bank and payments through the bank are more in number than mere cash
transactions.
Bank transactions are normally recorded in the cash book along with cash transactions. In other
words, the bank account is maintained in the cash book along with a cash account. It means the
addition of an amount columns on each side of the cash book, one each of discount, cash and bank.
That is why it is called three-column or triple-column cash book. It may be noted that there are
three different types of accounts. Discount account is a nominal account, cash account is a real
account and bank account is a personal account. The proforma of a three-column cash book is given
below:
Three-column Cash Book
Dr.
Cr.
Date Particulars LF Discount Cash Bank Date Particulars LF Discount Cash Bank
Allowed
(Rs.)
(Rs.)
Received (Rs.)
(Rs.)
(Rs.)
(Rs.)
Recording, Posting and Balancing
While recoding, posting and balancing the three-column cash book, the following points are to be
noted:
All Receipts of Cash or Cheques are Recorded on the Debit Side.

If cash is received, the
amount is recorded in the cash column, and if cheque is received, the amount is recorded in a bank
column on debit side. Generally, cheques received from various parties are sent to the bank for
collection on the same day. Therefore, bank account is directly debited with the amount of the cheques
deposited. If, for any reason, a cheque is not sent to the bank on the ACCOUNTANCY
355
day of receipt, that amount should be entered on the debit side of the cash column, treating the cheque
as cash. When the cheque is sent to the bank for collection, the bank account should be debited and the
cash account credited, it then becomes a Contra Entry.
If any discount is allowed to a party (on receipt of cash or cheque), such an amount is
recorded on the debit side in the discount allowed column. The recording in the other columns like
date, particulars and folio is as mentioned earlier.
All Payments are Recorded on the Credit Side.
If cash is paid, the amount is recorded in
the cash column and if payments are made from bank account, i.e., by issuing cheques, the amount is
recorded in the bank column. Discount received, if any, at the time of making the payment to a party is
entered in the discount received column.
Contra Entry.
The Latin word Contra means the other side. If both debit and credit
aspects of a transaction are recorded in the cash book itself, such entries are called Contra Entries.
For example, when a cash is deposited into the bank account, it is recorded on the debit side in the
bank column (as the bank is the receiver), and on the credit side in the cash column (as cash goes out)
of the cash book. Similarly, when cash is withdrawn from bank
account for office use, it is recorded in the cash column on the debit side (as cash comes in) and in the
bank column on the credit side (as bank is the giver), of the cash book. It must, however, be noted that
if cash is withdrawn from bank account for personal use of the owner (drawings account), it is not a
Contra Entry. In other words, a contra entry means an entry where cash account and bank account
affected at the same time. In order to denote contra
entries the letter C (capital letter) is written in LF column on both sides. It (C) means that the
particular entry is posted on the other side (contra) of the same page of the cash book, because cash
account and bank account are maintained in the cash book only. The letter 'C' also means that the
particular entry with 'C' needs no further posting in the ledger, as the double entry is completed in the
cash book itself.

Posting
Except the Contra entries, all other entries recorded in the cash book are to be posted to their
respective ledger accounts. For posting the entries, recorded on the debit side of the cash book, credit
the account concerned by writing By Bank A/c, if the entry is in bank column, By Cash A/c, if the
entry is in the cash column. Further, if the entry is made in the discount allowed column also for any
discount allowed it is necessary to post the same by writing By Discount allowed A/c in the
concerned personal account.
For posting the entries recorded on the credit side of the cash book, debit the accounts
concerned by writing To Bank A/c if the entry is in the bank column, and To Cash A/c
if the entry is in the cash column. Further, if the entry is made in the discount received column also for
any discount received, it is necessary to post the same by writing To Discount received A/c in the
concerned personal account.
356
Balancing
The cash and bank columns are balanced separately in the usual manner, the cash account (i.e.
cash column of the cash book) always shows a debit balance. The bank account (i.e. bank
column) normally shows a debit balance. A debit balance in the bank account indicates the cash held
by the business man in the bank. Sometimes the bank account may show a credit balance indicating
overdrop. Then the closing credit balance is carried down on the debit side of the bank account for
the purpose of balancing and later brought down on the credit side as the starting balance for the next
period.
The discount columns are not balanced but merely totalled. The totals are posted to the
respective discount accounts in the ledger, i.e., the total of discount column on the debit side posted to
the debit side of the discount allowed account as To Sundries, and the total of the discount column
on the credit side is posted to the credit side of the discount received account as By Sundries.
Illustration 5.16
Prepare the three-column cash book of Mr. Agarwal from the following
particulars:
2006
Rs.
Jan 1
Agarwal had cash in hand and
1,000
Cash at Bank
10,000
Jan 2
Received cheque from Ram
920
(in full settlement of debt of Rs. 950)
Jan 2
Paid for advertising by cheque
500
Jan 3
Cash sales
5,000
Jan 3
Paid salaries and wages
1,000
Jan 4
Amount withdrawn from Bank for office use
2,000
Jan 5
Drawn cash for domestic use by Mr. Agarwal

1,000
Jan 6
Issued cheque in favour of Ashok & Sons
1,500
(discount received Rs. 50)
Jan 8
Received cheque from Mohan Brothers
3,000
(discount allowed Rs. 100)
Jan 10
Sale of machinery and payment received in cheque
2,500
Jan 12
Bank returns cheque of Mohan Brothers, dishonoured
Jan 15
New machinery purchased and cheque issued
10,000
Paid installation expenses in cash
500
Bank charges as per pass book
50
ACCOUNTANCY
357
r.
nk
500
50
630
C
Ba (Rs.)
2,000
1,500
3,000
10,000
17,050
500
Cash (Rs.)
1,000
1,000
5,500
8,000
50
100
150
(Rs.)
Discount Received
LF
C
/c
ents
/cA
A
pass
/c
/c
A
A
/c
per
Paym
A
ages W
/c
/c
A
A
as
&
Drawings
Sons
c/d
/c
Brothers
expenses)
b/d
A
&
Charges
charges
dvertising A/c
r. Agarwal
Salaries
Cash
Ashok
Mohan
Machinery
Machinery
Bank
Balance
Balance
M
yA
y Agarwal
y
Particulars
B
By
By
B
B
By
By
By
(Installation
By
(Bank
book)
By
By
of
2
3
4
5
6
12
15
15
15
15
16
book
Date
2006
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
nk
cash
Ba (Rs.)
920
630
10,000
3,000
2,500
17,050
s.)
Cash (R
1,000
5,000
2,000
8,000
5,500
Three-column
30
(Rs.)
100
130
Discount Allowed
Receipts
LF
C
/cA
/cA
b/d
c/d
b/d
/c
/c
/c
Brothers
A
A
A
Balance
Ram
Sales
Bank
Mohan
Balance
Balance
Particulars
To
To
To
To
To
To Machinery
To
To
1
2
3
4
8
10
15
16
r.
Solution
D
Date
2006
Jan
Jan
Jan
Jan
Jan
Jan
Jan
Jan
358
Illustration 5.17:
Enter the following transaction in the cash book with Discount, Cash and
Bank columns in the books of Suryam.
2005
Rs.
Apr 1
Commenced business with cash
10,000
Apr 4
Received a cheque from ABC & Co. for
850
Cheque deposited into bank on 8th Apr 2004.
Apr 9
Paid to Suhani by cheque in full settlement of his account,
received discount Rs. 100
800
Apr 10
Bought goods for cash
4,000
Apr 11
Bought office furniture and paid by cheque
1,500
Apr 13
Sold goods for cash
5,000
Apr 15
Received interest on investments
1,000
Apr 16
Sundry expenses paid in cash
300
Apr 18
Received a cheque from Suresh
2,750
Discount allowed
75
Apr 20
Drew a cheque for office use
1,200
Apr 25
Drew a cheque for personal use
500
Apr 28
Paid staff salaries by cheque
2,500
Apr 30
Paid office rent in cash
1,250
Apr 30
Paid electricity charges in cash
200
Solution
Three-column cash book of Mr. Suryam

Dr.
Receipts
Payments
Cr.
Date
Particulars
LF Discount Cash
Bank Date
Particulars
LF Discount
Cash
Bank
Allowed
(Rs.)
(Rs.)
Received
(Rs.)
(Rs.)
(Rs.)
(Rs.)
2005
2005
Apr1
To Capital A/c
10,000
Apr 8
By Bank A/c
C
850
Apr 8 To ABC & Co. A/c
850
Apr 9
By Suhani A/c
100
800
Apr 8 To Cash A/c
C
850 Apr 10 By Goods A/c
4,000
Apr 13 To Goods A/c
5,000
Apr 11 By Office Furniture A/c
1,500
Apr 15 To Interest on
1,000
Apr 16 By Sundries
300
Investment A/c
Expenses A/c
Apr 18 To Suresh A/c
75
2,750 Apr 20 By Cash A/c
C
1,200
Apr 20 To Bank A/c
C
1,200
Apr 25 By Drawings A/c
500
Apr 28 By Salaries A/c
2,500
Apr 30 By Rent A/c
1,250
Apr 30 By Electricity Charges A/c
200
Apr 30 To Balance c/d
2900 Apr 30 By Balance c/d
11,450
75
18,050 6,500
100
18,050
6,500
May 1 To Balance b/d
11,450
May 1 By Balance b/d
2,900
CASH BOOK WITH DISCOUNT AND BANK COLUMNS ONLY
In the case of certain big business houses, the practice is that all receipts of cash/cheques are sent to
the bank immediately and all payments are made through cheques only. Such business houses maintain
a cash book with bank and discount columns only. For recording petty cash payments, a petty cash
book is maintained (which will be discussed later). The recording in a two-column cash book with
bank and discount columns is same as that of a two-column cash book discussed earlier.
ACCOUNTANCY
359
Illustration 5.18:
Compile a cash book with discount and bank columns only from the
following transactions, assuming that all receipts are sent to the bank immediately and all payments
made by cheques.
2006
Rs.
Apr 1
Opened bank account with capital
10,000
Apr 10
Made cash purchases of goods
1,800
Apr 15
Sold goods for cash

1,500
Apr 20
Received cheque from Suresh & Co.
480
Discount allowed
20
Apr 21
Paid Harish & Co.
790
Discount received
10
Apr 22
Purchased office furniture
1,000
Apr 24
Robinson paid cash
1,170
Discount allowed
30
Apr 25
Issued cheque to Ahmed & Co
980
Discount received
20
Apr 27
Received for cash sales
500
Apr 28
Paid for cash purchases
400
Apr 29
Drew cheque for petty cash
300
Apr 30
Drew for personal use
200
Apr 30
Paid office rent
400
Apr 30
Paid staff salaries
1,000
Solution
Cash Book with Discount and Bank Columns
Dr.
Receipts
Payments
Cr.
Date
Particulars
LF
Discount
Bank Date
Particulars
LF
Discount
Bank
Allowed
(Rs)
Received
(Rs.)
(Rs)
(Rs.)
2006
2006
Apr 1
To Capital A/c
10,000 Apr 10
By Purchases A/c
1,800
Apr 15
To Sales A/c
1,500 Apr 21
By Harish & Co. A/c
10
790
Apr 20
To Suresh & Co. A/c
20
480 Apr 22
By Office furniture A/c
1,000
Apr 24
To Robinson A/c
30
1,170 Apr 25
By Ahmed & Co. A/c
20
980
Apr 27
To Sales A/c
500 Apr 28
By Purchases A/c
400
Apr 29
By Petty cash A/c

300
Apr 30
By Drawings A/c
200
Apr 30
By Office rent A/c
400
Apr 30
By Salaries A/c
1,000
Apr 30
By Balance c/d
6,780
50 13,650
30
13,650
May 1
To Balance b/d
6,780
Note: The students should note that the term two-column cash book is popularly used to refer to cash
book with cash and discount columns. However, in examination problems, when it is clearly stated
that all receipts are banked and all payments are made by way of cheques, it is the cash book with
bank and discount columns that must be used.
PETTY CASH BOOK
Business enterprise has to make a large number of payments like carriage, cartage, coolie hire,
postage, refreshments to customers, etc. If all these payments are entered in the main cash book, it
will become very bulky. Usually, these payments are made and recorded by the petty cashier, a person
other than the main cashier. To record all these small payments, a separate book, 360
called Petty cash book is usually maintained. All small payments to be made by cash are recorded in
the petty cash book. If all these transactions are recorded in the main cash book, their recording will
not only be inconvenient but also consume a lot of valuable time of the cashier and the posting clerk.
A petty cashier is appointed by the business to make payments of all such petty expenses. He works
under the supervision of the chief cashier, who advances money in the beginning of every
month/quarter to meet petty expenses. At the end of the
month/quarter, the petty cashier submits a statement of account of the expenses incurred by him during
the month/quarter and gets a fresh advance.
IMPREST SYSTEM
The best system of petty cash is the imprest system. According to this system, a fixed amount in the
beginning of the period is given to the petty cashier by the chief cashier. He submits his accounts at
the end of the period along with vouchers. After scrutinizing the vouchers, the chief cashier gives a
fresh advance to the petty cashier equivalent to the amount spent by him, during the period. Thus the
next period (month/quarter) is again begun with the fixed sum of money. The amount so advanced to
him is termed as Imprest or Float. Whenever payment
is made to the petty cashier, petty cash account is debited and cash book is credited. The petty cash
account shows the total petty expenses only the amount actually in the hands of the petty cashier is
deducted. This amount in hand is, of course, an asset.
Analytical or Columnar Petty Cash Book
If the petty cashier is asked to analyze the petty cash payments, it will be known as to how the money
has been spent and then the relevant accounts can be debited (instead of just one Petty expenses A/c).
The petty cashier will be given a petty cash book. It has two sides. The left hand side records receipts
of cash from the main cashier and the right hand side records payments and analysis of payments.
There will be a number of columns to record payments
for wages, cartage, postage, stationery, etc. The petty cash book is balanced periodically. The various
expenses are debited and petty cash account is credited. The petty cash account will then show
balance equal to cash in hand of the petty cashier.
Illustration 5.19:
A petty cashier received Rs. 1,000 as the petty cash for petty cash payments
on March 1st 2006. During the month his expenses were as follows. Prepare an Analytical Petty Cash
Book.
2006
Rs.
Mar 2
Paid for postage
75
Mar 5
Paid for stationery
50
Mar 8
Paid for advertisement
100
Mar 12
Paid for wages
40
Mar 16
Paid for cartage
35
Mar 20
Paid for conveyance
45
Mar 25
Paid for travelling expenses
150
Mar 27
Paid for postage
110
Mar 28
Wages to office attendant
125
Mar 30
Paid for telegrams
50
Mar 31
Sent registered notice to landlord
25
ACCOUNTANCY
361
Cr.
the
and
Remarks
L.F.
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illustration.
the
in
Ledger Account
infrequent
shown
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it,
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45
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a
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Amount
(Total) (R
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2006,
ar 1
ar 5
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Dr
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362
BANK RECONCILIATION STATEMENT
Usually many transactions relating to cash receipts and cash payments take place everyday in a
business unit. Business people maintains a Bank current account to make payments to various parties
and also to receive money from different firms or persons. By maintaining a Bank
account, the businessman can relieve himself from the botheration of receiving and making payment
through cash. Every businessman who opens a current account in the bank is usually provided a pass
book which makes a record of the businessmans transactions with the bank.
This pass book is written by the bank. The businessman also records various transactions with the
bank either in a bank account opened in the Ledger or in bank column of his columnar
cash book (already discussed). The cash book of a bank column usually shows the debit
balance. It represents the amount held in deposit with the bank. The banker also records these
transactions with his customers in his ledger. The pass book usually shows a credit balance. It
represents the amount belonging to the customer in the bank.
The cash book debit balance and the pass book credit balance should show the same
amount, because the two parties record the transactions. But practically now and then these two books
may show different balances. This will happen when both parties are not recorded the transactions at
a time, because of time gap of intimation in recording the transactions between a businessman and a
banker.
METHOD OF RECODING BANKING TRANSACTIONS
When money is deposited by the firm into a bank, the firm debits the bank account since, bank account
is a personal account, and as per accounting rule, the bank being the receiver has to be debited.
Similarly, when money is withdrawn from the bank, the firm gives credit to the bank account since
bank is the giver. On the other hand, on receipt of money from the customer (i.e. the firm), the bank
gives credit to the customer since the customers account is a personal account and he is the giver.
Similarly, on money being withdrawn by the customer, the bank debits the account of the customer
since he is the receiver.
All transactions relating to the bank, i.e. deposits or withdrawals of the money in or from the bank are
recorded by the firm in the bank column maintained on each side of the cash book.
The deposit of the money into the business bank account is recorded on the debit side of the cash book
in the bank column, while the withdrawal of money from the bank is recorded on
the credit side in the bank column of the cash book. The bank also maintains the firms account in its
books. A copy of this account is submitted to the firm from time to time. The account so submitted by
the bank to the customer is known as the bank pass book or bank statement.
The proforma of a bank pass book or bank statement is given below:
Indian Bank
Current Account
Name of the Depositor(s) ..
Address ..
A/c
No
Date
Cheque No.
Particulars
Dr.
Cr.
Dr. or. Cr. Balance
Accountant Initials
withdrawals
Deposits
ACCOUNTANCY
363
The pass book or the bank statement is submitted by the bank to the customer for his
information. When the customer receives the bank pass book or bank statement, he compares its
entries with those in the cash book. Normally, entries in the cash book should tally with those in the
pass book and the balances shown by both the books should also be the same. But in practice these
generally differ, because the transactions are not recorded at a time by both the parties in cash book
as well as in pass book.
Example, suppose a businessman received a cheque from his customer and deposited in the
bank for collection. Before sending it to the bank, he enters in the cash book and cash book balance
(Bank column) increases immediately. It may take two or three days or more for the banker to collect
the cheque and credit to the customers account in the ledger.
If the businessman compares the cash book and the pass book between these days, the cash
book shows a higher balance than the pass book. So, if the transactions are recorded in both the books
at the same time there will not be any difference in the balances showing these books.
Because the transactions do not get record simultaneously, the two books are likely to show different
amounts as their balances. Whenever these two books show different balances, it is necessary to
reconcile these different balances. To reconcile the two books the businessman prepares a statement.
This statement is the previously discussed Bank Reconciliation
Statement.
CAUSES OF DIFFERENCE BETWEEN CASH BOOK
AND PASS BOOK
The causes of disagreement between the balance shown by the cash book and the balance shown by
the pass book can be classified as follows:
Transactions that Appear in the Cash Book but not in the
Pass Book
Cheques Issued by the Firm but not Presented for Payment to the Bank by the Parties
Concerned.
As soon as a cheque is issued, it is entered on the credit side of the cash book,
but the bank makes no entry for the cheque until it is actually presented for payment. This means that if
the cheque is not presented for payment before the date of preparation of bank reconciliation
statement, the balance as per pass book will be higher than the balance shown by the cash book.
Cheques or Cash Omitted to be Banked.
A cheque received from a customer might have
been debited in the bank column of the cash book but omitted to be deposited in the bank. The balance
as per cash book will increase without any corresponding increase in the balance as per pass book.
Same will be the case of cash recorded in the bank column of the cash book but omitted to be actually
banked.
Cheques Deposited by the Businessman in his Bank Account for Collection but are not
yet Cleared (i.e., Proceeds are not yet Collected and Credited).
As the bank account is
debited, the bank balance as per cash book would increase. The banker on receipt of cheques 364
will not immediately credit the businessmans account, but will wait till the cheques deposited are
actually collected. This is a major cause for the disagreement of two books.
Errors in the Cash Book.
The following are the possible errors:
1.
Undercasting of debit sides total of the cash book will decrease the balance as per the cash book.
2.
Overcasting of debit sides total of the cash book will increase the balance as per the cash book
3.
Undercasting of credit sides total of the cash book will increase its balance.
4.
Overcasting of credit sides total of the cash book will decrease its balance.
5.
Recording of a transaction more than once, recording wrong side of the cash book, wrong
balancing, wrong carry forward, etc. are also reasons for disagreement of two books.
Transactions Appear in the Pass Book with No Entry in the
Cash Book
Interest on Overdraft and Bank Charges.
The bank usually makes charges for the
collection of outstation cheques and for the various services rendered by it to the customer/
trader. If there is an overdraft, the bank will charge interest on the overdrawn amount. As a result, the
balance as per pass book is reduced by the amount of bank charges and interest whereas balance as
per cash book may not be reduced due to lack of information of these
charges up to the date of the preparation of the bank reconciliation statement. The businessman comes
to know of this information only when he receives the pass book from the bank duly
filled up.
Interest or Dividend on Investments and Rent on Property Collected by Bank on Behalf
of the Client.
The businessman may give instructions to the banker to collect interest or
dividend on investments and rent on property. Accordingly the banker will collect and credit to
customer account and increase his balance. This may not appear in cash book because of no
information to the customer regarding these amounts. Because of this, these two books will not tally.
Insurance Premium, Subscriptions to Periodicals and Other Payments made by the Bank
on Behalf of the Client.
The businessman may give standing instructions to his banker to
make the payment of insurance premium and other payments on his behalf when they fall due and
reduce his bank balance, but balance as per cash book will not reduce because of the
omission of the entry in the cashbook for payments made by the book.
Cheques or Bills of Exchange Dishonoured.
Cheques sent to the bank for collection or bills

discounted with the bank but returned as dishonoured will have the same effect as cheques paid into
bank but not yet collected by it. Balance as per pass book will decrease as compared to balance as
per cash book because the fact of dishonour of cheque or bill has not yet been recorded in the cash
book.
ACCOUNTANCY
365
Similarly, there can be certain other reasons of disagreement of two balances, such as:
(a) Payment by customers directly into businessmans account with the banker.
(b) Wrong debit or credit given in the pass book or the cash book.
(c) Interest on current account for keeping a minimum balance credited by the bank.
(d) Bills collected by the bank on behalf of the customers.
PREPARATION OF BANK RECONCILIATION STATEMENT
A bank reconciliation statement is a statement reconciling the balance as shown by the bank pass book
and the balance as shown by the cash book. The objective of preparing such a
statement is to know the causes of differences between the two balances and pass necessary
correcting or adjusting entries in the books of the firm. The bank reconciliation statement is prepared
at the end of a period, i.e., a quarter, a half year or year as may be found convenient and necessary by
the firm taking into account the number of transactions involved.
Procedure for Preparation of Bank Reconciliation Statement
The cash book should be completed and the balance as per the bank column should be found
out on a particular date for which reconciliation statement has to be prepared. Further,
1. The bank should be requested to complete and send to the firm the bank pass book.
2. The balance as shown by any book (i.e., the cash book or the bank pass book) should
be taken as the base. This is as a matter of fact the starting point for determining the
balance as shown by the other book after making suitable adjustments taking into
account the causes of difference.
3. The effect of the particular cause of difference should be studied on the balance
shown by the other book.
4. In case the cause has resulted in an increase in the balance shown by the other book,
the amount of such increase should be added to the balance as per the former book
which has been taken as the base.
5. In case the cause has resulted in decrease in balance shown by the other book, the
amount of such decrease should be subtracted from the balance as per the former
book which has been taken as the base.
Illustration 5.20:
From the following particulars, prepare a bank reconciliation statement as
on 31st December, 2005
1. Balance as per cash book Rs. 11,600
2. Cheques issued but not presented for payment Rs. 4,000
3. Cheques sent for collection but not collected up to 31st December, 2005 Rs. 3,000
4. The bank had wrongly debited the account of the firm by Rs. 400 which was rectified
by them after 31st December, 2005
5. Balance as per pass book is Rs. 12,200
366
Solution
There is a difference of Rs. 600 between the balance as shown by the cash book and the balance as
shown by the bank pass book. A reconciliation statement can be prepared to reconcile on the
following basis the balances shown by the two books:
1. The balance as shown by the cash book will be taken as the starting point.
2. The cheques issued but not presented for payment have not been recorded in the bank
pass book. The balance as per pass book has to be found out. The bank has not yet
passed the entry for the payment of these cheques since they have not been presented
for payment. The balance, therefore, in the pass book should be more. The amount
of Rs. 4,000 should, therefore, be added to the balance as shown by the cash book.
3. Cheques sent for collection but not yet collected must have been entered in the cash
book but not credited by the bank to the firms account since they have not yet been
collected. The balance in the pass book should, therefore, be less as compared to the
cash book. The amount of Rs. 3,000 should, therefore, be deducted from the balance
shown by the cash book.
4. The bank has wrongly debited the firms account. This must have resulted in reducing
balance as per the bank pass book. The amount should, therefore, be deducted from
the balance shown by the cash book.
The bank reconciliation statement will appear as follows:
Bank Reconciliation Statement as on 31st December, 2005
Particulars
Rs.
Rs.
Balance as per cash book
11,600
Add: Cheques issued but not presented for payment
4,000
4,000
15,600
Less: Cheques sent for collection but not yet collected
3,000
Amount wrongly debited by bank
400
3,400
Balance as per pass book
12,200
Illustration 5.21:
From the following particulars, prepare a bank reconciliation statement
showing the balance as per cash book as on 31st March, 2004.
1. Cheques amounting to Rs. 10,000 paid into bank on 25th March, out of which
Rs. 4000 appears to have been credited in the pass book in the month of April, 2004.
2. Cheques had been issued for Rs. 15,000, out of which only Rs. 7,000 have been
encashed before the date.
3. Bankers have given a wrong credit to the firms account Rs. 2,000.
4. Bank charges entered in pass book, but no entry appears in cash book Rs. 500.
5. Pass book shows a credit of Rs. 1,500 towards interest on investments collected by
bank.
6. The bank balance as per pass book showed Rs. 18,000.
ACCOUNTANCY
367
Solution
Bank Reconciliation Statement as on 31st December, 2004
Particulars
Rs.
Rs.
Balance as per pass book
18,000
Add: Cheques paid into bank but not credited by bank
4,000
Bank charges appears in pass book but no entry in cash book
500
4,500
22,500
Less: Cheques issued but not cashed
8,000
Wrong credit given by bank
2,000
Interest on investments collected and credited by bank but no
adjustment is made in cash book
1,500
11,500
11,000
Illustration 5.22:
On 31st March, 2004 the cash book of a firm showed a bank balance of
Rs. 6,000. From the following information prepare a bank reconciliation statement, showing the
balance as per pass book:
1. Cheques worth of Rs. 1,000 were deposited on 25th March but had not been credited
by bank. One cheque for Rs. 500 was entered in the cash book on 30th March but
was banked on 3rd April, 2004.

2. Cheques have been issued for Rs. 5,000 out of which cheques worth Rs. 2,000 only
were presented for payment.
3. Pass book showed bank charges Rs. 50 debited by bank. It also showed Rs. 500
collected by the bank as interest.
4. A cheque from Kiran for Rs. 400 was paid on 25th March but was dishonoured and
the advice was received on 2nd April, 2004.
5. One of the debtors deposited a sum of Rs. 500 in the account of the firm on 22nd
March. Intimation in this respect was received from the bank on 5th April, 2004.
Solution
Bank Reconciliation Statement as on 31st March, 2004
Particulars
Rs.
Rs.
6,000
Add: Cheques issued but not yet presented for payment (5000 2000) 3,000
Interest collected by the bank but not recorded in the cash book
500
Amount deposited by the customer directly into the bank and not
recorded in the cash book
500
4,00
10,000
Less: Cheques deposited into bank but not yet credited by the bank
1,000
Cheque entered in the cash book but was omitted to be banked up
to 31st March.
500
Bank charges entered in pass book but not in cash book
50
Cheque from Kiran paid into bank dishonoured, but not yet recorded
in cash book
400
1,950
Balance as per passbook
8,050
368
Illustration 5.23:
Prepare a bank reconciliation statement from the following particulars:
1. Credit balance as per pass book on 31st March, 2004 Rs. 20,000.
2. Cheques amounting to Rs. 3,000 were deposited for collection but cheques for
Rs. 1,500 have been credited in the pass book in April, 2004.
3. Cheques amounting to Rs. 2,000 were drawn on 28th March, 2004, out of which
cheques for Rs. 1,000 were cashed up to 31st March, 2004.
4. A wrong debit of Rs. 200 appears in the pass book.
5. Bank charges of Rs. 60 appears in the pass book but not in the cash book.
6. Interest on investments collected by the bank and credited in the pass book Rs. 600
but not entered in the cash book.
7. A cheque for Rs. 400 received from a customer was entered in the cash book in
March, 2004, but the same was omitted to be paid into bank.
Solution
Particulars
Rs.
Rs.
Credit Balance as per pass book
20,000
Add: Cheques deposited but not collected by bank before 31st March
1,500
Wrong debit given in pass book
250
Bank charges recorded only in pass book
60
Cheque received from customer was recorded in cash book but
not sent to the bank
400
2,160
22,160
Less: Cheques drawn but not cashed before the date
1,000
Interest on investments collected and credited in pass book

but not entered in cash book
600
1,600
20,560
Bank Overdraft
So far we were assuming that cash book shows a debit balance or pass book a credit balance, i.e.,
bank owes amount to the trader. But sometimes cash book may show a credit balance or pass book a
debit balance. This means that the trader owes the amount to the bank, i.e., he has drawn more amount
than his balance in the bank. Such a balance is technically known as
Bank Overdraft.
The easier method of preparing Bank reconciliation statement in case of bank overdraft is to treat
such a balance as a minus balance because balance at bank is treated as plus balance.
The rest of the items causing difference in balances disclosed by the cash book and the pass book can
be treated in the same way as we have done in case of favourable balance. Therefore, two separate
columns are prepared, one for recording plus items and the other for minus items.
If the total of minus items exceeds the total of plus items, the result is minus and is bank
ACCOUNTANCY
369
overdraft as per cash book or pass book as the case may be. On the other hand, if the total of plus
items exceeds that of minus items, the result is plus and is a balance in favour of the trader.
Illustration 5.24:
On 31st March 2004, the cash book of Mr. Suresh showed an overdraft
balance of Rs. 25,000. From the following information, prepare bank reconciliation statement and
show the balance as per pass book.
1. Two cheques of Rs. 1,500 and Rs. 3,000 were issued to Ramesh on 25th March, but
the cheque for Rs. 3,000 was cashed in the month of April, 2004
2. Out of the three cheques paid into bank for collection on 25th March, for Rs. 3,000,
Rs. 4,000 and Rs. 5,000, the cheque for Rs. 3,000 alone was collected before 31st
March, 2004.
3. There are debits of Rs. 1,000 for interest on overdraft and Rs. 500 for bank charges
in the pass book, but no entry in the cash book for these amounts.
4. A wrong credit of Rs. 500 relating to some other account was found in the pass book.
5. The pass book showed that bank had collected Rs. 2,000 as interest on government
securities but there is no entry in the cash book for this.
6. A bill receivable for Rs. 5,000 discounted with the bank in Jan 2004 was dishonoured
on 30th March, 2004 and was debited in the pass book.
Solution
Particulars
Rs.
Rs.
Overdraft as per Cash Book
25,000
Add: Cheques paid into bank but not collected before the date
(4000+5000)
9,000
Bank charges and interest on overdraft is debited in the pass book,
but no entry in the cash book (1000+500)
1,500
Bill discounted and dishonoured
5,000
15,500
40,500
Less: Cheque issued but not presented for payment
3,000
Wrong credit relating to some other account appears in pass book
500
Interest on government securities collected and credited by bank
2,000
5,500
Overdraft as per pass book
35,000
Illustration 5.25:
On 31st March, 2004 the pass book of Mr. Prakash showed a debit balance
of Rs. 35,000. Prepare a bank reconciliation statement with the following information:
1. Cheques amounting to Rs. 15,000 were drawn on 27th March, 2004, out of which
cheques for Rs. 11000 were cashed before 31st March, 2004.
2. A wrong debit of Rs. 1000 has been given by the bank in pass book.
3. A cheque for Rs. 500 was credited in pass book but was not recorded in cash book.
370
4. Cheques amounting to Rs. 20,000 were deposited for collection, but cheques for
Rs. 8,000 have been credited in pass book on 10th April, 2004.
5. A cheque for Rs. 500 returned dishonoured and were debited in pass book only.
6. Interest and bank charges amounted to Rs. 500 were not recorded in cash book.
7. A cheque for Rs. 500 debited in the cash book but it was not deposited in the bank.
Solution
Bank Reconciliation Statement of Mr. Prakash as on 31st March, 2004
Particulars
Rs.
Rs.
Debit balance (i.e. overdraft as per pass book)
35,000
Add: Cheques issued but not presented for payment (1500011000)
4,000
Cheque credited in pass book only but no entry in cash book
500
4,500
39,500
Less: Wrong debit appears in pass book only
1,000
Cheques deposited but not collected
8,000
Dishonoured cheque debited in pass book but not adjusted
in cash book
500
Interest and bank charges recorded only in pass book
500
A cheque debited in cash book but not sent to the bank

500
10,500
Overdraft as per cash book
29,000
FINAL ACCOUNTS
The main objectives of maintaining accounts are to find out the profit or loss made by the business at
the end of periodical intervals and to ascertain the financial position of the business on a given date.
After accuracy of the books of accounts are determined by means of preparing a Trial Balance, every
businessman is interested in knowing about financial performance of the business and financial
position of the business. Final accounts are prepared to ascertain profit earned or loss suffered by the
business and also to know the Assets and Liabilities of the business at the end of each financial year.
The statement prepared to know the profit or loss is known as Income Statement or Trading and
Profit and Loss Account. The other statement called Balance Sheet is prepared to know the
financial position of the business. These two statements are prepared to know the final results of the
business. The two statements together (i.e. income statement and the balance sheet) are called as final
accounts.
Final accounts convey a concise picture of profitability and financial position of the
business to the management, owners and other interested parties. These accounts summarise all the
accounting information recorded in the subsidiary books and the ledger.
CAPITAL AND REVENUE
The distinction between Capital and Revenue as regard to expenditure, payments, profits,
receipts and losses, is one of the fundamental principles of correct accounting. This distinction should
be observed for right allocation of amounts between Capital and Revenue.
ACCOUNTANCY
371
Determination of the net profit or net income of a business requires matching of expense with the
revenue. This means that first of all revenue is determined and then the expense incurred for earning
that revenue is matched with that revenue for determination of net income. We should understand
clearly the nature of different types of income and expenditure, receipts and payments before matching
revenue with expense for ascertaining the amount of profit or loss made during a particular period.
Clear distinction should be made between Capital and Revenue nature of items to post them into
Trading and Profit and Loss Account and a Balance Sheet.
All revenue items will go to the Trading and Profit and Loss Account and all Capital items to the
balance sheet. Though it is difficult to give a clear-cut rule as to the distinction between the Capital
and Revenue expenditure, distinction between Capital and Revenue expenditure may be made based
on the nature and prupose of expenditure.
CLASSIFICATION OF EXPENDITURE
The expenditure can be classified into three categories:
Capital Expenditure.
It is an expenditure, which has been incurred for the purpose of
obtaining a long-term advantage for the business. The benefit from this expenditure is not fully
consumed in one period but spread over several periods. It includes assets acquired for the purpose
of earning and not for resale, improving and extending fixed assets, increasing the earning capacity of
the business and raising capital for the business. Purchase of fixed assets, such as plant and
machinery, additions to the buildings, cost of removing the business to more spacious and better
suited premises, brokerage and commission paid for procuring long-term loans are some of the
examples of such expenditure. Such expenses are taken in the balance sheet.
Revenue Expenditure.
An expenditure incurred in the course of regular business transactions
of a concern is termed as revenue expenditure. It consists of expenditure incurred in one financial
year, the full benefit of which is consumed in that financial year. It includes purchasing assets
required for resale at a profit, or for being made into saleable goods, maintaining fixed assets in good
condition, meeting the day-to-day expenses of carrying on business. Cost of goods purchased for
resale, expenses of administration, cost incurred in manufacturing and selling the products in the
normal course of running the business,
expenditure incurred to maintain the business, e.g., money spent for repairs of existing assets or cost
of stores consumed, depreciation on fixed assets, interest on loans for the business are few examples
of revenue expenditure. Such items appear in the Trading and Profit and Loss accounts to ascertain the
profit or loss of the business by comparing its revenues and expenses during a particular period
(generally one financial year).
Deferred Revenue Expenditure.
It is an expenditure, which would be treated as revenue
expenditure, but it is not written off in one period, as its benefit is not completely exhausted in the
year in which it is incurred or is of a non-recurring and special nature and is large in amount. This
expenditure is generally spread over a number of years and proportionately
charged to the profit and loss account of each year and the balance is carried forward to subsequent
years and is shown as an asset in the balance sheet.
372
For example, an amount of Rs. 50,000 has been spent on advertisement campaign and the
benefit of this does not exhaust in the year in which it is spent. This should be spread over the
estimated years during which the benefit is to be derived. Such expenditure is called deferred
revenue expenditure. As a rule, an item falling under this heading is a fictitious asset, i.e., although, it
is shown on the assets side of the balance sheet. It is not really an asset at all but a capital or
abnormal loss, which has not been written off.
REVENUE EXPENDITURE BECOMING CAPITAL
EXPENDITURE
Some of the item pertain to revenue nature becomes capital expenditure, such as:
Repairs.
The repairs are usually a revenue charge, but if we purchase a second-hand plant
and pay for immediate repairs necessary to make it fit for our purpose, then such repairs become
capital expenditure and should be added to the plant as part of its cost.
Wages.
Wages are also revenue item, but the wages paid to workmen to erect and fit some
new machinery, or wages paid to workmen engaged in the construction of any fixed asset are capital
expenditure and must be treated as part of the cost of the asset.
Legal Expenses.
These are usually taken as revenue charge, but the legal expenses incurred
in connection with the purchase of fixed asset must be treated as part of the cost of the fixed asset.
Transport Charges.
Transport charges are generally of a revenue nature, but transport
charges incurred for a new plant and machinery are taken as expenditure of a capital nature and are
added to the cost of the asset.
Interest on Capital.
Interest on capital paid during the construction of works or buildings
or plant may be capitalized and thus added to the cost of the asset concerned.
Raw Materials and Stores.
They are usually taken as a revenue nature, but raw materials
and stores consumed in construction of the fixed assets should be treated as capital expenditure and
be taken as part of the cost of such fixed asset.
Carriage and Freight.
Such expenses in connection with the acquisition of a fixed asset are
capital expenditure.
Advertising.
The cost of special advertising undertaken for the purpose of introducing a new
product should be treated as capital expenditure as the benefit of such advertising will be available in
future also.
Preliminary or Formation Expenses.
All expenses incurred before incorporation of a
company are called preliminary or formation expenses and must be treated as capital
expenditure as the benefit of such expenses will be available in future years also.
Development Expenditure.
Some concerns such as tea and rubber plantations, horticulture,
collieries, etc. require a very long period of development before they can begin to earn income.
All such expenditure incurred during the period of development is called development
ACCOUNTANCY
373
expenditure and must be treated as capital expenditure. However, once the tea plants begin to bear
tea leaves, the expenditure incurred to maintain them will be revenue expenditure.
Expenditure incurred on advertising and preliminary expenses are generally treated as deferred
revenue expenditure. They are usually written off over a period of 3-4 years.
CLASSIFICATION OF RECEIPTS
Receipts can be classified into two categories:
Capital Receipts.
Capital receipts consist of additional payments made to the business either
by the shareholders of the company or by the properties of the business or receipts from sale of fixed
assets of the business. Example, the amount raised by the company by way of share capital is a capital
receipt. Similarly, if a firm sells its machinery for a sum of Rs. 25,000, the receipt is a capital
receipt.
Revenue Receipts.
Any receipt which is not a capital receipt is a revenue receipt. Most of
the receipts in business are revenue receipts. Revenue receipts are cash from sales, discounts
received, commission, interest on investments, transfer fees, etc. Revenue receipts are
transferred to profit and loss account and capital receipts are taken in the balance sheet.
Capital and Revenue Profit.
Capital profit is a profit made on the sale of a fixed asset or
a profit earned on getting capital for the business. For example, if the shares having an original cost of
Rs. 5,000 are sold for Rs. 6,000, the profit of Rs. 1,000 is a capital profit. Similarly, premium
received on the issue of shares and debentures is capital profit. Capital profits should not be
transferred to the profit and loss account but should be transferred to capital reserve which would
appear as a liability in the balance sheet. Revenue profit, on the other hand, is a profit made by
trading, e.g., profit on sale of goods, income from investments, discount received, commission
earned, etc. Such profits are taken to Profit and Loss Account.
Capital and Revenue Losses.
Capital losses are those which occur on selling fixed assets or
raising share capital. For example, if an original cost of equipment is Rs. 20,000 and these are sold
for Rs. 15,000, there will be a capital loss of Rs. 5,000.
If the shares of the face value of Rs. 100 are issued for Rs. 90 (i.e. at discount), the amount of
discount (Rs. 10 per share) will be a capital loss. Capital losses should not be debited to profit and
loss account but may be shown as an asset in the balance sheet. If any capital profits arise, these
losses are met against them. Revenue losses are those losses which arise during the normal course of
business, such as losses on the sale of goods. Such losses are debited to profit and loss account.
After having an idea of capital nature and revenue nature of expenses and revenues,
preparation of final accounts or financial statements, i.e. income statement and balance sheet is very
simple and easy.
TRADING AND PROFIT AND LOSS ACCOUNT
Every businessman is interested to know how much profit the firm has earned or loss suffered.
This is done by preparing an account called profit and loss account at the end of each financial 374
year, usually one year. In this account all revenue items, both income and expenses are
recorded. The net result is profit or loss. This account is usually divided into two parts. The first part
is known as Trading Account and second part is called Profit and Loss Account.
Trading Account
Trading account shows the broad results of trading or manufacturing. In trading concerns the sale
proceeds are compared with the amount paid for purchases together with the expenses
directly related to purchases. The difference between the sales and cost of goods sold is gross profit
or gross loss. In case of a manufacturing concern, the sale proceeds will be compared to the total
cost incurred in manufacturing goods. If the sale proceeds exceed the cost of manufacture, the
difference will be gross profit, but if the sales proceeds are less than the cost of manufacture, the
difference will be gross loss. The gross profit or loss as revealed by the Trading Account will be
transferred to the Profit and Loss Account. The proforma of a Trading Account is given as follows:
Trading Account of for the year ended ..
Dr.
Cr.
Particulars
Amount
Amount
Particulars
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Opening Stock
..
By Sales
..
..
To Purchases
..
..
Less: Sales Returns
..
..
Less: Purchase Returns (if any)
..
..
By Closing Stock
..
To Direct Expenses:
..
Carriage Inwards
..
Wages
Fuel and Power
Manufacturing Expenses
Coal, Water and Gas
Motive Power
Octroi Duty
Import Duty
Customs Duty
Consumable Stores
Foreman/Works Managers Salary
Royalty on Manufactured Goods
*To Gross Profit c/d
*By Gross Loss c/d
*Balancing figure will be either gross profit or gross loss.

Note: The two amount columns opened on either side of the Trading Account are referred to as inner
column and outer column respectively. The inner column is used for showing details or for additions
and subtractions, if any. The outer column is meant for showing the final figures.
ACCOUNTANCY
375
Important Points Regarding Trading Account
Stock.
Stock may be of two types: (a) Opening Stock and (b) Closing Stock.
Opening Stock means goods lying unsold at the beginning of the accounting period for which the
trading account is prepared. Opening stock consists of raw materials, work in
progress and finished goods. This should be shown on the debit side of the trading account.
Closing stock includes goods lying unsold at the end of the accounting period. Stock at the end of the
accounting year is taken after the books of accounts have been closed. The amount of closing stock
should be shown on the credit side of the trading account and as an asset in the balance sheet. The
closing stock is valued on the basis of cost or market price whichever is less principle. This
valuation is done because of the accounting convention of conservatism, according to which expected
losses are to be taken into account but not expected profits. The Journal entry for recording closing
stock is:
Closing Stock Account
Dr
To Trading Account
(Being the value of closing stock brought into account).
Purchases.
Purchases include both cash and credit purchases of goods which are for resale
purpose. Purchase returns and discounts on purchases, if any, should be deducted from
purchases and only net purchases are shown in the trading account.
The important points regarding purchases are:
(a) Goods Purchased but in transit will not affect the trading account. Goods in transit
account should be debited and suppliers account should be credited. Goods in transit
account appears as an asset and suppliers account as a liability in the Balance Sheet.
(b) Goods purchased for personal use of the proprietors should be recorded first as
ordinary purchases debiting purchases account and crediting the suppliers account.
Then it should be recorded as goods withdrawn by the proprietor for personal use.
The entry for this will be:
Drawings A/c
Dr
To Purchases A/c
(Being goods withdrawn for personal use)
(c) Sometimes invoices of goods purchased may be received in advance before the actual
receipts of such goods. In this case, neither the purchases account will be debited nor
the goods will be included in the closing stock.
(d) Any purchases made under the future transactions (i.e. goods will be delivered in
future) and goods received on consignment or on behalf of third party, should not
be included in purchases.
(e) Any assets purchased for permanent use in the business such as purchase of plant,
furniture, etc. should not include in the purchase of goods.
(f) Some business concerns prefer to adjust the opening and closing stock for comparison
purposes through purchases account. The entries for this will be:
For adjustment of Opening Stock
Purchases Account
Dr
To Opening Stock Account
376
For adjustment of Closing Stock
Closing Stock Account
Dr
To Purchases Account
After these adjustments there will be no opening stock in the Trial Balance. Adjusted purchases
account is shown on the debit side of Trading account and closing stock (having debit balance)
appears as an asset in the balance sheet.
Direct Expenses.
Direct expenses are those expenses which are directly attributable to the
purchase of goods or to bring the goods in saleable condition. These expenses are shown
separately in the Trading account on debit side. Some examples of direct expenses are given below:
Carriage, Cartage or Freight.
If these expenses are paid on purchase of goods, they
should be taken on debit side of Trading Account. If such expenses incurred on purchase of assets,
they should be capitalized by debiting to asset account and should not be taken in Trading Account.
Wages.
Wages incurred in a business is direct, when it is incurred on manufacturing or
merchandise or on making it saleable. Other wages are indirect wages. Only direct wages are debited
to trading account. Other wages are debited to the profit and loss account. If it is not mentioned
whether wages are direct or indirect, it should be assumed as direct and should be taken in Trading
Account on the debit side.
Octroi.
When goods are purchased within municipality limits, generally Octroi duty has
to be paid on it. It should be debited to Trading Account.
Fuel, Power, Lighting and Heating Expenses.
Fuel and power expenses are incurred
for running the machines. These are considered as direct expenses since directly related with the
production and debited to trading account. Lighting and heating expenses of factory is also charged to
Trading account but lighting expenses of administrative office or sales office are charged to profit and
loss account.
Import Duty and Dock Charges.
If the goods are imported from abroad, customs duty,
dock charges, etc., have to be paid. As these relate to the goods purchased, they appear on the debit
side of trading account.
Packing Charges.
There are certain types of goods which cannot be sold without a
container or proper packaging. These form a part of the finished product. One example is ink, which
cannot be sold without a bottle. This type of packing charges are debited to Trading Account. But if
these goods are packed for their safe dispatch to customers, i.e. packing meant for transportation or
fancy packing meant for advertisement will appear in the profit and loss account.
Royalties.
These are the payments made to a patentee, author or landlord for the right
to use his patent, copyrights or land. If royalty is paid on the basis of production, it is debited to
trading account and if it is paid on the basis of sales, it is debited to profit and loss account.
Manufacturing Expenses.
All expenses incurred in manufacturing the goods in the
factory, such as factory rent, factory insurance, depreciation on factory machinery, factory lighting,
etc. are debited to trading account.
ACCOUNTANCY
377
Consumable Stores.
These are incurred to keep the machine in right condition and
include engine oil, soft soap, cotton waste, oil, grease and waste consumed in a factory. The amount
of such stores consumed during the year will be shown on the debit side of trading account.
Credit Side.
Here the following entities are shown:
Sales.
The balance of the sales account, as appears in the Trial balance shows the total
sales made during the accounting year which includes both cash and credit sales. In respect of sales,
the following points must be noted:
(a) If the goods are sold but yet to be dispatched, it should not be included in sales, but the closing
stock will be increased by the cost of such goods.
(b) If any fixed assets are sold, it should not be included in sales. If the amount realized from the sale
of an asset is included in sales, such amount should be deducted from
sales.
(c) Goods sold on approval or consignment or on hire purchase, should be recorded
separately. If these are included in sales, these should be deducted.
(d) Sale of goods on behalf of others and forward sales should also be excluded from
sales.
Sales Returns.
when goods are returned by the buyers for some reasons, in the books
of account Returns Inward Account or Sales Returns Account is debited and buyer is
credited. In the Trial Balance, it appears on the debit side. The amount of sales returns should be
deducted from sales and net sales should be taken in Trading Account.
Closing Stock.
The stock which remains unsold at the end of the period is called closing
stock. In case of merchandise business, the closing stock consists of different types of finished goods.
In case of manufacturing concern, closing stock consists of raw materials, work in progress and
finished goods. Where a separate manufacturing account is prepared, closing stock consists of only
finished goods. Closing stock is an item, which is not generally available in the Trial Balance.
However, if the closing stock is adjusted against the purchases, it will appear in the trial balance,
when closing stock is shown in the Trial balance, it will not be included in the Trading Account. It is
to be shown in the balance sheet as an asset. Closing stock is valued at cost or market price
whichever is less based on convention of conservatism, i.e., expected profits should be ignored but
possible losses should be duly provided for.
Balancing of Trading Account
After recoding the above items in the respective sides of the Trading account, the balance is
calculated to ascertain gross profit or gross loss. If the total of credit side is more than that of the
debit side, the excess represents gross profit. Conversely, if the total of debit side is more than that of
the credit side, the excess represents gross loss. Gross profit is transferred to the credit side of the
profit and loss account and gross loss is transferred to the debit side of the profit and loss account.
378
Closing Entries for Trading Account
The Journal entries necessary to transfer opening stock, purchases, sales and returns to the trading
account are called closing entries, as they serve to close these accounts. These are as follows:
1. For the items of Debit side:
Trading Account
Dr
To Opening Stock Account
To Purchases Account (Net)
To Direct expenses Accounts (individually)
(Being the transfer of the above accounts to Trading A/c)
2. For the items of Credit side:
Sales Account (Net)
Dr
To Trading Account
(Being the transfer of sale account to Trading A/c)
Note: Closing stock is not the balance of any account but the value of goods remaining unsold at the
end of the year. It is brought into the books by means of an adjusting entry. Hence, there is no closing
entry for this item.
3. For gross profit:
Trading Account
Dr
To Profit and Loss Account
(Being the transfer of gross profit to Profit and Loss A/c)
4. For gross loss:

Dr
To Trading Account
(Being the transfer of gross loss to Profit and Loss A/c)
Illustration 5.26:
Prepare a Trading Account of X for the year ending 31st December,
2005 from the following particulars:
Rs.
Stock on 1st January, 2005
1,25,000
Stock on 31st December, 2005
2,35,000
Cash Purchases
1,75,000
Credit Purchases
4,00,000
Cash Sales
2,50,000
Credit Sales
6,00,000
Cost of goods sent on consignment
5,000
Returns to suppliers
12,500
Returns by customers
10,000
Goods withdrawn by X for personal use
10,000
Goods distributed as free samples during the year
2,000
Duty and Clearing Charges
25,000
ACCOUNTANCY
379
Solution
Trading Account of X for the year ended 31st December, 2005
Dr.
Cr.
Particulars
Amount
Amount Particulars
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Opening Stock
1,25,000 By Sales: Cash Sales

2,50,000
To Purchases: Cash
1,75,000
Credit Sales 6,00,000
Credit
4,00,000
8,50,000
5,75,000
Less: Returns by
Less: Returns to suppliers
12,500
customers
10,000
8,40,000
5,62,500
By Closing Stock
2,35,000
Less: Goods withdrawn for
personal use
10,000
5,52,500
Less: Goods used for
samples
2,000
5,50,500
Less: Cost of goods sent
on consignment
5,000
5,45,500
5,45,500
To Duty and Clearing
Charges
25,000
To Gross Profit c/d
3,79,500
10,75,000
10,75,000
Illustration 5.27:
From the following information, prepare the Trading Account for the year
ending 31st March, 2006:
adjusted Purchases
Rs. 12,00,000
Sales
Rs. 13,50,000
Closing Stock
Rs. 85,000
Freight and Carriage Inwards
Rs. 10,000
Wages
Rs. 5,000
Freight and Cartage Outwards
Rs. 2,000
Solution
Trading Account for the year ended 31st March, 2006
Dr.
Cr.
Particulars
Amount
Amount
Particulars
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Adjusted Purchases
12,00,000 By Sales
13,50,000
To Freight and Carriage
Inwards
10,000
To Wages
5,000
To Gross Profit c/d
1,35,000
(Transferred to Profit and
Loss Account)
13,50,000
13,50,000
380
Note:
1. Adjusted purchases = Net Purchases + Opening Stock Closing Stock
2. Closing stock has not been shown on the credit side of Trading account since it has
already been adjusted while calculating adjusted purchases.
3. Freight and cartage outwards are indirect expenses and hence not debited to Trading
Account.
Illustration 5.28:
From the following information, prepare the Trading account for the year
ending on 31st December, 2006:
Cost of goods sold
Rs. 12,50,000
Sales
Rs. 13,25,000
Closing Stock
Rs. 75,000
Solution
Trading Account for the year ended 31st December, 2006
Dr.
Cr.
Particulars
Amount
Amount
Particulars
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Cost of goods sold
1250000
By Sales
1325000
To Gross Profit c/d
75000
(Transferred to Profit and
Loss A/c)
13,25,000
13,25,000
Notes:
Cost of goods sold = Opening Stock + Purchases + Direct Expenses Closing Stock
Closing stock has not been shown on the credit side of Trading account since it has already been
adjusted while calculating cost of goods sold.
MANUFACTURING ACCOUNT
Manufacturing account is prepared by an enterprise engaged in manufacturing activity. This account is
prepared to find out the cost of goods manufactured during an accounting period.
This account is closed by transferring its balance to the debit side of Trading Account. A general
format of a manufacturing account is shown as follows:
ACCOUNTANCY
381
Manufacturing Account of for the year ending on ..
Dr.
Cr.
Particulars
Amount Amount
Particulars
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Opening work in progress
xxxxx
By Work in progress
To Raw material consumed
(closing)
xxxxx
Opening Stock
xxxx
By Sale of scrap
xxxxx
Add: Purchase of raw
By Cost of production of
materials
xxxx
finished goods during
Add: Carriage/cartage inwards
xxxx
the period (transferred
Add: Freight inwards
xxxx
to the Trading A/c)
xxxxx
xxxx
Less: Closing stock of raw
materials
xxxx
xxxxx
To Wages (direct)
xxxx
To Factory Overheads:
Factory Lighting
xxxx
Factory Rent
xxxx
Factory Wages
xxxx
Factory Fuel and Power
xxxx
Repairs to plant
xxxx
Depreciation on plant
xxxx
Salary of Works Manager
xxxx
Stores Consumed
xxxx
xxxxx
xxxxx
xxxxx
Note: The amount of depreciation and expenses, which has been debited to
manufacturing account, shall not be debited again to Trading Account or Profit and Loss
Account.
This account is debited with all the expenses related to the manufacturing of the goods,
or production activity, or transformation of raw materials into finished goods, such as
opening stock of raw materials and work in progress, purchase of raw materials, manufacturing
wages and expenses, factory lighting and rent, depreciation of machinery and factory building, etc.,
and credited with the closing stock of work in progress and any direct revenue or
income to the factory in the form of sale of scrap. The excess of debit total over the credit total is
known as cost of production, and it will be transferred to the debit side of Trading Account.
The trading account in case of manufacturer will appear as follows:
382
Trading Account for the year ending
Dr.
Cr.
Particulars
Amount
Amount
Particulars
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Opening stock of
By Sales less returns

xxx
finished goods
xxx
By Closing stock of
To Cost of production of
finished goods
xxx
finished goods
(transferred from
Manufacturing Account)
xxx
To Purchase of finished
xxx
goods (if any)
xxx
xxx
Less: Returns
To Carriage on purchases
xxx
*To Gross profit c/d
xxx
*By Gross Loss c/d
xxx
xxx
xxx
* Only one figure of profit or loss will appear. The gross profit or loss shown by the trading account
will be taken to the profit and loss account.
Illustration 5.29:
From the following information, prepare the Manufacturing Account for
the year ending 31st March, 2006.
Work in progress (1st April, 2005)
5,000
General Expenses
2,000
Raw Materials (31st March, 2006)
75,000
Wages
25,000
Carriage Inwards
2,000
Salary of Works Manager
8,000
Freight Inwards
3,000
Power, Electricity and Water
6,000
Returns Outwards
2,500
Fuel
5,000
Sale of Scrap
2,000
Depreciation:
Work in progress (31st March, 2006) 5,000
On Plant and Machinery
10,000
Raw Material (1st April, 2005)
80,000
On Factory Building
5,000
Raw Material Purchased
50,000
Repairs & Insurance:
Factory Rent and Taxes
10,000
Plant and Machinery
5,000
Factory Building
2,000
ACCOUNTANCY
383
Solution
Manufacturing Account for the year ending 31st March, 2006

Dr.
Cr.
Particulars
Amount
Amount
Particulars
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Opening work in
By Closing work in
5,000
progress
5,000
progress
To Raw material consumed:
By Sale of scrap
2,000
Opening Stock
80,000
By Cost of production
Add: Purchases
50,000
of finished goods
Add: Carriage inwards
2,000
(Transferred to the
Add: Freight inwards
3,000
Trading A/c)
1,33,500
1,35,000
Less: Returns outwards
2,500
1,32,500
Less: Closing Stock
75,000
57,500
To Wages (direct)
25,000
To Salary of Works Manager
8,000
To Power, electricity, water
6,000
To Fuel
5,000
To Depreciation:
On plant & machinery
10,000
On factory Building
5,000
To Repairs & insurance:
On plant & machinery
5,000
On factory buildings
2,000
To Factory Rent and Taxes
10,000
To General Expenses
2,000
1,40,500
1,40,500
PROFIT AND LOSS ACCOUNT
After preparing a trading account, the next step is to prepare profit and loss account. The profit and
loss account is opened with gross profit transferred from the Trading account (or with gross loss
which will be debited to the profit and loss account). This account is prepared to ascertain the net
profit earned or net loss incurred by the business concern during an accounting period.
The trading account simply tells about the gross profit or gross loss made by a businessman on
purchasing and selling of goods. It does not take into account the other operating expenses incurred by
him during the course of running the business. There are certain items of incomes and expenses of the
business which must be taken into consideration for calculating the net profit of business. These are of
indirect nature, i.e., concerning the whole business and relating to various activities which are done
by the business for the purpose of making the goods
384
available to the consumers. Indirect expenses may be selling and distribution expenses,
management expenses, financial expenses, extraordinary losses, and expenses to maintain the assets in
working order. This account is prepared from nominal accounts and its balance is transferred to
capital account as the whole profit or loss will be that of the owner and it will increase or decrease
his capital. The specimen proforma of this account is as follows:
Profit and Loss Account for the year ended 31st December
Dr.
Cr.
Particulars
Amount Amount
Particulars
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Gross Loss b/d
xxx
By Gross profit b/d
xxx
To Selling and distribution
By Interest received
xxx
expenses:
By Discount
xxx
Advertisement
xxx
By Commission
xxx
Travellers, Salaries and
By Rent from tenants
xxx
expenses
xxx
By Income from investments
xxx
Bad debts
xxx
By Apprenticeship premium
xxx
Carriage outwards
xxx
By Interest on debentures
xxx
Bank charges
xxx
By Income from any other
Agents Commission
xxx
source
xxx
To Management expenses:
By Miscellaneous
Rent, rates & taxes
xxx
revenue receipts
xxx
Heating & Lighting
xxx
Office salaries
xxx
Printing & stationery
xxx
Postage & Telegrams
xxx
Telephone charges
xxx
Legal charges
xxx
Audit fees
xxx
Insurance
xxx
General expenses
xxx
To Depreciation &
maintenance:
xxx
To Financial expenses:
Discount allowed
xxx
Interest on capital
xxx
Interest on loans
xxx
Discount on bills
xxx
To Extraordinary expenses:
Loss by fire (not covered
by insurance)
xxx
*By Net loss (transferred
xxx
Cash defalcations
xxx
to capital A/c)
*To Net profit (transferred
to Capital A/c)
xxx
xxx
*Balancing figure will be either net profit or net loss.
ACCOUNTANCY
385
Important Points for Preparing Profit and Loss Account
Gross Profit or Gross Loss.
Gross profit or gross loss figure is brought down from the
Trading Account. There will be only one figure, i.e., either of gross profit or gross loss.
Salaries.
These include salaries paid to office, godown and warehouse staff, and should be
shown in profit and loss account. Salaries and wages are treated as unproductive and shown in profit
and loss account. If salaries are paid after deduction of income tax or provident fund then these
should be added back to the salaries in order to have gross figure of salaries to be shown in profit
and loss account.
If salaries are paid in kind by providing certain facilities to the employees such as rent-free
accommodation, meals, clothes, or any other facilities, then the value of such facilities should be
regarded as salaries.
Rent, Rates and Taxes.
These include office and warehouse rent, municipal rates and taxes.
Factory rent, rates and taxes should be debited to trading account and others to profit and loss
account. If rent is paid after deduction of some taxes, then these should be added back to the correct
amount of rent payable.

Interest.
Interest paid on loans, overdrafts and bills overdue is an expense and is taken into
the profit and loss account. Interest on capital should be shown separately on the debit side and
interest on drawings on the credit side of profit and loss account.
Commission.
Commission paid to the agents employed to sell the goods is debited and
commission received for doing the work for other firms is credited to the profit and loss account.
Depreciation.
This is an expense due to wear and tear, lapse of time and exhaustion of assets
used in business. This is loss sustained by fixed assets and should be charged to profit and loss
account.
Trade Expenses.
These are expenses of a varied nature for which it is not worthy to open
separate account. They are amalgamated under trade or general expenses. These are debited to profit
and loss account as miscellaneous business expenses.
Samples.
Samples of the goods manufactured by the business concerns are often distributed
free of charge to push up sales. Being indirect expenses, these are debited to profit and loss account.
Advertisement.
Amount spent on advertisement should be charged to profit and loss account.
If a large amount is paid under a contract covering two or three years, a proportionate part should be
charged to profit and loss account and the balance appears as an asset in the balance sheet.
Apprentice Premium.
This is the amount charged from a person to whom training is given
by the business. It is a gain and should be credited to profit and loss account. If some amount of
apprentice premium is received in advance, due adjustment must be done in order to

calculate the correct amount of income.
386
Abnormal Losses.
Some abnormal losses like loss on sale of fixed assets, cash defalcation,
stock destroyed by fire, not covered by insurance, etc., may arise during the accountancy period. Such
losses are taken as extraordinary expenses and debited to the profit and loss account.
Bad Debts.
Bad debts denotes the amount lost from debtors to whom the goods were sold
on credit. It is a loss and therefore should be debited to the profit and loss account.
The following items should not be shown in the profit and loss account:
Domestic and Household Expenses.
These expenses are not shown in the profit and loss
account, as these are personal expenses of the proprietor and should be treated as drawings.
Income Tax.
It should be treated as personal expenses of the proprietor and added to
drawings. It should not be shown as an expense in profit and loss account.
Life Insurance Premium.
Premium paid on the life policy of the proprietor should be
charged to the drawings account.
Closing Entries for Profit and Loss Account
The following Journal entries will be passed in the Journal proper for preparing the profit and loss
account.
1. For transfer of various expenses to profit and loss account:
Profit and Loss A/c

Dr
To Various expenses and losses A/c (Individually)
(Being the transfer of the above accounts to the profit and loss account)
2. For transfer of various incomes and gains to profit and loss account:
Various Incomes and Gains A/c
Dr (Individually)
To Profit and Loss A/c
(Being the transfer of above accounts to profit and loss account)
3. (a) For net profit:
Profit and Loss A/ c
Dr
To Capital A/c
(Being the transfer of net profit to Capital A/c)
(b) For net loss:
Capital A/c
Dr
(Being the transfer of net loss to Capital A/c)
Closing of Drawings Account
It has been said already that two accounts are maintained in the name of the proprietor of the business
for recording the amount of capital contributed by him and the sums withdrawn by ACCOUNTANCY
387
him for personal use. They are Capital Account and Drawings Account. At the end of each
year, the Drawings Account is closed by transfer to the Capital Account.
The entry is:

Capital Account
Dr
To Drawings Account
(Being the transfer of Drawings Account to Capital Account)
Usually, the items Capital and Drawings are given as two separate items in the Trial Balance.
In such a case, the item drawings is shown by way of deduction from Capital Account on the
liabilities side of the Balance Sheet.
Illustration 5.30:
From the following balances, prepare Profit and Loss Account for the year
ended 31st March, 2004:
Rs.
Rs.
Gross Profit
50,000
Rates and taxes
500
Bad debts
2,000
Travelling expenses
500
Fire insurance premium
1,000
Trade expenses
400
Carriage outward
2,500
Discounts (Dr)
1,000
Salaries
5,000
Apprentice premium (Cr)
2,000
Rent
5,500
Printing and stationery
400
Solution
Profit and Loss Account of M/s for the year ended 31st March, 2004
Dr.
Cr.
Particulars
Amount
Particulars
Amount
(Rs.)
(Rs.)
To Salaries
5,000
By Gross profit
50,000
To Carriage outward
2,500
By Apprentice premium
2,000
To Bad debts
2,000
To Fire insurance premium
1,000
To Rent
5,500
To Rates and taxes
500
To Travelling expenses
500
To Trade expenses
400
To Discounts
1,000
To Printing and stationery
400
To Net profit (Transferred to
Capital A/c)
33,200
52,000
52,000
Illustration 5.31:
From the following balances of Mr. Rajender, prepare the Trading
and Profit and Loss account for the year ended 31st March, 2004. Pass the necessary
closing entries.
388
Rs.
Stock at commencement
20,000
Salaries
25,000
Sundry Expenses
2,000
Rent and Taxes
3,000
Purchases
90,000
Freight Inward
2,500
Advertising
1,500
Sales
1,85,000
Discount Allowed
1,800
Discount Received
1,000
The closing stock was valued at Rs. 18,000.
Solution
Trading and Profit and Loss Account of Mr. Rajender
for the year ended 31st March, 2004
Dr.
Cr.
Particulars
Amount
Particulars
Amount
(Rs.)
(Rs.)
To Stock at commencement
20,000
By Sales
1,85,000
To Purchases
90,000
By Closing stock
18,000
To Freight inward
2,500
To Gross profit c/d
90,500
2,03,000
2,03,000
To Salaries
25,000
By Gross profit b/d
90,500
To Rent and taxes
3,000
By Discount received
1,000
To Sundry expenses
2,000
To Advertising
1,500
To Discount allowed
1,800
To Net profit
58,200
(Transferred to Capital A/c)

91,500
91,500
Closing Entries
Date
Particulars
Dr. (Rs.)
Cr. (Rs.)
2004
Mar 31
Trading Account
Dr
1,12,500
To Opening Stock A/c
20,000
To Purchases A/c
90,000
To Freight Inward A/c
2,500
(Being the transfer of the above accounts of Trading A/c)
Sales A/c
Dr
1,85,000
To Trading A/c
1,85,000
(Being the transfer of sales to Trading A/c)
(Contd.)
ACCOUNTANCY
389
Closing Entries (Contd.)
Date
Particulars
Dr. (Rs.)
Cr. (Rs.)
Profit and Loss A/c
Dr
33,300
To Salaries A/c
25,000
To Rent and Taxes A/c
3,000
To Sundry expenses A/c
2,000
To Advertising A/c
1,500
To Discount allowed A/c
1,800
(Being the transfer of the above items to Profit and
Loss A/c)
Discount received A/c
Dr
1,000
1,000
(Being the transfer of discount received to Profit and
Loss A/c)
Profit and Loss A/c
Dr
58,200
To Capital A/c
58,200
(Being the transfer of Net Profit to Capital A/c)
Illustration 5.32:
From the following ledger balances of Mr. X for the year ended 31st
March 2004, prepare Manufacturing, Trading and Profit and Loss account.
Purchase of raw materials
3,50,000
Carriage Outwards
10,000
Sales
5,40,000
Interest Paid
12,000
Opening stock of raw materials
1,20,000
Advertisement
15,000
Opening stock of finished goods
65,000
Miscellaneous Expenses
3,000
Discount (Dr)
2,500
Fuel and Coal
10,000
Carriage Inwards
10,000
Factory Power
15,000
Factory Wages
60,000
Fire Insurance
1,500
Rent and Taxes
14,000
Staff Salaries
12,000
Printing and Stationery
4,000
Electricity
3,000
Depreciation on plant and machinery
13,000
Bad Debts
5,000
Depreciation on furniture and
Closing stock of raw materials
50,000
fixtures
4,000
Closing stock of finished goods
1,50,000
390
Solution
Manufacturing Account of Mr. X for the year ended 31st March, 2004
Dr.
Cr.
Particulars
Amount
Amount
Particulars
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Raw materials
By Cost of goods
5,28,000
consumed:
manufactured (transOpening stock
1,20,000
ferred to trading
Add: Purchases
3,50,000
account)
4,70,000
Less: Closing stock
50,000 4,20,000
To Carriage inwards
10,000
To Factory wages
60,000
To Fuel and coal
10,000
To Factory power
15,000
To Depreciation on
plant & machinery
13,000
5,28,000
5,28,000
Trading and Profit and Loss Account of Mr. X for the year ended 31st March, 2004
Particulars
Amount
Particulars
Amount
(Rs.)
(Rs.)
To Opening stock of finished goods
65,000
By Sales
5,40,000
To Cost of goods manufactured
5,28,000
By Closing stock of finished

To Gross profit c/d
97,000
goods
1,50,000
6,90,000
6,90,000
To Discounts
2,500
By Gross profit b/d
97,000
To Rent and taxes
14,000
4,000
To Depreciation on furniture and
fixtures
4,000
To Carriage outwards
10,000
To Interest paid
12,000
To Advertisement
15,000
To Miscellaneous expenses
3,000
To Fire insurance
1,500
To Staff salaries
12,000
To Electricity
3,000
To Bad debts
5,000
To Net profit (transferred to
Capital a/c)
11,000
97,000
97,000
ACCOUNTANCY
391
Balance Sheet
After preparing the Profit and Loss Account, the next step is to prepare the Balance Sheet. A balance
sheet is one of the financial statements. The balance sheet is a statement prepared with a view to
measure the financial position of a business on a certain fixed date. The financial position of a
concern is indicated by its assets and liabilities on a particular date. It is called a Balance Sheet
because it is a sheet of the Balances of those Ledger accounts which have not been closed till the
preparation of the Trading and Profit and Loss Account. The excess of assets over liabilities
represent the Capital and is indicative of the financial soundness of a firm or business.
The Balance Sheet is a statement and not an account, and is prepared from Real and
Personal accounts. It has two sides. On the left hand side, the Liabilities of the business are shown,
while on the right side the Assets of the business are taken. The left hand side of balance sheet
shows how much capital was obtained from trade creditors, from banks, from bill holders and other
outside parties. The owners equity section shows the capital supplied by the owner.
Capital obtained from various sources will be invested in different economic activities of the
business to generate more revenue. A certain amount is invested in buildings, some amount in stock,
and some amount is retained as cash for the current needs of the business, and so on.
The balance sheet gives information related to
(i) The nature and value of assets
(ii) The nature and extent of liabilities
(iii) Whether the firm is solvent
(iv) Whether the firm is overtrading.
If assets exceed liabilities, the firm is solvent, i.e., able to pay its debts in full.
Grouping and Marshalling of Assets and Liabilities in the Balance Sheet
The arrangement of assets and liabilities in certain groups and in a particular order is called
Grouping and Marshalling of the Balance Sheet of a business. The term grouping means
putting together items of a similar nature under a common heading. For example, under the heading
Trade creditors the balances of the Ledger accounts of all the suppliers from whom goods have been
purchased on credit, will be shown. The term Marshalling refers to the order in which the various
assets and liabilities are shown in the balance sheet. The assets and liabilities can be shown either in
the order of liquidity or in the order of permanency.
Order of Liquidity.
When assets and liabilities are arranged according to their realisability
and payment preferences, such an order is called the liquidity order. The assets are arranged in the
order of their liquidity, i.e., the most liquid asset (e.g. cash in hand) shown first. The least liquid asset
(e.g. goodwill) is shown last. The least liquid asset does not mean an asset which cannot be
encashed.
The liabilities are arranged in the order of their urgency of payment, i.e., the most urgent payment to
be made (e.g. short-term creditors) is shown first, while the least urgent payment to be made (e.g.
long-term creditors) is shown last.
392
Usually, the banking and financial companies, and the sole proprietorship and the
partnership concerns prepare their balance sheet in the order of liquidity.
A general format of a balance sheet in the order of liquidity is shown below:
Balance Sheet of . as on ..
Liabilities
Amount Amount
Assets
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
Current Liabilities:
Current Assets:
Bank Overdraft
xxx
Cash in hand
xxx
Bills payable
xxx
Cash at bank
xxx
Outstanding expenses
xxx
Bills receivable
xxx
Sundry creditors
xxx
Sundry debtors (or Book
Income received in
Debts)
xxx
advance
xxx
Prepaid expenses
xxx
Long Term Liabilities:
Accrued income
xxx
Loan from banks
xxx
Closing stock
xxx
Debentures
xxx
Investments:
Fixed liabilities:
Fixed Assets:
Capital
Motor Vehicles
xxx
Opening balance
xxx
Patents & Trade Marks
xxx
Add Net profit
xxx
Furniture & fixtures
xxx
Less (Net loss)
xxx
Plant & Machinery
xxx
Less Drawings
xxx
xxx
Buildings
xxx
Land
xxx
Goodwill
xxx
xxx
xxx
Order of Permanence.
This order is exactly the reverse of the liquidity order. The assets are
arranged in the order of their permanence, i.e., the least liquid asset (e.g. goodwill) is shown first and
the most liquid asset (e.g. cash in hand) is shown last. On the liabilities side, the least urgent payment
to be made (e.g. owners) is shown first and the most urgent payment to be
made (e.g. short-term creditors) is shown last. This order is followed in case of joint stock
companies compulsorily but can be followed in other concerns also.
A general format of a Balance Sheet in the order of permanence is shown below:
Balance Sheet of . as on ..
Liabilities
Amount Amount
Assets
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
Capital:
Fixed assets:
Opening Balance
xxx
Goodwill
xxx
Add Net profit
xxx
Land
xxx
Less (Net loss)
xxx
Buildings
xxx
(Contd.)
ACCOUNTANCY
393
Balance Sheet of . as on .. (Contd.)
Liabilities
Amount Amount
Assets
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
Less Drawings
xxx
xxx
Plant & Machinery
xxx

Furniture & Fixtures
xxx
Loans
xxx
Investments:
Current liabilities:
Current Assets:
Income received in advance
xxx
Closing Stock
xxx
Sundry creditors
xxx
Accrued income
xxx
xxx
Prepaid expenses
xxx
Bills payable
xxx
Sundry debtors
xxx
Bank Overdraft
xxx
Bills receivable
xxx
Cash at bank
xxx
Cash in hand
xxx
xxx
xxx
Classification of Assets and Liabilities
Assets.
Assets are the property and possessions of a businessstock, land and buildings, book
debts, cash, bills receivable, etc., Depending on the nature of asset, they are classified into various
types as follows:
Fixed Assets.
Fixed assets refers to those assets which are held for the purpose of producing
goods or services and those which are not held for resale in the normal course of business.
Fixed assets may be classified as
Tangible Fixed Assets refers to those fixed assets which can be seen and touched, e.g.
land and buildings, plant and machinery, etc.
Intangible Fixed Asset refers to those fixed assets which can neither be seen nor be touched, e.g.
goodwill, patents, trade marks, etc.
Current Assets.
Current assets are those assets which are held:
1. In the form of cash, e.g. cash in hand, cash at bank, etc.

2. For their conversion into cash, e.g. stock of finished goods, debtors, bills receivables, accrued
income, etc.
3. For their consumption in the production of goods or rendering of services in the
normal course of business, e.g. stock of raw materials, work in progress, etc.
Fictitious Assets.
These assets are fictitious in nature, i.e., they are virtually non-assets.
These are either the past accumulated losses or the expenses which are incurred once in the life of a
business and are capitalized for the time being. Profit and loss account (debit balance), organizational
expenses, discount on the issue of shares and advertisement expenses capitalized for the time being
are examples of such assets.
394
Wasting Assets.
Those assets such as mines, quarries, etc. that become exhausted or reduce
in value by their working are called wasting assets.
Investments.
Investments represent an expenditure on assets to earn interest, dividend,
income, rent or other benefit, e.g. shares, debentures, bonds, investments and properties.
Contingent Assets.
It is an asset whose existence, value and ownership is dependent on the
prevalence or non-prevalence of a relevant favourable situation. Suppose a firm has filed a suit for
some specified property now in possession of someone else. If the suit is decided in the firms favour,
the firm will get the property. At the moment, it is a contingent asset.
Items to be Shown on Liabilities Side of a Balance Sheet
The credit balances of those Ledger accounts which have not been closed till the preparation of the
Trading and Profit and Loss Account are shown on the liabilities side of the Balance Sheet.
Liabilities.
Liabilities refers to the financial obligations of an enterprise other than owners
funds. Usually the following items are included in liabilities.
Long Term Liabilities.
Those liabilities which are not payable within the next
accounting period but will be payable within next five to ten years are called long term
liabilities, e.g loan from financial institutions, debentures, etc.
Fixed Liabilities.
These are the liabilities which are payable only on the termination of
business, such as capital, which is a liability to the owner.
Current Liabilities.
Those liabilities which are payable out of current assets within the
next accounting period usually year or are already due are called current liabilities. Sundry creditors,
bills payable and short-term bank overdraft are examples of such liabilities.
Contingent Liabilities.
A contingent liability is one which is not an actual liability but
which will become an actual one on the happening of some event which is uncertain. Thus,
such liabilities have two characteristics: (a) uncertainty as to whether the amount will be payable at
all, and (b) uncertainty about the amount involved. It is sufficient if the amount of such liability is
stated on the face of the Balance Sheet by way of a note unless there is a probability that a loss will
materialize. In that event it is no more a contingent liability and a specific provision should therefore
be made. Examples of such liabilities are: (a) claims against the companies not acknowledged as
debt, (b) uncalled liability on partly paid-up shares, (c) arrears of fixed cumulative dividend, (d)
estimated amounts of contracts remaining to be executed on Capital Account and not provided for, (e)
liability of a case pending in the court, and (f) bills of exchange, and guarantees given against a
particular firm or person.
Illustration 5.33:
From the following information prepare a balance sheet of Mr. Gupta as
on 31st December, 2003: (a) the order of liquidity and (b) the order of permanence:
ACCOUNTANCY
395
Plant & Machinery
50,000
20,000
Prepaid Expenses
1,000
Accrued Income
2,000
2,000
Outstanding Expenses
1,000
Bills Payable
3,000
Bills Receivable
2,000
Sundry Debtors
50,000
Investment in Shares of Y Ltd.
50,000
Bank Overdraft
10,000
Closing Stock
35,000
Long-term loan from bank
1,00,000
Building
1,00,000
Capital
2,00,000
Goodwill
50,000
Land
20,000
Net Profit
50,000
Drawings
10,000
Cash at bank
20,000
Cash in hand
5,000
Sundry Creditors
49,000
Solution
(a) Balance Sheet in the order of liquidity

Balanced Sheet of Mr. Gupta as on 31st December, 2003
Liabilities
Amount Amount
Assets
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
Current Assets:
Bank overdraft
10,000
Cash in hand
5,000
Bills payable
3,000
Cash at bank
20,000
1,000
Bills receivable
2,000
Sundry creditors
49,000
Sundry debtors
50,000
2,000
Prepaid expenses
1,000
Accrued income
2,000
Loan from bank
1,00,000
Closing stock
35,000
Capital
Investments:
Opening balance
2,00,000
Shares in Y Ltd.
50,000
Add: Net profit
50,000
Fixed Assets :
2,50,000
20,000
Less: Drawings
10,000 2,40,000
Plant & Machinery
50,000
Building
1,00,000
Land
20,000
Goodwill
50,000
4,05,000
4,05,000
(b) Balance Sheet in the order of permanence
Balance Sheet of Mr. Gupta as on 31st December, 2003
Liabilities
Amount Amount
Assets
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
Capital:
Fixed Assets:
Opening balance
2,00,000
Goodwill
50,000
Add: Net profit
50,000
Land
20,000
2,50,000
Building
1,00,000
(Contd.)
396
Balance Sheet of Mr. Gupta as on 31st December, 2003 (Contd.)
Liabilities
Amount Amount
Assets
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
Less: Drawings
10,000 2,40,000
Plant & machinery
50,000
Furniture and fixtures
20,000
Loan from bank
1,00,000
Investments:
Shares of Y; Ltd.
50,000
2,000
Current Assets:
Sundry creditors
49,000
Closing stock
35,000
1,000
Accrued income
2,000
Bills payable
3,000
Prepaid expenses
1,000
Bank overdraft
10,000
Sundry debtors
50,000
Bills receivable
2,000
Cash at bank
20,000
Cash in hand
5,000
4,05,000
4,05,000
Illustration 5.34:
From the following Trial Balance of M/s Rao & Sons, prepare the Trading
and Profit and Loss Account for the year ending 31st December, 2003 and a Balance Sheet
as on that date.
Trial Balance
Particulars
Dr. (Rs. )
Cr. (Rs.)
Opening Stock on 1st January, 2003
75,000
Motor vehicles
50,000
Fixtures & Furniture
45,000
Plant & Machinery
42,500
Land & Buildings
1,42,500
Purchases & Sales
5,00,000
6,05,000
Returns
5,000
2,500
Carriage Inwards
1,000
Carriage Outwards
2,000
Wages & Salaries
4,000
Salaries & Wages

20,000
Discounts
2,000
1,000
Commission
1,000
1,500
Interest
2,500
3,000
Rent, Rates and Taxes
3,000
Repairs
600
Insurance
3,600
Printing & Stationery
600
(Contd.)
ACCOUNTANCY
397
Trial Balance
Particulars
Dr. (Rs. )
Cr. (Rs.)
Water & Electricity
1,200
Postage & relegrams
500
Travelling expenses
1,600
Conveyance charges
1,200
Entertainment expenses
1,200
Staff welfare expenses
1000
Sales Promotion expenses
2,600
Bad Debts
1,000
Depreciation
20,000
Miscellaneous expenses
1,000
Miscellaneous income
1,500
Debtors/creditors
2,05,000
50,000
Bills receivable/payable
10,000
1,600
12% investments
50,000
Loan from bank (long term)
54,000
Cash in hand
5,000
Cash at bank
10,000
Drawings
12,500
Sales tax collected
4,000
Capital
5,00,000
12,24,100
12,24,100
Closing stock was valued at Rs. 45,000.
Solution
Trading Account of M/s Rao & Sons for the year ending 31st December, 2003
Dr.
Cr.
Particulars
Amount
Amount
Particulars
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Opening Stock
75,000
By Sales
6,05,000
To Purchases
5,00,000
Less: Returns
5,000 6,00,000
Less: Returns
2,500
4,97,500
By Closing Stock
45,000
To Carriage inwards
1,000
To Wages & Salaries
4,000
To Gross Profit (Transferred
to Profit and Loss A/c)
67,500
6,45,000
6,45,000
398
Profit and Loss Account of M/s Rao & Sons for the year ending 31st December, 2003
Dr.
Cr.
Particulars
Amount
Particulars
Amount
(Rs.)
(Rs.)
To Salaries & wages
20,000
By Gross Profit
67,500
2,000
By Discounts
1,000
To Discounts
2,000
By Commission
1,500
To Commission
1,000
By Interest
3,000
To Interest
2,500
By Miscellaneous income
1,500
To Rent, rates and taxes
3,000
To Repairs
600
To Insurance
3,600
To Printing & stationery
600
To Water & electricity
1,200
To Postage & telegrams
500
To Travelling expenses
1,600
To Conveyance charges
1,200
To Entertainment expenses
1,200
To Staff welfare expenses
1,000
To Sales promotion expenses
2,600
To Bad debts
1,000
To Depreciation
20,000
To Miscellaneous expenses
1,000
To Net profit (transferred to Capital A/c)
7,900
74,500
74,500
Balance Sheet of M/s Rao & Sons as on 31st December, 2003
Liabilities
Amount
Amount
Assets
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
Current Assets:
Creditors
50,000
Cash in hand
5,000
Bills payable
1,600
Cash at bank
10,000
Sales tax collected
4,000
Debtors
2,05,000
Loans:
Bills receivable
10,000
Loan from bank (long term)
54,000
Closing stock
45,000
Capital account
Investments:
Opening balance
5,00,000
12% investments
50,000
Add: Net profit
7,900
Fixed Assets:
5,07,900
Motor vehicles
50,000
Less: drawings
12,500
4,95,400

45,000
Plant & machinery
42,500
Land & Buildings
1,42,500
6,05,000
6,05,000
ACCOUNTANCY
399
Illustration 5.35:
From the following Trial Balance of Mr. Vivek, prepare the Manufacturing
Account, and the Trading and Profit and Loss Account, for the year ended 31st December,
2003 and the Balance Sheet as on that date:
Trial Balance as on 31st December, 2003
Particulars
Dr. (Rs.)
Cr. (Rs.)
Vivek Capital account
1,00,000
Vivek drawings account
10,000
Sundry creditors
45,000
Cash in hand
5,000
Cash at bank
60,000
Loan from bank
1,75,000
Sundry debtors
65,000
Patents
25,000
Plant and machinery
50,000
Land and buildings
1,00,000
Purchase of raw materials
50,000
Opening stock of raw materials
5,000
Opening work in progress
25,000
Opening stock of finished goods
14,000
Carriage inwards
10,000
Wages
15,000
Salary of works manager
10,000
Factory rent and taxes
5,000
Royalties paid on sales
12,000
Sales
1,50,000
Advertising
5,000
Insurance
4,000
3,000
Office expenses
2,000
Sale of scrap
10,000
Carriage outwards
2,000
Discounts
5,000
3,000
Bad debts
2,000
Bills receivables/Bills payable
3,000
4,000
4,87,000
4,87,000
The stock on 31st December was as follows:
Raw materials Rs. 5,000, Work in progress Rs. 6,000; Finished goods Rs. 25,000.
400
Solution
Manufacturing Account of Mr. Vivek for the year ending 31st December, 2003
Dr.
Cr.
Particulars
Amount Amount
Particulars
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Opening work in
By Closing work in
progress
25,000
progress
6,000
To Raw materials
By Sale of scrap
10,000
consumed
By Cost of goods manufactured (transfer to
Trading account)
99,000
Opening stock
5,000
Add: Purchases
50,000
55,000
Less: Closing stock
5,000 50,000
To Carriage inwards
10,000
To Wages
15,000
To Salary of works manager
10,000
To Factory rent and taxes
5,000
1,15,000
1,15,000
Trading Account and Profit and Loss Account of
Mr. Vivek for the year ending 31st December, 2003
Dr.
Cr.
Particulars
Amount Amount
Particulars
Amount Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Opening stock of
By Sales
1,50,000
finished goods
14,000
By Closing stock of
To Manufacturing A/c
finished goods
25,000
(cost of goods manufactured)
99,000
To Gross profit c/d
62,000
1,75,000
1,75,000
To Royalties
12,000
By Gross profit b/d
62,000
To Advertising
5,000
By Discounts
3,000
To Insurance
4,000
3,000
To Office expenses
2,000
2,000
To Discounts
5,000
To Bad debts
2,000
To Net profit c/d (transferred
to Capital Account)
30,000
65,000
65,000
ACCOUNTANCY
401
Balance Sheet of Mr. Vivek on 31-12-2003
Liabilities
Amount
Amount
Assets
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
Sundry creditors
45,000
Current Assets:
Bank loan
1,75,000
Cash in hand
5,000
Bills payable
4,000
Cash at bank
60,000
Capital:
Sundry Debtors
65,000
Opening balance
1,00,000
Bills receivable
3,000
Add: Net profit
30,000
Closing Stock:
1,30,000
Raw materials
5,000
Less: Drawings
10,000 1,20,000
Work in progress
6,000
Finished goods
25,000
36,000
Fixed assets:
Patents
25,000
Plant and machinery
50,000
Land and buildings
1,00,000
3,44,000
3,44,000
Adjustments
While preparing Trading and Profit and Loss Account the accountant must keep in mind that all
expenses and incomes for the full trading period are to be taken into consideration. This means that if
an expense has been incurred but not paid during that period, a liability for the unpaid amount should
be created before the accounts can be said to show the profit or loss.
All expenses and incomes should be adjusted properly through entries. These entries which are
passed at the end of the accounting period are called adjusting entries. The usual items of
adjustments have been discussed below:
Closing Stock.
Closing stock refers to the stock of unsold goods at the end of current
accounting period which is carried forward in the next accounting period as opening stock. The stock
of finished goods is valued at cost or net realisable value whichever is less. Its accounting treatment
will be as follows.
The adjustment entry to be passed at the end of the year:
Closing Stock A/c
Dr
To Trading A/c
(Being the value of closing stock brought into account)
(i) It will be shown on the credit side of the Trading Account.
(ii) Stock being debit balance will be shown on the assets side of the Balance Sheet as
a current asset.
If closing stock already appears in the Trial Balance, then no adjustment entry is required to be
passed since it has already been taken into account while computing the amount of adjusted
purchases or cost of good sold. Such closing stock will be shown only in the Balance Sheet and not
in the Trading Account.
402
Outstanding Expenses.
Outstanding expenses refer to those expenses which have been
incurred but not paid during the current accounting period. This happens particularly regarding those
expenses which accrue from day-to-day business but which are recorded only when they are paid.
Examples of such expenses are rent, salaries, interest, etc. In order to bring this fact into the books of
account, the following adjusting entry will be passed at the end of the year: Concerned Expenses A/c
Dr
To Outstanding Expenses A/c
(Being the outstanding expenses)
The twofold effect of the above adjustment will be as follows:
1. Outstanding expenses will be shown on the debit side of the Trading Account or
Profit and Loss Account by way of addition to the concerned expenses (e.g salaries)
based on the nature of expense (i.e. direct expense or indirect expense).
2. Again, outstanding expenses will be taken as one of the liabilities on the liabilities side of the
balance sheet. If outstanding expenses already appear in the trial balance,
then no adjusting entry is required to be passed since these expenses have already been
taken into account while computing the amount of relevant expenses. Such
outstanding expenses will be shown only in the balance sheet and not in the income
statement or profit and loss account.
Prepaid Expenses.
Prepaid expenses refer to those expenses which have been paid during the
current accounting period but the benefit of which will accrue only in the subsequent
accounting period or periods. Its accounting treatment is as follows:
Adjusting entry to be passed:
Prepaid Expenses A/c
Dr.
To Respective Expenses A/c
(Being prepaid expenses)
Two fold effect of prepaid expenses will be:
1. Prepaid expenses will be shown in the Profit and Loss Account by way of deduction
from the expenses, and
2. Prepaid expenses will be shown on the assets side of the Balance Sheet as a current
asset.
If prepaid expenses already appear in the Trial Balance, then no adjusting entry is required to be
passed since these expenses have already been excluded while computing the amount of
relevant expense. Such prepaid expenses will be shown only in the Balance Sheet and not in the
Income Statement.
Accrued Income.
Accrued income refers to that income which has been earned but not
received during the current accounting period. For example, if the business has invested Rs.
20,000 @ 5% in government securities on 1st January, 2003, but during the year Rs. 600 has been
received as interest on securities. Then Rs. 400 interest on securities earned and due for payment on
31st December, 2003, but not received, will be accrued interest for the year 2003.
ACCOUNTANCY
403
In order to bring accrued interest into books of accounts, the following adjusting entry will be passed:
Accrued Interest A/c
Dr
400
To Interest A/c
400
(Being accrued interest)
The twofold effect of accrued income will be:
1. Shown on the credit side of the Profit and Loss Account by way of addition to the
concerned income, and
2. Shown on the assets side of the Balance Sheet.
If accrued income already appears in the Trial Balance, then no adjustment is required since it has
already been taken into account while computing the amount of relevant income. Such accrued income
will be shown only in the Balance Sheet and not in the Income Statement.
Income Received in Advance.
Income received but not earned during the accounting year
is called an income received in advance. This includes certain prepayments, which the business may
receive during the course of the accounting period. In order to bring this into books of account, the
following adjusting entry will be passed for such income.
Concerned Income A/c

Dr
To Unaccrued Income A/c
or Income Received in Advance A/c
(Being income received in advance)
The twofold effect of this adjustment will be:
1. Shown on the credit side of the Profit and Loss Account by way of deduction from
the concerned income, and
2. Shown on the liabilities side of the balance sheet as a current liability.
If unaccrued income already appears in Trial Balance, then no adjusting entry is required to be passed
since it has already been excluded while computing the amount of relevant income.
Such unaccrued income will be shown only in the Balance Sheet and not in the Income
Statement.
Depreciation.
Depreciation represents that portion of the cost of a fixed asset which has been
used in the business for the purpose of earning profits. Value of Fixed assets may be reduced due to
its use, wear and tear or obsolescence. When an asset is used for earning purpose, it is necessary that
reduction due to its use, must be charged to the profit of that year in order to show correct profit or
loss and to show the asset at its correct value in the balance sheet.
Generally depreciation is charged at some percentage on the value of an asset. To bring this
depreciation into books of account, the adjusting entry is required to be passed are:
Depreciation A/c
Dr
To Respective Asset A/c
(Being depreciation charged)
404
The twofold effect of depreciation will be:

1. Depreciation is shown on the debit side of profit and loss account and
2. It is shown on the assets side by way of deduction from the value of concerned asset.
Interest on Capital.
Funds provided by the proprietor to run the business is termed as
Capital. In order to see whether the business is really earning profit or not, interest on capital at a
certain rate is provided. The interest on capital is to be brought into the books of account by passing
the following adjusting entry:
Interest on Capital A/c
Dr
To Capital A/c
(Being interest paid on capital)
The twofold effect of this adjusting entry will be:
1. Interest on Capital will be shown on the debit side of the Profit and Loss Account,
and
2. It will be shown on the liabilities side of the Balance Sheet by way of addition to
the capital.
Interest on Drawings.
Drawings denote the money withdrawn by the proprietor from the
business for his personal use. If interest on capital is allowed, it is usual practice to charge interest on
drawings of the proprietor, as drawings reduce capital. In order to bring this into books, the following
entry will be passed:
Capital A/c
Dr
To Interest on drawings A/c
(Being interest charged on drawings)
The twofold effect of interest on drawings will be:

1. Shown on the credit side of Profit and Loss Account as a separate item, and
2. Shown on the liabilities side by way of deductions from the capital.
Adjustment of Abnormal Loss of Stock.
The abnormal loss of stock is an unavoidable loss
and is usually caused by fire, theft, abnormal spoilage/leakages/pilferage, etc. The position of the
business may be:
(a) All the stock is fully insured
(b) The stock is partly insured
(c) The stock is not insured at all.
If the stock is fully insured, the whole loss (say, Rs. 10,000) will be claimed from the insurance
company. The following entry will be passed:
Insurance Company A/c
Dr
10,000
To Trading A/c
10,000
(Being loss claimed from insurance company)
ACCOUNTANCY
405
The twofold effect of this entry will be:
1. It will be shown on the credit side of the Trading Account and
2. It is shown on the assets side of the Balance Sheet.
If the stock is partly insured, the loss of stock covered by the insurance policy (say, Rs. 8,000) will
be claimed from the insurance company and the rest of the amount will be loss for the business. The
following entry will be passed:
Insurance Company A/c

Dr
8,000
Profit and Loss A/c
Dr
2,000
To Trading A/c
10,000
(Being part of the loss is covered by insurance company and the rest is transferred to
Profit and Loss Account)
1. It will be shown on the credit side of Trading Account with the value of stock and
shown on the debit side of Profit and Loss Account for that part of the stock which
is not insured, and
2. Loss of stock by fire is shown on the assets side of the Balance Sheet with the amount which is to
be released from the insurance company, i.e., that part of the loss which
is insured.
If the stock is not insured at all, the whole of the loss (say, Rs. 10,000) will be borne by the firm. The
entry for this will be:
Profit and Loss A/c
Dr 10,000
To Trading A/c
10,000
(Being whole loss is borne by the firm)
1. It is shown on the credit side of Trading Account and

2. It is shown on the debit side of the Profit and Loss Account
Bad Debts.
Bad Debt refers to a debt which became irrecoverable. In other words, it
represents the amount that was due from the customers but could not be recovered. Its
Accounting treatment will be:
Bad Debts A/c
Dr
To Debtors A/c
(Being bad debt is written off)
1. It should be shown on the debit side of Profit and Loss Account as a separate item,
and
2. Shown on the assets side by way of deduction from the debtors.
Provision for Doubtful Debts.
Sometimes, a trader finds on the last day of the accounting
year that certain debts are doubtful, i.e., the amount to be received may or may not be received.
406
It is one of the golden principles of Accounting that anticipated losses must be provided. So, the
provision for doubtful debts is generally made on the basis of some percentage (say, 10%) which is
fixed on the basis of past experience.
Suppose Sundry Debtors on 31.12.2003 are Rs. 50,000. Further bad debts are Rs. 1000;
provision of 5% is to be made on Debtors. In order to bring provision for doubtful debts of Rs. 2,450,
i.e. 5% on Rs. 49,000 (50,000 1000), the following entry will be made:
Profit and Loss A/c
Dr
2450
To Provision for doubtful debts A/c
2450
(Being the provision made for doubtful debts)
1. It will be shown on the debit side of the Profit and Loss Account or by the way of
addition to Bad Debts. (Old provision for doubtful debs at the beginning of the year
will be deducted.)
2. Provision of doubtful debts is shown on the assets side of the balance sheet by way
of deduction from Sundry Debtors (after deduction of further bad debts, if any).
Provision for Discount on Debtors.
Credit sales may be allowed by the merchant on the
condition that if the amount is paid within a certain period, he will allow a certain percentage of
discount. For example, goods worth Rs. 20,000 may be sold to X on 1st January, 2004
with the condition of 5% discount if payment is made within 40 days. On 31st January, 2004, when
accounts are to be closed, the position is that X may pay the amount of Rs. 20,000 upto 10th February
2004 and earn a discount of Rs. 1,000. For such discount, provision is made generally on the basis of
past experience and certain percentage (say, 5%) on debtors is
determined to calculate such provision. In order to incorporate such provision for discount on
debtors, an entry is made:
Profit and Loss A/c
Dr
1,000
To Provision for discount on debtors A/c
1,000
(Being the provision made for discounts on debtors)
Note: Such provision is made on debtors after deduction of further bad debts and provision for
doubtful debs, as discount is allowable to debtors who make prompt payments.
1. Such provision will be shown on the debit side of Profit and Loss Account and
2. It will be shown by way of deduction from Sundry Debtors (after deduction of
further bad debts and provision for doubtful debts) on the assets side of the Balance
Sheet.
Reserve for Discount on Creditors.
As the firm has to provide discount on debtors, similarly
the firm may have chance to receive discount on the last date of the accounting year if the payment is
made within the scheduled period. Such discount on creditors is anticipated profit and therefore
reserve for discount on creditors will be made instead of provision for discount on creditors.
Suppose on 31st December, 2003, the creditors are Rs. 20,000 and 5% reserve is to be made for
discount on creditors. In order to bring this into account, the following entry will be made:
ACCOUNTANCY
407
Reserve for discount on creditors A/c
Dr
1,000
1,000
(Being the provision made for discounts on creditors)
The twofold effect of this reserve will be:
1. It is shown on the credit side of the Profit and Loss Account, and
2. Reserve for discount on creditors is shown on the liabilities side of the Balance Sheet by way of
deduction from Sundry Creditors.
Deferred Revenue Expenditure.
The expenditure incurred in the initial stage but the benefit

of which will also be available in subsequent years is called deferred revenue expenditure. Part of
such expenditure will be written off in each year and the rest will be capitalized. The entry for this
expenditure (say advertisement Rs. 25,000 which will be spread over 5 years) will be: Profit and
Loss A/c
Dr
5,000
To Advertisement A/c
5,000
(Being part of advertisement expenditure is transferred to profit and loss account)
The twofold effect of this expenditure will be:
1. It is shown on the debit side of the Profit and Loss Account, and
2. It is shown on the assets side by way of deduction from capitalized expenditure.
Managers Commission.
Sometimes, in order to increase the profits of the concern, the
manager is given some percentage of commission on the profits of the concern. It can be given at a
certain percentage (say, 10%) on the net profits (say, Rs. 33,000) but before charging such
commission. In order to record commission payable, i.e., 10% of Rs. 33,000 or Rs. 3,300, the
Profit and Loss A/c
Dr
3,300
To Commission payable A/c
3,300
But sometimes the commission is allowed to the manager on the net profit after charging
such commission. The commission in such a case will be calculated by the following formula:
Percentage of commission
Commission payable =
esidual Profit
(100 + Rate of commission)
0
In the above case, the commission payable will be Rs. 3,000 (i.e.
33,000).
110
For Rs. 3,000, the same entry will be passed in the books as follows:
Profit and Loss A/c
Dr
3,000
To Commission Payable A/c
3,000
(Being Managers Commission charged to the Profit and Loss Account)
408
The twofold effect of this entry will be
1. Such commission will be shown on the debit side of the Profit and Loss Account,
and
2. Commission payable is shown on the liabilities side of the Balance Sheet.
Goods Sent on Sale or Approval Basis.
Sometimes, the goods are sold to the customers on
approval basis. If they approve, it will become sale. If such goods are lying with the customers on the
first day of the accounting year and can yet be returned, these should be treated as stock lying with the
customer. In such a case, two entries will be passed:
1.
Sales A/c
Dr
To Debtors A/c (With Sale Price of goods)
2.
Stock A/c
Dr
To Trading A/c (At Cost Price of goods)
The twofold effect of these entries will be:
1. It will be shown on the credit side of the Trading Account by way of deduction from
the sales at sale price and added to the closing stock at cost price, and
2. It is shown on the assets side as deduction from Sundry Debtors (Sale Price) and
stock at cost on the assets side of the Balance Sheet.
Goods in Transit.
Generally, goods in transit refer to those goods which have been purchased
but not received during the current accounting period. These goods should be treated as part of
closing stock. Its accounting treatment is:
Goods in Transit A/c
Dr
To Trading A/c
1. It is shown on the credit side of Trading account, and
2. Shown on the assets side as a current asset.
Goods Distributed as Free Samples.
Sometimes in order to promote the sale of goods, some
of the produced goods are distributed as free samples. For example, if goods worth Rs. 5,000
are distributed as free samples, then it will be an advertisement for the concern, and on the other
hand, stock will be less by such goods. In order to bring this into the books of account, the following
entry is passed:
Advertisement A/c
Dr
To Purchases A/c
1. It is deducted from the purchases, and
2. It is also shown on the debit side of the Profit and Loss Account as advertisement
expenses.
ACCOUNTANCY
409
Reserve Fund.
Reserve is created out of Profit and Loss Account and thus is an appropriation
of net profit for strengthening the financial position of the business. Suppose that Rs. 5,000
is to be transferred to the reserve fund from the net profit. The entry will be:
Profit and Loss A/c
Dr
5,000
To Reserve Fund A/c
5,000
1. It is shown on the debit side of Profit and Loss Account along with net profit in the
inner column, and
2. It is shown on the liabilities side of the Balance Sheet. If reserve fund is already
there, it will be shown by addition to the existing reserve fund on the liabilities side
of the Balance Sheet.
Hidden Adjustments.
There are certain items given in the Trial Balance and require
adjustment, though specially no adjustment is given relating to such items. For example, in the Trial
Balance, the following balances are given
Dr.
Cr.
6% loan on 1.1.2003
10,000
Interest on loan (Paid during the year)
200
Actually, Rs. 600 interest on loan should have been paid, but only Rs. 200 have been paid and the rest
of Rs. 400 is yet payable and outstanding. In order to bring this into the books of account, the
Interest on Loan A/c
Dr
400
To Loan A/c
400
(Being interest on Loan Outstanding)
1. It will be shown on the debit side of the Profit and Loss Account by way of addition
to the interest on loan, and
2. Interest on loan is shown on the liabilities side of the Balance Sheet by way of
addition to the loan account.
Those adjustments which are given clearly after the Trial Balance are known as self-evident
adjustments and adjustments hidden in the Trial Balance are called hidden adjustments.
Illustration 5.36:
From the following Ledger balances of Sreeram as on 31st March, 2003,
prepare the Trading and Profit and Loss Account and also the Balance Sheet as on 31st March, 2003.
Debit Balances:
Cash in Hand
500
Investments
10,000
Cash at Bank
2,670
Patents
7,500
Purchases
40,000
Salaries
15,000
Returns Inward
1,355
General Expenses
3,000
Wages
8,000
Insurance
1,200
Fuel and Power
5,210
Drawings
5,245
410
Carriage on sales
3,200
Sundry Debtors
13,900
Carriage on purchases
2,000
Stock (1.4.2002)
5,800
Buildings
44,000
Freehold land
50,000
Machinery
25,000
Credit Balances
Sales
1,10,780
Returns outwards
1,000
Capital
1,01,500
Sundry Creditors
21,300
Rent
9,000
Adjustments
1. Closing stock Rs. 6,000.
2. Depreciate machinery at 10% and patents at 20%.
3. Outstanding salaries for the month of March 2003 Rs. 1,500.
4. Prepaid Insurance Rs. 300.
5. Bad Debts Rs. 1,000.
6. Rent received in advance Rs. 1,000.
7. Interest on investment of Rs. 2,000 accrued.
Solution:
Trading and Profit and Loss Account of Mr. Sreeram for the year ended
31st March, 2003
Dr.
Cr.
Particulars
Amount Amount Particulars

Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Opening Stock
5,800 By Sales
1,10,780
To Purchases
40,000
Less: Sales returns
1,355
1,09,425
Less: Purchases Returns
1,000 39,000 By Closing Stock
6,000
To Wages
8,000
To Carriage on purchases
2,000
To Fuel & Power
5,210
To Gross profit c/d

55,415
1,15,425
1,15,425
To Carriage on sales
3,200 By Gross profit b/d
55,415
To Salaries
15,000
By Rent
9,000
Add: Outstanding salaries
1,500 16,500 Less: Rent received in
To General expenses
3,000
advance
1,000
8,000
To Insurance
1,200
By Accrued interest
2,000
Less: Prepaid insurance
300
900
To Depreciation on
10
machinery
25,000 100
2,500
20
Patents
7,500 100
1,500
To Bad debts
1,000
To Net Profit (transferred
to Capital Account)
36,815
65,415
65,415
ACCOUNTANCY
411
Balance Sheet of Sreeram as on 31st March, 2003
Liabilities
Amount
Amount
Assets
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
Sundry Creditors
21,300
Cash in hand
500
Outstanding Salaries
1,500
Cash at bank
2,670
Rent received in advance
1,000
Sundry debtors
13,900
Capital
1,01,500
Less: Bad debts
1,000
12,900
Less: Drawings
5,245
Closing stock
6,000
96,255
Prepaid insurance
300
Add: Net Profit
36,815
1,33,070
Buildings
44,000
Freehold land
50,000
Machinery
25,000
Less: Depreciation
2,500
22,500
Patents
7,500
Less: Depreciation
1,500
6,000
Investments
10,000
Add: Accrued interest
2,000
12,000
1,56,870
1,56,870
Illustration 5.37:
From the following Trial Balance of Mr. Viswanath, prepare Trading and
Profit and Loss Account for the year ended 30th September, 2003 and a Balance Sheet as on that date.
Amount (Dr.)
Amount (Cr.)
Drawings
6,500
Land and Buildings
1,00,000
Plant and Machinery
50,000
Furniture and Fixtures
5,000
Carriage inwards
10,000
Capital
2,00,000
Bad Debts provision
2,500
(as on 1-10-2002)
Sales
1,25,000
Discounts
4,800
500
Purchase returns
10,000
Wages
20,000
Salaries
15,000
Sales returns
1,500
Bank charges
500
Coal, gas and water
1,000
Rates and taxes
5,000
Purchases
75,000
Sundry creditors
24,500
Stock on 1-10-2002
10,000
Apprentice premium
1,000
Bills receivable
22,500
Bills payable
10,000
Sundry debtors
40,200
Trade expenses
6,500
3,73,500
3,73,500
412
The following adjustments are to be considered:
1. Depreciate machinery at 10% and land and buildings at 5%.
2. Make a provision of 10% on sundry debtors for doubtful debts.
3. Charge 10% interest on capital and interest on drawings is Rs. 1,000.
4. Carry forward the unexpired amounts for rates and taxes Rs. 500 and apprentice
premium Rs. 250.
5. The value of stock as on 30th September, 2003 was Rs. 30,500.
6. Outstanding wages are Rs. 2500 and salaries Rs. 4,000.

Solution
Trading Account of Mr. Viswanath for the year ended 30th September, 2003
Dr.
Cr.
Particulars
Amount
Amount
Particulars
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Opening Stock
10,000
By Sales
1,25,000
To Purchases
75,000
Less: Sales returns
1,500
1,23,500
Less: Purchase returns

10,000
65,000
By Closing Stock
30,500
To Carriage inwards
10,000
To Wages
20,000
Add: Outstanding wages
2,500
22,500
To Coal, gas and water
1,000
To Gross Profit c/d
45,500
1,54,000
1,54,000
Profit and Loss Account of Mr. Viswanath for the year ended 30th September, 2003
Dr.
Cr.
Particulars
Amount
Amount
Particulars
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Salaries
15,000
By Gross Profit b/d
45,500
Add: Outstanding Salaries
4,000
19,000
By Discounts
500
To Bank Charges
500
By Apprentice Premium
1,000
To Rates and Taxes
5,000
Less: Received in
advance
250
750
Less: Prepaid
500
4,500
By Interest on drawings
1,000
To Trade expenses
6,500
To Depreciation on
50,000
Machinery
10
100
5,000
Land & Buildings
1,00,000
5
100
5,000
(Contd.)
ACCOUNTANCY
413
Profit and Loss Account of Mr. Viswanath for the year ended 30th September, 2003 (Contd.) Dr.
Cr.
Particulars
Amount
Amount
Particulars
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
To Interest on Capital
2,00,000
10
100
20,000
To Discounts
4,800
To Bad Debts provision
40,200
10
100 = 4,020
Less: Old provision
2,500
1,520
By Net loss
(transferred to
Capital A/c)
19,070
66,820
66,820
Balance Sheet of Mr. Viswanath as on 30th September, 2003
Liabilities
Amount
Amount
Assets
Amount
Amount
(Rs.)
(Rs.)
(Rs.)
(Rs.)
Sundry Creditors
24,500
Bills receivable
22,500
Bills payable
10,000
Sundry Debtors
40,200
Apprentice premium received
Less: Provision for
in advance
250
Bad debts
4,020
36,180
Outstanding wages
2,500
Closing Stock
30,500
Outstanding salaries
4,000
Prepaid rates and taxes
500
Capital
2,00,000
Land and buildings
1,00,000
Less: Net Loss
19,070
Less: Depreciation
5,000
95,000
1,80,930
Plant & Machinery
50,000
Add: Interest on Capital
20,000
Less Depreciation
5,000
45,000
2,00,930
Furniture and Fixtures
5,000
Less: Drawings and Interest
on Drawings
Rs. (6,500 + 1,000)
7,500 1,93,430
2,34,680
2,34,680
FINANCIAL ANALYSIS
A financial statement is an organized collection of data according to logical and consistent accounting
procedures. Its purpose is to convey an understanding of some financial aspect of a business firm.
Thus, the term financial statements generally refers to two basic statements: 414
(i) the Income Statement, and (ii) the Balance Sheet. Income Statement (also called Profit and Loss
Account) is considered to be the most useful of all financial statements. It explains what has happened
to a business as a result of operations between two Balance Sheet dates. Balance Sheet is a statement
of financial position of a business at a specified moment of time.
Ratio Analysis
Ratio analysis is the process of determining and interpreting numerical relationships based on
financial statements. By computing ratios, it becomes easy to understand the financial position of the
firm. Ratio analysis is used to focus on financial issues such as liquidity, profitability and solvency of
a given firm.
Ratio
Ratio refers to the numerical or quantitative relationship between two variables which are
comparable. It can be expressed in terms of percentages, proportions and quotients also.
Based on their nature, the ratios can broadly be classified into:
1. Leverage or Capital Structure ratios
2. Activity ratios
3. Profitability ratios
Leverage or Capital Structure Ratios
The short-term creditors are interested in the current financial position of a firm, and they use
liquidity ratios.
The long term creditors would judge the soundness of a firm on the basis of the long term financial
strength in terms of its ability to pay the interest regularly as well as repay the instalment of the
principal on due dates, or in one lumpsum at the time of maturity.
The long term solvency of a firm can be examined by using leverage or capital structure
ratios. These may be defined as financial ratios which throw light on the long term solvency of a firm
as reflected in its ability to assure the long term creditors with regard to (a) periodic payment of
interest during the period of the credit and (b) repayment of principal on maturity or in predetermined
instalments at due dates.
These ratios are based on the relationship between borrowed funds and owners capital.
These ratios are computed from the balance sheet and have many variations such as debt-equity ratio,
debt-assets ratio, equity-assets ratio, and so on.
The second type of capital structure ratios are popularly called coverage ratios. These are calculated
from the profit and loss account. These are: (a) Interest Coverage ratio; (b) Dividend Coverage ratio;
(c) Total Fixed Charges Coverage ratio.
Debt-Equity (D/E) Ratio.

The relationship between borrowed funds and owners capital is
a popular measure of the long term financial solvency of a firm. This relationship is shown by the
debt-equity ratio. This ratio reflects the relative claims of creditors and shareholders
ACCOUNTANCY
415
against the assets of the firm. Alternatively, this ratio indicates the relative proportions of debt and
equity in financing the assets of a firm. The relationship between outside claims and owners capital
can be shown in different ways and accordingly there are many variants of the debt-equity ratio.
One approach is to express the D/E ratio in terms of the relative proportion of long term debt and
shareholders equity.
Long term debt/liability
Thus,
D/E ratio =
Shareholders equity
The debt considered here is exclusive of current liabilities. The shareholders equity includes both
ordinary as well as preference capital but excludes past accumulated losses (debit balance of the
profit and loss account), and deferred expenditures, if any. The shareholders equity so defined is
equal to net worth. The D/E ratio computed on this basis may also be called debt-to-net worth ratio.
Another approach to the calculation of the debt-equity ratio is to relate the total debt (not merely long
term debt) to the shareholders equity, that is,
Total debt
D/E ratio = Shareholders equity
The difference between the first approach and the second is essentially in respect of the treatment of
current liabilities. Should current liabilities be included in the amount of debt to calculate the D/E
ratio? There is no doubt that current liabilities are short term and the ability of a firm to meet such
obligations is reflected in the liquidity ratios, their amount fluctuates widely during a year and interest
payments on them are not large. They should form part of the total outside liabilities to determine the
ability of a firm to meet its long term obligations for a number of reasons.
For one thing, individual items of current liabilities are certainly short-term and may
fluctuate widely, but as a whole a fixed amount of them is always in use so that they are available
more or less on a long-term footing. Moreover, some current liabilities like bank credit are renewed
year after year and remain by and large permanently in the business. Also, current liabilities have,
like the long-term creditors, a prior right on the assets of the business.
Finally, short-term creditors exercise as much, if not more, pressure on management. The
omission of current liabilities in calculating D/E ratio would lead to misleading results.
How should the preference share capital be treated? Should it be included in debt or equity?
The exact treatment will depend upon the purpose for which the D/E ratio is being computed.
If the object is to examine the financial solvency of a firm in terms of its ability to avoid financial
risk, preference capital should be included in equity capital. If, however, the D/E ratio is calculated
to show the effect of the use of fixed interest or dividend sources of funds on the earnings available to
the ordinary shareholders, preference capital should be included in debt.
A high ratio indicates the larger claim of creditors and low ratio shows the smaller claim of
creditors. The D/E ratio indicates the margin of safety to the creditors. For instance, if the D/E ratio
is 1:2, it implies that for every rupee of outside liability, the firm has two rupees of owners capital.
The outside liability is half of the owners funds.
416
Debt-to-Total Capital Ratio.
The relationship between creditors funds and owners capital
can also be expressed in terms of another leverage ratio. This is the Debt-to-total capital ratio.
Here, the outside liabilities are related to the total capitalization of the firm and not merely to the
shareholders equity. Essentially, this type of capital structure ratio is a variant of the D/E ratio. It can
be calculated in different ways.
One approach is to relate the long-term debt to the permanent capital of the firm.
Permanent capital includes shareholders equity, as well as long-term debt.
Long term debt
Thus
Debt-to-total capital ratio = Permanent capital
Another approach for calculating the debt to total capital ratio is to relate the total debt to the total
assets of the firm. The total debt of the firm comprises long-term debt and current liabilities.
The total assets consist of Permanent Capital and Current Liabilities. Therefore,
Total debt
Debt-to-total capital ratio = Total assets
Total debt
= Permanent capital + Current liabilities
The debt-to-capital ratio can also be computed by dividing the shareholders equity by total assets
(that is, permanent capital plus current liabilities).
Total shareholders equity
Thus,
Debt-to-total capital ratio =
Total assets
Coverage Ratios.
The second category of leverage ratios are coverage ratios. Debt-equity
ratio and debt-to-total capital ratio indicate whether there is sufficient degree of safety available to
the creditors. But normally the assets of the firm will not be sold to satisfy the claims of the creditors.
The claims are usually met out of the regular earnings or operating profits of the firm. These claims
include interest on loans, preference dividend, repayment of loan and
redemption of preference shares. From long-term creditors point of view, the financial
soundness of the firm lies in its ability to service their claims. This ability is examined by coverage
ratios.
Thus coverage ratios may be defined as the ratios which measure the firms ability to
service fixed interest-bearing loans and other preference securities.
Interest Coverage Ratios.
This is one of the most conventional coverage ratios used for
measuring the firms debt servicing capacity. It is determined by dividing the operating profits or
earnings before interest and taxes (EBIT) by the fixed interest charges on loans.
EBIT
Interest coverage = Interest
This ratio indicates as to how many times the interest charges are covered by the earnings (before
interest and taxes) which are ordinarily available for paying the interest charges.
ACCOUNTANCY
417
A higher coverage ratio is desirable from creditors point of view. But too high a ratio
protection indicates that the firm is very conservative in using debt. A low ratio means
excessive use of debt or inefficient operations.
Dividend Coverage Ratio.
This ratio measures the ability of the firm to pay dividend
on the preference shares, which is usually a limited percentage.
Profit/Earning after tax
Dividend coverage =
Preference dividend
This indicates safety margin available to preference shareholders. As a rule, the higher the coverage
the better it is from their point of view.
Total Coverage Ratio or Fixed Charges Coverage Ratio.
While the interest coverage and
preference dividend coverage ratios relate the fixed obligations of a firm to the respective suppliers
of funds, i.e. creditors and preference shareholders, the total coverage ratio has wider coverage and
takes into account all the fixed obligations of a firm, that is: (a) interest on loan: (b) dividend on
preference shares; and (c) repayment of principal. It is calculated by dividing the EBIT by the total
fixed charges.
EBIT
Thus
Total coverage = Total Fixed Charges
The overall ability of a firm to service outside liabilities is truly reflected in the total coverage ratio.
The higher the coverage, the better the ability. A ratio of 6 to 7 per cent of net profit before tax or 3
per cent after tax is taken as standard for fixed charges coverage. Dividend coverage ratio of 2 per
cent is considered normal.
Activity Ratios
The finance obtained by a firm from its owners and creditors will be invested in assets. These assets
are used by the firm to generate sales and profit. The amount of sales generated and the profit earned
depends on effective and efficient management of those assets by the firm.
Activity ratios measure the efficiency with which the firm manages and uses its assets. That is why
activity ratios are also known as efficiency ratios. They are also called turnover ratios.
Thus the turnover ratios measure the relationship between sales and asset. Many activity ratios can be
calculated to measure the efficiency of asset utilization.
Total Assets Turnover Ratio.
Overall performance of the firm are measured by this ratio.
This ratio is calculated by dividing annual sales value by the value of total assets.The norm usually
adopted for this ratio is 2:1. A lower ratio than this means that the assets are lying idle, while a higher
ratio may indicate that there is overtrading. Some analysts exclude intangible assets (goodwill,
patents, etc.) from the total assets and calculate the total tangible assets-to-turnover ratio. For
calculating this ratio, fictitious assets (P & L a/c debit balance, deferred revenue expenditure, etc.)
should be ignored.
418
Capital Employed Turnover Ratio.
This is also known as sales net worth ratio. Capital
employed is equal to the owners equity plus non-current liabilities. This represents the long-term
funds or permanent capital invested by the owners and creditors to the firm. Capital employed is
equivalent to the non-current assets plus net working capital. This ratio measures the effectiveness
with which capital employed is used by the firm.
Sales
Capital employed turnover = Capital employed
This ratio measures the firms ability to generate sales per rupee of long-term funds or capital
employed. The higher the ratio, the more efficient the utilization of long-term funds. If this ratio is too
high when compared to other firms, then it is an indication of overtrading, i.e., handling of a larger
turnover than is warranted by its net worth.
Fixed Assets Turnover Ratio.
The efficiency with which a firm uses its fixed assets is
measured by this ratio. This ratio assumes importance for firms having large investment in fixed
assets.
Sales
Fixed Assets Turnover = Fixed Assets
A high ratio is an indicator of overtrading and a low ratio indicates idle capacity or excessive
investment in fixed assets. A ratio of 5 times is usually considered a norm for this ratio. Some
analysts exclude intangible assets from fixed assets to calculate this ratio. To calculate this ratio,
gross fixed assets are preferred to net fixed assets.
Current Assets Turnover Ratio.
This ratio measures contribution of current assets to sales
generation. It is calculated by dividing net sales value by the current assets value.
Working Capital Turnover Ratio.
This ratio measures the efficiency of the employment of
working capital. It is calculated by dividing the net sales value by the net working capital.
There is no standard norm for this ratio. A firm should have adequate working capital to justify the
sales generated.
Stock or Inventory Turnover Ratio.
This ratio indicates the efficiency of the firms
inventory management.
Cost of goods sold
Stock turnover =
Average stock
Cost of goods sold = Sales Gross profit
or
Opening stock + Purchases + Manufacturing cost Closing stock
Opening stock + Closing stock
Average stock =
2
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419
If particulars of cost of goods sold and average stock are not available in the financial statements, the
stock turnover can be calculated by dividing sales by the stock at the end. This ratio measures the
rapidity with which stock is turning into receivables through sales. A high inventory turnover is
considered as an index of good inventory management.
Debtors Turnover Ratio.
When a firm sells goods on credit, book debts are created
(Debtors). Debtors are expected to be converted into cash over a short period. The quality of debtors
can be judged on the basis of debtors and the average collection period.
Debtors turnover (accounts receivables turnover) ratio is calculated by dividing credit sales by
average debtors.
This ratio indicates the number of times, on an average, the debtors turnover each year.
Generally the higher the value of debtors turnover, the more efficiency is there in the
management of assets. Sometimes data relating to credit sales and opening and closing balances of
debtors may not be available. Then the debtors turnover can be calculated by dividing total sales by
closing balance of debtors.
Average Collection Period.
Average collection period is calculated by dividing days or
months in a year by the debtors turnover.
Days in a year
Average collection period = Debtors turnover
Days in a year
Days in a year
Debtors Debtors
Sales
Sales
Daily sales
Debtors
Profitability Ratios
Apart from the creditors, the owners and the management are also interested in the financial
soundness of the firm or the company itself. Profitability is the ability to make profits. Every firm
should earn some profit in order to survive in the business. Profitability is a measure of efficiency
and the search for it provides an incentive to achieve efficiency.
The profitability of a firm can be measured by its profitability ratios. The profitability ratios are
designed to provide answers to questions such as: (a) Is the profit earned by the firm adequate? (b)
What rate of return does it represent? (c) What is the rate of profit for various divisions and segments
of the firm? (d) What is the earnings per share? (e) What amount was paid in dividends? (f) What is
the rate of return to equity holders? and so on.
Profitability ratios can be determined on the basis of either sales or investments. The
profitability ratios in relation to sales are (a) Profit margin (gross and net), (b) Expenses ratio or
Operating ratio. Profitability in relation to investments is measured by: (a) Return on assets; (b)
Return on capital employed; (c) Return on shareholders equity.
Profitability Ratios Related to Sales.
These ratios are based on the premise that a firm
should earn sufficient profit on each rupee of sales. These ratios consist of (a) Profit margin and (b)
Expenses ratio.
420
Profit Margin.
The profit margin, as a profitability ratio, measures the relationship
between profit and sales. As the profit may be gross or net, there are two types of profit margin: (a)
Gross profit margin; (b) Net profit margin.
Gross profit margin is also known as gross margin. It is calculated by dividing gross profit by sales.
Thus,
Gross profit
Gross profit margin =
100
Sales
Since, Gross profit = Sales Cost of goods sold, the gross margin can also be calculated as follows:
Sales Cost of goods sold
Gross margin =
100
Sales
A high gross margin indicates lower cost of production of the firm, while a low margin
indicates higher cost of goods sold or lower sales value.
Net profit margin measures relationship between net profit and sales. The net profit is
arrived at by deducting operating expenses and income tax from gross profit. Usually nonoperating income and expenses are not considered for calculating this ratio.
This ratio measures the ability of the firm to turn each rupee of sales into net profit. A high net profit
margin is a welcome feature to a firm as it enables to accelerate its profits at a faster rate.
Depending on the concept of net profit employed, this ratio can be computed in three ways: 1. Net
profit after taxes before interest/Sales.
2. Net profit before taxes and interest/Sales.
3. Net profit after taxes and interest/Sales .
Expenses Ratio or Operating Ratio.
Another profitability ratio related to sales is the
expenses ratio. It is calculated by dividing expenses by sales. The term expenses refers to the
operating expenses of a firm exclusive of financial expenses like interest, taxes and dividends and
extraordinary losses due to theft of goods and so on.
There are different concepts of operating expenses.
(a) Total operating expenses consists of cost of goods sold, selling, general and
distributive expenses, and so on;
(b) Cost of goods sold; and
(c) Specific operating expenses.
Accordingly, the expenses ratio can be computed in three ways. That is,
1. Operating ratio = Cost of goods sold + Other operating expenses/Sales
2. Cost of goods sold ratio = Cost of goods sold/Sales
3. Specific expenses ratio = Specific operating expenses/Sales.
A higher operating ratio is always unfavourable to the firm as it would leave only a small amount of
operating income to meet non-operating items like interest dividends, etc.
ACCOUNTANCY
421
Illustration 5.38:
Calculate the profitability ratios relating to sales from the following
particulars of X Ltd.
Income Statement
Sales
40,00,000
() Cost of goods sold
28,00,000
Gross profit margin
12,00,000
() Operating expenses
Administration
1,00,000
Selling and Distribution
40,000
1,40,000
Gross operating margin
10,60,000
() Depreciation
2,60,000
Net operating margin
8,00,000
(+) Non-operating income
20,000
() Non-operating expense
40,000
() 20,000
Net profit before tax
7,80,000
() Tax 50%
3,90,000
3,90,000
Solution
Gross profit 12, 00, 000

Gross profit margin
100
Sales
40, 00, 000
Gross operating profit 10, 60, 000
106
Gross operating margin
100
26.5%
Sales
40, 00, 000
40
Net operating profit 8, 00, 000
Net operating profit margin
100 20%
Sales
40, 00, 000
3, 90, 000
Net profit margin
100
100 9.75%
Sales
40, 00, 000

Cost of goods sold
Operating expenses 32,00,000
Operating ratio
100 80%
Sales
40, 00, 000
[Q 28,00,000 + (1,00,000 + 40,000 + Depreciation 2,60,000) = 28,00,000 + 4,00,000 =
32,00,000]
28,00,000
Cost of goods sold to sales
100
40,00,000
1,00,000
Administration expenses to sales =
100 2.5%
40,00,000
422
40,000
Selling and distribution expenses to sales
100 10%
4,00,000
2,60,000
Depreciation to sales
100 6.5%
40,00,000
Profitability in Relation to Investment.
Profitability of a firm can also be studied in
relation to investment made. The term investment may refer to total assets, total operating assets,
capital employed or the owners equity. Accordingly many profitability ratios in relation to
investment can be calculated for study.
Return on Assets.
Here, the profitability ratio is measured in terms of the relationship
between net profits and assets. The return on assets may also be called profit-to-assets ratio.
There are various approaches possible to define net profits and assets, according to purpose and
intent of the calculation of the ratio.
The concept of net profit may be (a) Net profit after tax, (b) Net profit after taxes +
interest, and (c) Net profit after taxes + interest tax savings.
Net profit after taxes
Return on assets =
Total assets
Interest
= Net profit after taxes + Total assets
Interest
= Net profit after taxes + Tangible assets
Interest
= Net profit after taxes + Fixed assets
Operating Profit/Operating Assets
Operating assets are the assets which are used in the regular conduct of business operations of the
firm. They include mostly tangible fixed assets and current assets. Investments are usually excluded
while calculating the operating assets.
This ratio measures the profitability of the total assets of the firm. But this does not shed any light on
the profitability of the different sources of funds which have been used to finance the assets.
Return on Capital Employed.
This ratio is similar to return on assets except that in this
ratio profits are related to capital employed. The term capital employed refers to the long-term funds
supplied to the firm by creditors and owners. This ratio measures the efficiency of use of funds by the
management.
Capital employed in a firm can be found in two ways: by taking the non-current liabilities plus
owners equity or by considering net fixed assets + net working capital. The higher the ratio, the more
efficient has been the use of capital employed.
ACCOUNTANCY
423
This ratio of return on capital employed can be calculated by using different concepts of profit and
capital employed.
POCE = Total capital employed
Interest
= Net profit after taxes + Total capital employed
Interest
= Net profit after taxes + Total capital employed = Intangible assets
Illustration 5.39:
From the following particulars, calculate the profitability ratios in relation
to investment:
Balance Sheet (in Rs. lakhs)
Equity share capital
Goodwill
3
50,000 shares
10
Fixed assets 24
8% Preference shares
6
Current Assets 7
Reserves & Surplus
4
8% Long term loans
4
8% Debentures
6
Current liabilities
4
34
34
Net profit after tax Rs. 4 lakhs; interest Rs. 80,000.
Solution
Capital employed = Non-current Assets + Current Assets Current Liabilities
= 2,70,000 + 7,00,000 4,00,000 = 30,00,000
or
Owners equity + Long-term funds
= 20,00,000 + 10,00,000 = 30,00,000

Therefore, the ratios are:
Profit after tax
(a) ROCE = Capital employed
4,00,000
=
100 = 13.33%
30,00,000
424
Interest
(b) Profit after tax + Capital employed
4,80,000
=
100 = 16%
30,00,000
Interest
(c) Profit after tax +
Intangible Assets
Capital employed
4,80,000
=
= 17.78%
27,00,000
Return on Shareholders Equity.

This ratio is calculated to assess the profitability of
the owners investment. The shareholders equity is obtained by adding up equity share capital,
preference share capital, share premium reserves and surplus, and deducting accumulated losses from
this amount. Shareholders equity is also known as net worth. This can be shown as: Profit after tax
Return on shareholders equity = Shareholders equity
This ratio reveals the financial soundness and performance of the firm.
Return on Equity Shareholders Funds.
Equity shareholders are the real owners of the
company. They are the residual claimants of profits and ultimate beneficiaries of the company.
In view of this, the profitability of a firm should be assessed in terms of return on the equity
shareholders funds.
Preference dividend
Return on equity shareholders Fund = Profit after tax Equity shareholders equity
where
Equity shareholders equity equal to Total shareholders equity Preference share capital Earnings
Per Share (EPS).
EPS = Profit after taxes Preference dividend/No. of equity
shares outstanding
This ratio is valuable and widely used, especially for assessing the effect of a change in leverage and
also in evolving an appropriate capital structure of the firm.
Dividend Payout Ratio.
This is calculated by dividing dividend per share by the
earnings per share or by dividing the total dividends paid by total earnings made. This ratio reveals
the amount of dividends distributed out of the profits available to the ordinary
shareholders.
SUMMARY
Accounting is the process of identifying, measuring and communicating economic information to

permit informed judgments and decisions by users of the information. The functions of
Accounting are recording, classifying, summarizing, dealing with financial transactions,
analyzing, interpreting and communicating. Accountancy refers to a systematic knowledge
ACCOUNTANCY
425
consisting of principles, concepts, conventions and policies governing recording, classifying,
summarising, analysing and interpreting financial transactions, whereas the practice (i.e., art) of that
knowledge is called Accounting. Book-keeping is mainly concerned with recording of financial data
relating to the business operations in a significant and orderly manner.
The main objectives of Accounting are to keep systematic records, to protect business
properties, to ascertain the results of operations, to ascertain the financial position of the business and
to communicate the information to the user parties interested in accounting
information. The accounting information is of primary importance to the proprietors and the managers.
However, other persons such as creditors, prospective employees, etc. are also
interested in accounting information. Financial Accounting, Cost Accounting and Management
Accounting are the three branches of accounting. An accounting cycle is a complete sequence
beginning with the recording of the transactions and ending with the preparation of the final accounts.
Broadly there are two systems of accounting, viz., The Double Entry system and the
Single Entry system. The double entry system is one which recognizes and records both the aspects
of a transaction. Generally, what is not double entry accounting is termed single entry accounting,
thereby implying that the accounts are incomplete. To make the language convey the same meaning to
all people, accountants have developed certain rules, procedures and
conventions which represent a consensus view by the profession of good accounting practices and
procedures and are generally referred to as Generally Accepted Accounting Principles
(GAAP). Whenever there is a transaction in the business, it effects two accounts and entries are made
in those two accounts. This method of recording a transaction gives rise to the term
Double Entry. An account is a summarized record of transaction relating to a particular person or
thing. Accounts are classified into three types: Personal accounts, Real accounts are those which
relate to those assets of the firm which are real and tangible in nature. Personal accounts are opened
in the books to explain the nature of the transactions. They do not really exist.
A Journal may be defined as a book containing a chronological record of transactions. A
ledger account may be defined as a summary statement of all the transactions relating to a person,
asset, expense or income which have taken place during a given period of time and shows their net
effect. The Journal is divided into a number of separate journals. These are called subsidiary books.
In any large-scale business the following special journals are found, viz., Cash book, Purchases book,
Sales book, Purchases returns book, Sales returns book, Bills receivable book, Bills payable book
and Journal proper. A trial balance may be defined as a statement of debit and credit totals or
balances extracted from the various accounts in the Ledger with a view to test the arithmetical
accuracy of the books. The cash book is a special Journal which is used for recording all cash
receipts and cash payments. The most common
ones are simple cash book (also called single column cash book cash book with cash column only),
double column cash book (or cash book with cash and discount column), three-column cashbook (or
cashbook with cash, bank and discount columns) and petty cash book.
A bank reconciliation statement is a statement reconciling the balance as shown by the bank pass book
and the balance as shown by the cash book. Final accounts are prepared to ascertain profit earned or
loss suffered by the business and also to know the Assets and Liabilities of 426
the business at the end of each financial year. The statement prepared to know the profit or loss is
known as Income Statement or Trading and Profit and Loss Account. The other
statement called Balance Sheet is prepared to know the financial position of the business.
EXERCISES
1. Accounting is the language of business.
2. Accounting can be viewed as an information system, which has its inputs, processing
methods and outputs.
3. Accounting involves only the recording of business transactions.
4. Accounting records only those transactions and events which are of financial character.
5. Personal transactions are distinguished from business transactions in accordance with the business
entity concept.
6. Revenues are matched with expenses in accordance with the matching principle concept.
7. The economic life of an enterprise is artificially split into periodic intervals in accordance with the
going concern concept.
8. Principles which have substantial authoritative support become a part of the Generally Accepted
Accounting Principles.
9. The assets are classified as current assets and fixed assets in accordance with the
accounting period concept.
10. Debt equity ratio is a Solvency Ratio.
11. Ratio analysis is a technique of planning and control.
12. Acid Test denotes liquidity.
13. Rate of return on capital employed is a turnover ratio.
Answers:
1. True
2. True
3. False
4. True
5. True
6. True
7. False
8. True
9. False
10. True
11. False
12. True
13. False
1. Returns Outwards appearing in Trial Balance are deducted from:
(a) Sales
(b) Purchases
(c) Returns Inwards
2. Returns Inwards appearing in Trial Balance are deducted from
(a) Purchases
(b) Sales
(c) Returns Outwards
3. Outstanding Wages in Trial Balance are shown:
(a) On the debit side of the Profit and Loss Account
(b) On the debit side of the Trading Account
(c) On the liabilities side of the Balance Sheet
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427
4. Closing Stock appearing in the Trial Balance is shown:
(a) On the credit side of the Profit and Loss Account
(b) On the credit side of the Trading Account
(c) On the assets side of the Balance Sheet
5. Goodwill is
(a) current asset
(b) fictitious asset
(c) tangible asset
(d) intangible asset
6. Drawings are deducted from
(a) Sales
(b) Purchases
(c) Returns Outwards

(d) Capital
7. Discount allowed appearing in the Trial Balance are shown
(a) On the debit side of the Trading Account
(b) On the debit side of Profit and Loss Account
(c) On the assets side of the Balance Sheet
8. Carriage Outwards appearing in the Trial Balance are shown
9. Freight Inwards appearing in Trial Balance are shown
10. Sale of scrap of raw materials appearing in the Trial Balance are shown
(a) On the credit side of the Trading Account
(b) On the credit side of the Manufacturing Account
(c) On the credit side of the Profit and Loss Account
11. Debit means
(a) An increase in asset
(b) An increase in liability
(c) A decrease in asset
(d) An increase in proprietors equity
12. Credit means
(a) An increase in asset

(b) An increase in liability
(c) A decrease in liability
(d) A decrease in proprietors equity
13. Journal is a book of
(a) Original entry
(b) Secondary entry
(c) All cash transactions
(d) All non-cash transactions
14. Ledger is a book of
(a) Original entry
(b) Secondary entry
(c) All cash transactions
(d) All non-cash transactions
15. The process of recording a transaction in the Journal is called
(a) Posting
(b) Journalising
(c) Tallying
(d) Balancing
428
16. Which of the following is a cash transaction?
(a) Sold goods
(b) Sold goods to Ram
(c) Sold goods to Ram on credit

17. Which of the following is a credit transaction?
(a) Sold goods
(b) Sold goods for cash
(c) Sold goods to Ram for cash
(d) Sold goods to Ram
18. Purchases book is used to record:
(a) All purchases of goods
(b) All credit purchases
(c) All credit purchases of goods
(d) All credit purchases of assets other than goods
19. Sales book is used to record
(a) All sales of goods
(b) All credit sales
(c) All credit sales of assets other than goods
(d) All credit sales of goods
20. Purchases returns book is used to record
(a) Returns of goods purchased for cash
(b) Returns of fixed assets purchased on credit
(c) Returns of goods purchased on credit
21. Sales returns book is used to record
(a) Returns of fixed assets sold on credit
(b) Returns of goods sold for cash
(c) Returns of goods sold on credit
22. When a customer returns the goods

(a) An invoice is sent to him
(b) A debit note is sent to him
(c) A credit note is sent to him
23. When the goods are sent to the supplier
(a) An invoice is sent to him
(b) A credit note is sent to him
24. Journal proper is used to record
(a) All cash purchases of assets other than goods
(b) All cash sales of assets other than goods
(c) Returns of fixed assets purchased on credit
(d) Recovery of an amount already written-off as bad debts
25. Cash book is used to record
(a) All receipts only
(b) All payments only
(c) All cash and credit sales
(d) All receipts and payments of cash
26. Cash receipts are recorded
(a) On the debit side
(b) On the credit side
(c) On both sides
27. Cash payments are recorded
(a) On the debit side
(b) On the credit side
(c) On both sides

ACCOUNTANCY
429
28. Which of the following is correct?
(a) Cash book is a journal and not a ledger
(b) Cash book is a ledger and not a journal
(c) Cash book is both a journal and a ledger
29. Single-column cash book may show
(a) Only a debit balance
(b) Only a credit balance
(c) Either debit balance or a credit balance
30. When a firm maintains a three-column cash book, it need not maintain
(a) Cash account in the Ledger
(b) Bank account in the Ledger
(c) Discount account in the ledger
(d) Both cash account and bank account in the Ledger
31. When a cheque received on a particular date is not deposited the same day into bank, it is entered
in
(a) The Cash column on the debit side
(b) The Bank column on the debit side
(c) The Cash column on the credit side
(d) Cash column on the debit side and the credit side
32. When a cheque is returned dishonoured, it is recorded in
(a) The Cash column on the credit side
(b) The Cash column on the debit side
(c) The Bank column on the credit side

33. If the debit as well as credit aspects of a transactions are recorded in the cash book itself, it is
called
(a) An opening entry
(b) A compound entry
(c) A transfer entry
(d) A contra entry
34. Which of the following transactions is posted in the Ledger?
(a) Deposited into the bank
(b) Withdrew from bank
(c) Withdrew from bank for personal use.
35. Bank column of the cash book may show
(a) Only a debit balance
(b) Only a credit balance
(c) Either a debit balance or a credit balance
36. In a three-olumn cash book
(a) Only cash column and discount column are balanced
(b) Only bank column and discount column are balanced
(c) Only cash column and bank column are balanced
(d) Cash column, bank column and discount column are balanced
37. Bank rconciliation statement is
(a) A part of the cash book
(b) A ledger account
430
(c) A statement showing the causes of difference between the cash book and the pass
book
(d) Neither of the three.
38. Bank reconciliation statement is prepared by
(a) The bank
(b) A customer of the bank
(c) A creditor of a business
(d) Neither of the three
39. Debit balance in the cash book means
(a) Overdraft as per pass book (b) Credit balance as per pass book
(c) Overdraft as per cash book (d) Neither of the three
40. Credit balance in the cash book means
(a) Overdraft as per pass book (b) Favourable balance as per pass book
(c) Neither of the two
(d) Neither of the three
41. The three most useful general-purpose financial statements for management are:
(a) Income Statement, Statement of Retained Earnings and Balance Sheet
(b) Income Statement, Balance Sheet and Statement of Changes in Financial Position
(c) Income Statement, Statement of Retained Earnings and Funds Flow Statement
(d) Statement of Retained Earnings, Balance Sheet and Funds Flow Statement
42. Debt Equity Ratio is a
(a) Liquidity Ratio
(b) Solvency Ratio
(c) Profitability Ratio
43. Ratio of Net Profit before Interest and Tax to Sales is a

(a) Operating Profit Ratio
(b) Capital Gearing
(c) Solvency Ratio
44. Long-term solvency is indicated by
(a) Current Ratio
(b) Debt/Equity Ratio
(c) Net Profit Ratio
Answers:
1 (b)
2 (b)
3 (c)
4 (c)
5 (d)
6 (d)
7 (b)
8 (a)
9 (b)
10 (b))
11 (a)
12 (b)
13 (a)
14 (b)
15 (b)
16 (a)
17 (d)
18 (c)
19 (d)
20 (c)
21 (c)
22 (c)
23 (b)
24 (c)
25 (d)
26 (a)
27 (b)
28 (c)
29 (a)
30 (d)
31 (a)
32 (c)
33 (d)
34 (c)
35 (c)
36 (c)
37 (c)
38 (b)
39 (b)
40 (a)
41 (b)
42 (b)
43 (a)
44 (b)
1. What are Final Accounts?
2. What is a Trading Account?
3. What is a Manufacturing Account? What is the object of preparing it?
4. What are direct expenses?
ACCOUNTANCY
431
5. What do you understand by adjusted purchases?
6. What is Gross Profit?
7. What is Net Profit?
8. What is Depreciation? How is it shown in the Final Accounts?
9. What is a Current Asset?
10. What is a Current Liability?
11. What are closing entries?
12. Distinguish between Gross Profit and Net Profit.
13. Distinguish between Capital Expenditure and Revenue Expenditure.
14. Distinguish between Capital Receipts and Revenue Receipts.
15. Distinguish between a Trial Balance and a Balance Sheet.
16. Distinguish between tangible and intangible assets.
17. What is a bad debt? Why is it necessary to make provision for doubtful debts?
18. Explain the treatment of the following in the Final Accounts:
(a) Interest on Capital
(b) Interest on Drawings
19. How would you treat the following adjustments in the Final Accounts?
(a) Outstanding Expenses
(b) Prepaid Expenses
(c) Outstanding Income
(d) Income received in advance
20. What is meant by Accounting?
21. What is Book-keeping?
22. What is an accounting cycle?
23. Distinguish between Book-keeping and Accounting.
24. What are the objectives of Accounting?
25. Who are the users of Accounting information?
26. What are the branches of Accounting?
27. What are the advantages of Accounting?
28. What are the functions of Accounting?
29. What do you understand by double entry system?
30. What do you mean by accrual basis of accounting?
31. What is meant by Generally Accepted Accounting Principles (GAAP)?
32. What is meant by the business entity concept?
33. What is the going concern concept?
432

34. What is the cost principle?
35. What is the matching principle?
36. What is the full disclosure principle?
37. What is the materiality principle?
38. What is the consistency principle?
39. What is the conservatism principle?
40. What is the basic accounting equation?
41. What do you mean by Accounting Cycle?
42. What is an Account?
43. Give the form of an Account.
44. What are the various types of accounts?
45. What do you mean by the Double Entry principle?
46. What are the advantages of the Double Entry System?
47. Give the format of a Journal.
48. What is narration?
49. What is a Compound Entry?
50. What are the steps to be taken for Journalising?
51. What is a Ledger?
52. Why is the Ledger called the book of final entry?
53. What is posting?
54. What is the necessity of posting?
55. Does any book of original entry serve the purpose of a Ledger?
56. What is the balancing of an account?
57. What is the significance of balancing?

58. Give the format of the Ledger Account.
59. What is the need for special journals?
60. Write a shortnote on subsidiary books.
61. Distinguish between purchases book and sales book.
62. Distinguish between Purchases Returns and Sales Returns Book.
63. What do you understand by debit note and credit note?
64. What is a trade discount and a cash discount?
65. Explain Bills Receivable and Bills Payable.
66. What is a Journal Proper?
ACCOUNTANCY
433
67. Distinguish between Opening Entry and Closing Entry. Give Examples.
68. What is a transfer entry?
69. What is a Trial Balance?
70. What do you mean by the error of omission?
71. Why is Trial Balance prepared?
72. State the types of errors which a Trial Balance may not reveal.
73. State the types of errors which affect the agreement of a Trial Balance.
74. What is a cash book?
75. What is a petty cash book?
76. What is a contra entry?
77. How is contra entry distinguished from other entries?
78. What do you mean by analytical petty cash book?
79. Explain how the cash book records Journal as well as Ledger accounts.
80. What are the rules of posting from cash book?
81. What is a petty cash book? How will you maintain the petty cash book on the imprest
system?
82. What is a bank reconciliation statement?
83. What is a bank pass book?
84. What records are necessary to prepare a bank reconciliation statement?
85. Give two examples of transactions that are usually recorded first in the cash book and later in the
pass book.
86. Give two examples of transactions that are usually recorded first in the pass book and later in the
cash book.
1. Distinguish between Capital and Revenue Expenditure by giving examples.
2. What do you understand by Final Accounts? Explain the objects and advantages of
preparing Final Accounts.
3. Describe the various types of assets by giving examples.
4. Describe various types of liabilities by giving examples.
5. Give the closing entries of a Trading Account and Profit and Loss Account.
6. Explain the need for accounting in a business.
7. What is Accounting? Explain its advantages and limitations.
8. What are the parties interested in accounting information? Why do they need the
information?
434
9. What are the different systems of book-keeping? Explain with examples.
10. Explain the accounting process.

11. Discuss the basic concepts of Accounting.
12. Explain the accounting conventions.
13. What is the Principle of Double Entry? Explain with illustrations.
14. What do you understand by Account? Explain the nature of the different kinds of
accounts?
15. Define the term Journal. Why is it called the book of original entry? Give the rules and
advantages of Journal entry.
16. What are the important points that you will bear in mind while writing journal entries?
17. Write a note on Ledger posting with an example.
18. Write the procedure followed for balancing an account, with examples.
19. What do you understand by subsidiary books? Explain the objects of preparing such
books.
20. Name the various types of special books and give the scope and utility of each of them.
21. What type of transactions are recorded through the Journal Proper? Explain its uses in
Accountancy.
22. Why has the Journal been sub-divided? Name the special journals and give the ruling of each of
those journals.
23. What is a Trial Balance? Why it is prepared? Is the agreement of Trial Balance a
conclusive proof of the accuracy of accounts?
24. Draw a Trial Balance using imaginary accounts and figures.
25. What are the different kinds of cash books? How do they differ from one another? Under what
conditions is each of them maintained?
26. Explain the procedure of posting the entries from a triple-column cash book to the Ledger
accounts.
27. What is the need for the petty cash book? How is it maintained in a columnar form?
28. What are the causes of disagreement between the cash book and the pass book balances?
How do you reconcile these?

29. How is a bank reconciliation statement prepared?
30. Explain the procedure for preparing the bank reconciliation statement using items and figures of
your own.
31. Discuss the application of ratio analysis in the interpretation of financial statements and in
financial analysis. What are its limitations?
ACCOUNTANCY
435
PROBLEMS
1. Prepare the Final Accounts of Mr. Gupta for the year ending 31st December, 2003 from
the following information.
Particulars
Dr (Rs.)
Particulars
Cr (Rs.)
Buildings
2,15,000
Capital
84,950
Machinery
1,25,000
Loan
12,000
Drawings
9,000
Sales
4,20,000
Purchases
1,00,000
Returns
10,000
Returns
9,000
Outstanding salaries
200
Opening stock
35,000
Creditors
17,000
Salary
1,250
Commission
1,600
Rent
1,200
Bills payable
5,200
Insurance
600
Debtors
25,000
Interest receivable
600
Investments
8,000
Carriage
3,200
Printing
3,300
Cash in hand
7,000
Bills receivable
7,800
5,50,950
5,50,950
Additional information:
(i) The value of stock on 31st December, 2003 was Rs. 36,000.
(ii) Write off bad debts Rs. 2,500 and provide RBDD at 10% of debtors.
(iii) Commission Receivable Rs. 1,875.
(iv) Provide interest on Capital and Drawings at 10% per annum.
(v) Salary Outstanding Rs. 250 and Rent Outstanding Rs. 800.
( Answers: Gross Profit Rs. 3,18,800; Net Profit Rs. 3,02,530; Balance Sheet Rs. 4,21,525)
2. From the following balances and information received from the books of Mr. Venu on
31st March, 2004, you are required to prepare the Final Accounts.
Particulars
Dr (Rs.)
Cr (Rs.)
Capital
75,000
Sales
4,20,750
Creditors
15,000
Provision for Bad debts
200
Bills payable
2,000
Cash at Bank
12,500
Cash in hand
2,000
Coal and Gas
1,000
(Contd.)
436
Particulars
Dr (Rs.)
Cr (Rs.)
Opening stock
45,000
Purchases
2,25,000
Plant
75,000
Trade expenses
10,000
Carriage inwards
2,500
Carriage outwards
1,500
Factory rent
1,500
Discounts
350
Insurance
700
Debtors
60,000
Office Rent
3,000
Printing
600
General expenses
2,800
Advertising
15,000
Bills receivable
6,000
Drawings
6,000
Salaries
15,000
Wages
20,000
Furniture
7,500
5,12,950
5,12,950
Adjustments:
(i) Prepaid insurance Rs. 100; closing stock Rs. 35,000
(ii) Write-off 10% on plant
(iii) Increase provision for bad debts to 5%
(iv) Outstanding factory rent Rs. 300
(v) Outstanding office rent Rs. 600.
( Answers: Gross Profit Rs. 1,60,450; Net Profit Rs. 1,00,700; Balance Sheet Rs. 1,87,600)
3. The following are the balances extracted from the books of Mr. Flatfoot as on 31st
December 2003. You are required to prepare the Trial Balance and the Trading and Profit
and Loss Account for the year ending 31st December, 2003 and the Balance Sheet as on
that date.
Particulars
(Rs.)
Particulars
(Rs.)
Flatfoots capital
30,000
Sales returns
2,000
Flatfoots drawings
5,000
Discount allowed
1,600
Furniture & Fittings
2,600
Discount received
2,000
Bank overdraft
4,200
Taxes and insurance
2,000
Creditors
13,800
General expenses
4,000
Business premises
20,000
Commission paid
2,200
Stock on 1st Jan 2003
22,000
Salaries
9,000
Debtors
18,600
1,800
Rent from tenants
1,000
Provision for bad and doubtful debts
600
Purchases
1,10,000
Bad debts written off
800
Sales
1,15,000
ACCOUNTANCY
437
Adjustments:
(i) Stock on hand on 31st Dec 2003 was estimated Rs. 20,000
(ii) Rent Rs. 300 is still due from the tenants
(iii) Salaries Rs. 750 are as yet unpaid
(iv) Write off bad debts Rs. 600
(v) Depreciate business premises by Rs. 300, and Furniture and Fittings by Rs. 266
(vi) Make a provision of 5% on debtors for bad and doubtful debts and a provision
of 2% for discounts
(vii) Carry forward Rs. 700 for unexpired insurance
(viii) Allow interest on Capital at 5%
(ix) The manager is entitled to a commission of 10% on the profits remaining after
charging his commission
( Answers: Gross Profit Rs. 34,200; Net Profit Rs. 13,220; Balance Sheet Total Rs. 59,792)
(MCA, OU, Mar. 1995)
4. On 31st March 2004, the Trial Balance of Mr. Prabhu was as follows:
Particulars
Dr (Rs.)
Particulars
Cr (Rs.)
Stock on 1st April, 2003

Raw materials
21,000
Sundry creditors
15,000
Work in progress
9,500
Bills payable
7,500
Finished goods
15,500
Sale of scrap
2,500
Sundry debtors
24,000
Commission
450
1,500
Provision for doubtful debts
1,650
Bills receivable
15,000
Capital account
1,00,000
Wages
13,000
Sales
1,67,200
Salaries
10,000
Current account of Prabhu
8,500
Telephone, postage, etc.
1,000
Repairs to plant
1,100
Repairs to office furniture
350
Purchases
85,000
Cash at bank
17,000
Plant & Machinery
70,000
Office furniture
10,000
Rent
6,000
Lighting
1,350
General expenses
1,500
3,02,800
3,02,800
The following additional information is available:
(i) Stock on 31st March, 2004 were
(a) Raw materials: Rs. 16,200
(b) Finished goods: Rs. 18,100
(c) Semi-finished goods: Rs. 7,800
(ii) Salaries and wages unpaid for March 2004 were respectively Rs. 900 and Rs. 2000
438
(iii) Machinery is to be depreciated by 10% and office furniture by 71/2%
(iv) Provision for doubtful debts is to be maintained @ 1% of sales
(v) Office premises occupy 1/4th of total area. Lighting is to be charged as to 2/3rds
to factory and 1/3rd to office.
Prepare the Manufacturing as well as Trading and Profit and Loss Accounts for the year
ending 31st March, 2004 and the Balance Sheet as on that date.
( Answers: Gross Profit Rs. 50,800; Net Profit Rs. 34,778; Balance Sheet Total Rs.
1,68,678)
5. The following balances are extracted from the Ledger accounts of Mr. Bharat as on 31st December
2003.
Particulars
Dr (Rs.)
Cr (Rs.)
Bharats capital account
1,50,000
Bharats drawings account
10,000
Plant & Machinery
40,000
Stock on 1st Jan 2003
25,000
Purchases and sales
1,74,000
2,60,000
Furniture
5,000
Debtors and creditors
1,35,000
90,000
Wages
24,000
Freight inwards
4,000
Salaries
22,000
9,000
Rent, Rates & Taxes
12,000
Bills receivable
33,000
Bank
7,000
5,00,000
5,00,000
Adjustments:
(i) Closing Stock on 31st December, 2003 was valued at Rs. 80,000
(ii) A fire occurred on 1st December, 2003, and goods costing Rs. 10,000 were
destroyed. Insurance company accepted a claim of Rs. 8,000
(iii) Write off Rs. 7500 as bad debts
(iv) Purchases include purchase of furniture Rs. 2000 for the personal use of Mr. Bharat.
Prepare Trading Account, Profit and Loss Account and Balance Sheet as on 31st
December, 2003.
( Answers: Gross Profit Rs. 1,25,000; Net Profit Rs. 72, 500; Balance Sheet Total Rs. 3,00,500)
(PGD-MISCA, OU, 1998)
ACCOUNTANCY
439
6. The following is the Ledger of a trader as on 31st March, 2004:
Particulars
Dr (Rs.)
Particulars
Cr (Rs.)
Machinery
28,400
Capital
1,80,000
Manufacturing Wages
98,570
Bad debts reserve
2,000
Opening Stock
63,520
Creditors
48,740
Purchases
2,17,490
Sales
4,53,000
Carriage (Factory)
5,920
Bank loan
30,000
Repairs
2,440
Miscellaneous receipts
80
Rent and rates factory
12,480
Commission received
6,900
Rent and rates office
3,400
Bills payable
17,990
Advertising
12,870
General expenses
9,880
(3/4 factory and office 1/4)
Patents
98,570
Debtors
78,400
Bad debts
1,000
Office salaries
48,720
Sales returns
4,810
Managers salary
15,250
Cash in hand
1,950
Office furniture
7,500
Motor lorries
18,620
Travellers salaries
2800
Insurance Factory
5,620
Office 500
6,120
7,38,710
7,38,710
You are required to prepare the Trading and Profit and Loss Account for the year ended
31st March, 2004 and a Balance Sheet as on that date after taking into consideration the
following matters:
(i) Depreciation on machinery 10% and on office furniture 8%
(ii) Closing stock Rs. 87530
(iii) 1/3rd of the advertising is to be carried forward to next year

(iv) Bad debts Rs. 400
(v) Bad debts reserve carried to Rs. 5,000
( Answer: Gross Profit Rs. 1,24,710; Net Profit Rs. 39,690; Balance Sheet Total Rs.
3,16,420)
(MCA, OU, 2000)
7. From the information given below, prepare the Trading Account and the Profit and Loss
Account of Mr. Vasudeva Rao for the year ended March 31, 1995 and a Balance Sheet
as on that date. Vasudeva Raos Trial Balance as on 31st March, 1995 was as follows:
440
Particulars
Dr (Rs.)
Particulars
Cr (Rs.)
Land and Buildings
20,000
Capital
80,000
Machinery
50,000
Sundry Debtors
8,000
4,000
Discounts received
400
Opening Stock
16,300
1,550
Purchases
80,000
Sales
1,50,500
Salaries
6,000
Repairs and renewals provision
6,000
Carriage on sales
1,500
Freight on purchases
2,000
Customs duty on purchases
8,000
Advertising
5,400
Wages
15,000
Rent
3,000
Postage & Stationery
1,500
General expenses
3,200
Repairs to machinery
2,000
Loan to Kutumba Rao (given
on 1.10.94 @ 9%)
5,000
Prepaid insurance
200
Sundry debtors
20,000
Cash in hand
250
Cash at bank
3,100
2,46,450
2,46,450
The following additional information is also given to you:
(i) Stocks on 31st March, 1995 was Rs. 14,900
(ii) Machinery was purchased on 1.10.1994 for Rs. 10,000 and was installed by own
workmen.
(iii) Depreciation is to be written off @ 30% on land and buildings, 10% on machinery
and 5% on furniture and fixtures.
(iv) Provision for repairs and renewals is credited with Rs. 1,500 every year.
(v) A provision of 2% is to be made on creditors for discount.
( Answer: Gross Profit Rs. 44,600; Net Profit Rs. 15,960; Balance Sheet Total 1,12,850) (MCA, OU,
1996)
8. Krishna Rao commenced business on 1st January, 2004. His transactions for the month
are given below. Journalise them.
2004
Rs.
Jan 1
Commenced business with Capital
30,000
Jan 2
Bought goods from Chand & Co.
7,500
Jan 3
Sold goods for cash
1,000
Jan 4
Purchased furniture
1,500
Jan 6
Purchased goods on account from Gopal & Co.

5,000
ACCOUNTANCY
441
Jan 7
Returned goods to Gopal & Co.
150
Jan 10
Paid for advertisement
400
Jan 14
Cash sales
800
Jan 17
Sold goods on account to Venkat
1,000
Jan 18
Venkat returns goods
75
Jan 23
Paid Chand & Co. on account
3,000
Jan 24
Paid office expenses
50
Jan 27
Received from Venkat on account
500
Jan 31
Paid salaries
800
Jan 31
Drew cash for private expenses
600
9. Journalise the following transactions:
2004
Mar 1
Cash sales to A
Rs. 1,000
Mar 2
Bought goods from B
3,000
Mar 2
Paid cartage on goods
500
Mar 3
Old newspapers sold
500
Mar 4
Paid municipal taxes
1,500
Mar 5
Paid repairs for machinery
800
Mar 6
Received commission
500
2004
Jan 2
Purchased goods for cash
Rs. 2,000
Jan 4
Purchased goods from Rama on credit
5,000
Jan 5
Sold goods to Hari
2,000
Jan 6
Cash sales
1,000
Jan 7
Cash sales to Mohan

750
Jan 9
Returned goods to Rama
500
Jan 10
Hari returned goods
100
2004
Apr 1
Bought furniture from Gopi & Co. for cash
Rs. 5,000
Apr 3
Purchased machinery on credit from Sony & Co.
50,000
Apr 4
Sale of old furniture
5,000
Apr 7
Paid to Ram Mohan
4,000
Apr 9
Paid to Gopal
1,500
Apr 10
Paid Wages
1,200
Apr 12
Bought stationery
600
Apr 15
Paid rent
2,500
Apr 15
Received commission
500
12. Give Journal entries to record the following transactions:
2004
Jun 1
Ashok Brothers commenced business with Capital
Rs. 1,75,000
Jun 1
Purchased a truck
75,000
442
Jun 2
Purchased goods from Anand

25,000
Jun 3
Sold goods
1,000
Jun 4
Returned goods to Anand
1,000
Jun 7
Sold goods to Chand
3,000
Jun 8
Chand returned goods
500
Jun 11
Cash purchases
5,000
Jun 14
Purchased postage stamps
200
Jun 16
Paid for advertising
2,000
13. Journalise the following transactions and post them into the Ledger:
2004
Apr 2
Cash sales
Rs. 6,500
Apr 5
Paid salaries
2,500
Apr 8
Sold goods to P
4,000
Apr 12
Cash purchases
3,000
Apr 14
Paid for stationery
50
Apr 17
Goods taken by proprietor for personal use
800
Apr 22
Bought goods from Q
6,000
Apr 23
Received from P on account
2,000
Apr 27
Sold goods for cash
1,000
Apr 30
Received interest on investments
600
14. Journalise the following transactions, post them into the Ledger and balance the accounts: 2004
Jan 1
Suraj commenced business with cash
Rs. 20,000
Jan 2
Purchased furniture for cash from A & Co.
4,000
Jan 2
Purchased goods from B
6,000
Jan 3
Sold goods for cash
800
Jan 4
Paid rent
500
Jan 6
Sold goods to C
1,500
Jan 7
C returned goods
75
Jan 10
Bought goods from D
4,000
Jan 11
Returned goods from D
100
Jan 14
Paid for advertising
250
Jan 15
Paid for stationery
50
Jan 17
Drew for personal use
400
Jan 20
Cash sales
1,600
Jan 21
Received from C
425
15. Journalise the following transactions, post them into the Ledger and balance the accounts: 2003
Sep 1
Manohar started business with cash
Rs. 2,00,000
Sep 1
Bought machinery
50,000
Sep 2
Bought furniture from Rahim & Co.
10,000
Sep 2
Purchased typewriter
2,500
ACCOUNTANCY
443
Sep 3
Purchased goods
17,000
Sep 7
Paid wages
2,000
Sep 9
Bought packing materials

1,000
Sep 10
Cash sales
3,000
Sep 11
Credit sales to Krishna
5,000
Sep 14
Paid wages
2,000
Sep 15
Purchased goods from Ramji
10,000
Sep 16
Retuned goods to Ramji
500
Sep 20
Purchased stationery
200
Sep 21
Bought postage stamps
80
Sep 23
Paid for repairs

400
Sep 24
Paid miscellaneous expenses
150
Sep 27
Paid printing charges
200
Sep 30
Paid salaries
6,000
Sep 30
Paid to Rahim & Co.
5,000
16. From the following particulars given below , write up the purchases day book of
M/s Universal Electric Co., which deals in electrical goods.
2004
Jan 5
Purchased on credit from Bajaj Electronic Co.:
10 electric irons @ Rs. 100 each; 5 electric stoves @ Rs. 75 each
Jan 15
Purchased on credit from Capital Electric Co.:
50 electric heaters @ Rs. 100 each; 20 electric kettles @ Rs. 60 each
Jan 25
Purchased from Paul Electric Co.:

10 toasters @ Rs. 120 each; 5 electric heaters @ Rs. 60 each
Jan 30
Purchased from Bombay Electric Stores on credit:
20 electric shavers @ Rs. 200 each; 5 electric fans @ Rs. 400 each
( Answer: Total of purchases book Rs. 15,075)
17. From the following particulars of M/s Andhra Furnitures, prepare their sales book. Write up the
Ledger accounts also.
2004
Apr 5
Sold on credit to Raju & Co.
10 wooden Almirahs @ Rs. 1000 each
Apr 10
Sold to M/s Anand Wood Works on credit:
5 tables @ Rs. 500 each; 15 chairs @ Rs. 200 each. Trade discount 10%.
Apr 15
Sold on credit to Venkateswara Lodge:
20 cots @ Rs. 1000 each; 20 tables @ Rs. 500 each; 25 stools
@ Rs. 100 each.
Trade discount 10%.
Apr 30
Sold for cash a book rack to Ashok Rs. 500.
( Answer: Total of sales book Rs. 44,200)
Hint: Omit the cash sale
444

18. From the following information, write up a purchases returns book of M/s Goyal and
Sons and post them into Ledger.
2004
May 1
Returned to Uptron Television Co. Ltd.: 4 Colour TVs @ Rs. 10,000 each.
May 15
Returned to Philips (India) Ltd.: 4 pieces of Two-in-Ones @ Rs. 2,500
each.
May 20
Returned to Rama Krishna Electricals Ltd.: 5 pieces of electric heaters @
Rs. 100 each.
May 30
Returned to BPL India Ltd.: 2 VCRs @ Rs. 10,000 each.
( Answer: Total of purchases returns book Rs. 70,500)
19. Rao & Sons is a wholesale stationery merchant. From the following particulars prepare the sales
returns book and its Ledger postings:
2004
May 15
Sanjay & Co. returned 6 dozen pens @ Rs. 50 per dozen, and 2 dozen fine
nibs @ Rs. 10 per dozen.
May 20
M/s Raju Stationers returned 4 dozen 100-page notebooks @ Rs. 25 per
dozen; 2 dozen 200-page notebooks @ Rs. 50 per dozen.
May 25
Sreerama & Co. returned 1 dozen gum bottles @ Rs. 20 per dozen; 3 dozen
ink bottles @ Rs. 35 per dozen; 3 dozen erasers @ Rs. 10 per dozen.
( Answer: Total of sales returns book Rs. 675)
20. Ramanand gives the following information about his business. Record them in the
concerned subsidiary books and post them to Ledger accounts.
2004
Mar 1
Purchased goods from Madhu at the list price Rs. 30,000 less 10% trade
discount.
Mar 5
Sold goods to Raju for Rs. 10,000 less 5% trade discount.
Mar 8
Returned goods to Madhu at the list price Rs. 5,000.
Mar 10
Raju returned us goods at the list price Rs. 1,000.
Mar 12
Purchased goods from Srikant at the catalogue price of Rs. 10,000 less 20%
trade discount.
Mar 15
Sold goods to Sridhar at the catalogue price of Rs. 5,000 less 10% trade
discount.
Mar 18
Returned goods to Srikant at the list price Rs. 2,000.
Mar 20
Sridhar returned us goods at the list price Rs. 1,000.

Mar 22
Purchased goods form Madhu at Rs. 15,000 less 10% trade discount.
Mar 25
Sold goods to Raju for Rs. 10,000.
Mar 27
Sold goods to Madhu for Rs. 5,000.
Mar 28
Purchased goods from Sridhar at the list price Rs. 5,000 less 5% trade
discount.
Mar 29
Ramesh returned us goods Rs. 1,000.
Mar 30
Returned goods to Sridhar at the list price Rs. 500.
( Answer: Total of purchases book Rs. 53,250; Sales book Rs.29,000; Purchases Returns book Rs.
6575; Sales Returns book Rs. 2850)
ACCOUNTANCY
445
21. The following are the Bill transactions of M/s Nagesh Traders, Vijayawada. All the Bills
accepted by M/s Nagesh Traders are payable at the State Bank of Hyderabad. Prepare bills
receivable and bills payable books.
2004
Mar 2
Received a bill duly accepted by S.P. Jain payable at Syndicate Bank,
Hyderabad, after 3 months for Rs. 3,000.
Mar 5
Sent out acceptance to Krishna Mohan of Khammam, payable after one
month for Rs. 2,000.
Mar 10
Drew a bill on M/s Ram & Co. of Warangal for Rs. 1,500 payable after
2 months at State Bank of Hyderabad, Warangal.
Mar 12
Accepted a Bill dated 8.3.2004, drawn by Mohan of Vijayawada for
Rs. 5,000 payable after 3 months.
Mar 15
Received an acceptance from Rama Krishna for Rs. 4,000 payable at Canara
Bank, Hyderabad two months after date, which was endorsed to Sreedhar
Babu on the same day.
Mar 22
Accepted the Bill drawn by Rajaram for Rs. 2,500 payable after two
months.
Mar 25
Drew a Bill on M/s Saptagiri Traders for Rs. 4,500 payable after 90 days
at State Bank of Hyderabad, Tirupathi.
Mar 30
A Bill is drawn on M/s Hariram & Sons payable at Bank of India,
Hyderabad for Rs. 5,000 at 3 months. The Bill is duly accepted and is
discounted with State Bank of Hyderabad, Hyderabad @ 10%.
Mar 31
Accepted the Bill dated 28.3.2004 drawn by Patel & Co. for Rs. 2,500
payable after 2 months.
( Answer: Total of bills receivable book Rs. 18,000; bills payable book Rs. 12,000) 22. From the
following details, prepare a Trial Balance:
Particulars
(Rs.)
Particulars
(Rs.)
Opening Stock
80,000
Postage, Telegrams & Telephones
1,800
Purchases
8,20,000
Discount Received
750
Sales
8,58,000
Discount Allowed
2,000
Purchases Returns
2,500
Bad Debts
1,500
Sales Returns
5,000
Sundry Debtors
2,00,000
Carriage Inwards
3,000
Sundry Creditors
75,000
Carriage Outwards
5,000
Loan
82,750
Bank Overdraft
42,000
Investments
20,000
Cash
8,000
Accrued Income
1,200
Capital
2,55,500
Interest
7,000
Drawings
20,000
Interest Income
600
Wages
14,600
Reserve for Bad Debts
3,500
Salaries
22,000
15,000
Outstanding Expenses
2,000
Machinery
95,000
Prepaid Expenses
1,500
( Answer: Total of Trial Balance Rs. 13,22,600)
446
23. From the following balances from Agarwal's Ledger, prepare a Trail Balance as on 31st
December, 2003:
Particulars
(Rs.)
Particulars
(Rs.)
Building
15,000
Drawings
9,000
Capital
84,950
Loan
12,000
Sales
1,20,000
Returns inward
9,000
Purchases
1,00,000
Stock
35,000
Insurance
600
Salary
1,250
Sundry debtors
25,000
Rent
1,200
Bills receivable
7,800
Salary payable
200
Bills payable
5,200
Sundry Creditors
17,000
Investments
8,000
Commission (Cr.)
1,600
1,500
Interest receivable
600
Cash in hand
7,000
Carriage
3,200
Plant & Machinery
25,000
Advertisement
1,800
Returns Outward
10,000
( Answer: Total of Trial Balance Rs. 2,50,950)
24. From the following list of balances extracted from the books of Rajesh, prepare a Trial Balance
as on 31st March, 2004:
Particulars
(Rs.)
Particulars
(Rs.)
Capital
24,405
Salaries
2,000
Drawings
1,500
Bank loan
2,400
Freehold premises
5,800
Sales
22,500
Sundry debtors
6,750
Stock on 1st April, 2003
10,000
Purchases
11,500
Bills payable
3,425
Sundry creditors
4,250
150
Furniture and Fittings
2,500
Wages
7,535
General expenses
1,625
Bank charges
150
Returns inwards
450
Carriage on sales
175
Postage and Stationery
125
Discount received
140
Discount allowed
420
Cash in hand
240
Cash at bank
1,200
Bills receivable
5,000
( Answer: Total of Trial Balance Rs. 57,120)
25. From the particulars given below, prepare a three-column cash book.
2004
Mar 1
Cash on hand
500
Cash at bank
15,000
Mar 2
Received from Uday
990
Discount allowed
10
Mar 3
Deposited into bank
600
ACCOUNTANCY
447
Mar 4
Purchased goods and paid by cheque
3,000
Mar 5
Sold goods to Ramjee on credit
800
Mar 7
Received cheque from Ramjee
800
Mar 8
Sold goods for cash
1,400
Mar 9
Paid to Kishanlal by cheque
1,400
Discount received
100
Mar 10
Paid salaries
200
Mar 11
Paid telephone bill

100
Mar 13
650
Mar 17
Paid cash to Yadav
300
Discount received
20
Mar 19
Withdrew from bank
1,800
Mar 21
Purchased goods and paid by cheque
500
Mar 22
Sold goods and received payment by cheque
800
Mar 25
Paid rent by cheque
200
Mar 27
Received form Seth & Co. in full settlement of Rs. 700
680
Mar 29
Deposited in bank
600
Mar 31
Paid for stationery
30
( Answer: Cash in hand Rs 2,890 and Cash at bank Rs. 10,900)
26. Prepare a three-column cash book from the following transactions:
2003
Rs.
Sep 1
Anand commenced business with cash
20,000
Sep 2
Paid into bank
10,000
Sep 2
1,600
Sep 3
Sold goods to Kamal and received a cheque
2,400
Sep 6
Bought office furniture and paid by cheque

800
Sep 6
Cheque given by Kamal was deposited in Bank
Sep 8
Received a cheque from Madhu
4,600
Discount allowed
150
Sep 10
Paid to David by cheque
3,000
Discount received
250
Sep 18
Purchased machinery by cheque
6,000
Sep 19
Paid to Naresh
2,800
Discount received
120
Sep 20
900
Sep 21
4,500
Sep 25
Paid rent by cheque
600
Sep 31
Paid electricity charges by cheque
130
Sep 31
Paid salaries
700
( Answer: Cash in hand Rs. 9,400; Cash at bank Rs. 1,070; Discount Dr. Rs. 150 and Discount Cr.
370)
448
27. Prepare a three-column cash book from the following particulars:
2004
Jan 1
Mr. Nanda starts business with capital
Rs.100,000
Jan 2
Opened bank account
10,000
Jan 3
Purchased fixed assets
50,000
Jan 4
10,000
Jan 5
Sales made for cash
50,000
Jan 6
Deposited in bank
40,000
Jan 7
Paid salaries through cheque
10,000
Jan 8
Paid to Mehta in full settlement of his account for Rs. 10,000
9,800
Jan 9
Paid advertising expenses
2,000
Jan 10
Received cash from X & Co. Ltd. in full settlement of
their account for Rs. 15,000
14,500
Jan 11
Paid wages
10,000
Jan 12
Cheque received towards dividend
2,000
( Answer: Cash in hand Rs. 32,700; Cash at bank Rs. 42,000; Discount Dr. 500 and Discount Cr. Rs.
200)
28. Prepare a three-column cash book from the following transactions of JK Brothers:
2004
Rs.
Jun 01
Cash balance in hand
5,000
Cash at Bank
25,000
Jun 04
Invested further capital
10,000
Jun 05
Deposited into bank
4,000
Jun 08
Sold goods for cash
3,500
Jun 10
Cash received from Ashok Brothers
5,000
Discount allowed
150
Jun 11
6,000
Jun 12
Paid to Raghu by cheque
2,500
Discount received
50
Jun 15
Commission paid to agent Mr. Keerthy
400
Jun 16
Purchase office furniture and paid by cheque
11,000
Jun 17
1,000
Jun 22

5,000
Jun 25
Dividend received by cheques and deposited into bank on
the same day
500
Jun 27
Paid into bank
8,000
Jun 30
Paid office rent in cash
2,000
Jun 30
Paid salaries to staff by cheque
5,000
( Answers: Cash in hand Rs. 8,100; Cash at bank Rs. 13,000; Discount Dr. Rs. 150 and Discount Cr.
Rs. 50)
ACCOUNTANCY
449
29. From the following information, prepare a Bank Reconciliation Statement as on 31st
December, 2003.
(a) Balance as per Pass Book (Credit Balance) Rs. 20,000.
(b) Cheques drawn, but not cashed at Bank Rs. 3,000.
(c) Cheques deposited in Bank, but not shown in the Pass Book Rs. 2,250.
(d) Dividend of Rs. 2,000 collected by Bank directly on 30.12.2003 was not recorded
in Cash Book.
(e) Cheque amounting to Rs. 600 was deposited in Bank but it was recorded in the debit
side of the Pass Book.
(f) Bank charges recorded twice in the Cash Book Rs. 50.
( Answer: Balance as per Cash Book Rs. 28,500.)
30. Prepare Bank Reconciliation Statement from the following particulars:
On 31st December 2003, M/s Vani Traders' Pass Book showed a Debit Balance of
Rs. 25,500, but the cash book did not tally with the Pass Book.
(a) Cheques issued but not presented for payment Rs. 8,000.
(b) Two cheques of Rs. 5,000 and Rs. 7,000 deposited in Bank, but the cheque of Rs.
7,000 was collected before 31.12.2003.
(c) Rs. 550 was debited in the pass book towards interest on overdraft, but this amount
was not recorded in the cash book.
(d) Dividends collected and credited in the pass book Rs. 1,500 but no entry in the cash
book.
(e) One of the customers directly remitted into the bank account of M/s Vani Traders
Rs. 2,000. But this transaction was not recorded in cash book before 31.12.2003.
( Answer: Overdraft as per Cash Book Rs. 31,450)
31. Prepare Bank Reconciliation Statement from the following particulars as on 31st March, 2004.
(a) Balance as per the cash book Rs. 30,000.
(b) Cheques of Rs. 2,400, Rs. 1,500 and Rs. 800 were paid into the firm's current
account till March 1990, but out of these a cheque of Rs. 800 was credited by bank
before this date.
(c) Three cheques for Rs. 1,000, Rs. 2,000 and Rs. 3,000 were issued but only first two
cheques were cashed with the bank.

(d) Bank charges of Rs. 100 and interest on firm's deposits Rs. 500 were found only in
pass book.
(e) A customer of a firm remits money in the firm's bank account Rs. 500 but it was
not recorded in the cash book.
(f) Interest on investment collected by the bank on behalf of the firm Rs. 2,500 but this amount was not
found in the cash book.
( Answer: Balance as per pass book Rs. 32,500)
450
32. From the following particulars, prepare a Bank Reconciliation Statement:
(i) Bank overdraft as per cash book Rs. 16,200.
(ii) A cheque deposited as per bank statement but not recorded in the cash book Rs. 700.
(iii) Debit side of the Bank column of the cash book Rs. 100.
(iv) A cheque for Rs. 5,000 deposited, but collection as per bank statement Rs. 4,996.
(v) Bills collected directly by Bank Rs. 3,500.
(vi) A party's cheque returned dishonoured as per Bank statement Rs. 530.
(vii) Bank charges recorded twice in the cash book Rs. 25.
(viii) Bill for Rs. 8,000 discounted for Rs. 7,960 returned dishonoured by the Bank.
Noting charges Rs. 15.
( Answer: Overdraft as per Pass Book Rs. 20,424)
CHAPT E R
6
Types of Business Organisation
LEARNING OBJECTIVES
After studying this chapter, you will be able to understand:

the meaning and characteristics of types of business organizations
the advantages and disadvantages of types of business organizations
the suitability of types of business organizations
the different types of partners and the meaning of Joint Stock Company.
the difference between partnership and sole proprietorship form of business organization
the difference between partnership and Joint Stock Company form of business organization
the procedure of formation of a co-operative society
the different types of public enterprises
the problems in different types of public enterprises
INTRODUCTION
We purchase several items from the local shopkeepers to meet our daily needs. When we
observe their activities, we can understand the process of their business and also their motive.
Actually they buy goods from different sources and then sell those to us according to our expectations.
In this process they earn some profit. We can say that they all are engaged in business. Similarly, the
individuals who produce products for sale, publish magazines and newspapers, provide services like
e-seva, cable TV connection, booking rail tickets, etc. are all engaged in business. These are some of
the examples of business activities. People engaged in business undertake their activities regularly
and thereby earn profit. Although, all these businesses have a common objective of earning profit,
they differ from each other with respect to their size, nature, volume of transaction, management and
ownership, etc. Thus, structurally, they are different.
451
452
FACTORS INFLUENCING THE CHOICE OF SUITABLE FORM
OF ORGANISATION
Capital Requirement.
The need for capital will depend upon the nature of business and scale
of operations. Larger the organization, more will be the capital requirement and vice versa.
After determining the capital needs, the form of organization should be selected. For example, a joint
stock company requires more capital than sole proprietorship and partnership.
Liability.
Liability depends upon the nature of business. There are two types of liability:
limited liability and unlimited liability. In sole proprietorship and partnership, the liability of owners
is unlimited. In case of companies the liability of shareholders is limited to the value of shares they
have purchased. The shareholders can be required to pay only the unpaid amount of shares they are
having. When a business involves many risks, then company form of
organization will be most suitable; otherwise sole proprietorship or partnership should be preferred.
Managerial Needs.
Managerial and administrative requirements are also one of the factors
which influence the choice of form of organization. When the concern is small and it caters to local
needs only, then one person will be enough to manage the business. Sole proprietorship is more
suitable for such business. If the business caters to more areas, then more persons will be required to
look after the business. Partnership form of organization will be more suitable.
When a business is to run on a large-scale basis, it will require the services of experts to manage
various units of a concern. The company form of organization will be most suitable.
Continuity.
If the concern is stable and exists continuously, it will attract more investment.
The trained and skilled people will like to join the concern. The company form of organization
ensures stability and continuity. On the other hand, sole proprietorship and partnership do not exist
after the death or insolvency of owner or partners. They do not have permanent life. A company form
of organization will be more suitable if stability of operations is essential.
Tax Liability.
A joint stock company has more tax liability as compared to a sole
proprietorship and a partnership form of organization. A company is taxed as an individual first and
the profits distributed to shareholders are again liable to tax as income of the recipients.
On the other hand, sole proprietorship and partnership are not separately taxed. A small scale concern
will be able to avoid higher tax liability.

Government Regulations.
Government regulations is another factor influencing a decision
about the form of organization. A number of formalities are required to be complied with while
incorporating a company. A company needs to keep its records transparent for the government every
year. There are no such formalities for the formation of a sole proprietorship and
partnership. In case of partnership, registration of a firm is not compulsory.
Relationship between Ownership and Management.
There is a direct relationship between
ownership and management in sole proprietorship and partnership form of organization. In
company form of organization, management and ownership are in two different hands. The
owners are the shareholders who do not take active interest in the working of the enterprise while
management is in the hands of Board of Directors. When the investors want to retain management in
their own hands, then sole proprietorship or partnership are more suitable.
TYPES OF BUSINESS ORGANISATION
453
Ease in Formation.
The formalities required at the time of formation of a form of
organization depends upon the nature of business. Sole proprietorship and partnership do not require
much legal formalities and are very easy to form and wind up. On the other hand, a company requires
the services of qualified persons for getting it registered and bringing a company into existence. It
need to mobilize huge funds.
Flexibility.
A good form of organization should also provide for flexibility in its operations.
It should be possible to change its operations according to the situation. A sole proprietorship is more
flexible than partnership and company. A sole proprietor has absolute power over the affairs of his
business and is able to introduce changes quickly to meet the needs of changing time and situations
without involving expenditure.
Stability.
Continuity and stability of its operations is another factor that influences the choice
of suitable form of organization. A company form of organization offers the maximum stability or
continuity, as it is not affected in any way by the death or insolvency of its members. On the other
hand, a sole proprietorship comes to an end with the death of the sole proprietor. A partnership form
also gets dissolved due to the death or insolvency of the partners.
The growth of forms of business organizations is closely interconnected with the stages of economic
development of a country. The business unit gradually expanded from Sole Traders into Partnership
Firms and then into Private Limited Companies and into big Public Limited Companies and finally
into huge business combinations like holding companies. The newer
forms of business organization could satisfy all the demands of a growing national economy and they
could systematically look after the ever-expanding and elaborate modern industrial and commercial
activities.
The various forms of business organization can be considered from the point of view of
their ability to raise capital (money), their ability to minimise risk, and their ability to provide some
sort of clear organisational structure. The following are the different types of business organizations
(see Fig. 6.1):
Fig. 6.1 Types of business organisations.
454
A number of forms of organizations exist to suit requirements of different business
undertakings. There are three types of business undertakings:
1. Private Undertakings
2. Public Undertakings
3. Joint Sector Undertakings.
Private Undertakings
These undertakings have the following types of organization:
(i) Sole Proprietorship
(ii) Partnership
(iii) Joint Hindu Family Business

(iv) Joint Stock Company
(v) Co-operative Societies
Public Undertakings
Business organizations owned or operated by public authorities are known as public or state
undertakings. In these undertakings, either whole or most of the investment is done by the
government. The aim of these undertakings is to provide goods and services to the public at a
reasonable rate though profit earning is not entirely excluded. These undertakings have the following
forms of organization:
(i) Departmental Organisations
(ii) Public Corporations
(iii) Government Companies
Joint Sector Undertakings
These undertakings have been recognized after Industrial Policy Resolution of 1956, where a concept
of mixed economy was used. The term Joint Sector was first used by the Dutta
Committee. A joint sector enterprise is intended to be a form of partnership between the private
sector and the government in which government participation of the capital will not be less than 26
per cent. The day-to-day management will normally be in the hands of the private sector partner, and
control and supervision will normally be exercised by a board of directors on which government is
adequately represented.
The different types of organizations are discussed below in detail.
Sole Proprietorship
We go to the market to buy items of our daily needs. In the market we find a variety of shops
some of them small and some of them big. We may find some persons selling vegetables,
peanuts, newspapers, etc. on the roadside. We may also find the cobbler repairing shoes on the
455
footpath. Everyday you come across such types of shops in our locality. In these businesses the owner
invests capital to start the business, takes all decisions relating to business, looks after the day-to-day
functioning of the business, and finally, is responsible for the profit or loss. In some businesses a
single individual and in some businesses a group of individuals perform all these activities.
Meaning of Sole Proprietorship.
Sole means single and proprietorship means ownership.
It means only one person or an individual becomes the owner of the business. Thus, the
business organisation in which a single person owns, manages and controls all the activities of the
business is known as sole proprietorship form of business organisation. The individual who owns
and runs the sole proprietorship business is called a sole proprietor or sole trader. A sole
proprietor pools and organises the resources in a systematic way and controls the activities with the
sole objective of earning profit. Small shops like vegetable shops, grocery shops, telephone booths,
chemist shops, etc. are some of the commonly found sole proprietorship form of business
organisation. Apart from trading business, small manufacturing units, fabrication units, garages,
beauty parlours, etc., can also be run by a sole proprietor. This form of business is the oldest and
most common form of business organisation. It is the first stage in the evolution of the forms of
organization and is thus the oldest among them. It is as old as civilization. This form of organization is
also known as Sole-Trade, Individual-Proprietorship and Single-Entrepreneurship.
Definitions of Sole Proprietorship.
Some important definitions of sole proprietorship form
of organization are as follows:
The sole-trader is a person who carries on business on his own, that is, without the assistance of a
partner. He brings in his own capital and uses all his labour. He also gets himself assisted by
others to whom he pays a salary by way of remuneration.
S.R. Davar
The individual entrepreneurship is the form of business organization on the head of which stands
an individual as the one who is responsible, who directs its operations, who alone runs the risk of
failure.
L.H. Haney
We can now define sole proprietorship as
A business enterprise exclusively owned, managed and controlled by a single person with all
authority, responsibility and risk.
Characteristics of Sole Proprietorship.
Sole proprietorship form of business organisations
has the following characteristics:

1. Single ownership
2. No sharing of profit and loss
3. One-mans capital
4. One-man control
5. Unlimited liability
6. Less legal formalities
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Single Ownership.
A single individual always owns sole proprietorship form of business
organization. That individual owns all assets and properties of the business. Consequently, he alone
bears all the risk of the business. All the profits and losses are taken by the single individual. Thus,
the business of the sole proprietor comes to an end at the will of the owner or upon his death.
No Sharing of Profit and Loss.
The entire profit arising out of sole proprietorship
business goes to the sole proprietor. If there is any loss it is also to be borne by the sole proprietor
alone. Nobody else shares the profit and loss of the business with the sole proprietor.
One Mans Capital.
The capital required by a sole proprietorship form of business
organisation is totally arranged by the sole proprietor. He provides it either from his personal
resources or by borrowing from friends, relatives, banks or other financial institutions.
One-man Control.
The controlling power in a sole proprietorship business always
remains with the owner. The owner or proprietor alone takes all the decisions to run the
business. Of course, he is free to consult anybody as per his liking.
Unlimited Liability.
The liability of the sole proprietor is unlimited. The proprietor is
responsible for all losses arising from the business. The liability is not limited only to his investments
in the business but his private property is also liable for business obligations.
Less Legal Formalities.
The formation and operation of a sole proprietorship form of
business organisation requires almost no legal formalities. It also does not require to be registered.
However, for the purpose of the business and depending on the nature of the
business, the sole proprietorship has to have a seal. He may be required to obtain a licence from the
local administration or from the health department of the government, whenever necessary.
Advantages of Sole Proprietorship.
The sole proprietorship form of business is the most
simple and common in our country. It has the following advantages:
Easy of Formation and Dissolution.
A sole proprietorship form of business is very easy
to form. With a very small amount of capital you can start the business. There is no need to comply
with any legal formalities, except for those businesses which required licence from local authorities
or health department of government. Just like formation it is also very easy to wind up the business. It
is your sole discretion to form or wind up the business at any time.
There are no legal formalities in regard to winding up and all that the businessman has to arrange for
is the satisfaction of creditors claims.
Quick Decision and Prompt Action.
In a sole proprietorship business the sole
proprietor alone is responsible for all decisions. Of course, he can consult others. But he is free to
take any decision on his own. Since no one else is involved in decision-making it becomes quick and
prompt action can be taken on the basis of this decision. This enables him to take advantage of
business opportunities for gain.
Direct Motivation.
The profits earned belong to the sole proprietor alone and he bears
the risk of losses as well. Thus, there is a direct relationship in efforts and reward. If he works hard,
then there is a possibility of getting more profit and of course, he will be the sole TYPES OF
BUSINESS ORGANISATION
457
beneficiary of this profit. Nobody will share this reward with him. Thus, self-interest can be a
powerful driving force to secure economy and efficiency.
Better Control.
In sole proprietorship business the proprietor has full control over each
and every activity of the business. He is the planner as well as the organiser, who co-ordinates every
activity in an efficient manner. Since the proprietor has all authority with him, it is possible to
exercise better control over business.
Secrecy.
Business secrecy is an important factor for every business. It refers to keeping
the future plans, technical competencies, business strategies, etc. secret from outsiders or
competitors. In the case of sole proprietorship business, the proprietor is in a very good position to
keep his plans to himself since management and control are in his hands. There is no need to disclose
any information to others. This business need not publish annual accounts. There is minimum legal
control. Hence under sole proprietorship, privacy and business secrecy in the affairs of the concern
can be maintained.
Flexibility in Operation and Management.
The sole proprietor is free to change the
nature and scope of business operations as and when required as per his decision. A sole
proprietor can expand or curtail his business according to the requirement. The sole
proprietorship is highly flexible as it is capable of adjustment to the requirements of changing
business conditions. Many of the businesses fail in changing their policies according to the situation.
Facility of Co-ordination.
There is no problem of co-ordination. The proprietorship
himself has to decide everything, and therefore he will not take a decision by which the various
interests of the firm clash.
Personal Relationship.
The sole proprietor is always in a position to maintain good

personal contact with the customers and employees. Direct contact enables the sole proprietor to
know the individual likes, dislikes and tastes of the customers. Also, it helps in maintaining close and
friendly relations with the employees, and thus business runs smoothly.
Lower Costs of Management.
The business is mostly supervised, managed and
controlled by the sole proprietor alone. He can avoid wastage in his business. In this way managerial
costs are saved to a maximum extent.
Encourages Self-employment.
Sole proprietorship form of business organization leads
to creation of employment opportunities for people. Not only is the owner self-employed,
sometimes he also creates job opportunities for others. You must have observed in different shops that
there are a number of employees assisting the owner in selling goods to the
customers. Thus, it helps in reducing poverty and unemployment in the country.
Limitations of Sole Proprietorship.
One-man business is the best form of business
organization because of the above-discussed advantages. Still there are certain disadvantages too.
They are:
Limited Capital.
In sole proprietorship business, it is the owner who arranges the
required capital of the business. It is often difficult for a single individual to raise a huge 458
amount of capital. The owners own funds as well as borrowed funds sometimes become
insufficient to meet the requirement of the business for its growth and expansion.
In case the sole proprietor fails to pay the business obligations and
debts arising out of business activities, his personal properties may have to be used to meet those
liabilities. Unlimited liability also discourages the expansion of business. The sole trader will have
to think twice before adopting new and risky adventures as his private property is constantly in
danger of getting liquidated for meeting the debts and obligations of his business.
Lack of Continuity.
The existence of sole proprietorship business is linked to the life
of the proprietor. Illness, death or insolvency of the owner brings an end to the business. The
continuity of business operation is therefore uncertain.
Limited Size.
In sole proprietorship form of business organisation there is a limit beyond
which it becomes difficult to expand its activities. It is not always possible for a single person to
supervise and manage the affairs of the business if it grows beyond a certain limit.
Lack of Managerial Expertise.
A sole proprietor may not be an expert in every aspect
of management. Modern business is full of complications especially due to the ever-changing nature
of the market and the various laws that are being enacted. An individual may not be an expert in all
matters and therefore sometimes his decisions may be unbalanced. Again,
because of limited financial resources it is also not possible to employ a professional manager.
Thus, the business lacks benefits of professional management.
No Economies of Large Scale and Specialisation.
A sole trader cannot secure many
economies due to small size of the business and as the degree of specialization is very small the
benefits of specialization or services of experts cannot be obtained.
The advantages and limitations of sole proprietorship can be summed up as follows:
Advantages
Limitations
Ease of formation and dissolution
Limited capital
Quick decision and prompt action

Unlimited liability
Direct motivation
Lack of continuity
Better control
Limited size
Secrecy
Lack of managerial expertise
Flexibility in operation and management
No economies of large scale
Facility of co-ordination
and specialisation
Personal relationship
Lower costs of management
Encourages self-employment
Suitability of Sole Proprietorship Form of Business.
From the above merits and demerits
of sole proprietorship, it can be concluded that one-man control of business would be most efficient
and profitable if only that one man has the capacity to manage anything indefinitely.
Unfortunately such a person does not exist. This form of business is, therefore, suitable in the
following cases:
459
Where the market for the product is small and local. For example, selling grocery items, books,
stationery, vegetables, etc.
Where customers are given personal attention, according to their personal tastes and
preferences. For example, making special type of furniture, designing garments, etc.
Where the nature of business is simple. For example, grocery, garments business,
telephone booth, etc.
Where capital requirement is small and risk involvement is not heavy. For example,
vegetables and fruits business, tea stall, etc.
Where manual skill is required. For example, making jewellery, haircutting or tailoring, cycle or
motorcycle repair shop, etc.
Sole proprietorship has its own scope of activity, and continues to exist in spite of the development of
bigger organizations. However, simplicity of operation, ease of formation, availability of flexibility
and freedom of action are the important points of this form of organization and these are responsible
for making sole proprietorship a relatively more common and popular form of organization. Thus, in
India, the individual entrepreneur organization is still quite popular.
Partnership
Suppose if you want to open a departmental store, restaurant, etc. in your locality. You will need to
gather together a lot of things. You may find that it is not possible to arrange the money required to
start and run the business alone. You may then talk to your friends and all of you agree to run the
restaurant by contributing a certain amount of money and the other things required. So all of you join
hands together to become the owners and share the profits and losses. This is another form of
business organisation. It is different from sole proprietorship form of organization.
Meaning of Partnership.
You have studied that sole proprietorship form of business
organisation has certain limitations. In sole proprietorship, financial and managerial resources are
limited, one man cannot supervise all the business activities personally and risk-bearing capacity of
an individual was also limited. It is also not possible to expand the business activities beyond a
certain limit. In order to overcome these drawbacks, another form, i.e.
partnership form of business has come into existence.
Partnership is basically a relation between two or more persons who join hands to form
a business organisation with the objective of earning profit. The persons who join hands are
individually known as Partners and collectively a Firm. The name under which the business is
carried on is called its Firm Name.
The partners provide the necessary capital, run the business jointly and share the
responsibility. They decide: (i) the amount of capital to be contributed by each one of you; (ii) who
will manage; (iii) how will the profits and losses be shared. Thus, there must be some agreement
between the partners before they actually start the business. This agreement is termed as Partnership
Deed, which lays down certain terms and conditions for starting and running the partnership firm.
This agreement may be oral or written. Actually, it is always better to insist on a written agreement
among partners in order to avoid future controversies.
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Definitions of Partnership.
A partnership firm is governed by the provisions of the Indian
Partnership Act, 1932. Section 4 of the Indian Partnership Act, 1932, defines partnership as A
relation between persons who have agreed to share the profits of a business carried on by all or
any of them acting for all.
The relationship between persons who agree to carry on a business in common with a view to
private gain
L.H. Haney
Two or more individuals may form a partnership by making a written or oral agreement that they
will jointly assume full responsibility for the conduct of business
John A. Shubin
Partnership has two or more members, each of whom is responsible for the obligation of the
partnership. Each of the partners may bind the others and the assets of the partners may be taken
for debts of partnership.
Kimball and Kimball
Characteristics of Partnership Form of Business Organisation.
The characteristic features
of this form of business organization are:
Association of Two or More Members.
In partnership, there must be at least two
persons. The persons becoming partners must be competent to enter into a contract. According to
Section 11 of the Contract Act there is no maximum limit on partners in Partnership Act, but
according to the Companies Act the maximum number of members should not exceed 10
in case of banking business and 20 in case of other business. If the number of members exceeds this
maximum limit, then that business cannot be termed partnership business.
Agreement.
Whenever you think of joining hands with others to start a partnership
business, first of all there must be an agreement between all of you. This agreement contains the
amount of capital contributed by each partner; profit or loss sharing ratio; salary or commission
payable to the partner, if any; duration of business, if any; names and addresses of the partners and the
firm; duties and powers of each partner; nature and place of business; and any other terms and
conditions to run the business.
Lawful Business.
The partners should always join hands to carry on any kind of lawful
business. To indulge in smuggling, black marketing, etc. cannot be called partnership business in the
eyes of the law. Again, doing social or philanthropic work is not termed partnership.
Competence of Partners.
Since individuals join hands to become the partners, it is
necessary that they must be competent to enter into a partnership contract. Thus, minors, lunatics and
insolvent persons are not eligible to become partners. However, a minor can be admitted to the
benefits of partnership, i.e., he can have a share in the profits only.
Sharing of Profit.
The main objective of every partnership firm is sharing of profits of
the business amongst the partners in the agreed proportion. In the absence of any agreement for the
profit sharing, it should be shared equally among the partners.
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Just like the sole proprietor, the liability of partners is also
unlimited. That means if the assets of the firm are insufficient to meet the liabilities, the personal
properties of the partners, if any, can also be utilised to meet the business liabilities.
The creditors can recover their dues from the property of any or all partners in case the firms assets
are insufficient. Suppose the firm has to make payment of Rs. 1,00,000 to the suppliers of goods. The
partners are able to arrange only Rs. 75,000 from the business. The balance amount of Rs. 25,000
will have to be arranged from the personal properties of the partners.
Voluntary Registration.
It is not compulsory that you register your partnership firm.
However, if you dont get your firm registered, you will be deprived of certain benefits, therefore it is
desirable. The effects of non-registration are:
Your firm cannot take any action in a court of law against any other parties for
settlement of claims.
In case there is any dispute among partners, it is not possible to settle the disputes
through a court of law.
Your firm cannot claim adjustments for amount payable to or receivable from any other
parties.
No Separate Legal Existence.
Just like sole proprietorship, partnership firm also has no
separate legal existence from that of it owners. Partnership firm is just a name for the business as a
whole. The firm means the partners and the partners collectively mean the firm.
Principal-Agent Relationship.
All the partners of the firm are the joint owners of the
business. They all have an equal right to actively participate in its management. Every partner has a
right to act on behalf of the firm. When a partner deals with other parties in business transactions,
he/she acts as an agent of the others and at the same time the others become the principal. So there
always exists a principal-agent relationship in every partnership firm.
Restriction on Transfer of Interest.
A partner cannot transfer his share to an outsider
without the consent of the other partners. This is so because partnership is a contract between
individual partners and contract resting on utmost good faith.
Utmost Good Faith.

A partnership agreement rests on utmost good faith. The partners
must therefore be just and honest to one another. It is very important that partners should act as
trustees and for the common good of all. They must disclose every information and present true
accounts to one another.
Continuity of Business.
A partnership firm comes to an end in the event of death, lunacy
or bankruptcy of any partner. Even otherwise, it can discontinue its business at the will of the
partners. At any time, they may take a decision to end their relationship.
Advantages of Partnership Form of Business Organisation.
Partnership form of business
organization is an excellent form of organization when the business is to be conducted on a medium
scale and when the partners work in a harmonious manner. It has certain advantages, which are as
follows:
462
Easy Formation.
Like sole proprietorship, the partnership business can be formed easily
without any legal formalities. It is not necessary to get the firm registered. A simple agreement, either
oral or in writing, is sufficient to create a partnership firm. The agreement can be altered at the will
of the partners. In short, the partnership form of business enjoys considerable flexibility.
Larger Resources.
Since two or more partners join hand to start partnership business it
may be possible to pool more resources as compared to sole proprietorship. The partners can
contribute more capital, more effort and also more time for the business. A partnership
commands more resources than a sole proprietor and hence the scale of operations can be
enlarged to reap important economies. As a firm requires more resources, more partners can be
admitted.
Promptness in Decisions.
The partners are the owners of the business. Each of them has
equal right to participate in the management of the business. In case of any conflict they can sit
together to solve the problems. Since all partners participate in decision-making, there is less scope
for reckless and hasty decisions. Thus, partnership can take advantage of business
opportunities for gain.
Flexibility in Operations.
The partnership firm is a flexible organisation. At any time
the partners can decide to change the size or nature of business or area of its operation. There is no
need to follow any legal procedure. Only the consent of all the partners is required.
Personal Supervision.
Partners look after the business personally and guard against
wastage. Besides, the staff can be supervised more effectively when the partners show an active
interest in management.
Reduced Risk.
The losses incurred by the firm will be shared by all partners and hence
the share of loss of each partner will be less than in case of sole proprietorship.
Secrecy.
The business affairs and accounts of the partnership do not require publicity by
law as in the case of companies. Hence, all affairs of the firm can be kept secret. Annual accounts
need not be maintained in any prescribed form and auditing of account is also not required by law.
Protection of Interest of Each Partner.
In a partnership firm every partner has an equal
say in decision-making. If any decision goes against the interest of any partner he can prevent the
decision from being taken. In extreme cases a dissenting partner may withdraw himself from the
business and can dissolve it.
Benefits of Specialization.
Since all the partners are owners of the business they can
actively participate in every aspect of business as per their specialisation and knowledge. If you want
to start a firm to provide legal consultancy to people, then one partner may deal with civil cases, one
in criminal cases, and another in labour cases and so on as per their specialization.
Similarly two or more doctors of different specialization may start a clinic in partnership.
Simple Dissolution.
The dissolution of partnership is also easier. In case of partnershipat-will, it can be dissolved by giving 14 days notice to other partners. The partnership is purely
463
a voluntary association and the procedure for the dissolution of partnership is simple.
Generally, the partnership agreement provides regulations for the dissolution of the firm.
Limitations of Partnership Form of Business Organisation.
In spite of all these advantages
as discussed above, a partnership firm also suffers from certain limitations. They are:
All the partners are jointly as well as separately liable for the debt
of the firm to an unlimited extent. Thus, they can share the liability among themselves or any one can
be asked to pay all the debts even from his personal properties.
Uncertain Life.
The partnership firm has no legal entity separate from its partners. It
cannot enjoy continuous existence as in case of Joint Stock Company. It comes to an end with the
death, insolvency, incapacity or the retirement of any partner. Further, any dissenting member can also
give notice at any time for dissolution of partnership.
Lack of Harmony.
You know that in a partnership firm every partner has an equal right
to participate in the management. Also, every partner can place his or her opinion or viewpoint
before the management regarding any matter at any time. Because of this sometimes there is a
possibility of friction and quarrel among the partners. Difference of opinion may lead to closure of
the business on many occasions. The business may be paralysed and may come to
an end due to conflicts among partners.
Limited Resources.
Since the total number of partners cannot exceed 20, the capital to
be raised is always limited. Also, because of the need to keep down the number as far as
possible for harmonious working, the total resources of the partnership are rather limited.
Therefore, it may not be possible to start a very large business in partnership form.
No Transferability of Share.
The partnership share is not freely transferable. If you are
a partner in any firm you cannot transfer your share of interest to outsiders without the consent of
other partners. This creates inconvenience for the partner who wants to leave the firm or sell part of
his share to others. The transfer of share without the consent of other partners can act as the cause for
the dissolution of the firm with the help of the court.
Limited Risk-taking.
The unlimited liability of a partner commits even his private
property. Partners, therefore, tend to play safe and pursue unduly conservative policies.
Lack of Prompt Decisions.
All important decisions are taken by the consent of partners,
and so decision-making process becomes time-consuming. There may be possibility of losing
business opportunities because of slow decision-making.
Burden of Implied Authority.
A partner can bind the business by his acts. He can act
as an agent of the business. A dishonest partner may lead the business in difficulties. The other
partners will have to meet the obligations incurred by the partner. The provision of implied authority
may create problems for the business.
No Public Confidence.
In the absence of publication of accounts and in absence of any

stricter legal control over the affairs of partnerships, it is said that there is much less public
confidence in partnerships.
464
The advantages and limitations of a partnership can be summed up in the following way:
Advantages
Limitations
Easy formation
Unlimited liability
Larger resources
Uncertain life
Promptness in decisions
Lack of jarmony
Flexibility in operations
Limited resources
Personal supervision
No transferability of shares
Reduced risk
Limited risk-taking
Protection of interest of each partner
Lack of prompt decisions
Benefits of specialization
Burden of implied authority
Simple dissolution
No public confidence
On the whole, the partnership form of organization is excellent when the size of the
business is not large and when partners can work in full co-operation with one another. When the firm
becomes large and partners cannot cope with the needs of expansion, the business should better be
organised as a joint stock company. Thus, the partnership form of organization is suitable mainly for
medium-scale business.
Kinds of Firms.
In the United Kingdom, there are two kinds of firms: (a) general firms and
(b) limited firms. In a general firm all partners have unlimited liability and in a limited firm all except
one may have limited liability. In India, all partnerships are general firms and we have no such
limited partnership. The general or unlimited firms may be of three types:
(a) partnership-at-will; (b) partnership for a specific period or duration and (c) partnership for a
certain adventure or purpose. The partnership-at-will is terminable at the will of any partner and
termination can be brought about by serving 14 days notice on other partners. The second and the
third types of partnerships are terminable at the expiry of the period and at the completion of the
adventure respectively.
Kinds of Partners.
In a partnership firm you can find different types of partners. Some may
actively participate in the business while others prefer not to keep themselves engaged actively in the
business activities after contributing the required capital. Also, there are certain kinds of partners
who neither contribute capital nor actively participate in the day-to-day business operations. The
following are the different kinds of partners (see Fig. 6.2).
Active Partners.
The partners who actively participate in the day-to-day operations of
the business are known as active or working partners. They enjoy full voice in its management.
They contribute capital and are also entitled to share the profits of the business. They may act in
different capacities such as manager, organizer, adviser and controller of all the affairs of the firm.
They are also liable for the debts of the firm. They may also be called working partners.
Sleeping Partners or Dormant Partners.
Those partners who do not participate in the
day-to-day activities of the partnership firm are known as dormant or sleeping partners. They have
no voice in its management. They only contribute capital and share the profits or bear the losses, if
any. To the third parties they are equally liable as other partners, that is to say, their liability too is
unlimited.
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Active
Partner
Sleeping or
Sub-partner
Dormant
Partner
Secret Partner
Kinds of
Partners
Nominal Partner
.
Partner by
holding out
Partner in
Profits
Partner by
Minor as a
estoppel
Partner
Fig. 6.2 Kinds of partners.
Nominal Partners.
These partners only allow the firm to use their name as a partner.
They do not have any real interest in the business of the firm. They do not invest any capital or share
profits, and also do not take part in the conduct of the business of the firm. He is just an ornament to
the firm and on the strength of his reputation and goodwill the firm may attract additional business and
fresh capital. He may or may not be given some share in the profit. However, they remain liable to
third parties for the acts of the firm.
Partner in Profits.
A person may become a partner for sharing the profits only. He
contributes capital and is also liable to third parties like other partners. He is not allowed to take part
in the management of the business. Such partners are associated for their money and goodwill.
Minor as a Partner.
A minor, i.e., a person under 18 years of age is not eligible to
become a partner. Since a minor does not enjoy the capacity to enter into contracts in his own right, he
cannot be a full-fledged partner in a partnership firm. He can, however, be admitted to the benefits of
partnership. However in special cases a minor can be admitted as partner with certain conditions. A
minor can only share the profit of the business. In case of loss his liability is limited to the extent of
his capital contribution for the business. On attaining majority, or on his coming to know of his
admission as a partner, he has to choose whether he will continue as a partner or not. If he does not
give a public notice of his choice within six months, he will be treated as having decided to continue
as a partner. In case he chooses or is deemed to be a partner, his liability will become unlimited with
effect from the date of his original admission to the benefits of the partnership.
Partner by Estoppel.
If a person falsely represents himself as a partner of any firm, or
behaves in a way so that somebody can have an impression that such person is a partner, and on the
basis of this impression transacts with that firm, then that person is held liable to the third party. The
person who falsely represents himself as a partner is known as partner by 466
estoppel. Take an example. Suppose in Rama Krishna & Co. firm there are two partners. One is
Rama, the other is Krishna. If Gopi, an outsider, represents himself as a partner of Rama Krishna &
Co. and transacts with Viki then Gopi will be held liable for any loss arising to Viki.
Here Gopi is partner by estoppel.
Partner by Holding Out.

If a person is declared (by word or deed) to be a partner by
another person, the person concerned should deny it immediately on coming to know of such a
declaration. If he does not, he will be liable to those third parties who lend money or otherwide give
credit to the firm on the basis of his being a partner. Such a partner is known as a partner by holding
out.
Secret Partner.
The position of a secret partner lies between active and sleeping partner.
His membership of the firm is kept secret from outsiders. His liability is unlimited and he is liable for
the losses of the business. He can take part in the working of the business.
Sub-partner.
A partner may associate anybody else in his share in the firm. He gives
a part of his share to the stranger. The relationship is not between the sub-partner and the firm but
between him and the partner. The sub-partner is a non-entity for the partnership. He is not liable for
the debts of the firm.
Rights and Obligations of Partners.
The relationship of partners among themselves, their
rights and obligations are generally specified in the partnership agreement or deed. If
partnership deed is silent about it, then the partners shall have rights and obligations mentioned in the
Partnership Act.
Rights of a Partner
1. Every partner has a right to take part in the conduct and management of the business.
2. Every partner has a right to be consulted before taking important decisions.
3. The partners will have a right to inspect books of accounts.
4. Every partner will have an equal share in profits, unless otherwise mentioned, in
partnership deed.
5. No new partner can be admitted into partnership without the consent of all partners.
6. Every partner has a right to receive interest per annum on the excess money supplied
over his capital.
7. Every partner has a right to be indemnified by the firm in respect of expenses
incurred or losses suffered for the normal conduct of the business.
8. A partner has a right to get the firm dissolved under appropriate circumstances.
Obligations of a Partner
1. Every partner should carry on the business to the common advantage.
2. All partners much perform their duties honestly and diligently.
3. A partner is not entitled to get remuneration for the conduct of business, unless
otherwise it is specially mentioned in the partnership deed.
4. A partner is bound to keep and render true and correct accounts of the business.
5. A partner cannot carry on a competing business. If he carries on such business he
shall account for and pay to the firm all profits made by him in that business.
6. A partner is bound to act within the scope of his authority.
467
7. No partner can make a secret profit of the partnership business by way of
commission, etc. If he does so, he must return the money to the firm.
Partnership Agreement or Partnership Deed.
The partnership deed is a must for
partnership. The partnership agreement contains the terms and conditions relating to partnership and
the regulations governing its internal management and organization. When there is no
agreement among the partners, differences may develop. It is for this reason that before the
partnership is formed, all mutual rights, powers and obligations should be discussed and
incorporated in a agreement. The contents of a partnership agreement are settled by mutual consent of
all the partners. Sometimes it is called the Articles of Partnership. It may be oral or in writing. To
avoid future controversies, agreement in writing if preferred. The services of a lawyer should be
utilized for drafting the agreement. The Deed has to be stamped in
accordance with the Indian Stamps Act and it is also registered in a court of law. Thus, a deed from a
partnership agreement enjoys legal status and it can act as legal evidence in future to settle any
dispute or differences. A regular partnership agreement signed by all partners can ensure smooth
running of the partnership business. Each partner should have a copy of the Deed. It may contain the
following clauses:
1. The nature of business;
2. The name of the business and the town and place where it will be carried on;
3. The amount of capital to be contributed by each partner;
4. Whether loans will be accepted from a partner over and above the capital and, if so,
at what rate of interest;
5. The duties, powers and obligations of all the partners;
6. The method of preparing accounts and arrangement for audit;
7. The appropriation of profit with particular reference to the questions as to:
(a) whether interest will be allowed on capitals and, if so, at what rate;
(b) whether a partner will be allowed salary or commission for work done by him;
and
(c) profit sharing ratio.
8. The amount to be allowed as private drawings for each partner and the interest to be
charged on the drawings;
9. The method by which a partner may retire and the arrangements for payment of the
dues of a retired or deceased partner;
10. The method of valuation of goodwill on admission or death or retirement of a
partner;
11. The method of revaluation of assets and liability on admission or retirement or death of a partner;
12. Whether a partner can be expelled and, if so, the procedure for expulsion;
13. The circumstances under which the partnership will stand dissolved, and in case of
dissolution, the custody of books;
14. Arbitration in case of disputes among partners; and
15. Arrangement in case a partner becomes insolvent.
Registration of Partnership.
The Indian Partnership Act does not make it compulsory for
a firm to be registered, but there are certain disabilities which attach to an unregistered firm.
468
These disabilities make it virtually compulsory for a firm to be registered. As per the Act, the firm
may be registered at any time. However, provisions of the Act with reference to
registration are framed in such a manner that in practice every firm cannot afford to remain
unregistered for a long time.
Registration Procedure.
The partners have to prepare a statement which will give the
following particulars:
1. Name of the firm;
2. Principal place of business of the firm;
3. Name of other places where the firm carries on business;
4. Names in full, and addresses of the partners;
5. The dates on which various partners joined the firm; and
6. The duration of the firm.
The statement shall be duly dated and signed by all the partners. It will be submitted to the Registrar
of Firms along with necessary registration fee. The Registrar will enroll the name of the firm and
names of partners on the Registrar of Firms. Changes in the above particulars have to be
communicated to the Registrar within 14 days of such alterations. The entries made in the register
maintained by the Registrar will be treated as conclusive.
Effects of Non-registration.
As per the Partnership Act, an unregistered firm will have
to suffer from a number of handicaps or disabilities. But the moment the firm is registered, it will be
free from all such difficulties. The unregistered firm will have the following disabilities:
1. The firm or its partner cannot take legal action against third parties.
2. Rights of third parties or outsiders are unaffected even if the firm is unregistered.
3. The firm cannot demand a set-off or balancing of debt against the credit as long as
it is unregistered.
4. A partner cannot sue the firm or other partners as long as the firm is unregistered.
However, only under one exceptional situation a partner can sue the firm and that is
for the dissolution of the firm with the help of a court of law.
5. The firm cannot take court action against any partner as long as it is unregistered.
The transactions of an unregistered firm are perfectly legal. But it will not be allowed to take the help
of the court to settle its disputes with outsiders or partners. At present, generally all trading concerns
are doing majority of their transaction on credit basis and cash basis, are rather rare. Hence, in
practice, all firms should get themselves registered as early as possible.
All the disabilities of a non-registered firm are automatically removed as soon as the firm is duly
registered.
Difference between Partnership and Sole Proprietorship.
In the previous section you
learnt about sole proprietorship form of business organisation. Now you have gone through the
partnership form of business organisation. These forms have their own distinctive features,
advantages and limitations. Let us compare them to find out the difference between them.
469
Basis of Difference
Partnership
Sole Proprietorship
1.Formation
It can be formed only on the
No agreement is required to
basis of an agreement among
start the business. It is formed
the partners.
at any time whenever desired
by the sole proprietor.
2.Governing Act
It is governed by the Indian
There is no specific Act that
Partnership Act, 1932.
governs a sole proprietorship
business.
3.Number of members
Minimum two and maximum
Only one member.
10 in banking and 20 in other
businesses.
4.Registration
A partnership firm needs
No registration of a sole-trade
registration to get certain
business is required except

advantages of registration.
under
the
Shops
and
Though registration is not
Establishment Act.
compulsory, non-registration
puts a restriction on firms to
take legal actions.
5.Capital
Capital is provided by partners
Capital is arranged by sole
in an agreed ratio.
proprietor alone.
6.Decision-making
It takes time to decide upon
Decision-making is very quick
important matters because all
because there is no need to
the
partners
must
be
consult anyone else for taking
consulted for taking decisions.
decisions.
7.Sharing of profit and
Profits and losses are shared
The question of sharing of
loss
by partners as per agreement.
profits or losses does not
arise. The sole proprietor
alone takes all profits and
bears all losses.
8.Ownership and manageOwned,
controlled
and
This is completely owned,
ment
managed by partners.
controlled and managed by
the sole proprietor.
9.Secrecy
The secrets of the business
There is a complete secrecy in

are in the knowledge of all the
the business because the
partners, and so there is a fear
owner does not share the
of these being leaked out.
secrets with anybody else.
10.Risk
The business risk is shared
The whole risk is borne by the
by all the partners in
sole trader.
proportion of their shares.
11.Uncertainty of life
The life of a partnership is
The life of sole proprietorship
more certain than that of a
is linked to the life of the
sole proprietorship.
proprietor. Illness, death or
insolvency of the owner
bringsan end to the business.
The continuity of business
operation is therefore uncertain.
470
Dissolution of Partnership.
A partnership is dissolved automatically when:
1. the term for which the partnership was entered into expires;
2. the venture for which the partnership was formed is completed; and
3. a partner dies, becomes insolvent or retires.
It is not necessary that when a partnership is dissolved, the firm should also stand dissolved because
it is up to the remaining partners to agree to continue the firm; the partnership is changed to continue
the old business. The dissolution of the firm takes place in the following circumstances:
(a) when the partners agree that the firm should be dissolved;
(b) when all the partners (or all except one) become insolvent;
(c) when the business becomes illegal;
(d) when a partner gives notice of dissolution in case the partnership is at will; and
(e) when a court of law orders that the firm be dissolved.
Dissolution by Court of Law.
The circumstances in which the court may order the
dissolution of the firm are as follows:
(a) when a partner becomes unsound of mind;
(b) when a partner becomes permanently incapacitated;
(c) when a partner is guilty of misconduct affecting the business;
(d) when a partner or partners persistently disregard the partnership agreement;
(e) when a partner transfers or assigns his interest or share in the firm to a third person; (f) when the
business cannot be carried on except at a loss; and
(g) when it appears just and equitable to the court.
In the above circumstances the court of law has option to refuse to order dissolution. In case the firm
is dissolved, the rights and obligations of partners are not affected till the business is completely
wound up.
Suitability of Partnership Form of Business Organization.
Partnership form of
organization was developed because of certain drawbacks in sole proprietorship form of
organization. The advancement in the technology has necessitated more investment and a need for
specialized people. Partnership form of organization is suitable under certain situation. It is more
suitable under the following circumstances:
(a) A partnership firm is suitable in case of small and medium scale concerns where the
capital requirement is medium, i.e., it is neither too large nor too small. The market
for their products is limited. Business like retail and wholesale trade or small
manufacturing units can be successfully started by partners.
(b) You learnt that in a partnership firm persons having different ability, managerial
talent, skill and expertise join together. So it is most suitable for construction,
business, legal firms, etc., where each partner contributes the best as per his
specialization.
(c) A partnership firm is suitable in those businesses where there is a need of direct
contact with the consumers. For example, doctors, chartered accountants, wholesale
and retail trade, etc.
471
In short, partnership is an ideal form of organization for small-scale and medium-size
business where we have limited market, limited risk of loss, limited capital and limited
specialization in management.
Joint Hindu Family Business
This form of organization is prevalent in India only and that too among Hindus. The
membership can be acquired only by birth or by marriage to a male person who is already a member
of a Joint Hindu Family. The business of a Joint Hindu Family is controlled by the Hindu Personal
Law instead of Partnership Act. All the affairs of the Joint Hindu Family are controlled and managed
by one person who is known as the Karta or Manager. He has a
very unique position which no other officer of any organisation has. He works in consultation with
other members of the family but ultimately he has a final say. The liability of Karta
is unlimited but the liability of other members is limited to their shares in the business.
Characteristics
Governed by Hindu Law.
The control and management of the Joint Hindu Family is
done according to the uncodified or codified Hindu Law. The uncodified Hindu Law consists of two
schools, Mitakshara and Dayabhaga. Dayabhaga is prevalent in Bengal and Assam,
whereas in the rest of India, it is Mitakshara. Mitakshara is applicable even in Bengal and Assam on
the points where Dayabhaga is silent. The rights and duties of its members are
governed by uncodified Hindu Law.
Management.
The family affairs are managed by the seniormost male member of the
family known as the Karta or Manager. The powers of management are unlimited. The
management is more effective due to the natural love and affection with the members of the family.
The members also have full faith and confidence in the Karta. Only the Karta is entitled to deal
with third parties. Others can transact with outsiders only with the permission of Karta.
Membership.
The membership of the family can be acquired only by birth. Whosoever
is born in the family becomes a member. Unlike other business organizations, outsiders cannot be
admitted to this by contract. Membership can be acquired by adoption or by marriage with the male
member. These are the only two exceptions by which membership is acquired other
than birth.
Liability.
The liability of the Karta is unlimited by the liability of other members is
limited to the extent of property which is jointly held by the family. The self-acquired property of any
member cannot be taken in order to satisfy the loans taken by the family. It is only the joint family
property which is liable for satisfying debts.
Continuity.
A Joint Hindu Family consists of a common ancestor, which is a must to
bring a Joint Hindu Family into existence. This consists of all his male descendants upto any
generation along with their wives and unmarried daughters. The death of a common ancestor does not
bring the Joint Hindu Family to an end. It continues till perpetuity, as upper links are removed by
death and lower ones are added by birth.
472
Maintenance of Accounts.
Accounts are maintained by the Karta but this is not
obligatory on his part. He is not accountable to any member and no member can ask what are the
profits and losses of a transaction.
Advantages
Centralised Management.
The management of a Hindu Joint Family firm is centralized
in the hands of one man known as the Karta. He takes all decisions and gets them
implemented with the help of other members. No other members interferes in his management.
Secrecy.
As the Joint Hindu Family firm is maintained by the head of the family known
as the Karta, he can maintain utmost secrecy, which no other business can maintain. He can keep
secret even from the other members of the family.
Liability.
The liability of all the members of the family firm is limited to the extent of
their undivided shares in the property of the family. However, the Kartas liabilities are unlimited.
Quick Decisions.
In Joint Hindu Family firm, as the Karta is the only decision-maker,
he can take a very quick and immediate decision. The decision which is taken by the Karta is final.
This advantage is lacking in other forms of organization like joint stock company, partnership, etc.
where the decisions are taken by all the members or partners.
Mobilisation of Funds.
In Joint Hindu Family Firm, the credit facilities are more as the
liability of the Karta is unlimited. There is also an obligation on the part of the Kartas sons to satisfy
even the unsatisfied debts raised by him during his lifetime.
Allocation of Work.
Unlike other business organizations, the work is assigned to the
members according to their capacity and skills. More capable persons may be given more work than
incapable persons in the family.
Economy.
As the profits of the firm form the part of joint family property, the family
members are careful in the maintenance of the affairs. The Karta spends money with great care and
economy.
Love and Affection.
The members in the firm are acquired by birth, adoption or by
marriage, and not by any other contract like in other forms of organization. Rather than
contractual relationship, we find natural love and affection which the members have for each other.
Due to this, they ignore the drawbacks or limitations of each other and help to run the business more
smoothly and efficiently.
Limitations
Limited Capital.
The investments are limited only up to the resources of one family.
They may not be able to meet the business requirements for expansion of business. Only small and
medium industries are encouraged in these firms.
Limited Managerial Skills.

Only the head of the family, i.e., Karta will manage the
family business. He will be performing all the functions of management. He may not be wellconversant with the knowledge of business and the problems in it. As the other members of TYPES
OF BUSINESS ORGANISATION
473
the family do not get involved and take decisions relating to business, they may not be in a position to
guide the Karta.
No Reward.
The work is assigned according to the capacity and skills of the family
members. The persons who work more efficienty are not rewarded for their work due to which they
get discouraged. Due to no reward all the family members try to contribute very less towards the
business and sometimes they try to avoid work.
Suspicion.
The Karta is empowered with vast power of secrecy and he can keep a thing
secret even from other family members. But there is no restriction on him that he cannot
disclose anything to any person with whom he is having more attachment and love. This leads to
suspicion among the members themselves which can affect the smooth functioning of the
business.
The advantages and limitations of a Joint Hindu Family Business can be summed up as
follows:
Advantages
Limitations
Centralised management
Limited capital
Secrecy
Limited managerial skills
Liability
No reward
Quick decisions
Suspicion
Mobilisation of funds
Allocation of work
Economy
Joint Stock Company
You must have heard about Reliance Industries Limited (RIL), Tata Iron and Steel Company
Limited (TISCO), Steel Authority of India Limited (SAIL), Maruti Udyog Limited (MUL),
etc. Have you ever thought. Who owns them? What is the volume of financial transactions of these
companies? If you think about it, you will find that these organisations are quite large in size and their
activities are spread all over the country. Thus, it is not possible for these organisations to be formed
as sole proprietorship or partnership form of business. Then, how are they formed and managed?
Actually, they are a different form of business organisation and require much more capital and
manpower than sole proprietorship and partnership form of
business organisation.
Meaning of Joint Stock Company.
In a partnership firm we know that the number of
partners cannot exceed 20. So there is a limit to the contribution of capital. Secondly, even if the
partners could contribute a large amount of capital, they would hesitate to do so
considering the risk involved in business and their unlimited liability. Mainly to take care of these
two problems, a company form of business organisation came into existence. The
emergence of company as a form of organization immediately solved all these three difficulties and
helped tremendous growth of industry, trade and commerce.
A company form of business organisation is known as a Joint Stock Company. It is a
voluntary association of persons who generally contribute capital to carry on a particular type 474
of business, and which is established by law and can be dissolved only by law. Persons who
contribute capital become members of the company. This form of business has a legal existence
separate from its members, which means that even if its members die, the company remains
in existence. This form of business organisation generally requires huge capital investment, which is
contributed by its members. The total capital of a joint stock company is called its share capital and
it is divided into a number of units called shares. Thus, every member has some shares in the
business depending upon the amount of capital contributed by him. Hence, members are also called
shareholders.
Definitions.
The companies in India are governed by the Indian Companies Act, 1956. The
Act defines a company as an artificial person created by law, having a separate legal entity, with
perpetual succession and a common seal.
Lord Justice Lindley defines a company as follows: A company is a voluntary association or an
organization of many persons who contribute money or moneys worth to a common stock and
employ it in some trade or business and who share the profit or loss arising there from.
The common stock so contributed is denoted in money and is the capital of company. The persons
who contribute it are members and the proportion of capital to which each member is entitled is
his share. The shares are of fixed value and the whole capital of the company is divided into equal
number of shares. The shares are generally transferable although under certain circumstances, the
right to transfer may be restricted.
Characteristics of Joint Stock Company.
You are now familiar with the concept of
company as a form of business organisation. Let us now study its characteristics.
Legal Formation.
No single individual or a group of individuals can start a business and
call it a joint stock company. A joint stock company comes into existence only when it has been
registered after completion of all formalities required by the Indian Companies Act, 1956.
Artificial Person.
Just like an individual who takes birth, grows, enters into relationships
and dies, a joint stock company takes birth, grows, enters into relationships and dies. However, it is
called an artificial person as its birth, existence and death are regulated by law and it does not
possess physical attributes like that of a normal person.
Separate Legal Entity.

Being an artificial person, a joint stock company has its own
separate existence independent of its members. It means that a joint stock company can own property,
enter into contracts and conduct any lawful business in its own name. It can sue and can be sued by
others in the court of law. The shareholders are not the owners of the property owned by the company.
Also, the shareholders cannot be held responsible for the acts of the company.
Common Seal.
A joint stock company has a seal which is used while dealing with others
or entering into contracts with outsiders. It is called a common seal as it can be used by any officer at
any level of the organisation working on behalf of the company. Any document, on which the
companys seal is put and is duly signed by any official of the company, become binding on the
company. For example, a purchase manager may enter into a contract for buying raw materials from a
supplier. Once the contract paper is sealed and signed by the purchase manager, it becomes valid. The
purchase manager may leave the company thereafter or may
475
be removed from the job or may have taken a wrong decision, yet for all purposes the contract is
valid till a new contract is made or the existing contract expires. It is affixed on all important legal
documents and contracts. It is in the custody of the Board of Directors. It is affixed by a Board
Resolution and two directors have to sign as witnesses.
Perpetual (Continuous) Existence.
As a company is an artificial person enjoying
individuality. Perpetual succession therefore means that the membership of a company may
keep changing from time to time but that does not effect its continuity, just like the river Ganges which
remains the same river, though the parts which compose it are changing every instant. Thus, the death,
lunacy, insolvency or retirement of any of its members does not, in any way, affect the corporate
existence of the company. For example, in case of a private limited company having four members, if
all of them die in an accident the company will not be closed. It will continue to exist. The shares of
the company will be transferred to the legal heirs of the deceased members. A companys formation is
voluntary but continuance is
compulsory. Once a company is formed, it cannot be dissolved as long as the law recognizes its
dissolution and till it is wound up as per the relevant Act. Thus, it enjoys a perpetual life and a very
stable existence.
Separate Property.
A company being a legal person and entirely distinct from its
members, is capable of owning, enjoying and disposing of property in its own name. The
company is the real person in which all its property is vested, and by which it is controlled, managed
and disposed of. In other words, the property of the company is not the property of the individual
members. Thus, incorporation helps the property of the company to be clearly distinguished from that
of its members.
Limited Liability.
In a joint stock company, the liability of a member is limited to the
extent of the value of shares held by him. While repaying debts, for example, if a person owns 1,000
shares of Rs. 10 each, then he is liable only up to Rs. 10,000 towards payment of debts.
He shall not have any future liability at all. Thus every member knows in advance the
magnitude of risk of loss. Even though his company goes into liquidation his private property is not
attachable for the debts of the company and he will lose only his shares worth Rs. 10,000.
Transferability of Shares.
The capital of a company is divided into parts called shares.
The shares of a company can be transferred by its members. Whenever the members want to
dispose of the shares, they can do so by following the procedure devised for this purpose.
Under Articles of Association, the company can put certain restrictions on the transfer of shares but it
cannot altogether stop it. However, private companies can put more restrictions on transferability of
shares.
Capacity to Sue and be Sued.
A company being a body corporate can sue and be sued
in its own name. All legal proceedings against the company are to be instituted in its own name.
Similarly, the company may bring an action against anyone in its own name.
Democratic Management.
Joint stock companies have democratic management and
control. That is, even though the shareholders are owners of the company, all of them cannot
participate in the management of the company. Normally, the shareholders elect representatives from
among themselves known as Directors to manage the affairs of the company.
476
Kinds of Companies.
The joint stock companies may be classified as follows:
1. According to incorporation
2. According to liability
3. According to ownership
4. According to number of members
5. According to nationality.
See Fig. 6.3.
Kinds of Companies
According
According
According
According
According
to
to
to
to
to
Incorporation
Liability
Ownership
Number of
Nationality
Members
Chartered
Companies
Government
Companies
Limited by
Companies
Private
Indian
shares
Companies
Companies
Statutory
Companies
Holding
Companies
Limited by
Companies
Guarantee
Registered
Unlimited
Subsidiary
Public
Foreign
Companies
Companies
Companies
Companies
Companies
Fig. 6.3 Kinds of companies.
There are three ways in which companies may be incorporated:
Chartered Companies.
A company created by the grant of a charter by the Crown is
called a Chartered Company and is regulated by that Charter. Chartered companies were
popular in England in the nineteenth century. The East India Company and the Standard
Chartered Bank are examples of Standard Chartered Companies. These companies are no longer
formed in any country.
Statutory Companies.
These are constituted by a special Act of Parliament or state
legislature. The objects, powers, rights and responsibilities of these companies are clearly defined in
the Act. Generally, companies for public utility services are formed under special statutes. Examples
of this type are Reserve Bank of India, Life Insurance Corporation of India, Industrial Finance
Corporation of India, State Trading Corporation of India, etc.
Registered Companies.
These are the companies which are incorporated under the
Companies Act, 1956. These companies are registered under this Act. Registered companies
may be limited by shares, or limited by guarantee of unlimited companies.

477
According to liability, there are three types of companies:
Unlimited Companies.
In this type of company, the members are liable for the
companys debts in proportion to their respective interests in the company and their liability is
unlimited. Such companies may or may not have share capital. This may be either a public company
or private company though these days, such companies are rare.
Companies Limited by Guarantee.
A company that has the liability of its members
limited to such amount as the members may respectively undertake, by the memorandum, to
contribute to the assets of the company in the event of its being wound-up, is known as a company
limited by guarantee. The members of a guarantee company are, in effect, placed in the position of
guarantors of the companys debts upto the agreed amount.
Companies Limited by Shares.
A company that has the liability of its members limited
by the memorandum to the amount, if any, unpaid on the shares respectively held by them is termed as
a company limited by shares. For example, a shareholder who has paid Rs. 75 on
a share of face value Rs. 100 can be called upon to pay the balance of Rs. 25 only.
According to ownership, there are the following three types:
Government Companies.
In these companies the Government (either state or central or
both) holds a majority share capital, i.e., not less than 51%. However, companies having less than
51% shareholding by the government can also be called Government companies provided
control and management lie with the government. Examples of government companies are
Mahanagar Telephone Nigam Limited and Bharat Heavy Electricals Limited.
Holding Companies.
If a company can control the policies of another company through
the ownership of its share or through control over the composition of its Board of Directors, the
company is called a holding company. A company, the policies of which are controlled, is called a
subsidiary company.
Subsidiary Companies.
This is a company that is completely controlled by another
company. A company is called a subsidiary company when one of the following conditions is
fulfilled: (a) if the formation of Board of Directors is controlled by another company; (b) the other
company controls more than half of the maximum value of the shares in the company;
and (c) the other company owns more than half of the maximum value of the shares in the
company.
According to number of members, there are two types:
Private Companies.
These companies can be formed by at least two individuals but the
maximum number of shareholders cannot exceed 50. A private company restricts by its articles, (a)
the right of members to transfer their shares; (b) limits the number of its members to 50 members and
(c) prohibits any invitation to the public to subscribe to its shares and
debentures. They are required to use Private Limited after their names.
Public Companies.
Section 3(1)(iv) of the Indian Companies Act, 1956 says that all
companies other than private companies are to be called public companies. A minimum of
seven members are required to form a public limited company. There is no restriction on
maximum number of members. The shares allotted to the members are freely transferable.
478
These companies can raise funds from general public through open invitations by selling its shares or
accepting fixed deposits. A public company can start work only after getting a
Certificate of Commencement from the Registrar of Companies. These companies are
required to write either Public Limited or Limited after their names. Examples of such companies
are Hyundai Motors India Limited, Steel Authority of India Limited, etc.
Differences between Private Companies and Public Companies
Basis
Private Limited Company
Public Limited Company
Membership
Minimum 02
Minimum 07
Maximum 50
Maximum no restriction
Formation
Only one certificate, i.e.,
Two certificates are required,
certificate of incorporation is
i.e., certificate of incorporation
enough.
and certificate of commencement of business.
Name
Use a suffix Private Limited
Use a suffix Limited after its
after its name.
name.
Allotment of Shares
No restrictions on allotment
There are a number of legal
of shares
restrictions on allotment of
shares
Transferability of Shares
Restricted by its Articles
Freely transferable
Issue of Prospectus
A private company cannot
A public company must issue
issue a prospectus giving
a prospectus or a statement in
public invitation for purchase
lieu of prospectus for inviting
of its shares. No public notice
public for the purchase of its
for the sale of shares or
shares and debentures.
debentures can be issued.
Raising of funds
Cannot give open invitation to
Can raise as much money as

the public to subscribe the
required from the public.
shares.
Signing of Memorandum of
Only two members have to
Seven members have to sign.
Association and Articles of
sign
Memorandum
and
Association
Articles.
Board of Directors
At least two directors
At least three directors.
Filing of documents
A private company need not
The list of directors, their
send the list of directors, their
consent and a contract with
consent, etc. to the Registrar
them must be sent to the
of Companies.
Registrar of Companies.
Statutory meeting and Report
Not required.
Compulsory.
Quorum for Meeting
The quorum for a meeting of a
Five members constitute the
private company is zero.
quorum.
479
According to nationality, there are two types:
Indian Companies.
A company having business operations in India and registered under
the Indian Companies Act, 1956 is called an Indian company. An Indian company may be
formed as a public limited, private limited or government company.
Foreign Companies.
A foreign company is a company formed and registered outside
India having business operations in India. Such companies have to furnish some information as
required by the Registrar of Companies in India.
You have just read about the different types of companies. Now we shall discuss the
advantages and limitations of the company form of business organisation.
Advantages of Joint Stock Company.
You must be keen to know why any one should form
a company for carrying out business. Obviously, this is because there are many advantages which the
company form of business organisation enjoys over other forms of business

organisation. Let us read about those advantages.
The main advantages of a Joint Stock Company are:
Large Financial Resources.
A joint stock company is able to collect a large amount of
capital through small contributions from a large number of people. In public limited company shares
can be offered to the general public to raise capital. They can also accept deposits from the public
and issue debentures to raise funds.
Limited Liability.
In case of a company, the liability of its members is limited to the
extent of the value of shares held by them. Private property of members cannot be attached for debts
of the company. This advantage attracts many people to invest their savings in the company and it
encourages the owners to take more risk.
Professional Management.
Management of a company is vested in the hands of
directors, who are elected democratically by the members or shareholders. These directors as a
group known as Board of Directors (or simply Board) manage the affairs of the company
and are accountable to all the members. So members elect capable persons having sound
financial, legal and business knowledge to the board so that they can manage the company
efficiently.
Large-scale Production.
Due to the availability of large financial resources and technical
expertise it is possible for the companies to have large-scale production. It enables the company to
produce more efficiently and at lower cost.
Contribution to Society.
A joint stock company offers employment to a large number
of people. It facilitates promotion of various ancillary industries, trade and auxiliaries to trade.
Sometimes it also donates money towards education, health and community services.
Research and Development.
Only in company form of business is it possible to invest
a lot of money on research and development for improved processes of production, new design,
better quality products, etc. It also takes care of training and development of its employees.
480
Limitations of Joint Stock Company.
In spite of many advantages of the company form
of business organisation, it also suffers from some limitations. Many of the disadvantages are due to
the malpractices and unscrupulous methods adopted by company promoters and company managers.
Difficult to Form.
The formation or registration of joint stock company involves a
complicated procedure. A number of legal documents and formalities have to be completed
before a company can start its business. It requires the services of specialists such as Chartered
Accountants, Company Secretaries, etc. Therefore, cost of formation of a company is very
high.
Excessive Government Control.
Joint stock companies are regulated by government
through Companies Act and other economic legislations. Particularly, public limited companies are
required to adhere to various legal formalities as provided in the Companies Act and other
legislations. In order to abide by the statutory requirements, a company has to maintain a special
secretarial department in charge of an expert company secretary. Non-compliance with these invites
heavy penalty. This affects the smooth functioning of the companies.
Fraudulent Management.
Companies may be formed by unscrupulous promoters, and
directors who may exploit the companys property and assets for making personal profits, at the cost
of shareholders. If the company managers are honest and loyal, if they act as trustees and custodians
of the companys capital and funds, full benefit of separation of control or management from
ownership can be enjoyed.
Conflicting Interest.
The top management has to secure effective resolution of many
conflicting interests. Employees demand higher wages and salaries, consumers expect good
quality of products or services at low price, shareholders expect higher dividends, etc. It is difficult
to satisfy such diverse interests.
Delay in Policy Decisions.
Generally policy decisions are taken at the Board meetings
of the company. In taking decisions on various problems of administration, meetings are
necessary, and there must be requisite quorum also for such meetings. A certain time-interval is
necessary to hold meetings. Further the company has to fulfill certain procedural formalities.
These procedures are time-consuming and therefore may delay action on the decisions.
Absence of Personal Interest and Personal Element.
In a company form of
organization there is a representative management. Lack of personal interest on the part of salaries
managers may lead to inefficiency and waste. This is due to absence of direct
relationship between the effort and the reward under company organization.
Concentration of Economic Power and Wealth in a Few Hands.
A joint stock
company is a large-scale business organisation having huge resources. This gives a lot of economic
and other power to the persons who manage the company. Any misuse of such power
creates unhealthy conditions in the society, e.g. having monopoly over a particular business or
industry or product; or exploitation of workers, consumers and investors.
481
The advantages and limitations of a Joint Stock Company can be summed up as follows:
Advantages
Limitations
Large financial resources
Difficult to form
Limited liability
Excessive government control
Professional management
Fraudulent management
Large-scale production
Conflicting interest
Contribution to society
Delay in policy decisions
Research and Development
Absence of personal interest and
personal element
Concentration of economic power
and wealth in few hands
Differences between Partnership and Joint Stock Company
Basis
Partnership
Joint Stock Company
1.Governing Status
A partnership concern is
Joint Stock company is
governed by the partnership

governed by the Companies
Act, 1932
Act, 1956
2.Registration
The
registration
of
a
The registration of a company
partnership concern is not
is compulsory. There are two
compulsory. There are certain
stages in registering public
privileges
given
to
the
company,
the
first
is
registered firm, which is
Incorporation and the second
denied to, unregistered ones.

is
Commencement
of
These privileges indirectly
business. A public company
encourage registration.
can start business only after
obtaining
the
second
certificate. However, a private
company can start business
after obtaining certificate of
incorporation.
3.Membership
Minimum 2
Private Company: Minimum
Maximum 10 in Banking
2 and Maximum 50
20 in Trading.
Public Company: Minimum
7 and Maximum Unlimited
Number.
4.Legal position
No separate legal entity
Separate legal entity created
by law.
5.Liability
The liability of partners is
The
liability
of
the
unlimited. The partners are
shareholders is limited to the
jointly
and
separately
value of shares held by them.
responsible for the liabilities of
The
members
are
not
the business.
personally liable for the
obligations of the business.
(Contd.)
482
Basis
Partnership
Joint Stock Company
6.Continuity of life
Terminable by death or
Continuous existence, life of a
insolvency of any partner.
company is not affected by
death
or
insolvency
of
members.
7.Transfer of shares
A partner can transfer his
A shareholder can sell his
shares only with the consent
shares whenever he feels so.
of all other partners.
There is no binding on the
transfer of shares of a
company.
8.Ownership and
A partnership concern is
A company is managed by the
management
managed and controlled by
elected representatives of the
the partners. The partners
shareholders, i.e., Board of
have a right to participate in
Directors. But the members
the
administration
of
cannot participate in the daybusiness.
to-day working of the company.
9.Authority of members
A partner can bind the firm by
A shareholder has no implied
his acts. There is an implied
authority to bind the company.
authority. A partner is an agent
A shareholder cannot act on
of the firm.
behalf of the company.
10.Winding up
A partnership concern can be
A company is wound up only
dissolved easily. No legal
through court. If the court is
formalities are required for
satisfied
that
there
is
winding up a partnership firm.
reasonable ground for winding
up the company only then it is
to be wound up. A proper
procedure is also be followed.
Suitability of Joint Stock Company.
A joint stock company form of business organisation
is found to be suitable where the volume of business is large and huge financial resources are needed.
Since members of a joint stock company have limited liability it is possible to raise capital from the
public without much difficulty. This form of organisation is also suitable for businesses, which
involve heavy risks. Again, for business activities which require public support and confidence, joint
stock form is preferred as it has a separate legal status. Certain types of businesses like production of
pharmaceuticals, machine manufacturing, information technology, iron and steel, aluminum, fertilisers,
cement, etc., are generally organised in the form of Joint Stock Companies.
Co-operative Society
So far you have learnt about sole proprietorship, partnership and joint stock company as
different forms of business organisation. You must have noticed that besides many differences among
them in respect of their formation, operation, capital contribution as well as liabilities, one common
similarity is that they all engage in business activities to earn profit. Without profit it is impossible for
them to survive and grow. But there are certain organizations which TYPES OF BUSINESS
ORGANISATION
483
undertake business activities with the prime objective of providing service to the members.
Although some amount of profit is essential to survive in the market, their main intention is not to
generate profit and grow. They pool available resources from the members, utilise the same in the
best possible manner and the benefits are shared by the members.
Meaning of Co-operative Society.
Let us take one example. Suppose a poor villager has two
cows and gets ten litres of milk. After consumption by his family everyday he finds a surplus of five
litres of milk. What can he do with the surplus? He may want to sell the milk but may not find a
customer in the village. Somebody may tell him to sell the milk in the nearby town or city. Again he
finds it difficult, as he does not have money to go to the town to sell milk.
What should he do? He is faced with a problem. Does he have any solution? Yes, people facing such
problems have solutions. There are many others in the village and also in the nearby village who face
a similar problem. All of them can sit together and find a solution to a common problem. In the
morning he can collect the surplus milk at a common place and send somebody to the nearby town to
sell it. Again in the evening, he can sit together and distribute the money according to the contribution
of milk after deducting all the expenses from the sale proceeds.
He tells everybody about this new idea, and all villagers agreed to it and form a group of milk
producers in his village. By selling the milk in the nearby town they were all able to earn money.
After that they do not face any problem of finding a market for the surplus milk. This process
continues for a long time. One day somebody suggest that instead of selling only milk they should also
produce other milk products like ghee, butter, cheese, milk powder, etc. and sell them in the market at
a better price. All of them agree and do the same. They produce quality milk products and find a very
good market for their products, not only in the nearby town but in the entire country.
Just think it over. A poor villager, who may not able to sell five litres of milk in
his village, can now sell milk and milk products throughout the nation. He can now enjoy a good life.
How does it happen? What makes it possible? This is the reward of joint effort or co-operation.
The term co-operation is derived from the Latin word co-operari, where the word co means with
and operari means to work. Thus, co-operation means working together. So those who want to work
together with some common economic objective can form a society
which is termed a co-operative society. It is a voluntary association of persons who work together to
promote their economic interest. It works on the principle of self-help as well as mutual help. The
main objective is to provide support to the members. Nobody joins a
cooperative society to earn profit. People come forward as a group, pool their individual resources,
utilise them in the best possible manner, and derive some common benefit out of it.
In the above example, all producers of milk of a village join hands, collect the surplus milk at a
common place and sell milk and milk products in the market. This is possible because of their joint
effort. Individually it will not be possible either to sell or to produce any milk product in that village.
They form a co-operative society for this purpose. The objectives of a co-operative society are to
render service rather than make profit, to extend mutual help instead of competing and promoting selfhelp instead of dependence.
484
In a similar way, the consumers of a particular locality can join hands to provide goods
of their daily need and thus form a co-operative society. Now they can buy goods directly from the
producers and sell those to members at a cheaper price. Why is the price cheaper? Because they buy
goods directly from the producer and thereby the middlemens profit is eliminated.
Do you think it would have been possible on the part of a single consumer to buy goods
directly from the producers? Of course, not.
In the same way, people can form other types of co-operative societies as well. Let us know about
them.
Definitions of Co-operative Societies.
The Indian Co-operative Societies Act, 1912 defines
co-operatives in Section 4 as a society which has its objectives the promotion of economic interests
of its members in accordance with co-operative principles.
Co-operation is a form of organization wherein persons voluntarily associate together as human
beings on the basis of equality for the promotion of the economic interests of themselves.
Hubert Calvest
Types of Co-operative Societies.
Although all types of cooperative societies work on the

same principle, they differ with regard to the nature of activities they perform. Some are started to
help consumers and others to help small producers. Following are the different types of cooperative
societies that exist in our country:
Consumers Co-operative Society.
These societies are formed to protect the interest of
general consumers by making consumer goods available at a reasonable price. They buy goods
directly from the producers or manufacturers and thereby eliminate the middlemen in the
process of distribution. The membership of these societies is open to everyone irrespective of caste,
creed, colour, etc. The societies charge small profit to cover up administrative costs. The cooperative stores are working both in urban and rural areas. Kendriya Bhandar, Apna Bazar and
Sahkari Bhandar are examples of consumers co-operative society.
Producers Co-operative Society.
These societies are formed to protect the interest of
small producers by making available items of their need for production like raw materials, tools and
equipments, machinery, etc. The purpose is to improve economic conditions of small
producers by giving them necessary facilities. Handloom societies like APPCO, Bayanika,
Haryana Handloom, etc., are examples of producers co-operative society.
Co-operative Marketing Society.
These societies are formed by small producers and
manufacturers who find it difficult to sell their products individually. The society collects the
products from the individual members and takes the responsibility of selling those products in the
market. These societies also provide services like grading, warehousing, transportation, insurance
and financing, etc. The marketing societies also collect marketing information and supply it to the
producers for their benefit. Gujarat Co-operative Milk Marketing Federation, that sells Amul milk
products is an example of marketing co-operative society.
Co-operative Credit Society.
These societies are formed to give financial help to small
farmers and other poor sections to the society. The society accepts deposits from members and grants
them loans at reasonable rates of interest in times of need. Village Service Co-operative Society and
Urban Cooperative Banks are examples of co-operative credit society.

485
Co-operative Farming Society.
These societies are formed by small farmers to work
jointly and thereby enjoy the benefits of large-scale farming. Better farming increases
production and improves the economic position of members. Small farmers will not be able
to use improved technology for want of resources and small holdings. The land is pooled to take
advantage of agricultural technology. Lift-irrigation cooperative societies and pani panchayats are
some of the examples of co-operative farming society.
Housing Co-operative Society.
These societies are formed to provide residential houses
to members. They purchase land, develop it and construct houses or flats and allot the same to
members. Some societies also provide loans at low rate of interest to members to construct their own
houses. These societies are helpful in arranging cheap plots and loans for the
members. The loans are advanced against the security of the houses. The purpose of all these
societies is to help their members in purchasing land and constructing houses. The Employees
Housing Societies and Metropolitan Housing Co-operative Societies are examples of housing cooperative society.
Characteristics of Co-operative Societies.
A co-operative society is a special type of
business organisation different from other forms of organisation you have learnt earlier. Let us discuss
its characteristics.
Open Membership.
The membership of a co-operative society is open to all those who
have a common interest. A minimum of ten members are required to form a cooperative
society. The Co-operative Societies Act does not specify the maximum number of members for any
co-operative society. However, after the formation of the society, the member may specify the
maximum number of members.
Voluntary Association.
Members join the co-operative society voluntarily, that is, by
choice. A member can join the society as and when he likes, continue for as long as he likes, and
leave the society at will.
State Control.
To protect the interest of members, co-operative societies are placed
under state control through registration. While getting registered, a society has to submit details about
the members and the business it is to undertake. It has to maintain books of accounts, which are to be
audited by government auditors.
Sources of Finance.
In a co-operative society capital is contributed by all the members.
However, it can easily raise loans and secure grants from government after its registration.
Democratic Management.
Co-operative societies are managed on democratic lines. The
society is managed by a group known as Board of Directors. The members of the board of
directors are the elected representatives of the society. Each member has a single vote,
irrespective of the number of shares held. For example, in a village credit society the small farmer
having one share has equal voting right as that of a landlord having 20 shares.
Service Motive.
The primary objective of co-operative societies is to provide service to
their members. The aim is not to earn profits as in the case in all other forms of organization.
For example, in a Consumer Co-operative Store, goods are sold to its members at a reasonable 486
price by retaining a small margin of profit. It also provides better quality goods to its members and
the general public.
Separate Legal Entity.
A co-operative society is registered under the Co-operative

Societies Act. After registration a society becomes a separate legal entity, with limited liability of its
members. Death, insolvency or lunacy of a member does not affect the existence of a society. It can
enter into agreements with others and can purchase or sell properties in its own name.
Distribution of Surplus.
Every co-operative society, in addition to providing services to
its members also generates some profit while conducting business. Profits are not earned at the cost
of its members. Profit generated is distributed to its members not on the basis of the shares held by the
members (like the company form of business), but on the basis of members
participation in the business of the society. For example, in a consumer co-operative store only a
small part of the profit is distributed to members as dividend on their shares; a major part of the profit
is paid as purchase bonus to members on the basis of goods purchased by each member from the
society.
Self-Help Through Mutual Cooperation.
Co-operative societies thrive on the principle
of mutual help. They are the organisations of financially weaker sections of society.
Co-operative societies convert the weakness of members into strength by adopting the principle of
self-help through mutual co-operation. It is only by working jointly on the principle of
Each for all and all for each that the members can fight exploitation and secure a place in society.
Formation of a Co-operative Society.
A co-operative society can be formed as per the
provisions of the Co-operative Societies Act, 1912. At least ten persons having the capacity to enter
into a contract with common economic objectives, like farming, weaving, consuming, etc.
can form a co-operative society. A joint application along with the bye-laws of the society containing
the details about the society and its members, has to be submitted to the Registrar of Co-operative
Societies of the concerned state. After scrutiny of the application and the bye
laws, the registrar issues a Certificate of Registration. The requirements for registration are as
follows:
1. Application with the signature of all members
2. Bye-laws of the society containing:
(a) Name, addresses and aims and objectives of the society;

(b) Names, addresses and occupations of members;
(c) Mode of admitting new members;
(d) Share capital and its division.
Advantages of Co-operative Society.
A co-operative form of business organisation has the
following advantages:
Easy Formation.
Formation of a co-operative society is very easy compared to a joint
stock company. Any ten adults can voluntarily form an association and get it registered with the
Registrar of Co-operative Societies.
487
Open Membership.
Persons having common interest can form a co-operative society.
Any competent person can become a member at any time he or she likes and can leave the
society at will.
Democratic Control.
A co-operative society is controlled in a democratic manner. The
members cast their vote to elect their representatives to form a committee that looks after the day-today administration. This committee is accountable to all the members of the society.
Limited Liability.
The liability of members of a co-operative society is limited to the
extent of capital contributed by them. Unlike sole proprietors and partners the personal
properties of members of the co-operative societies are free from any kind of risk because of
business liabilities.
Elimination of Middlemens Profit.

Through co-operatives the members or consumers
control their own supplies and thus the middlemens profit is eliminated.
State Assistance.
Both Central and State governments provide all kinds of help to the
societies. Such help may be provided in the form of capital contribution, loans at low rates of
interest, exemption in tax, subsidies in repayment of loans, etc.
Stable Life.
A co-operative society has a fairly stable life and it continues to exist for
a long period of time. Its existence is not affected by the death, insolvency, lunacy or
resignation of any of its members.
Limitations of Co-operative Society.
Besides the above advantages, the co-operative form
of business organisation also suffers from various limitations. These limitations are:
Limited Capital.
The amount of capital that a cooperative society can raise from its
member is very limited because the membership is generally confined to a particular section of the
society. Again, due to low rate of return, the members do not invest more capital.
Governments assistance is often inadequate for most of the co-operative societies.
Problems in Management.
Generally it is seen that co-operative societies do not
function efficiently due to lack of managerial talent. The members or their elected
representatives are not experienced enough to manage the society. Again, because of limited capital
they are not able to get the benefits of professional management.
Lack of Motivation.
Every co-operative society is formed to render service to its

members rather than to earn profit. This does not provide enough motivation to the members to put in
their best effort and manage the society efficiently.
Lack of Co-operation.
The co-operative societies are formed with the idea of mutual cooperation. But it is often seen that there is a lot of friction between the members because of
personality differences, ego clash, etc. The selfish attitude of members may sometimes bring an end to
the society.
Dependence on Government.
The inadequacy of capital and various other limitations
make cooperative societies dependent on the government for support and patronage in terms of grants,
loans subsidies, etc. Due to this, the government sometimes directly interferes in the management of
the society and also audit their annual accounts.
488
The advantages and limitations of co-operative societies can be summed up as follows:
Advantages
Limitations
Easy formation
Limited capital
Open membership
Problems in management
Democratic control
Lack of motivation
Limited liability
Lack of cooperation
Elimination of middlemans profit
Dependence on government
State assistance
Stable life
Suitability of Co-operative Societies.
You have learnt that the main objective of cooperative form of business organisation is to provide service rather than to earn profit. The
cooperative society is the only alternative to protect the weaker sections of the society and to promote
the economic interest of the people. In certain situations when it is not possible to achieve the target
by individual effort, collective effort in the form of a co-operative society is preferred. Housing cooperatives, marketing co-operatives, etc. are formed to achieve the common economic objectives of
the members. Generally, co-operative society is suitable for small and medium business operations.
Public Enterprises
Public enterprises as a form of business organization have gained importance only in recent times.
During the twentieth century, the outbreak of two world wars, depression in many
countries and the social evils of the Industrial Revolution of earlier times compelled state
governments to participate in planning and developing the industrial structured of their
countries. In India, a socialistic order has been established after independence. The Industrial
Resolutions of 1948 and 1956 have clearly defined the role of public and private sectors. Most of the
public sector enterprises are engaged in manufacturing, trading as well as service activities.
Definitions
State enterprise is an undertaking owned and controlled by the local or state or central
government. The basic aim of a state enterprise is to provide goods and services to the public at a
reasonable rate. The primary objective of these enterprises is social service.
Public enterprise means state ownership and operation of industrial, agricultural, financial and
commercial undertakings.
A.H. Hansen
Public enterprises are autonomous or semi-autonomous corporations and companies
established, owned and controlled by the state and engaged in industrial and commercial
activities.
N.N. Mallya

489
Characteristics of Public Enterprises
Financed by Government.
Public enterprises are financed by the government. They are
either owned by the government or majority shares are held by the government.
Government Management.
Public enterprises are managed by the government. In some
cases government has started enterprises under its own departments. In other cases, government
nominates persons to manage the undertakings. Even autonomous bodies are directly and
indirectly controlled by the government departments.
Financial Independence.
Though investments in government undertakings are done by the
government, they become financially independent. They are not dependent on the government for their
day-to-day needs. These enterprises arrange and manage their own finances.
Service Motive.
The primary aim of public enterprises is to provide service to the societal
people. These enterprises are started with an objective of service rather than profit motive. On the
other hand, private enterprises start an enterprise only if possibilities of earning profits exist.
Concentration on All Sectors.
Public enterprises serve all sectors of the economy rather than
serving only particular sectors where they earn more profits. Private enterprises enter only those
sectors where they earn more profits.
Monopoly Enterprises.
In most of the cases, public enterprises are monopoly enterprises.
Private sector is not allowed to enter that line. This is specially the case in public utility services.
Implementation of Government Plans.

Economic policies and plans of the government are
implemented through public enterprises.
Autonomous or Semi-autonomous Bodies.
These enterprises are autonomous or semiautonomous bodies. In some cases they work under the control of government departments, and in
other cases, they are established under official statutes and under the Companies Act.
Objectives of Public Enterprises
Public enterprises are established to implement economic policies of the government. The
primary objective of the public enterprises is to serve the people and help in creating an environment
of industrial activity. The main objectives of public enterprises are as follows: 1. To accelerate and
maximize the rate of capital formation or economic growth.
2. To provide various necessities like electricity, coal, gas, transport and water facilities to the
people.
3. To provide sound economic foundation for increasing opportunities of gainful
employment and for increasing standard of living of masses.
4. Prevention of concentration of economic power in fewer hands.
490
5. Reduction in the disparities in income and wealth.
6. To help in all-round industrialization of the country, i.e., all types of industries
whether they are profitable or not.
7. Extension of industrial democracy and removal of exploitation of labour.
8. To provide goods and services at reasonable rates.
Rationale of Public Enterprises
There have been two opinions about the need of public enterprises. Some people are of the view that
government should develop infrastructural facilities and initiatives for setting up industrial units
should be with the private entrepreneurs. Others have strongly advocated the need for setting up
public sector units for speeding up the pace of development. Both these viewpoints are discussed as
follows:
Arguments in Favour of Public Enterprises
Promotion of Public Welfare.
Private enterprise works with an object of earning profit.
Private entrepreneurs prefer those fields for setting up industrial limits where higher rate of return on
investments is assured. They will ignore those areas where return is low. This creates imbalance in
the economy. Nationalisation is therefore essential to ensure that the society is not denied certain
basic necessities of life because of private enterpreneurs lust for profit.
Abolition of Monopoly.
When whole industialisation is in the hands of private entrepreneurs
then it will lead to concentration of economic power in the hands of few industrial houses.
They will start exploiting weaker sections of society. To curb this concentration public sector is
essential. Nationalisation will ensure that monopolies do not exploit the consumer.
Balanced Regional Growth.
Private entrepreneurs do not prefer to set up units in backward
areas because facilities like electricity, transport, communication etc. are not available. They will set
up new units only in areas where infrastructual facilities are available. This will result in
concentration of industrial units in some areas only. Nationalisation is therefore essential to set up
units in backward areas so that people of those areas are able to get employment
opportunities. This is essential for having balanced developments of all areas.
Greater Economy and Co-ordination.
There is greater harmony and co-ordination among
the various industries which are brought under or initiated under state control.
Mobilisation of Surplus.
The profits earned by public sector units are re-invested for
expansion and diversification purposes. On the other hand, private sector units distribute the major
part of their surpluses to shareholders in the shape of dividend. This restricts their capacity to make
further investments. On the other hand, public sector units use surpluses for further industrialization.
Employment Opportunities.
As the public sector units enter into all types of industries,
employment will be provided to the fullest extent. Sometimes private sector units are not run TYPES
491
efficiently. After running into losses these units face closure. The closure of such units means
unemployment of workers employed in those units. In the interest of the nation such units are
sometimes taken over by the government and run as public enterprises.
Arguments Against Public Enterprises
The critics of public undertakings focus their arguments on the following limitations and shortcomings
of such undertakings:
Lack of Initiative and Efficiency.
Public sector undertakings are generally presumed to be
less efficient than privately owned concerns. Lack of profit motive is said to lead to
inefficiency. It is argued that the bureaucrats who manage public enterprises run them like government
departments where decision-making and implementation are generally
characterized by red-tapism and postponement.
Political Interference.
Under public undertakings there is a constant danger of undue
interference in the working by politicians. The members of the party in power try to influence the
policies of public enterprises. Such interference is undesirable as it may tamper with their smooth
and efficient working on sound business principles.
Open to Public Criticism.
The results of the working of public undertakings are exposed
so much to the critical eyes of the general public, which may not always be justified. As a result the
people who manage public enterprises develop in them unadventurous and red-tapist frame of mind
which is harmful to the running of business undertakings.
Rigidity of Public Control.

Public accountability of public enterprises is very often stretched
too far and the flexibility of private enterprise, which is essential for the successful working of an
industrial undertaking, is denied to them.
Inadequate Returns.
Most of the public enterprises fail to earn a fair return on investment.
Inspite of many advantages and infrastructural facilities enjoyed by these units, many of them are
either running up losses or are earning inadequate returns as compared to investments.
Rigid Financial Control.
Public enterprises are generally subject to such strict and rigid
financial control by government auditors and parliamentary committees that managerial
personnel are left with practically no enthusiasm to push up the business under their charge.
Improper Manpower Planning.
Public sector units employ persons disproportionate to their
needs. The jobs are created to fulfil employment goals of the government and not as per the needs of
the organization. Overstaffing of these units brings inefficiency.
More Labour Problems.
As the labour in public enterprises are more secured than private
enterprises they expect more from government-run units. The employees expect frequent wage hikes
and resort to strikes for achieving their goals.
The various drawbacks of a public enterprise mentioned here are in fact the most important problems
with which it has to grapple. In judging the various arguments against public
492
enterprise, especially with respect to inefficiency and bureaucratic management, one has to apply the
standard of welfare of the community. Both public and private sector industries must be organized,
managed and operated to serve the widest interests of the community as a whole.
Forms of Public Enterprises

Public enterprise can adopt a variety of forms of organization for its administration. A suitable form
of organization will increase the efficiency of the concern. Excessive dependence on government for
finances will increase government interference in the day-to-day working.
These enterprises should be run on business lines and necessary autonomy should be allowed to them.
Among various types, the most preferred forms of organization in India are:
1. Departmental Organisation
2. Statutory or Public Corporation
3. Government Company
Departmental Organisation.
Department form of organization is the oldest form of
organization. In this form, the enterprise works as a part of government department. The
finances are provided by the government and management is in the hands of civil servants. The
Minister of the Department is the ultimate incharge of the enterprise. The enterprise is subjected to
legislative scrutiny. This form of organization is most suitable for public utility services and strategic
industries. In India, railways, post and telegraph, etc. are working as government departments. In the
same way, strategic industries like defence, atomic power, etc. are under the government.
Characteristics.
The characteristics of departmental form of organization are as follows:
1. The enterprise is managed by a government department, with a Minister at the top,
responsible to Parliament for its operation.
2. These undertakings produce largely, if not entirely, for the State itself.
3. These enterprises are manned by civil servants who are recruited in the same way as
the civil servants responsible for other governmental functions.
4. These enterprises are financed by annual appropriations from the Treasury, and the
estimates of expenditure and revenue are shown in the national budget. The avenues,
or at least a major portion thereof, are paid into the Treasury.
5. It is subject to the budget, accounting and audit controls applicable to other

government activities.
6. As the enterprise is a sub-division of a department of the government, it can be sued
only by following the procedure prescribed for filing suits against the government.
Advantages
1. Government has full control over the production of commodity or offer of services.
These undertakings are associated with one of the government departments.
2. The State can make use of these undertakings as instruments of its economic and
social policy.
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3. It can help the government to earn maximum income or maintain a service at
reasonable cost to the society.
4. Public dissatisfaction can be ventilated directly in the parliament and immediate
action is possible to remove the public grievances.
5. It is very suitable for industries where secrecy and strict control are needed.
6. Projects in the promotion stage or projects for which necessary finance is to be
procured until their completion can be easily kept under departmental management.
Disadvantages
1. The undertakings are under the control of ministers and the political parties to which they belong.
They may hardly understand the problems of management of industry
and trade. Their policies may suffer from instability because of the uncertainty
attached to the tenure of political parties and ministers.
2. The undertaking fails to provide flexibility which is essential for effective business operations.
3. Public enterprises very often become synonymous with red tape, delays, inadequate
service and insensitivity to consumer needs.

4. Shortage of really competent qualified and experienced top civil personnel for
professional management.
5. Subject to undue scrutiny, criticism, and investigation by Parliament.
6. Either it is only extended to the monopoly fields or it turns out to be a State
monopoly.
7. Losses and inefficiency are not taken seriously. No efficiency standards are set for
these undertakings.
8. Absence of stability and continuity of policies due to sudden and frequent transfers
of officers.
9. Political and other considerations rather than business or economic considerations
assume undue importance in the running of the enterprise.
10. Excessive centralization in finance and top managerial control.
11. Lack of necessary autonomy and presence of red-tapism.
Public Corporation.
A public corporation is a corporate body created by the legislature
under a separate statute of a state or central government, which sets out its powers, purpose, duties
and immunities. It is financially independent and has a clear-cut jurisdiction over a specified area or
a particular type of industrial activity. It is administered by a Board of Directors appointed by the
government, to which it is answerable. A public corporation is a separate legal entity created for a
specific purpose. In India, RBI, DVC, STC, IDBI, etc. are some of the corporations created by
special Acts of Parliament.
A public corporation is very much like a public company except in two cases. A company
is incorporated by registration under the Companies Act, while a public corporation is created by an
Act of Parliament or any state legislature, which sets out its powers, duties and functions.
Secondly, the shareholders of a public corporation, where there are any number of them, have no
equity interests, no voting rights and no powers to appoint Directors.
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Characteristics
1. It is a corporate body created by a special law defining its objects, powers and
privileges, and prescribing the form of management and its relationship with
government departments and ministries.
2. It is owned wholly by the state. The state is the only subscriber to its share capital.
3. The public corporation is the combination of public ownership, public accountability
and business management for public ends.
4. It is a legal person and can sue and be sued, enter into contracts, and acquire and own property in
its own name. It is a public authority for public purpose.
5. Since it is a separate legal entity, the employees of a public corporation are not
government servants and are not governed by Civil Service Rules. They are employed
and remunerated independently by each public corporation.
6. It enjoys financial autonomy and is expected to be self-supporting. Unlike a
department undertaking its income and outlay are not shown in the annual budget of
the Government.
7. Unlike a private undertaking, a public corporation is formed primarily for offering
public service and promoting public welfare, and profit is only a secondary
consideration with it.
8. It enjoys complete internal autonomy and is free from parliamentary or political
control in the internal and routine management.
9. A public corporation has flexibility of operation, accountability to the Parliament but no
bureaucracy. For the success of business enterprise, flexibility is the essential
prerequisite. It is available in public corporation.
Advantages
1. It enjoys internal autonomy, and there is no interference by government officers.
2. There is no rigidity in their working as in the case of departmental undertakings. It
retains the flexibility and effectiveness of private enterprise.
3. It can work within the framework of parliamentary control and ministerial
responsibility and it can ensure national policy.
4. These corporations utilize the services of competent persons. They are free to employ
persons according to their requirements.
5. These undertakings are run on commercial lines. They also earn profits like private
concerns. It helps these undertakings to finance their schemes and undertake
expansion plans.
6. These undertakings are accountable to the legislature for their performance. They try
to increase their efficiency, otherwise they are criticized in the Parliament or state
legislature.
7. These undertakings provide commodities and services to the people at reasonable
prices. Though they also earn profits, their primary aim is to help the society in
getting various services.
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Disadvantages
1. It has created a difficult problem of autonomy. The concerned government
department exercises direct or indirect control over these bodies.
2. It is suitable only for the management of very big enterprises.
3. It needs special legislation and hence its formation is elaborate and time-consuming.
4. Any change in the sphere of activities of the corporations involves change in the
statute of the corporation. The statute can be amended only by a legislature.
5. Financial autonomy of the corporation is, sometimes, misused by the management.
Public money may be wasted on unnecessary projects.
6. Though these corporations are autonomous bodies, still there are many controls
exercised by the government.
Government Company.
A company owned by central and/or state government is called a
government company. Section 617 of the Companies Act, 1956, defines a government company
as any company in which not less than 51 percent of the paid-up share capital is held by the central
government or by any state government or governments, or partly by the central
government and partly by one or more state governments.
Government companies are registered both as public limited and private limited companies, though
the management remains with the government in both the cases. Government companies enjoy some
privileges which are not available to non-government companies. No special statute is required to
form government companies.
Characteristics
1. It is a body corporate created under the Companies Act.
2. The whole of the share capital, or 51 per cent or more of it, is held by the
government.
3. It can sue and be sued, enter into contracts, and acquire and hold property in its own name.
4. All or majority of the directors are nominated by the government.
5. The concerned ministry performs the functions of shareholders and exercises ultimate
control over the entire operations of the company.
6. It is free from the budget, audit and accounting laws applicable to other departments.
7. Its funds are obtained from government, and in some cases, from private
shareholders, and through revenues derived from the sale of its goods and services.
8. Its employees, excluding the officers taken from government departments on
deputation, are not civil servants.
Advantages.
The main advantages of a government company are:
1. It is a handy organization, easy to form with minimum legal formalities and is more
autonomous than private ones.
2. There is freedom and flexibility in the management of government companies.
Companies can organize their working according to the necessity of the situation.
3. They run on sound business lines. They earn surpluses to finance their own expansion
plans.
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4. It provides healthy competition to the private sector.
5. These companies are dependent on the government only for their initial investments.
They can plan their own capital structure. The companies earn profits and these
profits can be used for further investments.
6. Government companies can enter all the neglected areas and can help in all-round
growth.
Disadvantages.
The disadvantages of a government company are as follows:
1. It can bypass constitutional responsibilities of a state enterprise.
2. These companies are not generally as efficient as units in the private sector.
3. The separate legal personality and autonomy exist only on paper. In reality all
functions and management powers are virtually reserved for the government.
4. There is a lot of political interference in government companies. Every government
tries to nominate directors for its own political considerations.
5. These companies are dependent on the government for taking important policy
decisions.
6. Red-tapism in government departments affects the working of these companies.
Problems of Public Enterprises
Public enterprises suffer from a number of problems. Some of the problems relate to their day-to-day
working and others relate to policy matters and control. The problems of public
enterprises are as follows:
Form of Organisation.
This is one of the important problems of public enterprises. The
relative merits and demerits of different forms of organizations adopted for the establishment of
public enterprises in India have been discussed previously. The working of the undertaking entirely
depends upon the form of its organization. Different undertakings are suitable for different industries.
For example, departmental form of organization is suitable for strategic industries and public utilities,
public corporations are suitable for big undertakings and government undertakings are suitable for
undertakings on commercial lines. Before taking a decision regarding the form of an enterprise,
different factors need to be considered like nature of work, capital required, requirement of
managerial skills, policy, etc.
Managerial Autonomy.
How much autonomy should be allowed to the management is
another important factor. There is a tendency on the part of the operating ministries to interfere with
their day-to-day working to regulate them supposedly in the interest of the public.
Interference is certainly prejudicial to the efficiency and operating flexibility of these enterprises, for
it leaves practically no initiative and discretion with the management, and introduces the usual redtape and bureaucratic characteristics of government departments.
Autonomy is essential for the business to run on sound business principles and practices. The
managements of these enterprises should be given a free hand to take their own decisions.
Public Accountability.
Accountability to the public implies answerability to the community

at large. Public enterprises are financed by public money and they are primarily formed for TYPES
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public service. Public should be aware of the working of these enterprises. Such steps will include
parliamentary control, provision of public reporting and ministerial responsibility for the working of
State enterprises.
Composition of Board of Directors.
Since the Board of Directors is the highest organ of
policy-making and direction in any enterprise, the efficiency and effectiveness of the concern will
depend to a considerable extent upon the quality of the Board members in terms of their skill,
creativity, talent, autonomy, etc. In many cases, the Board is unable to play a vital role because they
are usually nominated by the government from the officials of the various
ministries. It is essential that the Board of Directors should consist of financial talent, administrative
talent, technical skill, representatives of labour and management, etc., and they should be kept away
from politicians as far as possible.
Pricing Policy.
Pricing policy of public enterprises has always remained a topic of
controversy. The principal considerations in the formulation of a price policy for public enterprises
are: generation of surpluses for reinvestment, attainment of the optimum level of operation, making
products available to consumers, coping with competition, etc. A sound
pricing policy should aim at earning some profit so that these units become economically viable units.
SUMMARY
Sole proprietorship is a form of business organization in which a single person owns, manages and
controls the business enterprise with all authority, responsibility and risk. The individual who owns
and runs the business is called the sole proprietor. In sole proprietorship business there is single
ownership. The sole proprietor controls the business and his liability is unlimited.
The proprietor bears the profit or the loss and invests capital from own sources. Starting and
operating the business does not require any legal formalities. Sole proprietorship business is easy to
form and wind up. In this business, decisions are taken quickly, better control can be exercised over
the business activities and sole proprietorship secrecy can be maintained.
Personal contact with the customer and flexibility in operations is possible. Employment
opportunity for the owner and for others is also created by this form of business organisation.
The insufficiency of capital and unlimited liability of the sole proprietor restricts the growth and
expansion of sole proprietorship business. Life of the business is dependent on the life of the
proprietor, which leads to uncertainty in its continuity. This form of business organisations also suffer
from the limitations of small size of the business and is deprived of the benefit of professional
management. Sole proprietorship form of business is suitable for simple business involving less
capital and low risk. Business requiring manual skill or personal attention to customers are generally
organised in the form of sole proprietorship.
Partnership is the relationship between two or more persons who have agreed to share the
profits of a business carried on by all or any of them acting for all. The persons who join hands are
individually known as Partners and collectively as a Firm. The name under which the business is
carried on is called Firm Name It is a form of business in which two or more competent persons
join together to carry on any lawful business after entering into an
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agreement to share the profit and loss of the business. They are free to get their firm registered under
the Act of the government. A partnership firm does not have any legal entity separate from that of its
partners. It can continue for a long period of time and can also come to an end at any time if the
partners so desire. It automatically comes to an end in the event of death, lunacy and insolvency of
any partner. The relationship amongst the partners can be compared with that of Principal and Agent.
No partner can transfer or sell his interest in the business without the consent of others and the
liability of each partner is unlimited.
A partnership firm is very easy to form and also flexible in its operation. It pools resources from the
partners and makes for their optimum utilization by taking better decisions. It protects the interest of
each and every partner and gets benefit out of the specialized knowledge and skill of individual
partners. A partnership firm suffers from many limitations like uncertain life, disharmony among
partners, and inability to pool large resources because of restriction on number of members, and it
does not permit the transfer of the interest of individual partners.
The different types of partners are Active Partner, Dormant Partner, Nominal Partner, Minor as a
Partner, Partner by Estoppel and Partner by holding out. Partnership form of business is most suitable
for retail or wholesale trade and for small manufacturing units. Persons
having different specializations can also form partnership firms like construction firms and legal
firms.
A joint stock company is an artificial person created by law, having separate legal entity, with
perpetual succession and a common seal. It is a voluntary association of persons who generally
contribute capital to carry on a particular type of business, and which is established by law and can
be dissolved only by law. Persons who contribute capital become members of the company. The
companies are governed by the Indian Companies Act, 1956.
A co-operative society is a voluntary association of individuals having common needs who
join hands for the achievement of common economic interest. Its aim is to serve the interest of the
poorer sections of society through mutual help. Membership of co-operative societies is voluntary
and open to all. It is democratically managed and it has a separate legal existence.
The main motive is to provide service to the members. It works on the principle of
self-help through mutual cooperation of members. Co-operative societies are classified as: (a)
Consumers co-operative society, which is formed to eliminate the role of middlemen and to supply
high-quality goods and services at reasonable price to consumers; (b) Producers cooperative society,
which is formed to help producers to procure raw materials, tools,
equipment, etc. (c) Co-operative marketing society, which is formed to ensure a favourable market for
small producers to sell the output and get a good return on sale; (d) Co-operative credit society,
which is formed to provide financial help to members through loans at low interest rates. They
encourage saving habit among members; (e) Co-operative farming society, which is formed to
achieve economies of large-scale farming and maximization of agricultural output; and (f) Housing
co-operative society, which is formed to provide residential houses to members by constructing them
or providing loans to members to construct their own houses.
Public enterprise is an undertaking owned and controlled by the local, state or central
government. The basic aim of a state enterprise is to provide goods and services to the public at a
reasonable rate. Public enterprises are established to implement economic policies of the
government. The primary objective of the public enterprises is to serve the people and help in
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creating an environment of industrial activity. There have been two opinions about the need for public
enterprises. Some people are of the view that government should develop
infrastructural facilities only, and initiatives for setting up industrial units should be left to the private
entrepreneurs. Others have strongly advocated the need for setting up public sector units for speeding
up the pace of development.
Public enterprises can adopt a variety of forms of organization for its administration. A suitable form
of organization will increase the efficiency of the concern. Excessive dependence on government for
finances will increase government interference in the day-to-day working.
These enterprises should be run on business lines and necessary autonomy should be allowed to them.
Among various types, the most preferred forms of organization in India are
departmental organisations, statutory or public corporations and government companies. Public

enterprises suffer from a number of problems. Some of the problems relate to their day-to-day
working and others relate to policy matters and control.
EXERCISES
True or False Questions
1. Which of the following statements about sole proprietorship are true and which are false?
(i) The business is started by one person.
(ii) It is managed by the employees of the business.
(iii) It is the oldest form of organization.
(iv) No legal formalities are required to start a sole-trade business.
(v) The risk of the business is shared with the employees of the business.
(vi) Death of a sole-trader does not affect the continuity of business.
(vii) Secrecy can be maintained in a sole proprietorship form of business organization.
2. Which of the following statements about partnership are true and which are false?
(i) The number of partners should not exceed 20 in case of banking business.
(ii) There must be a written agreement between all the partners.
(iii) It is compulsory to get the partnership firm registered.
(iv) No partner can transfer his interest to any other without the consent of the other
partners.
(v) Partnership firm has no separate legal existence.
(vi) All partners can participate in the working of the business.
(vii) A minors liability is limited only up to his share in the firm.
(viii) The partners can bind the firm by their acts.
(ix) Insolvency of a partner can dissolve the firm.
3. Which of the following statements about a joint stock company are true and which are
false.
(i) No legal formality is required to form a joint stock company.
(ii) A joint stock company dies with the death of its shareholders.
(iii) The shareholders of a joint stock company have limited liability.
(iv) A joint stock company can own property on its own name.
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(v) A joint stock company is managed by the elected representatives of shareholders.
(vi) A public company must have at least three directors.
4. Which of the following statements about co-operative societies are true and which are
false?
(i) Any competent person can become a member of a society at any time.
(ii) The liability of the members is unlimited.
(iii) The government encourages and supports the formation of co-operative societies by
providing subsidies and exemptions.
(iv) It can exist for long due to a legal entity separate from its members.
(v) The society is managed by one person only.
5. Which of the following statements about public enterprises are true and which are false?
(i) A public enterprise is financed by the government.
(ii) Public corporations are set up under the Companies Act.
(iii) Government companies can be registered as private limited companies also.
(iv) Public utilities are profit-earning organizations.
(v) A joint sector is that where private and public sector cooperate.
Answers
1. (i) True
(ii) False
(iii) True
(iv) True
(v) False
(vi) False
(vii) True
2. (i) False
(ii) False
(iii) False
(iv) True
(v) True
(vi) True
(vii) True
(viii) True
(ix) True
3. (i) False
(ii) False
(iii) True
(iv) True
(v) True
(vi) True
4. (i) True
(ii) False
(iii) True
(iv) True
(v) False
5. (i) True
(ii) False
(iii) True
(iv) False
(v) True
Fill in the blanks:
1. Fill in the blanks with the appropriate word(s) relating to sole proprietorship.
(i) The owner of the business owns the properties and assets and bears all the ______
of the business.
(ii) All decisions for running the business are taken by the________ .
(iii) The owner arranges capital for the business from ________ resources or loans.
(iv) The liability of the owner in the business is __________ .
(v) The business does not require registration and almost no _______ formalities.
(vi) Due to limited financial resources and limitation of the expertise of the owner, the business may
lack professional ___________ .
(vii) The form is suitable for simple business where __________ skill is required.
(viii) Sole proprietorship caters best to the needs of customers where the market for the product is
_____________ and ____________ .
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2. Fill in the blanks with the appropriate word(s) relating to partnership.
(i) Partnership is basically a ________ between persons.
(ii) The name under which the business of partnership is carried on is called ________.
(iii) The agreement, which lays down the terms and conditions of partnership is termed
a _________.
(iv) Section 4 of the _________ Act 1932 defines partnership.
(v) Partners agree to share ____________ of business.
(vi) It is _______ to get the partnership firm registered.
(vii) In partnership, business risk is ________ by all the partners.
(viii) Partnership is a _______ effort.
(ix) A partnership firm requires at least _________ persons.
(x) Registration of partnership is ________.
(xi) A partnership has ____ separate legal entity.
(xii) Liability in partnership is _________.
3. Fill in the blanks with the appropriate word(s) relating to joint stock companies:
(i) There should be at least __________ members in a public limited company.
(ii) Transfer of shares freely from one member to another is not possible in case of a
_________company.
(iii) A foreign company is formed ____________ India.
(iv) The liability of members of a joint stock company is limited to the extent of the
____________.
(v) A joint stock company form of business organisation is managed by the ________.
(vi) Government companies are registered under the __________ Act.
4. Fill in the blanks with the appropriate word(s) relating to co-operative societies.
(i) Through housing co-operative societies, members may get _______ at low rates of
interest to construct their own houses.
(ii) Small producers who find it difficult to sell their products individually may form
_________________ co-operative societies to sell their produce.
(iii) Consumers co-operative societies help to eliminate ________ in the process of
distribution of goods.
(iv) A co-operative society is a _____ association of individuals who come together to
achieve common _____ objectives.
(v) Their motive is to provide ____ to the members.
(vi) They have a separate ____ from the members.
(vii) Profit is shared amongst members on the basis of members ____________ in the
business of the society.
(viii) The co-operative society suffers due to limited capacity of members to contribute
_________.
(ix) Co-operative societies are formed to provide service rather than to maximize
_______.
5. Fill in the blanks with the appropriate word(s) relating to public enteprises:
(i) A public enterprise is an undertaking owned and controlled by the __________.
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(ii) Public corporations are created by the _____________ of central or state
governments.
(iii) In a government company, at least _________ shares are owned by the government.
Answers
1. (i) risks
(ii) proprietor
(iii) personal
(iv) unlimited
(v) legal
(vi) management
(vii) manual
(viii) limited, localized.
2. (i) relation
(ii) firm name
(iii) partnership deed
(iv) Indian Partnership
(v) profits and losses
(vi) not necessary
(vii) shared
(viii) group
(ix) two
(x) voluntary
(xi) no
(xii) unlimited.
3. (i) seven
(ii) private limited
(iii) outside
(iv) value of shares held by them
(v) Board of Directors
(vi) Joint Stock Companies.
4. (i) loans
(ii) marketing
(iii) middlemen
(iv) voluntary, economic
(v) service
(vi) legal entity
(vii) participation
(viii) capital
(ix) profit
5. (i) government
(ii) special status
(iii) 51 per cent
1. The primary aim of business is
(a) To earn profit
(b) To provide service
(c) To help its employees
(d) To help community
2. The liability of partners in a firm is
(a) Limited
(b) Unlimited
(c) A joint liability
3. The minimum number of persons required to form a private company is:
(a) Two
(b) Seven
(c) Ten
(d) Fifty
4. A sole-trade business is started by
(a) One person
(b) At least two persons
(c) At least five persons
(d) Unlimited people
5. Sole proprietorship is suitable for
(a) Large scale business
(b) Medium scale business
(c) Small scale business
(d) All types of business
6. The liability of sole proprietor is
(a) Limited only to his investment in the business
(b) Limited to the total property of the business
(c) Unlimited
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7. A partnership firm can be registered under the Partnership Act of
(a) 1923
(b) 1932
(c) 1956
(d) 1948
8. A partnership can be formed by (at least)
(a) Two persons
(b) Five persons
(c) Seven persons
(d) Unlimited number of persons
9. The liability of partners in partnership is
(a) Limited up to their capital (b) Limited up to their profits
(c) Unlimited
10. A partner who takes active part in the working of the concern is called a/an
(a) Sleeping partner
(b) Active partner
(c) Nominal partner
(d) All the above
11. A joint stock company is registered under the
(a) Indian Contract Act
(b) Companies Act
(c) Chartered Act
(d) Statutory Act
12. A Public Limited company must have at least
(a) two persons
(b) seven persons
(c) ten persons
(d) twenty persons

13. Government companies are registered under the
(a) Indian Contract Act
(b) Companies Act, 1956
(c) Special Statutes of the government
(d) Royal Charter
Answers
1. (a)
2. (b)
3. (a)
4. (a)
5. (c)
6. (c)
7. (b)
8. (a)
9. (c)
10. (b)
11. (b)
12. (b)
1. What is a partnership agreement?
2. Who is a nominal partner?
3. What is a government company?
4. What is a joint hindu family business?
5. What is a co-operative form of organisation?

6. What is the joint sector?
7. Define a sole proprietorship.
8. What is a Partnership?
9. Who is a partner by estoppel?
10. Can a minor be a partner?
11. Is registration of partnership compulsory?
12. List the contents of partnership deed.
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13. State the rights and obligations of partners.
14. Who is an active partner?
15. Define sleeping partner.
16. Explain the term: Partner by holding out.
17. What are unlimited companies?
18. What are holding and subsidiary companies?
19. What is the meaning of Joint Stock Company?
20. List the different types of Joint Stock Company.
21. What is the meaning of co-operative society?
22. What is meant by marketing co-operative society?
23. What are government companies?
24. What is a public company?
25. What is a subsidiary company?
26. What is meant by Holding Company?

1. Describe the characteristics of a sole proprietorship form of organization. Discuss its merits and
demerits.
2. What are the different forms of business organization? If you were to start a business, which one of
these forms would you prefer and why?
3. What are the factors influencing the choice of a suitable form of organization?
4. Define sole proprietorship. Explain any four characteristics of this form of business
organisation.
5. In which conditions is sole proprietorship a suitable form of business organization?
6. How does unlimited liability lead to risk for the sole proprietor? Explain with the help of an
example.
7. What are the merits and demerits of the sole trader as a form of business organization?
What are the prospects for such a business organization in India at present?
8. Sole proprietorship form of business is the best form of business. Do you agree with this
statement? Justify your answer.
9. Define partnership and bring out its main characteristics.
10. Distinguish between the partnership and sole proprietorship forms of business
organisation.
11. What is a partnership deed? Discuss its main contents and utility.
12. Explain different types of partners.
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13. If you do not register your partnership firm, you will be deprived of certain benefits.
In the light of this statement, state the effects of non-registration of a partnership firm.
14. Partnership form of business is suitable for every type of business organistion. Do you agree?
Give reasons.
15. What are the salient features of a partnership firm? Describe the advantages and
disadvantages of this form of organisation.

16. When is the registration of a partnership firm necessary? How is it done?
17. What is a joint stock company and what are its characteristics? Describe its advantages and
disadvantages as a form of business organization.
18. What is a co-operative society? What are the distinctive features of a co-operative society?
19. Discuss the merits and demerits of a co-operative form of organization.
20. What are the alternative forms of organization to run public enterprises?
21. One-man control is the best in the world if that one man is big enough to manage
everything. Explain this statement.
22. Define a public company and distinguish it from a private company.
23. What is a joint stock company? Explain its salient features.
24. Discuss the advantages and disadvantages of the joint stock company form of
organization.
25. What is a joint stock company? Distinguish between a partnership and a joint stock
company.
26. What is meant by a private limited company? Distinguish it from a public limited
company.
27. What is the meaning of co-operative society? State the functions of co-operative credit societies.
State the types of co-operative credit societies, giving one example of each.
28. Give the difference between producers co-operative society and marketing cooperative society.
Glossary
Accept-Reject Criterion
Evaluation of capital budgeting proposals to determine whether the
projects under consideration satisfy the minimum acceptance standard and should be accepted.
Account
Summarized record of transactions relating to a particular person or thing.

Accountancy
A systematic field of knowledge consisting of principles, concepts, conventions
and policies governing recording, classifying, summarising, analysing and interpreting financial
transactions.
Accounting
The process of identifying, measuring and communicating the economic
information of an organization to its users who need the information for decision-making.
Accounting Rate of Return
The ratio of the net average annual income from the project to
the initial investment.
Acid-Test Ratio
The ratio calculated by dividing the current assets excluding inventory and
pre-paid expenses by current liabilities.
Active Forecast
A prediction about a future situation, assuming that the firm changes its
action plan.
Activity or Turnover Ratios
Ratios which measure the efficiency with which the firm uses
its assets.
Actual Costs
Costs that are actually incurred in acquiring or producing goods or services.
Aggregate Demand
Total demand of all the individuals in the market.
Aggregation
A method of simplifying theory by combining many markets into a large,
composite market.
Allocation
The determination of what goods and services will be produced from available
resources. Allocation can be done with markets or with hierarchy.
Annuity
A series of receipts or payments of a fixed amount for a specified number of years.
507
508
GLOSSARY
Autonomous Demand
Demand when a good is needed for direct use and not as an input to
produce another good.
Average Collection Period
The number of days taken on an average for collecting amounts
from the debtors.
Average Fixed Cost (AFC)
Total fixed costs divided by output.
Average Product (AP)
The total product divided by the quantity of the variable input used.
Average Revenue
Total revenue divided by the quantity sold.
Average Total Cost (ATC)
Total costs divided by output.

Average Variable Cost (AVC)
Total variable costs divided by output.
Balance
Difference between the total debits and total credits recorded in an account.
Balance Sheet
Statement of assets and liabilities on a specific date.
Bank Overdraft
The amount that a trader owes to a bank.
Barometric Forecasting
The method of forecasting turning points in business cycles by the
use of leading economic indicators.
Bilateral Monopoly
A market situation where there is only one buyer and one seller of the
commodity.
Bonds
Long-term debt instruments.
Book-keeping
Systematic recording of business transactions in financial terms.
Break-even Analysis
An analytical technique for studying the relationship between fixed
costs, variable costs, profits and sales.
Break-even Chart
A graphical presentation of the break-even analysis.
Break-even Point
The point which represents the level of sales at which the operating
income and operating costs are equal, so that operating profit is zero.
Business Enterprise
A business unit formed for the purpose of carrying on some kind of
economic activity with a profit motive.
Capital Budgeting
The process of planning expenditures that gives rise to revenues or
returns over a number of years.
Capital Good
A good that helps in further production of goods and services.
Capital Structure
The mix of the various types of long-term sources of funds, namely debt,
preference shares, debentures and equity, including retained earnings.
Cash Flows
The actual receipts and payments by a firm.
Cash Outflow
Expected investment required for an investment proposal.
Change in Demand
A shift in the demand curve of a commodity as a result of a change in
the non-price factors like consumers income, price of related goods, tastes and fashions of
consumers, etc.
GLOSSARY
509
Change in the Quantity Demanded

The movement along a particular demand curve
resulting from a change in the price of the commodity, while holding everything else constant.
A production function of the form Q = AKaLb, where
Q, K, and L are physical units of output, labour, and capital, and A, a and b are the parameters to be
estimated empirically.
Competition
Rivalry among individuals in order to acquire more of something that is scarce.
Complementary Goods
A pair of goods where the quantity demanded of one increases when
the price of a related good decreases.
Complete Enumeration
A method in which every consumer is contacted to forecast demand.
Constant Returns to Scale (CRS)
A long-run production concept where a doubling of all
factor inputs exactly doubles the amount of output.
Consumer (Household)
An economic agent that desires to purchase goods and services with
the goal of maximizing the satisfaction from consumption of those goods and services.
Consumer Durables
The goods which are needed for direct consumption and have repeated
uses.
Consumer Optimum
Identification of an attainable bundle of goods that maximizes a
consumers level of satisfaction given his/her level of income and market prices.
Consumer Surveys
The survey of a sample of consumers about how they would respond to
particular changes in the price and other determinants of the demand for the commodity.
Consumers Surplus
The difference between what a consumer is willing to pay for each unit
of a commodity consumed and the price actually paid.
Consumption
The using up of a resource.
Consumption Function
The mathematical relationship between the amount of consumption
and the level of income.
Contra Entry
Both debit and credit aspects of a transaction are recorded in the cash book.
Contraction of Demand
A movement upward on the demand curve.
Contribution Margin
The difference between selling price and variable cost.
Correlation Coefficient
Degree or intensity of relationship between two variables.
Cost Accounting
The process of accounting and controlling the cost of a product, operation
or function.
Coverage Ratios
Ratios that measure the ability of a firm to meet its fixed obligations.
Credit
The giving aspect of the benefit in a transaction.
Creditor
A party whose account shows a credit balance.
The percentage change in the demand for commodity X divided
by the percentage change in the price of commodity Y, while holding constant all other variables in
the demand function.
510
GLOSSARY
Current Assets
Assets which can be converted in the ordinary course of business into cash
within a year or length or operating cycle, whichever is higher.
Current Liabilities
Liabilities that are intended to be paid within a year in the ordinary
course of business from the date of inception.
Current Ratio
Current ratio is the ratio of current assets to current liabilities.
Cyclical Fluctuations
The major expansions and contractions in most economic time series
that recur after a number of years.
Debit
The receiving aspect of the benefit in a transaction.
Debt-Equity Ratio
A ratio which measures the proportion of outsiders funds in relation to
the shareholders equity.
Debt Ratio
Ratio of debt to total assets or capital.
Debtors Turnover Ratio
Ratio of total credit sales and average debtors.
Decreasing Returns to Scale (DRS)
factor inputs results in less than double the amount of output.
Deflation
The reverse of inflation wherein the price level falls persistently.
Delphi Method
The forecasting method based on polling the firms top executives or outside
experts separately and then providing feedback in the hope that they would reach a consensus
forecast.
Demand
A relationship between market price and quantities of goods and services purchased
in a given period of time. Represents the behaviour of buyers in the market place.
Demand Curve
The relationship between price and the amount of a product that people want
to buy.
Demand Forecasting
Ascertaining the expected level of demand in the period under
consideration.
Demand Function
The relationship of demand with the determinants that influence it.
Derived Demand
The firms demand for the inputs or factors of production required in the
production of the commodity that the firm sells.
Differentiated Oligopoly
An oligopoly in which the products of the firms in the industry are
differentiated.
Differentiated Products
Products that are similar and that satisfy the same basic need.
Diffusion Index
An index that measures the percentage of the leading indicators moving
upward.
Diminishing Marginal Productivity (DMP)
A short-run production concept where increases
in the variable factor of production lead to less and less additional output.
Diminishing Marginal Utility (DMU)
An economic concept that refers to the notion that
additional units consumed of a particular commodity provide less and less additional
satisfaction relative to previous units consumed.
GLOSSARY
511
Direct Demand
Demand for consumption products.
Discount Rate
The rate used in the discounting process to determine present values of future
benefits.
Discounted Cash Flow Techniques
Capital budgeting techniques that adjust cash flow over
the life of the project for the time value of money.
The increase in the unit cost of production as the firm increases its
capacity.
Disequilibrium
A condition that exists when a system is not at rest and has a tendency to
change.
Distribution
The supplying of goods and services to retailers and others so that peoples
needs can be met.
The cash book which contains columns for discount in addition
to cash columns.
Double Entry Principle
The principles that both aspects i.e. receiving aspect (debit) and the
giving aspect (credit) must be recorded to show the two-fold effect of each transaction.
Duopoly
A market in which there are two sellers.
Durable Goods
The goods which are used again and again.

Econometrics
The empirical estimation and testing of economic relationships and models.
Economic Agent
A decision-maker involved in any type of economic activity.
Economic Costs
Alternative or opportunity costs.
Economic Efficiency
A situation in which value is maximized. Given resources, technology,
and preferences, no changes will increase value. Also called Pareto optimality.
Economic Inefficiency
A situation in which there is potential value that no one captures.
Given resources, technology, and preferences, there is some change which will improve the wellbeing on one individual without harming anyone else.
Economic Profit
The revenue of the firm minus its economic costs.
Economic Theory
The study of microeconomics and macroeconomics.
Economics
The study of choice and decision-making in a world with limited resources.
Economies of Scale
The reduction in the unit cost as the firm increases all of its inputs.
Efficiency
A situation in the allocation of resources where the benefits of consuming one
more unit exactly equal the (social and private) costs of producing that good.
Elasticity
A measure of responsiveness.
Endogenous Variables
Factors controlled by the firm.
Entity An economic unit that performs economic activities.
Entrepreneur
An individual who creates a new organization, market, or product, usually in
the quest for profit. Entrepreneurs are innovators.
512
GLOSSARY
Equilibrium
A condition where there is no tendency for an economic variable to change.
The principle which states that an input must be so allocated
between various uses that the value added by the last unit of the input is the same in all its uses.
Event
A happening of financial consequence to an entity.
Exogenous Variables
Factors outside the control of a firm.
Expenditure
The amount spent by a consumer on a bundle of goods or services (the product
of market price and quantity demanded).
Expert Opinion Survey
This technique for forecasting demand seeks the views of experts

on the likely level of demand in future.
Explicit Costs
The actual expenditures of the firm required to hire or purchase inputs.
Exponential Smoothing
A smoothing method of forecasting that assigns greater importance
to more recent data than to those in the more distant past.
Export
To send and/or sell goods and services outside ones country.
Extension of Demand
A movement downward on the demand curve.
Factors of Production
An exhaustive list of inputs required for any type of production.
Final Goods and Services
Goods and services that are purchased for direct consumption.
The process of identifying, measuring, recording, classifying, and
summarising the financial transactions and events.
Firm
An organization that combines and organizes resources for the purpose of producing
goods and/or services for sale.
Fixed Assets
Long-term assets that would be in use for longer than one year.
Fixed Cost
Cost that does not change as output changes.

Folio
A page of a Ledger/Journal/any book of account.
Forecasting
An estimation of the future situation.
Function
A mathematical relationship between two variables wherein one of the variables
depends on the other.
Giffen Good
A commodity in whose case a decrease in price of a good results in decrease
in its quantity demanded and vice versa. It is an exception to the law of demand.
Good
An object or service that increases utility.
Gross Profit
The difference between receipts and payments over a time-period.
Gross Profit Margin
The margin calculated by dividing the gross profits by net sales.
Implicit costs
The value of the inputs owned and used by the firm.
Import
To bring in and/or buy goods and services from another country.
Income
The amount of money one earns. This can be through ones job or through
investments, etc.
GLOSSARY
513
Income Effect
A reaction of consumers demand for goods or services due to changes in
purchasing power, holding relative prices constant.
The percentage change in the demand for a commodity
divided by the percentage change in consumers income, while holding constant all the other variables
in the demand function.
Increasing Returns to Scale (IRS)
factor inputs more than doubles the amount of output.
Incremental Analysis
The comparison of the incremental revenue to the incremental cost in
managerial decision-making.
Incremental Costs
The total increase in costs from implementing a particular managerial
decision.
Independent Projects
Capital budgeting alternatives that compete with each other, but
acceptance of one does not preclude the acceptance of the others.
Indifference Curves
A set of points that represent different bundles of goods which provide
the consumer with the same level of satisfaction (or utility).
Indifference Map
A set of indifference curves.

Individual Demand Curve
The graphical relationship between the price and the quantity
demanded of a commodity by an individual per time-period.
Individual Demand Schedule
The tabular relationship between the price and the quantity
demanded of a commodity by an individual per time-period.
Industry
The manufacturing (making) and selling of a particular type of good or service, for
example the auto industry.
Inferior Good
A good where quantity demanded decreases when consumer income increases
(that is, there is an inverse relationship between quantity demanded and income).
Inflation
Increase in the overall level of prices over an extended period of time.
Inputs
Resources used in the production of goods and services.
Interdependent
People and/or businesses depending on or helping each other.
Intermediate Goods and Services
Goods (or services) used to produce other goods (i.e.
capital equipment).
Internal Rate of Return (IRR)
The rate of return that equates the present value of future
cash flows to the initial investment on the project.

Investment
To commit (money or capital) in order to gain a financial returnto put ones
money into a business or project to make more money.
Invoice
A business document or statement giving the details of goods issued by a seller to
the purchaser.
Iso-cost
A line representing different combinations of two inputs that a firm can purchase
with the same amount of money.
514
GLOSSARY
Iso-cost line
It shows the various combinations of two inputs that the firm can hire with a
given total cost outlay.
Iso-quant
A curve showing the various combinations of two inputs that can be used to
produce a specific level of output.
Journal
A book where daily record of transactions is initially made. It is the book of original
entry.
Journal Proper
A book to record transactions which cannot be recorded in any of the special
journals/books.
Journalising
The process of recording the transactions in the Journal.
Kinked Demand Curve
A graphical representation of a situation wherein rival firms do not
follow the price increase of a firm but follow its price cuts.
Lagging Indicators
When one time series moves up and down behind some related time
series.
Law of Demand
The inverse relationship between the price and the quantity demanded of
a commodity per time-period.
The law which states that as a consumer increases the
consumption of a product, the utlity gained from successive units goes on decreasing.
Law of Diminishing Returns
The law which states that adding more of one input while
holding other inputs constant eventually results in smaller and smaller increases in added output.
Leading Indicators
The variable whose movement precedes the movement of some other
related variable.
Least Cost Combination of Inputs
An inputs combination which costs the minimum output
out of a given choice of alternative input combinations producing the same output.
Ledger
The book of final entry, containing accounts in which all the transactions relating to
a particular account are brought together and recorded at one place.
Leverage Ratios
Ratios which measure the extent of debt to equity in the capitalization of
a firm.
Liabilities
Currently existing obligations which a business enterprise intends to meet at some
time in future.
Liquidation
The sale of assets of a firm either voluntarily or in bankruptcy.
Liquidity
The ability of an asset to be converted into cash without a significant price
concession.
Liquidity Ratios
Ratios which indicate the liquidity of the firm.
Long run
The time period when all inputs are variable.
Long-run Cost
The cost which varies with output when all the factor inputs change.
Long-run Cost-Output Relationship
The behaviour of cost to the changes in output when
even the plant size is varying, i.e. all the factors inputs are variable.
GLOSSARY
515
Long-run Production
Production activity where all factors of production may vary in
quantity. The firm has the freedom to substitute among these factors of production in attempts to
minimize costs.
Macroeconomics
The study of the total or aggregate level of output, income, employment,
consumption, investment, and prices for the economy viewed as a whole.
Accounting techniques for providing information designed to help
all levels of management in planning and controlling the activities of business enterprise and in
decision-making.
The science of directing scarce resources to manage cost effectively.
Manufacture
To make or process (a raw material) into a finished product, especially by
means of a large-scale industrial operation.
Margin of Safety
The excess of budgeted or actual sales over the break-even sales.
Marginal Cost (MC)
Change in total cost caused by a one-unit change in an activity, or the
slope of the total cost curve. In the case of a business, the change in total cost is caused by a change in
output.
Marginal Product (MP)
The change in total product per unit change in the variable input
used.
Marginal Rate of Substitution

The rate at which one commodity can be substituted for
another, if the utility is to remain unchanged.
Marginal Rate of Technical Substitution (MRTS)
The absolute value of the slope of the
iso-quant. It equals the ratio of the marginal products of the two inputs.
Marginal Revenue (MR)
The change in total revenue per unit change in quantity sold.
Marginal Utility
The satisfaction a consumer receives by consuming one more unit of some
good or service.
Market
A place or institution where buyers and sellers come together and exchange factor
inputs or final goods and services.
Market Demand Function
The relationship that identifies the determinants of the total or
aggregate demand for a commodity.
Market Experiments
Attempts by the firm to estimate the demand for the commodity by
changing price and other determinants of the demand for the commodity in the actual
marketplace.
Market Failure
A situation in which a market yields a result that is economically inefficient,
that is, there is value that is not captured.
Market Structure
The competitive environment in which the buyers and sellers of the
product operate.
Market Value
The market price at which an asset trades.
Maximization Principle
The rule that net benefits are maximized when marginal benefit
equals marginal cost.
516
GLOSSARY
Microeconomics
The study of the economic behaviour of individual decision-making units.
Money
The accepted common medium of exchange for goods and services in the marketplace
that functions as the unit of account, a means of deferred payment and a store of value.
The form of market organization in which there are many sellers
of a differentiated product and entry into or exit from the industry is rather easy in the long run.
Monopoly
A market structure where only one firm exists in a given industry. This firm has
a high degree of market power such that it is able to act as a price-maker with respect to market
prices.
Monopsony
A market with only one buyer but many sellers.
Moving Average
The smoothing technique in which the forecasted value of a time series in
a given period is equal to the average value of the time series in a number of previous periods.
Multiple Regression
Regression analysis with more than one independent or explanatory
variable.
Mutually Exclusive Project
A project whose acceptance precludes the acceptance of one or
more alternative projects.
Naive Forecasting
When past data is just projected into future without explaining the reasons
for future trends.
Needs
Goods and services essential for human survival.
Net Present Value
A method of evaluation consisting of comparing the present value of all
net cash flows.
Net Working Capital
Current assets minus current liabilities.
Nominal Accounts
Accounts of all expenses, losses, incomes and gains.
Normal Good
A good whose quantity demanded increases when consumer income increases
(a direct relationship between quantity demanded and income).
Normal Profit
The minimum expected return to keep an entrepreneur in his present business.
Normative Analysis
An analysis based on a judgement about what is desirable and what is
undesirable.
Oligopoly
A market structure with only a few firms in a given industry.
Operating Cycle
The operating cycle of a firm begins with the acquisition of raw materials
and ends with the collection of receivables.
Operating Leverage
The use of fixed operating costs by the firm.
Operating Ratio
Ratio of cost of goods sold and operating expenses to sales.
Opportunity Cost
The value of a resource applied to its next best use.
Optimal Decision
The decision which enables the decision-maker to attain its desired
objective most closely.
GLOSSARY
517
Optimal Solution
The best of the feasible solutions.
Partial (Simple) Correlation
Correlation in which only one independent variable is taken to

explain the variation in a dependent variable.
Partnership
A business form in which two or more individuals act as owners.
Passive Forecast
Estimation of the value of dependent variable, while taking into account no
action of the firm affecting the independent variables.
Payback Period
The period of time required for the cumulative expected cash flows from
an investment project to equal the initial cash outflow.
Perfect Competition
A market structure where many firms exist, each with a small
percentage of market share selling a homogeneous product. These firms are all price-takers with no
influence on market price.
Personal Accounts
Accounts which are concerned with the individual persons, partnership
firms, companies or other organizations.
Petty Cash Book
The book which contains a number of columns to record all petty expenses.
Positive Analysis
An analysis limited to statements about the actual consequences of an event
or policy, with no judgement about whether the consequences are desirable or not.
Present Value
The concept which states that money in the future is less valuable than an
equivalent amount of money now because money in the future gives fewer options. The
comparison of money in different time-periods is made with a present value computation.

Price
The amount of money, or other goods, that you have to give up to buy a good or
service.
Price Discrimination
Charging different prices for the same good or service.
Price Effect
Change in the consumption of the good due to change in the price of the good.
Price Elastic Demand
When the percentage change in quantity demanded exceeds the
percentage change in market price.
Price Elasticity of Demand
The measure of the responsiveness of demand for a product to
the changes in the price of the product, keeping all the other variables constant.
Price Floor
Legally established minimum price a seller can be paid.
Price Inelastic Demand
When the percentage change in quantity demanded is less than the
percentage change in market price.
Price Searcher
A seller (buyer) who can influence price by the amount he sells (buys).
Price Taker
A seller (buyer) who has no control over price, but sells (buys) at the given
price.
Producer (Business Firm)

An economic agent that converts inputs (factors of production)
into output (goods and services) with the goal of maximizing profits from production and sale of those
goods and services.
518
GLOSSARY
Producers Goods
The inputs used by the firm to product the goods and services demanded
by consumers.
Producer Optimum
A choice of input combinations or output levels that maximize the
profits of a producer, taking all prices as a given.
Producers Surplus
The difference between the lowest price a producer will accept and the
actual price. Also called economic rent.
Product
Something produced or made by human or mechanical effort, or by a natural
process. In business, products are things or items to be bought and/or sold.
Production is the act of making things, in particular the act of making products that will be traded or
sold commercially.
Production Function
A technical relationship between a certain level of factor inputs and
the corresponding level of output.
Production-possibilities Frontier
Frontier that separates outcomes that are possible for an
individual (or a group) to produce from those that cannot be produced.

It presents the summary of revenues, expenses and net income or
net loss of a firm.
Profit
The excess of income over all costs, including the interest cost of the wealth invested.
This means making money after one has paid all the expenses in a business.
Profit Margin
Net profit divided by sales revenue.
Profit Maximisation
Maximizing a firms earnings after taxes (EAT).
Profit Seeking
Efforts to obtain value through exchange by providing a good or service that
others consider valuable. (See rent seeking for the alternative.)
Profitability Index
The ratio of the present value of a projects future net cash flows to the
projects initial cash outflow.
Profitability Ratios
Ratios which measure the profitability of a firm in relation to either
sales or investment.
The measure of responsiveness of demand for a
commodity to the changes in the outlay on advetisement and other promotional efforts.
Pure Oligopoly
An oligopoly in which the products of the firms in the industry are

homogenous.
Qualitative Forecasts
Subjective forecasts based on intuition, personal experiences,
judgement and opinion.
Quantitative Forecasts
Forecasts that employ a variety of statistical methods and
mathematical models using historical data and casual variables to forecast demand.
Quick Ratio
Ratio which measures the relationship between quick assets and current
liabilities.
Ratio Analysis
Uses of financial ratios to evaluate performance such as liquidity, solvency
and profitability.
GLOSSARY
519
Real Account
Account which relates to the assets of the firm, which are real and tangible
in nature.
Relevant Cost
The cost that actually affects a given business decision and should therefore
be considered in the decision process.
Resources
The raw materials and other factors of production that enter the production process
or final goods and services that are desired by economic agents.

Return
Income received on an investment plus any change in market price, usually expressed
as a percentage of the initial market price of the investment.
Returns of Scale
The relationship between output and variations of all the inputs taken
together.
Revenue
The amount received by a producer from the sale of goods and services (the product
of market price and quantity sold).
Risk
A measure of uncertainty about the value of an asset or the benefits of some economic
activity.
Sales Force Opinion Survey
This method forecasts demand by asking the employees of the
company who are part of the sales and marketing team to predict the future levels of demand.
Savings
The excess of income over expenditure.
Scarcity
The condition in which human wants exceed the available supply of goods, time,
and resources. In a world without scarcity, there would be no economics.
Secular Trend
The long-run increase or decrease in a data series.
Secured Loans
A form of debt for money borrowed in which specific assets have been
pledged to guarantee payment.
Services
The performance of any duties or work for another helpful or professional activity.
Short-run Production
Production activity where only one factor of production may vary in
quantity. All other factors of production are fixed in quantity. Substitution among factors is not
possible.
Short Run
The time-period when at least one input is fixed.
Shortage
A market condition where the quantity demanded of a particular good or service
exceeds the quantity available.
Short-run Cost
The cost that varies with output when fixed plant and equipment remain the
same.
Short-run Cost-Output Relationship
The behaviour of cost with varying output in the short
run.
Simple Interest
Interest paid (earned) on only the original amount or principal, borrowed
(lent).
Simple Regression Analysis
The regression analysis with only one independent or
explanatory variable.
520
GLOSSARY
Simultaneous Equations Method
Forecasting of demand using multiple simultaneous
equations.
Single Entry System
The system that is different from double entry accounting.
Social Sciences
A group of academic disciplines that study the human aspects of the world.
The main social sciences include Anthropology, Communication, Economics, Education,
History, Geography, Linguistics, Law, Political Sciences, Psychology, Sociology, Cultural Studies,
and Social Policy.
Sole Proprietorship
A business form for which there is one owner.
Speculation
Attempting to buy when the price is low and to sell when it is high.
Substitute Goods
A pair of goods where the quantity demanded of one increases when the
price of a related good also increases.
Substitution Effect
The reaction of a consumers demand for goods based on changes in
relative prices, holding purchasing power (or utility) constant (see Income Effect).
Sunk Cost
Cost that cannot be recovered.
Supply
A relationship between market price and quantities of goods and services made
available for sale in a given period of time.
Supply and Demand
Supply is the amount of goods available at a given price at any time.
Demand indicates the number of consumers that desire the goods that are in supply.
Supply Curve
The relationship between the quantity sellers want to sell during some timeperiod (quantity supplied) and price.
Surplus
A market condition where the quantity supplied of a particular commodity exceeds
the quantity demanded.
Temporary/Variable Working Capital
The amount of current assets that varies with
seasonal requirements.
Term Loan
Debt originally scheduled for repayment in more than 1 year, but generally in
less than 10 years.
Test Marketing
Launching a product in a selected test area in the same manner in which it
is proposed to be finally launched.
Theory of the Firm
The postulate that the primary goal or objective of the firm is to
maximize the wealth or value of the firm.
Time Series Data

It consists of observations regarding a given variable over a period of time.
Time Series Forecasting
A method of forecasting from past data by taking time as the
independent variable affecting demand.
Total Costs (TC)
Total fixed costs plus total variable costs.
Total Effect
The observed change in quantity demanded due to a price change of one
particular good.
GLOSSARY
521
Total Fixed Costs (TFC)
The total obligations of the firm per time-period for all the fixed
inputs used.
Total Product (TP)
The output produced by using different quantities of an input with fixed
quantities of others.
Total Revenue
The sum total of the revenue received on selling all the units of the
commodity.
Total Variable Cost (TVC)
The total cost associated with the level of output.
Trade
The voluntary exchange of goods, services, or both.

Trade Credit
Credit granted from one business to another.
Transaction
An event involving transfer of money or moneys worth from one party to
another.
Trend
Long-run pattern of increase or decrease.
Trend Projection Method
Method of forecasting demand wherein the historical data is
collected and fitted into some type of trend.
Triple Column Cash Book
The cash book which contains columns for discount, cash and
bank columns.
Uncertainty
Unpredictable changes that cannot be insured against.
Unitary-elastic
Demand when the percentage change in quantity demanded is exactly equal
to the percentage change in market price.
Unrelated Goods
A pair of goods where the quantity demand of one is unaffected by changes
in the price of the other.
Unsecured Loans
A form of debt for money borrowed that is not backed by the pledge of
specific assets.
Utility
A measure of the satisfaction received from some type of economic activity (i.e.,
consumption of goods and services or the sale of factor services).
Utility Function
A mathematical way of saying that utility depends on consumption of goods
and services.
Variable Costs
The costs that vary with the changes in output.
Variable Inputs
Inputs that can be varied easily and on a very short notice.
Wages
The payment for work or services to workersthe money people are paid at their jobs.
Wants
Preferences for goods and services over and above human needs.
Working Capital Management
The administration of the firms current assets and the
financing needed to support current assets.
Bibliography
Aryasri, A.R., Managerial Economics and Financial Analysis, Tata McGraw-Hill, New Delhi,
2005.
Baumol, W.J., Economic Theory and Operations Analysis, Prentice-Hall of India, New Delhi, 1985.
Bhattacharyya, Asish K., Financial Accounting for Business Managers, 2nd ed., Prentice-Hall of
India, New Delhi, 2005.
Bhattacharya, S.K. and John Deardon, Accounting for Management, Vikas Publishers.
Brigham, E.F. and L. James Pappas, Managerial Economics, Dryden Press, Hinsdale, Illinois.
Brigham, E.F., Financial Management: Theory and Practice, 2nd ed., Dryden Press, Hinsdale,
Illinois, 1979.
Brigham, Fundamentals of Financial Management, Thomson, 2006.
Chandra, Prasanna, Financial Management: Theory and Practice, Tata McGraw-Hill, 1997.
Davis, R. and S. Chang, Principles of Managerial Economics, Prentice-Hall, 1986.
Dean, Joel, Managerial Economics, Prentice-Hall, Engelwood Cliffs, N.J., 1951.
Dean, Managerial Economics, Prentice-Hall of India, New Delhi, 2005.
Douglas, Evan J., Managerial Economics: Theory Practice and Problems, Prentice-Hall.
Dwivedi, D.N. and Abhishek Dwivedi, Engineering Economics, Vikas Publishing, New Delhi.
Dwivedi, D.N., Managerial Economics, 6th revised ed., Vikas Publishing, 2001.
Dwivedi, D.N., Principles of Economics, Vikas Publishing, 2nd ed., New Delhi.
Dwivedi, Microeconomics: Theory and Application, Pearson Education India, Delhi, 2005.
Ferguson, C.E., Microeconomic Theory, 3rd ed., Richard D. Irwin, Inc., Illnois, 1972.
523
524
BIBLIOGRAPHY
Ghosh, P.K., G.S. Maheswari and R.N. Goyal, Studies in Accounting Theory, Wiley Eastern, 2000.
Graham, P., Managerial Economics, Addison-Wesley, 1980.
Grewal, T.S., Introduction to Accountancy, S. Chand, New Delhi.
Gupta, Managerial Economics, Tata McGraw-Hill, New Delhi, 2005.
Gupta, S.P., Management Accounting, Sahitya A. Bhava Publications, Agra.
Hague, D.C., Managerial Economics: Analysis for Business Decisions, Longmans, London, 1969.
Hampton, John J., Financial Decision Making, Prentice-Hall of India, New Delhi.
Hirschey, Economics for Managers, Thomson, 2006.
Horngren, Introduction to Financial Accounting, 8th ed., Pearson Education India, Delhi, 2005.
Keown, Martin, Petty and Scott, Financial Management: Principles and Applications, 9th ed.,
Prentice-Hall of India, 2005.
Khan and Jain, Financial Management: Text, Problems and Cases, 4th ed., Tata McGraw-Hill,
2005.
Khan, M.Y. and P.K. Jain, Financial Management, Tata-McGraw-Hill, New Delhi.
Lewis, Petersen, Managerial Economics, 4th ed., Prentice-Hall of India, 2005.
Maheshwari, A., Textbook of Accounting for Management, Vikas Publishing, 2006.
Maheshwari, S.N., An Introduction to Accountancy, 5th ed., Vikas Publishing, 2001.
Maheshwari, S.N., and S.K. Maheswari, An Introduction to Accountancy, 9th ed., Vikas Publishing,
2006.
Maheshwari, Yogesh, Managerial Economics, Prentice-Hall of India, New Delhi.
Maheswari, Managerial Economics, 2nd ed., Prentice-Hall of India, 2005.
Mansfield, Edwin, Microeconomics: Theory and Application, Dryden Press, Hinsdale, Illinois.
Mathur, A.B., Working Capital Management and Control: Principles & Practice, New Age
International, 2005.
Megis, Walter B., Charles E. Johnson and Robert F. Megis, Accounting: The basis for Business
Decisions, 10th ed., McGraw-Hill, New Delhi.
Mehta, P.L., Managerial Economics: Analysis, Problems and Cases, Sultan Chand, New Delhi.
Mithani, D.M., Managerial Economics: Theory and Applications, Himalaya Publishing House,
Mumbai.
Mote, V.L., Samuel Paul and G.S. Gupta, Managerial Economics: Concepts and Cases, Tata
McGraw-Hill, New Delhi.
Narayanaswamy, R., Financial Accounting: A Managerial Perspective, Prentice-Hall of India, New
Delhi.
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Pandey, I.M., Financial Management, 8th ed., Vikas Publishing, 2001.
Panneerselvam, R., Engineering Economics, Prentice-Hall of India, New Delhi.

Pappas, J.L. and E.E. Brigham, Fundamentals of Managerial Economics, Dryden Press, Hinsdale,
Illinois, 1981.
Peterson, Graig and W. Cris Lewis, Managerial Economics, Prentice-Hall of India, New Delhi.
Pindyck and Rubinfeld, Microeconomics, 3rd ed., Prentice-Hall of India, 2001.
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Principles of Accountancy, Hi-Tech Publishers, Hyderabad.
Reddy, D. Raghunatha, and M.V. Narasimhachary, Managerial Economics and Financial
Analysis, Scitech Publications.
Salvatore, Dominick, Managerial Economics in Global Economy, 4th ed., Thomson Western College
Publishing, Singapore.
Salvatore, Managerial Economics in a Global Economy, Thomson.
Salvatore, Theory and Problems of Microeconomic Theory, 3rd ed., Tata McGraw-Hill, 2005.
Seo, K.K., Managerial Economics, Richard D. Irwin, 1992.
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Sharma, K.K., Principles of Economics, Abhishek Publications, 2002.
Sloman, Economics, 3rd ed., Prentice-Hall of India, 2001.
Spencer, M.H. and L. Siegelman, Managerial Economics, Richard Irwin, 1964.
Tulsian, P.C., Accountancy, Tata McGraw-Hill., New Delhi.
Tulsian, P.C., Financial Accounting, Tata McGraw-Hill, New Delhi.
Van Horne, Financial Management and Policy, Prentice-Hall of India, 2005.
Van Horne, Fundamentals of Financial Management, Prentice-Hall of India, New Delhi.
Varshney, R.L. and K.L. Maheswari, Managerial Economics, Sultan Chand.
Model Questions
SET NO. 1
1. Discuss the utility of demand forecasting. What are the criteria of a good forecasting method for
(a) New products

(b) Existing products?
2. Explain the following:
(a) Internal Economies
(b) External Economies.
3. How do you determine BEP in terms of physical units and sales value? Explain the
concepts of margin of safety and angle of incidence. Illustrate through a breakeven chart.
4. What is Perfect Competition? How is Market Price determined under conditions of
Perfect Competition?
5. (a) What are the characteristics of a business unit?
(b) Explain the features of sole trader form of organization. Discuss the advantages and
limitations of sole trader form of organization.
6. Determine the payback period from the information given below.
(a) The project cost is Rs. 20,000
(b) The life of the project is 5 years
(c) The cash flows for the 5 years are Rs. 10,000, Rs. 12,000, Rs. 13,000, Rs. 11,000
and Rs. 10,000 respectively; and
(d) Tax rate is 20%.
527
528
MODEL QUESTIONS
7. During January 2003, Narayan transacted the following business:
Date
Rs.
1
40,000
2
Purchased goods on credit from Shyam
30,000
3
Received cash from Murthy as advance for goods ordered by him
3,000
4
Paid wages
500
5
Goods returned to Shyam
200
6
Goods sold to Kamal
10,000
7
Goods returned by Kamal
500
8
Paid into bank
500
9
Goods sold for cash
750
10
1,000
11
Paid salaries
700
12
Withdrew cash for personal use
1,000
Journalize the above transactions and prepare the Cash Account.
8. The following are the extracts from the financial statements of Blue and Red Ltd., as on 31st
March, 2001 and 2002 respectively.
31 March 2001
31 March 2002
Stock
10,000
25,000
Debtors
20,000
20,000
Bills receivable
10,000
5,000
Cash in hand
18,000
15,000
Bills payable
15,000
20,000
Bank overdraft
2,000
9% debentures
5,00,000
5,00,000
Sales for the year
3,50,000
3,00,000
Gross profit
70,000
50,000
Compute for both the years the following:
(a) Current ratio
(b) Acid ratio
(c) Stock turnover ratio. Also interpret the results.
SET NO. 2
1. (a) What are the possible approaches to forecasting demand for new products?
(b) Discuss the utility of demand forecasting.
2. Define production function. Discuss in detail the different types of production functions.
3. Write shortnotes on the following:
(a) Profit-Volume Ratio
(b) Margin of Safety
MODEL QUESTIONS
529
(c) Angle of Incidence
(d) Contribution
4. (a) What are the causes for the emergence of monopoly?
(b) How is the equilibrium position attained by a monopolist under varying cost
conditions?
5. Evaluate the partnership form of business organization. How does it overcome the
limitations of proprietory form of business?
6. What are the components of working capital? Explain each of them.
7. Prepare Trading and Profit and Loss Account for the year ended 31.12.2001 and a
Balance Sheet as on that date from the following Trial Balance:
Dr. (Rs.)
Cr. (Rs.)
Furniture
6,500
Plant and machinery
60,000
Buildings
75,000
Capital
1,25,000
Bad debts
1,750
Reserve for bad debts
3,000
Sundry debtors
40,000
Sundry creditors
24,000
Stock (1.1.2001)
34,600
Purchases
54,750
Sales
1,54,500
Bank overdraft
28,500
Sales returns
2,000
Purchases returns
1,250
Advertising
4,500
Interest
1,180
Commission received
3,750
Cash in hand
6,500
Salaries
33,000
General expenses
7,820
Car expenses
9,000
Taxes and insurance
3,500
3,40,000
3,40,000
8. Following is the Profit and Loss Account and Balance Sheet of Jai Hind Ltd. Calculate
the following ratios:
(a) Gross Profit Ratio
(b) Current Ratio
(c) Quick Ratio.
530
MODEL QUESTIONS
Particulars
Dr. (Rs.) Particulars
Cr. (Rs.)
To Opening stock of finished goods 1,00,000 By Sales
8,00,000
To Opening stock of raw materials
50,000 By Closing stock of raw
To Purchase of raw materials
3,00,000
materials
1,50,000
To Manufacturing expenses
1,00,000 By Closing stock of finished
To Administrative expenses
50,000
goods
1,00,000
To Selling and distribution
By Profit or sale of shares
50,000
expenses
50,000
To Loss on sale of plant

55,000
To Interest on debentures
10,000
To Net profit
3,85,000
11,00,000
11,00,000
Balance Sheet
Liabilities
Rs. Assets
Rs.
Share Capital:
Fixed assets
2,50,000
1,00,000 Stock of raw materials
1,50,000
Preference share capital
1,00,000 Stock of finished goods
Reserves
1,00,000 Sundry debtors
1,00,000
Debentures
2,00,000 Bank balance

Sundry creditors
1,00,000
1,00,000
Bills payable
50,000
50,000
6,50,000
6,50,000
SET NO. 3
1. (a) Explain the various factors that influence the demand for a computer.
(b) What is cross-elasticity of demand? Explain.
2. Why does the Law of Diminishing Returns operate? Explain with the help of assumed
data and also represent it in a diagram.
3. A company reported the following results for two periods:
Period
Sales
Profit
I
Rs. 20,00,000
Rs. 2,00,000
I
Rs. 25,00,000
Rs. 3,00,000
Ascertain the BEP, P/V Ratio, Fixed Cost and Margin of Safety.
4. (a) What are the causes for the emergence of Monopoly?
conditions?
MODEL QUESTIONS
531
7. (a) What is Trial Balance? Why is it prepared?
(b) From the following list of balances, prepare a Trial Balance as on 30.6.2003.
i. Opening stock
1,800
xii. Plant
750
ii. Wages
1,000
xiv. Machinery tool
180
iii. Sales
12,000
xv. Lighting
230
iv. Bank loan

440
xvi. Creditors
800
v. Coal and coke
300
xvii. Capital
4,000
vi. Purchases
7,500
xviii. Misc. receipts
60
vii. Carriage
150
xix. Office furniture
60
viii. Income tax
150
xx. Patents
100
ix. Debtors
2,000
xxi. Goodwill
1,500
x. Leasehold premises
600
xxii. Cash at bank
510
xi. Cash in hand
20
8. What are the limitations of Ratio Analysis? Does ratio analysis really measure the
financial performance of a company?
SET NO. 4
2. Explain the following with reference to production function:
(a) Marginal rate of technical substitution
(b) Variable proportions of factors.
3. How do you determine BEP in terms of physical units and sales value? Explain the
concepts of margin of safety and the angle of incidence. Illustrate through a breakeven
chart.
4. Define Monopoly. How is it further classified? How is price determined under Monopoly?
5. What do you understand by Joint Stock Company? What are its salient features?
6. (a) Describe the institutions providing long-term finances.
(b) What are the different market situations in Imperfect Competition?
7. What do you understand by Double Entry Book Keeping? What are its advantages?
8. What are the limitations of Ratio Analysis? Does Ratio Analysis really measure the
financial performance of a company?
532
MODEL QUESTIONS
SET NO. 5
1. What is meant by elasticity of demand? How do you measure it?
2. Explain and illustrate Laws of Returns.
3. Sales are Rs. 1,10,000 yielding a profit of Rs. 4,000 in period-I. Sales are Rs. 1,50,000
with a profit of Rs. 12,000 in period-II. Determine BEP and Fixed Expenses.
4. Define Monopoly. How is it further classified? How is price determined under Monopoly?
6. What are the merits and limitations of Payback period? How does Discounting approach
overcome the limitations of Payback method?
7. The following figures have been extracted from the records of Fancy Stores, a proprietary concern,
as on 31.12.2003.
Furniture
15,000 Insurance
6,000
Proprietors capital a/c
54,000 Rent
22,000
Cash in hand
3,000 Sundry debtors
60,000
Opening stock
50,000 Sales
6,00,000
Fixed deposit
1,34,600 Advertisement
10,000
Drawings
5,000 Postages and telephone
3,400
Provision for bad debts
3,000 Bad debts
2,000
Cash at bank
10,000 Printing and stationery
9,000
Purchases
3,00,000 General charges
13,000
Salaries
19,000 Sundry creditors
40,000
Carriage inwards
41,000 Deposit from customers
6,000
Prepare Trading, Profit and Loss Account and Balance Sheet after taking into
consideration the following information:

(a) Closing stock as on 31st March was Rs. 10,000
(b) Salary of Rs. 2,000 is yet to paid to an employee.
8. Following is the Profit and Loss Account and Balance Sheet of Jai Hind Ltd: Calculate
the following ratios:
(a) Gross Profit Ratio
(b) Current Ratio
(c) Liquidity Ratio.
MODEL QUESTIONS
533
Dr.
Cr.
Particulars
Rs. Particulars
Rs.
To Opening stock of finished
By Sales
8,00,000
goods
1,00,000 By Closing stock of raw
To Opening stock of raw materials
50,000
materials
1,50,000
To Purchase of raw materials
3,00,000 By closing stock of
To Manufacturing expenses
1,00,000
finished goods
1,00,000
To Administrative expenses
50,000 By Profit or sale of shares
50,000
To Selling and distribution expenses
50,000
To Loss on sale of plant
55,000
To Interest on debentures
10,000
To Net profit
3,85,000
11,00,000
11,00,000
Balance Sheet
Liabilities
Rs. Assets
Rs.
Share Capital:
Fixed assets
2,50,000
1,00,000 Stock of raw materials
1,50,000
Preference share capital
1,00,000 Stock of finished goods
1,00,000
Reserves
1,00,000 Sundry debtors
1,00,000
Debentures
2,00,000 Bank balance
50,000
Sundry creditors
1,00,000
Bills payable
50,000
6,50,000
6,50,000
SET NO. 6
2. How will you define economies of scale? Explain how increasing returns to scale work
out in reality.
3. The PV ratio of Matrix Books Ltd. is 40% and the margin of safety is 30%. You are
required to work out the BEP and Net Profit, if the sales volume is Rs. 14,000.
4. What is Perfect Competition? How is Market Price determined under conditions of
Perfect Competition?
5. (a) Define partnership and explain its salient features and limitations.
(b) What Qualities do you expect in persons to become good partners in business?
534
MODEL QUESTIONS
7. What is three-columnar cash book? What is contra entry? Illustrate.
8. Following is the Balance Sheet of XYZ Company as on 31st Dec. 2000.
Liabilities
Rs. Assets
Rs.
20,000 Goodwill
12,000
Capital reserve
10,000 Fixed assets
28,000
8% loan on mortgage
16,000 Stocks
6,000
Trade creditors
8,000 Debtors
6,000
Bank overdraft
6,000 Investments
2,000
Cash in hand
6,000
60,000
60,000
Sales amounted to Rs. 1,20,000. Calculate ratios for
(a) testing liquidity, and
(b) solvency of the company.
SET NO. 7
1. What is demand? State and explain the Law of Demand. Are there any exceptions to the
law?
2. Why does the Law of Diminishing Returns operate? Explain with the help of assumed
data and also represent in a diagram.
3. A company prepares a budget to produce 3 lakh units, with fixed costs as Rs. 15 lakhs
and average variable cost of Rs. 10 each. The selling price is to yield 20% profit on cost.
You are required to calculate
(a) P/V ratio.
(b) Breakeven point.
4. (a) What are the causes for the emergence of monopoly?

conditions?
5. (a) Define partnership and explain its salient features and limitations.
(b) What qualities do you expect in persons to become good partners in business?
6. What are the merits and limitations of Payback period? How does Discounting approach
overcome the limitations of Payback method?
MODEL QUESTIONS
535
7. Prepare a Trial Balance from the following data for the year 2003:
Dr.
Cr.
Rs.
Rs.
Freehold property
10,800 Discount received
150
Capital
40,000 Return inwards
1,590
Return outwards
2,520 Office expenses
5,100
Sales
80,410 Bad debts

1,310
Purchases
67,350 Carriages outwards
1,590
Depreciation of furniture
1,200 Carriage inwards
1,450
Insurance
3,300 Salaries
4,950
Stock (1.1.2003)
14,360 Book debts
11,070
Creditors for expenses
400 Cash at bank
2,610
Creditors
4,700
8. The following are the extracts from the financial statements of Blue and Red Ltd., as on 31st
March, 2001 and 2002 respectively:
31 March 2001
31 March 2002
(Rs.)
(Rs.)
Stock
10,000
25,000
Debtors
20,000
20,000
Bills receivable
10,000
5,000
Cash in hand
18,000
15,000
Bills payable
15,000
20,000
Bank overdraft
2,000
9% debentures
5,00,000
5,00,000
Sales for the year
3,50,000
3,00,000
Gross profit
70,000
50,000
Compute for both the years the following:
(a) Current Ratio
(b) Liquidity Ratio
(c) Stock Turnover Ratio.
Also interpret the results.
SET NO. 8
1. What is meant by elasticity of demand? Ho do you measure it?
2. Define production function. Discuss in detail the different types of production functions.
3. Explain the utility of Break-even Analysis in managerial decision-making.
4. What are the features of monopolistic competition? How is it different from Monopoly?
5. Evaluate the partnership form of business organization. How does it overcome the
limitations of proprietory form of business?
536
MODEL QUESTIONS
6. Consider the case of the company with the following two investment alternatives each
costing Rs. 9 lakhs. The details of the cash inflows are as follows:
Year
Rs. in Lakhs
Project 1
Project 2
1
3
6
2
5
4
3
6
3
The cost of capital is 10% per year. Which are will you choose under NPV method.
7. During January 2003, Narayan transacted the following business:
Date
Rs.
1
40,000
2
Purchased goods on credit from Shyam
30,000
3
Received cash from Murthy as advance for goods ordered by him
3,000
4
Paid wages
500
4
Goods returned to Shyam
200
5
Goods sold to Kamal
10,000
6
Goods returned by Kamal
500
7
Paid into bank
500
8
Goods sold for cash
750
9
1,000
10
Paid salaries
700
11
Withdrew cash for personal use
1,000
Journalize the above transactions and prepare Cash Account.

8. Following is the Balance Sheet of XYZ Company as on 31st Dec. 2000.
Liabilities
Rs. Assets
Rs.
20,000 Goodwill
12,000
Capital reserve
10,000 Fixed assets
28,000
8% loan on mortgage
16,000 Stocks
6,000
Trade creditors
8,000 Debtors
6,000
Bank overdraft
6,000 Investments
2,000
Cash in hand
6,000
60,000
60,000
Sales amounted to Rs. 1,20,000. Calculate ratios for

(a) testing liquidity, and
(b) solvency of the company.
MODEL QUESTIONS
537
SET NO. 9
1. What is managerial economics? Explain its focus areas.
2. Why does the Law of Diminishing Returns operate? Explain with the help of a diagram.
3. When do Maximal cost (MC) and Average cost (AC) change: (a) at the same rate, (b)
at a higher rate or (c) at a lower rate? Illustrate your answer through a diagram.
4. Explain how an individual firm attains equilibrium in the short run and in the long run under
conditions of Perfect Competition.
5. Define a Joint Stock Company and explain its basic features.
6. What do you understand by working capital cycle and what is its importance?
7. (a) What is Trial Balance? Why is it prepared?
(b) From the following list of balances prepare a Trial Balance as on 30.06.2003.
Dr.
Cr.
Rs.
Rs.
Opening Stock
1,800 Plant
750
Wages
1,000 Machine tools
180
Sales
12,000 Lighting
230
Bank loan
440 Creditors
800
Coal and coke
300 Capital
4,000
Purchases
7,500 Misc. receipts
60
Repairs
200 Office salaries
250
Carriage
150 Office furniture
60
Income tax
150 Patents
100
Debtors
2,000 Goodwill
1,500
Leasehold premises
600 Cash at bank
510
Cash in hand
20
8. Explain and illustrate the types and significance of
(a) Profitability ratios
(b) Operating ratio.
SET NO. 10
1. Point out the importance of managerial economics in decision-making.
2. Explain the nature and uses of production function?
3. What cost concepts are mainly used for managerial decision-making? Illustrate.
4. How does a Monopoly firm attain equilibrium under different cost conditions?
5. Write shortnotes on (a) Sole Trader (b) Stationary Company.
6. (a) Describe the institutions providing long term finances.
(b) What are the different market situations in imperfect competition?
538
MODEL QUESTIONS
7. (a) How do you know that given Trial balance is correct or not?
(b) From the following Ledger Account balances prepare a Trial Balance as on
31.12.2002:
Dr.
Cr.
Rs.
Rs.
Opening stock
15,600 Insurance
400
Freehold premises
30,000 Bad reserve
300
Plant & machinery
9,000 Commission received
3,000
Wages
2,000 Commission paid
1,000
Sundry debtors
12,000 Bad debts
300
Carriages inwards
180 Office expenses
1,500
Carriage outwards
200 Salaries
2,000
Factory expenses
1,600 Travelling expenses

200
Royalty
200 Legal expenses
200
Purchase of machinery
15,000 Cash at bank
840
Office rent
1,400 Cash in hand
800
Capital
16,000 Loan taken
6,000
Discount allowed
800 Office rent
800
Discount received
720 Net sales
66,000
Sundry creditors
4,000
8. Given the following information from the Kamal Plastics Limited, compute (a) Assets
Turnover, (b) Return on Equity, (c) Return on Assets and (d) Net Profit Ratio and
comment on the results.

2001
2002
Net sales
86,000
71,000
Profit after taxes
12,000
11,000
Total assets
49,000
41,000
Shareholders equity
27,000
21,000
SET NO. 11
1. What is meant by elasticity of demand? How do you measure it?
2. Explain and illustrate Laws of Returns.
3. The PV Ratio of Matrix Books Ltd. is 40% and the margin of safety is 30%. You are
4. Compare and contrast Perfectly Competitive Firm and Monopoly Firm.
5. Explain the basic features of Government Company and Public Enterprise.
6. What do you understand by Net Present Value method of appraising long-term investment
proposal? Explain with the help of an example of your choice.
MODEL QUESTIONS
539
7. Record the following transactions in the suitable form of cash book
2004
Jan 1
Started business with cash
20,000
2
Paid for purchase of machinery from M/s. Ram and Co.
3,000
3
Paid insurance premium
200
5
Paid rent for the month of Dec. 2003
500
8
Paid cash for purchase of goods
3,000
10
Sold goods for cash
4,000
12
Drew cash for personal use
500
14
Paid Arun Rs. 400 in full settlement of Rs. 500
15
Received cash from Karuna Rs. 1,000 in full settlement of Rs. 1,050
Also prepare Cash Account.
8. Calculate the Gross profit margin, Net operating margin and Operating ratio, from the
following information:
Sales
Rs. 10,00,000
Cost of goods
Rs. 6,00,000
Selling and administrative costs
Rs. 2,00,000
Depreciation
Rs. 1,00,000
Also comment on the results.
SET NO. 12
1. Define elasticity of demand. Explain different types of price elasticity of demand.
2. (a) Explain how production function can be made use of to reduce cost of production?
(b) Explain Law of Increasing Returns? Also illustrate the same.
3. A company reported the following results for two periods:
Period
Sales
Profit
I
Rs. 20,00,000
Rs. 2,00,000
I
Rs. 25,00,000
Rs. 3,00,000
Ascertain the BEP, PV Ratio, Fixed Cost and margin of safety.
4. What is price discrimination? Discuss the different ways of price discrimination.
5. Define Joint Stock Company. Explain its advantages and disadvantages.
6. A company is considering two investment opportunities (A and B) that cost Rs. 4,00,000
and Rs. 3,00,000 respectively. The first project generates Rs. 1,00,000 a year for four
years. The second generates Rs. 60,000, Rs. 1,00,000, Rs. 80,000, Rs. 90,000 and
Rs. 70,000 over a five-year period. The companys cost of capital is 8%. Which project
will you choose under NPV method?
540
MODEL QUESTIONS
7. What is three-column cashbook? What is contra entry? Illustrate.
8. Calculate (a) Net Sales to Fixed Assets (b) Net Sales to Inventory (c) Net Profit Ratios, from the
following, and explain their significance in decision-making:
Rs.
Net Sales
10,00,000
Fixed Assets
8,00,000
Inventory
2,20,000
69,840
SET NO. 13
1. What is demand analysis? Explain the factors influencing the demand for a product.
2. (a) What are isocosts and isoquants? Do they intersect each other?
(b) Explain Cobb-Douglas production function.
3. If sales is 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?
4. Explain the role of time factor in the determination of price. Also explain price output
determination in case of perfect competition.
5. Explain the features of sole trader form of organization. Discuss the advantages and
6. What is the importance of Capital Budgeting? Explain the basic steps involved in
evaluating capital budget proposals.
7. Explain the basic accounting concepts and convention. Give examples.
8. From the following extract of a Balance Sheet of an Airlines company, calculate the debt-equity
ratio and interest coverage ratio. Given that the debt-equity ratio is in the range of 10:1, how do you
interpret this ratio?
50,000 10% preference shares of
Rs. 100 each
2,00,000 equity shares of
Rs. 10 each
10%, 30,000 debentures of
Rs. 100 each

Net profit during the year was Rs. 10,00,000
SET NO. 14
2. Explain the following with reference to production function:
(a) Marginal Rate of Technical Substitution
(b) Variable proportions of factors.
MODEL QUESTIONS
541
3. The PV ratio of Matrix Books Ltd. is 40% and the margin of safety is 30%. You are
4. Explain how an individual firm behaves under perfect competition. Also explain the firm and
industry equilibrium under perfect competition.
5. Small is Beautiful. Do you think this is the reason for the survival of the sole trader form of
business organization? Support you answer with suitable examples.
6. What is meant by discounting and time value of money? How is it useful in Capital
Budgeting?
7. What is three-column cash book? What is contra entry? Illustrate.
8. State the different types of liquidity ratios and turnover ratios, and explain their
significance.
SET NO. 15
1. (a) What is meant by demand? Every one desires an Ambassador car does this mean
that the demand for Ambassador cars is large?
(b) Calculate price elasticity of demand
Q 1 = 4000
P 1 = Rs. 20
Q 2 = 5000
P 2 = Rs. 19
How do you interpret the result?
2. Explain and illustrate the following:
(a) The Law of Constant Returns
(b) The Law of Increasing Returns.
3. Sales are Rs. 1,10,000 producing a profit of Rs. 4,000 in period-I. Sales are Rs. 1,50,000
producing a profit of Rs. 12,000 in period-II. Determine BEP and fixed expenses.
4. Explain how the price is determined under conditions of perfect competition. Illustrate this with the
help of diagrams.
5. What are the reasons for Joint Stock Company being popular as a form of business
organisation? Explain.
6. Explain the factors affecting the requirement of working capital.
7. Journalise the following transactions and post them to ledger:
(i) Ram invests Rs. 10,000 in cash.
(ii) He bought goods worth Rs. 2,000 from Shyam.
(iii) He bought a machine for Rs. 5,000 from Lakshman on account.
(iv) He paid to Lakshman Rs. 2,000.
(v) He sold goods for cash Rs. 3,000.
(vi) He sold goods to A on account Rs. 4,000.
(vii) He paid to Shyam Rs. 1,000.
(viii) He received from A an amount of Rs. 2,000.
542
MODEL QUESTIONS
8. As a financial analyst, what precautions would you take while interpreting ratios
meaningfully?
SET NO. 16
1. Define price elasticity of demand. What are the various degrees of price elasticity.
Illustrate graphically.
2. (a) What is meant by internal and external economies of scale?
(b) What are the sources of internal and external economies?
(c) Discuss various types of internal economies available to a firm.
3. Sales of a product amounts to 20 units per month at Rs. 10 per unit. Fixed overheads
is 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. How many units must be sold to
earn a target profit of present level?
4. Monopoly is disappearing from markets. Do you agree with this statement? Do you
advocate for monopoly to continue in market situations?
5. Discuss the factors that help in choosing a suitable form of business organisation.
6. What are major sources of short-term finance? Evaluate.
7. State the nature of account (nominal, real and personal) and show which account will be debited
and which account will be credited:
(i) Rent received
(ii) Machinery purchased
(iii) Discount received
(iv) Interest paid
(v) Rent paid
(vi) Commission received
(vii) Capital introduced

(viii) Buildings sold
(ix) Goods purchased
(x) Goods sold.
8. Explain and illustrate the types and significance of
(i) Profitability ratios
(ii) Operating ratios
SET NO. 17
1. What is an oligopolistic market?
2. What is meant by an explicit costs and implicit costs?
3. What do you mean by Working Capital?
4. Differentiate between Journal and Ledger.
MODEL QUESTIONS
543
5. What is an Equi-marginal principle?
6. What do you mean by Trial Balance and Balance Sheet?
7. Explain Liquidity and Profitability.
8. What are the Economies of Scale?
9. What are the exceptions to law of demand?
10. Distinguish between Economics and Managerial Economics.
11. Explain the important concepts of managerial economics that are useful to a manager
in his decision-making activity.
12. What do you mean by demand forecasting? Explain different methods of demand
forecasting.
13. Explain the cost-output relationship in the short run and in the long run.
14. Explain the significance and factors determining the optimum size of working capital.
15. (a) What is Breakeven Analysis? Explain its managerial uses.
(b) From the following information, calculate:
(i) BEP in units and sales value.
(ii) Number of units to be sold to earn a profit of Rs. 50,000.
(iii) Variable manufacturing cost per unit Rs. 6
(iv) Variable selling cost per unit Rs. 2
(v) Selling price per unit Rs. 12.
16. A company is in the consideration of two mutually exclusive projects which require an initial
investment of Rs. 25,000 each and have a life of 5 years. The companies required rate of return is
10%. Tax rate is 50%. The company follows straight method of
depreciation. The cash inflows before depreciation and tax are as follows:
Year I
Year II
Year III
Year IV
Year V
Project-A
Rs. 15,000
15,000
15,000
15,000
15,000
Project-B
Rs. 8,000
6,000
8,000
7,000
6,000
Calculate
(i) The Payback period
(ii) The Average Rate of Return
(iii) The Net Present Value.
17. From the following Trial Balance, prepare Trading and Profit and Loss Account for the year
ended 31.3.2005 and the Balance Sheet as on that date:
544
MODEL QUESTIONS
Trial Balance
Particulars
Dr. (Rs.)
Cr. (Rs.)
Capital
1,50,000
Opening stock
15,200
Purchases
1,28,000
Sales
1,84,800
Returns
5,000
Wages
8,000
Salaries
18,000
Fuel and power
4,000
Carriage inwards
2,600
Insurance
6,000
General expenses
2,000
Selling expenses
9,000
Debtors
16,000
Creditors
22,000
Bad debts
1,600
Bank loan
28,500
Furniture
13,200
Machinery
56,000
Buildings
78,000
Bills receivables
6,800
Discounts
2,100
Cash in hand
6,200
Cash at bank
18,000
Bills payable
5,200
3,95,800
3,95,800
Adjustments
(i) Outstanding salaries Rs. 3,000
(ii) Prepaid insurance Rs. 600
(iii) Depreciate machinery at 10%
(iv) Calculate interest on Capital at 10%
(v) Closing stock value Rs. 18,000.
SET NO. 18
1. Explain the Discounting Principle.
2. List the determinants of demand.
3. Explain discriminating monopoly.
4. What is meant by input cost?
MODEL QUESTIONS
545
5. Differentiate between Firm and Industry.
6. What are the important sources of capital?
7. Differentiate between Gross working capital and Net working capital.
8. What is Accounting?
9. What do you understand by a Bank Reconciliation Statement?
10. What is Debt-Equity Ratio?
11. What is Managerial Economics? Explain the scope and utility of Managerial Economics.
12. Explain the importance of Demand Forecasting. What are the methods used for
forecasting demand?
13. Explain the concept of production function and the laws of returns to scale.
14. Explain the price-output determination under perfect competition.
15. (a) Discuss the cost-output relationship in the long-run.
(b) Given the selling price Rs. 20, Variable cost Rs. 12, Fixed cost Rs. 24,000, find the breakeven
sales. How many units are to be sold to earn a profit of Rs. 40,000?
16. A company has an investment opportunity costing Rs. 1,25,000 with the following
expected net cash flows (i.e. after tax but before depreciation):
Year
Net Cash Flows (Rs.)
1
15,000
2
17,000
3
19,000
4
20,000
5
22,000
6
16,000
7
20,000
8
30,000
9
20,000
10
8,000
Using 10% as the rate of discount, determine the following:
(1) Payback period
(2) Net present value
(3) Profitability index.
17. From the following Trial Balance of Ramesh Co. Ltd. on 31st March, 2005 prepare
Trading and Profit and Loss Account and also a Balance Sheet as on 31.3.2005:
546
MODEL QUESTIONS
Trial Balance
Particulars
Dr. (Rs.)
Cr. (Rs.)
Capital
1,50,000
Drawings
15,000
Machinery
65,000
Wages
8,000
Opening stock
24,500
Purchases
2,22,000
Carriage inwards
10,000
Creditors
45,000
Sales
3,12,000
Repairs
4,000
Rent and taxes
12,000
Advertising
25,000
General expenses
5,000
Patents
25,000
Debtors
15,000
Bad debts
1,000
Bank loan
55,000
Miscellaneous receipts
300
Salaries
75,000
Returns
10,000
15,000
Cash in hand
12,000
Office furniture
49,000
Insurance
6,000
Discounts
1,500
2,500
Commission received
1,200
Cash at bank
5,000
Bills receivable and payable
15,000
6,05,000
6,05,000
Adjustments:
(1) Closing stock value Rs. 28,000
(2) Depreciate Machinery at 10% and Furniture at 20%
(3) Outstanding salaries Rs. 5,000
(4) Prepaid insurance Rs. 1,000.
SET NO. 19
1. Explain the difference between Economics and Managerial Economics.

2. State the determinants of demand.
3. Calculate the point price elasticity of demand at price Rs. 2 when Q = 20 2 P.
4. What do you understand by opportunity cost?
MODEL QUESTIONS
547
5. Given the production function Q = 100 K 0.5 L 0.5, find out the production when K = 4 and L = 2
and when K = 2 and L = 1. State whether the production function provides constant returns to scale.
6. What do you understand by Working Capital?
7. What do you understand by Capital Budgeting?
8. Distinguish between funds flow and cash flow.
9. Explain the meaning of Journal.
10. Explain the rules for recording real account transactions.
11. Explain the meaning and utility of Managerial Economics.
12. Explain the Law of Demand and its assumptions and exceptions.
13. What do you understand by Monopoly? Explain how the price and spent decisions are
made under monopoly?
14. What do you understand by isoquants and isocosts?
15. A firm has a fixed cost of Rs. 50,000. Selling price per unit is Rs. 50 and variable cost per unit is
Rs. 25. Present level of production is 3,500 units.
(i) Determine the BEP in terms of volume and sales value.
(ii) Calculate margin of safety.
(iii) If the fixed cost increases to Rs. 60,000, calculate the new BEP and margin of safety.
16. An asset costing Rs. 25,000 has 5 years life and is expected to yield Rs. 20,000,
Rs. 30,000, Rs. 35,000, Rs. 30,000 and Rs. 25,000. Its operating cash expenses are 40%
of the estimated revenues each year. The asset is subject to 20% depreciation. Tax rate
is 30%. Estimate the cash inflows each year.
17. From the following Trial Balance and adjustments, prepare Trading and Profit and Loss A/c for
the year ended December 31, 2004 and the Balance Sheet as on that date:
Dr.
Cr.
Rs.
Rs.
Sundry debtors
64,000
Stock (1.1.2004)
44,000
Cash in hand
70
Plant and machinery
35,000
Creditors
21,300
General expenses
2,150
Sales
2,69,000
Salaries
4,450
Carriage outwards
800
Rent
1,800
Bills payable
15,000
Purchases
2,37,740
Discount
2,200
Buildings
69,000
Capital
1,59,000
Cash at bank
3,090
4,64,300
4,64,300
548
MODEL QUESTIONS
Adjustments:
(i) Stock as on December 31, 2004 was Rs. 24,900.
(ii) Outstanding rent Rs. 170, General expenses Rs. 300.
(iii) Bad debts Rs. 800.
(iv) Depreciation on buildings 10% per annum.
SET NO. 20
1. Distinguish between tangible and intangible assets.
2. Explain the Law of Variable Proportions.
3. What is Trial Balance? Explain its purpose.
4. Define demand and narrate its exceptions.
5. Differentiate between Average Cost and Marginal Cost.
6. What is the purpose of Journal?
7. What is a Bad Debt?
8. Explain briefly about Liquidity Ratios.
9. What is Cross-elasticity of Demand?
10. What is Margin of Safety?
11. Define demand forecasting and explain the methods of demand forecasting.
12. Explain the features of Perfect Competition with suitable examples.
13. Why are cost curves U shaped? Explain.
14. Draft the models of Trading and Profit and Loss Account and discuss their contents.
15. Write notes on the following:
(a) Profitability Ratios.
(b) Bank Reconciliation Statement.
16. Discuss various methods of evaluation of project proposals for investment.
17. Define Managerial Economics and explain with examples. How is it useful to engineers.
SET NO. 21
1. Distinguish between average cost and marginal cost.
2. What is Break-even Analysis?
3. How is depreciation to be treated in final accounts, when it is given as an adjustment item?
4. Explain the purpose of preparation of Bank Reconciliation Statement.

5. What is cross-elasticity of demand?
MODEL QUESTIONS
549
6. State the reasons for Monopoly.
7. Explain the Law of Demand.
8. What is ARR method?
9. Explain the significance of Debt-Equity Ratio.
10. Differentiate between Firm and Industry.
11. Define managerial economics and explain its scope and importance in decision-making.
12. Discuss different economies of large-scale production.
13. Explain the sources of capital of a corporate organisation.
14. Define Accountancy and explain the principles of Double Entry System.
15. Discuss the equilibrium price determination in perfect competition.
16. A company is considering two mutually exclusive projects X and Y, each involving
a cost of Rs. 30,000 and have an expected life of five years. The cash flows after taxes
expected to be generated by the projects are as follows:
Year
Project X
Project Y
1
10,000
5,000
2
10,000
5,000
3
10,000
10,000
4
10,000
20,000
5
10,000
10,000
Decide which project should be selected by computing:
(i) Payback method
(ii) NPV.
17. Prepare Final Accounts from the following Trial Balance for the year ending 31.12.2002: S. No.
Particulars
Debit Amount (Rs.)
Credit Amount (Rs.)
1.
Wages
48,000
2.
Freight Inward
8,000
3.
Salaries
44,000
4.
Capital Account
3,00,000
5.
Purchases and Sales
3,48,000
6.
Drawings Account
20,000
7.
Plant and Machinery
80,000
8.
Furniture
10,000
9.
Debtors and Creditors
2,70,000
1,80,000
10.
Printing and Stationery
18,000
11.
Bills Receivable
66,000
12.
Bank
14,000
13.
Rent and Taxes
24,000
Stock as on 1.1.2002
50,000
10,00,000
10,00,000
550
MODEL QUESTIONS
Adjustments:
(1) Closing Stock Rs. 1,60,000
(2) Outstanding Salaries Rs. 4,000.
SET NO. 22
1. Distinguish between Cash discount and Trade discount.
2. Explain the features of Monopoly.
3. What is single entry system?
4. Differentiate between direct cost and indirect cost.
5. Explain the purpose of Trial Balance.

6. What is Return on Investment Ratio?
7. What is oligopoly?
8. Explain the properties of Isoquants.
9. Explain the law of demand.
10. What is creditors account?
11. What is production function? Explain the law of variable proportions.
12. Discuss the equilibrium of the firm during short-run and long-run conditions under
perfect competition.
13. What is break-even analysis? Explain its objectives.
14. Discuss the law of elasticity of demand and explain various types of price elasticities of demand.
15. What is working capital? Explain the factors determining the working capital
requirements of a firm.
16. A company is considering two projects, each involving capital outlay of Rs. 1,00,000.
The companys cost of capital is 10%. The expected cash inflows after taxes are given
below:
Year
Project X (Rs.)
Project Y (Rs.)
1
30,000
50,000
2
30,000
40,000
3
30,000
30,000
4
30,000
20,000
5
30,000
10,000
Calculate (1) NPV and (2) Profitability index and determine the desirability of projects.
MODEL QUESTIONS
551
17. From the following balances of Gupta, prepare Final Accounts for the year ended
31.3.2004.
Rs.
Rs.
Capital
50,000 Buildings
37,500
Drawings
9,000 Motor van
17,500
Sales
50,000 Purchases
37,500
Opening stock
12,500 Manufacturing expenses
37,500
Wages
4,500 Insurance
500
Commission received
3,750 Debtors
10,000
Bank
14,000 Creditors
5,000
Purchases returns
1,250 Loan
75,000
Interest paid
4,500
Adjustments:
1. Closing Stock Rs. 16,000
2. Bad Debt Rs. 1,000
SET NO. 23
1. Define Managerial Economics. How can you distinguish it from economics?
2. Distinguish between Demand function and Demand schedule.

3. Distinguish between Oligopoly and Monopoly.
4. Explain Cobb-Douglas production function.
5. What are the features of Long Run Average Cost Curve (LAC)?
6. What do you mean by Payback method?
7. What is Double entry principle?
8. Distinguish between Journal and Ledger.
9. What do you mean by Convention of Conservatism?
10. What is Capital budgeting. List out the sources of long-term finance.
11. Describe the nature and scope of Managerial Economics. Is it relevance to an engineer?
12. What do you understand by Demand Forecasting? Explain various methods to forecast the
demand.
13. What is meant by production function? Explain the firms equilibrium output by using
Iso-quants and iso-cost curves.
14. (a) Explain the managerial uses of Break-even Analysis.
(b) What is meant by Law of Demand? Explain its characteristics and limitations.
15. A company is considering an investment proposal which requires an initial outlay of
Rs. 50,000 and has a life of 5 years with no salvage value.
552
MODEL QUESTIONS
The estimated cash flows are as follows:
Y
ear
1
2
3
4
5
Cash flows
10,000
11,000
14,000
15,000
25,000
Calculate
(a) Payback period and
(b) Net Present Value
The companys required rate of return is 10%.
16. (a) From the given information, calculate
(i) P/V ratio
(ii) Fixed cost
(iii) Sales volume to earn a profit of Rs. 80,000.
Sales Rs. 2,00,000; Profit Rs. 20,000; Variable cost 70%.
(b) From the following information prepare a Bank Reconciliation statement as on 31st
December 2003.
(i) Balance as per pass book (Credit balance) Rs. 20,000
(ii) Cheques issued but not presented for payment before 31-12-2003 Rs. 5,000
(iii) Cheques deposited into bank, but not shown in the pass book before the date
Rs. 3,000
(iv) Bank charges of Rs. 50 and interest on deposits Rs. 500 was recorded in pass
book but no entry was made in cash book.
17. Prepare Trading Account, Profit and Loss Account and also a Balance sheet from the
following Trial Balance for the year ended 31.12.2003.
Trial Balance as on 31.12.2003
Particulars
Dr. (Rs.)
Cr. (Rs.)
Capital
1,40,000
Drawings
15,000
Plant and machinery
1,00,000
Sales
1,50,000
Returns outwards
5,000
Bad debts
1,000
Sundry debtors
15,000
Purchases
1,00,000
Returns inwards
3,000
Carriage inwards
4,000
1,000
Advertisement
5,000
Commission received
1,500
Travelling expenses
2,000
(Contd.)
MODEL QUESTIONS
553
Trial Balance as on 31.12.2003 (Contd.)
Particulars
Dr. (Rs.)
Cr. (Rs.)
Stock (1.1.2003)
50,000
Salaries
10,000
Wages
5,000
Sundry creditors
14,500
Rent
1,000
Insurance
2,000
Cash at bank
5,000
Cash in hand
1,000
Bills payable
9,000
3,20,000
3,20,000
Adjustments:
(a) Closing stock Rs. 25,000
(b) Insurance prepaid Rs. 500
(c) Oustanding salaries Rs. 2,000
(d) Depreciate machinery at 10%.
SET NO. 24
1. What do you mean by principle of time perspective?
2. What is demand? Mention its determinants.
3. What is production function? What are its assumptions?
4. What are the iso-quant curves?

5. What do you mean by Gross working capital and Net working capital?
6. What is capital budgeting decision? When is it made?
7. Differentiate account and accounting.
8. What do you mean by accounting concepts and accounting conventions?
9. Explain the terms Monopoly and Duopoly.
10. What do you mean by fixed cost and variable cost?
11. Define Managerial Economics and explain its relevance and scope to engineers.
12. What is working capital? Explain briefly its determinants in a manufacturing
organization.
13. What is perfect competition? Explain its salient features.
14. Explain in detail the Law of Diminishing Marginal Returns.
15. (a) What do you mean by contribution and contribution-sales ratio?
(b) Calculate the profit-volume ratio, break-even point in units and value, and margin
of safety from the following figures relating to production and sales of 10,000 units:
554
MODEL QUESTIONS
Rs.
Rs.
Sales
4,00,000
Fixed expenses
60,000
Variable expenses:
Direct materials
1,00,000
Direct labour
60,000
Other variable expenses
80,000
16. A company is considering a project, requiring an initial cash outlay of Rs. 10,000 with an
expected life of five years. The companys required rate of return is 10 per cent and
the project will be depreciated on a straight-line basis. The net income after tax generated by the
project are as follows:
Y
ears
1
2
3
4
5
Net income after tax
1,000
1,000
1,000
1,000
1,000
Calculate: (i) the payback period, (ii) the average rate of return, (iii) the net present value, and (iv)
profitability index of the project. Suggest its acceptability.
17. The Trial Balance of Mr. Success on 31st December, 2003 revealed the following balances:
Debit Balances
Rs. Credit Balances
Rs.
Plant and machinery
80,000 Capital account
1,00,000
Purchases
68,000 Sales
1,27,000
Sales returns
1,000 Purchases returns
1,275
Opening stock
30,000 Discount received
800
Discount allowed
350 Sundry creditors
25,000
Bank charges
75
Sundry debtors
45,000
Salaries
6,800
Wages
10,000
Freight inwards
750
Freight outwards
1,200
Rent, rates and taxes
2,000
Advertisements
2,000
Cash at bank
6,900
2,54,075
2,54,075
Adjustments:
(a) The stock on 31st December, 2003 was valued at Rs. 35,000.
(b) Wages outstanding Rs. 500
(c) Prepaid rent Rs. 200
(d) Depriciation on Plant and Machinery @ 10%
Prepare Trading and Profit and Loss Account for the year ending 31st December, 2003
and a Balance Sheet as on that date.
Present Value Tables (A.1 to A.4)
Table A.1 The Compound Sum of One Rupee
Year
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1
1.010
1.020
1.030
1.040
1.050
1.060
1.070
1.080
1.090
1.110
2
1.020
1.040
1.061
1.082
1.102
1.124
1.145
1.166
1.188
1.210
3
1.030
1.061
1.093
1.125
1.158
1.191
1.225
1.260
1.295
1.331
4
1.041
1.082
1.126
1.170
1.216
1.262
1.311
1.360
1.412
1.464
5
1.051
1.104
1.159
1.217
1.276
1.338
1.403
1.469
1.539
1.611
6
1.062
1.126
1.194
1.265
1.340
1.419
1.501
1.587
1.677
1.772
7
1.072
1.149
1.230
1.316
1.407
1.504
1.606
1.714
1.828
1.949
8
1.083
1.172
1.267
1.369
1.477
1.594
1.718
1.851
1.993
2.144
9
1.094
1.195
1.305
1.423
1.551
1.689
1.838
1.999
2.172
2.358
10
1.105
1.219
1.344
1.480
1.629
1.791
1.967
2.159
2.367
2.594
555
11
1.116
1.243
1.384
1.539
1.710
1.898
2.105
2.332
2.580
2.853
12
1.127
1.268
1.426
1.601
1.796
2.012
2.252
2.518
2.813
3.138
13
1.138
1.294
1.469
1.665
1.886
2.133
2.410
2.720
3.066
3.452
14
1.149
1.319
1.513
1.732
1.980
2.261
2.579
2.937
3.342
3.797
15
1.161
1.346
1.558
1.801
2.079
2.397
2.759
3.172
3.642
4.177
16
1.173
1.373
1.605
1.873
2.183
2.540
2.952
3.426
3.970
4.595
17
1.184
1.400
1.653
1.948
2.292
2.693
3.159
3.700
4.328
5.054
18
1.196
1.428
1.702
2.026
2.407
2.854
3.380
3.996
4.717
5.560
19
1.208
1.457
1.753
2.107
2.527
3.026
3.616
4.316
5.142
6.116
20
1.220
1.486
1.806
2.191
2.653
3.207
3.870
4..661
5.604
6.727
21
1.232
1.516
1.860
2.279
2.786
3.399
4.140
5.034
6.109
7.400
22
1.245
1.546
1.916
2.370
2.925
3.603
4.430
5.436
6.658
8.140
23
1.257
1.577
1.974
2.465
3.071
3.820
4.740
5.871
7.258
8.954
24
1.270
1.608
2.033
2.563
3.225
4.049
5.072
6.341
7.911
9.850
25
1.282
1.641
2.094
2.666
3.386
4.292
5.427
6.848
8.623
10.834
30
1.348
1.811
2.427
3.243
4.322
5.743
7.612
10.062
13.267
17.449
35
1.417
2.000
2.814
3.946
5.516
7.686
10.676
14.785
20.413
28.102
40
1.489
2.208
3.262
4.801
7.040
10.285
14.974
21.724
31.408
45.258
45
1.565
2.438
3.781
5.841
8.985
13.764
21.002
31.920
48.325
72.888
50
1.645
2.691
4.384
7.106
11.467
18.419
29.456
46.900
74.354
117.386
556
Table A.1 The Compound Sum of One Rupee (Contd.)
PRESENT
Year
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1
1.110
1.120
1.130
1.140
1.150
1.160
1.170
1.180
1.190
1.200
VALUE
2
1.232
1.254
1.277
1.300
1.322
1.346
1.369
1.392
1.416
1.440
3
1.368
1.405
1.443
1.482
1.521
1.561
1.602
1.643
1.685
1.728
4
1.518
1.574
1.630
1.689
1.749
1.811
1.874
1.939
2.005
2.074
TABLES
5
1.685
1.762
1.842
1.925
2.011
2.100
2.192
2.288
2.386
2.488
6
1.870
1.974
2.082
2.195
2.313
2.436
2.565
2.700
2.840
2.986
7
2.076
2.211
2.353
2.502
2.660
2.826
3.001
3.185
3.379
3.583
8
2.305
2.476
2.658
2.853
3.059
3.278
3.511
3.759
4.021
4.300
9
2.558
2.773
3.004
3.252
3.518
3.803
4.108
4.435
4.785
5.160
10
2.839
3.106
3.395
3.707
4.046
4.411
4.807
5.234
5.695
6.192
11
3.152
3.479
3.836
4.226
4.652
5.117
5.624
6.176
6.777
7.430
12
3.498
3.896
4.334
4.818
5.350
5.936
6.580
7.288
8.064
8.916
13
3.883
4.363
4.898
5.492
6.153
6.886
7.699
8.599
9.596
10.699
14
4.310
4.887
5.535
6.261
7.076
7.987
9.007
10.147
11.420
12.839
15
4.785
5.474
6.254
7.138
8.137
9.265
10.539
11.974
13.589
15.407
16
5.311
6.130
7.067
8.137
9.358
10.748
12.330
14.129
16.171
1.8.488
17
5.895
6.866
7.986
9.276
10.761
12.468
14.426
16.672
19.244
22.186
18
6.543
7.690
9.024
10.575
12.375
14.462
16.879
19.673
22.900
26.623
19
7.263
8.613
10.197
12.055
14.232
16.776
19.748
23.214
27.251
31.948
20
8.062
9.646
11.523
13.743
16.366
19.461
23.105
27.393
32.429
38.337
21
8.949
10.804
13.021
15.667
18.821
22.574
27.033
32.323
38.591
237.373
22
9.933
12.100
14.713
17.861
21.644
26.186
31.629
38.141
45.923
55.205
23
11.026
12.552
16.626
20.361
24.891
30.376
37.005
45.007
54.648
66.247
24
12.239
15.178
18.788
23.212
28.625
35.236
43.296
53.108
85.031
79.496
25
13.585
17.000
21.230
26.461
32.918
40.874
50.656
62.667
77.387
95.395
30
22.892
29.960
39.115
50.949
66.210
85.849
111.061
143.367
184.672
237.373
35
38.574
52.799
72.066
98.097
133.172
180.311
243.495
327.988
440.691
590.657
40
64.999
93.049
132.776
188.876
267.856
378.715
533.846
750.353
1051.642
1469.740
45
109.527
163.985
244.629
363.662
538.752
795.429
1170.425
1716.619
2509.583
3657.176
50
184.559
288.996
450.711
700.197
1083.619
1670.669
2566.080
3927.189
5988.730
9100.191
Year
21%
22%
23%
24%
25%
26%
27%
28%
29%
30%
1
1.210
1.220
1.230
1.240
1.250
1.260
1.270
1.280
1.290
1.300
2
1.464
1.488
1.513
1.538
1.562
1.588
1.613
1.638
1.664
1.690
3
1.772
1.816
1.861
1.907
1.953
2.000
2.048
2.097
2.147
2.197
4
2.144
2.215
2.289
2.364
2.441
2.520
2.601
2.684
2.769
2.856
5
2.594
2.703
2.815
2.932
3.052
3.176
3.304
3.436
3.572
3.713
6
3.138
3.297
3.463
3.635
3.815
4.001
4.196
4.398
4.608
4.827
7
3.797
4.023
4.259
4.508
4.768
5.042
5.329
5.629
5.945
6.275
8
4.595
4.908
5.239
5.589
5.960
6.353
6.767
7.206
7.669
8.157
9
5.560
5.987
6.444
6.931
7.451
8.004
8.595
9.223
9.893
10.604
10
6.727
7.305
7.926
8.594
9.313
10.086
10.915
11.806
12.761
13.786
11
8.140
8.912
9.749
10.657
11.642
12.708
13.862
15.112
16.462
17.921
12
9.850
10.872
11.991
13.215
14.552
16.012
17.605
19.343
21.236
23.298
13
11.918
13.264
14.749
16.386
18.190
20.175
22.359
24.759
27.395
30.287
14
14.421
16.182
18.141
20.319
22.737
25.420
28.395
31.691
35.339
39.373
15
17.449
19.742
22.314
25.195
28.422
32.030
36.062
40.565
45.587
51.185
16
21.113
24.085
27.446
31.242
35.527
40.357
45.799
51.923
58.808
66.541
17
25.547
29.384
33.758
38.740
44.409
50.850
58.165
66.461
75.862
86.503
18
30.912
35.848
41.523
48.038
55.511
64.071
73.869
85.070
97.862
112.454
19
31.404
43.735
51.073
59.567
69.389
80.730
93.813
108.890
126.242
146.190
20
45.258
53.357
62.820
73.863
86.736
101.720
119.143
139.379
162.852
190.047
21
54.762
65.095
77.268
91.591
108.420
128.167
151.312
178.405
210.079
247.061
PRESENT
22
66.262
79.416
95.040
113.572
135.525
161.490
192.165
228.358
271.002
321.178
23
80.178
96.887
116.899
140.829
169.407
203.477
244.050
292.298
349.592
417.531
24
97.015
118.203
143.786
174.628
211.758
256.381
309.943
374.141
450.974
542.791
25
117.388
144.207
176.857
261.539
264.698
323.040
393.628
478.901
581.756
705.627
VALUE
30
304.471
389.748
497.904
634.810
807.793
1025.904
1300.477
1645.488
2078.208
2619.936
35
789.716
1053.370
1401.749
1861.020
2465.189
3258.053
4296.547
5653.840
7423.988
9727.598
TABLES
40
2048.309
2846.941
3946.340
5455.797
5723.156
10346.879
14195.051
19426.418
26520.723
36117.754
45
5312.758
7694.418
11110.121
15994.316
22958.844
32859.457
46897.973
66748.500
94739.937 134102.187
50
13779.844
20795.680
31278.301
46889.207
70064.812 104354.562 154942.687 229345.875 338440.000 497910.125
557
558
PRESENT
Year
31%
32%
33%
34%
35%
36%
37%
38%
39%
40%
VALUE
1
1.310
1.320
1.330
1.340
1.350
1.360
1.370
1.380
1.390
1.400
2
1.716
1.742
1.769
1.796
1.822
1.850
1.877
1.904
1.932
1.960
TABLES
3
2.248
2.300
2.353
2.406
2.460
2.515
2.571
2.628
2.686
2.744
4
2.945
3.036
3.129
3.224
3.312
3.421
3.523
3.627
3.733
3.842
5
3.858
4.007
4.162
4.320
4.484
4.653
4.826
5.005
5.189
5.378
6
5.054
5.290
5.535
5.789
6.053
6.328
6.612
6.907
7.213
7.530
7
6.621
6.983
7.361
7.758
8.172
8.605
9.058
9.531
10.025
10.541
8
8.673
9.217
9.791
10.395
11.032
11.703
12.410
13.153
13.935
14.758
9
11.362
12.166
13.022
13.930
14.894
15.917
17.001
18.151
19.370
20.661
10
14.884
16.060
17.319
18.666
20.106
21.646
23.292
25.049
26.924
28.925
11
19.498
21.199
23.034
25.012
27.144
29.439
31.910
34.567
37.425
40.495
12
25.542
27.982
30.635
33.516
36.644
40.037
43.716
47.703
52.020
56.694
13
33.460
36.937
40.745
44.912
49.469
54.451
59.892
65.830
72.308
79.371
14
48.832
48.756
54.190
60.181
66.784
74.053
82.051
90.845
100.509
111.119
15
57.420
64.358
72.073
80.643
90.158
100.712
112.410
125.366
139.707
155.567
16
75.220
84.953
95.857
108.061
121.713
136.968
154.002
173.005
194.192
217.793
17
98.539
112.138
127.490
144.802
164.312
186.277
210.983
238.747
269.927
304.911
18
129.086
148.022
169.561
194.035
221.822
253.337
289.046
329.471
375.198
426.875
19
169.102
195.389
225.517
260.006
299.459
344.537
395.993
454.669
521.525
597.625
20
221.523
257.913
299.937
348.408
404.270
468.571
542.511
627.443
724.919
836.674
21
290.196
340.446
398.916
466.867
545.764
637.256
743.240
865.871
1007.637
1171.343
22
380.156
449.388
530.558
625.601
736.781
866.668
1018.238
1194.900
1400.615
1639.878
23
498.004
593.192
705.642
838.305
994.653
1178.668
1394.986
1648.961
1946.854
2295.829
24
652.385
783.013
938.504
1123.328
1342.781
1602.988
1911.129
2275.564
2706.125
3214.158
25
854.623
1033.577
1248.210
1505.528
1812.754
2180.063
2618.245
3140.275
3761.511
3499.816
30
3297.081
4142.008
5194.516
6503.285
8128.426
10142.914
12636.086
15716.703
19517.969
24201.043
35
12719.918
16598.906
21617.363
28096.695
36448.051
47190.727
60983.836
78660.188 101276.125 130158.687
40
49072.621
66519.313
89962.188 121388.437 1633433.875 219558.625 294317.937 393684.687 525508.312 700022.688
Table A.2 The Compound Value of an Annuity of One Rupee
Year
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
2
2.010
2.020
2.030
2.040
2.050
2.060
2.070
2.080
2.090
2.100
3
3.030
3.060
3.091
3.122
3.152
3.184
3.215
3.246
3.278
3.310
4
4.060
4.122
4.184
4.246
4.310
4.375
4.440
4.506
4.573
4.641
5
5.101
5.204
5.309
5.416
5.526
5.637
5.751
5.867
5.985
6.105
6
6.152
6.308
6.468
6.633
6.802
6.975
7.153
7.336
7.523
7.716
7
7.214
7.434
7.662
7.898
8.142
8.394
8.654
8.923
9.200
9.487
8
8.286
8.583
8.892
9.214
9.549
9.897
10.260
10.637
11.028
11.436
9
9.368
9.755
10.159
10.583
11.027
11.491
11.978
12.488
13.021
13.579
10
10.462
10.950
11.464
12.006
12.578
13.181
13.816
14.487
15.193
15.937
11
11.567
12.169
12.808
13.486
14.207
14.972
15.784
16.645
17.560
18.531
12
12.682
13.412
14.192
15.026
15.917
16.870
17.888
18.977
20.141
21.384
13
13.809
14.680
15.618
16.627
17.713
18.882
20.141
21.495
22.953
24.523
14
14.947
15.974
17.086
18.292
19.598
21.015
22.550
24.215
26.019
27.975
15
16.097
17.293
18.599
20.023
21.578
23.276
25.129
27.152
29.361
31.772
16
17.258
18.639
20.157
21.824
23.657
25.672
27.888
30.324
33.003
35.949
17
18.430
20.012
21.761
23.697
25.840
28.213
30.840
33.750
36.973
40.544
18
19.614
21.412
23.414
25.645
28.132
30.905
33.999
37.540
41.301
45.599
19
20.811
21.840
25.117
27.671
30.539
33.760
37.379
41.446
46.018
51.158
20
22.019
24.297
26.870
29.778
33.066
36.785
40.995
45.762
51.169
57.274
21
23.239
25.783
28.676
31.969
35.719
39.992
44.865
50.422
56.754
65.002
PRESENT
22
24.471
27.299
30.536
34.248
38.505
43.392
49.005
55.456
62.872
71.402
23
25.716
28.845
32.452
36.618
41.340
46.995
53.435
60.893
69.531
79.542
24
26.973
30.421
34.426
39.082
44.501
50.815
58.176
66.764
76.789
88.496
25
28.243
32.030
36.459
41.645
47.726
54.864
63.248
73.105
84.699
98.346
VALUE
30
34.784
40.567
47.575
56.084
66.438
79.057
95.459
113.282
136.305
164.491
35
41.659
49.994
50.461
73.651
90.318
11.432
138.234
172.314
215.705
271.018
TABLES
40
48.805
60.401
75.400
95.024
120.797
154.758
199.630
259.052
337.872
442.580
45
56.479
71.891
92.718
121.027
159.695
212.737
285.741
386.497
525.840
718.881
50
64.461
84.577
112.794
152.664
209.341
290.325
406.516
573.756
815.051
1163.865
559
560
Table A.2 The Compound Value of an Annuity of One Rupee (Contd.)
PRESENT
Year
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
VALUE
2
2.110
2.120
2.130
2.140
2.150
2.160
2.170
2.180
2.190
2.200
3
3.342
3.374
3.407
3.440
3.472
3.506
3.539
3.572
3.606
3.640
TABLES
4
4.710
4.779
4.850
4.921
4.993
5.066
5.141
5.215
5.291
5.338
5
6.228
6.353
6.480
6.610
6.742
6.877
7.014
7.154
7.297
7.442
6
7.913
8.115
8.323
8.535
8.754
9.897
9.207
9.442
9.683
9.930
7
9.783
10.089
10.405
10.730
11.067
11.414
11.772
12.141
12.523
12.916
8
11.859
12.300
12.757
13.233
13.727
14.240
14.773
15.327
15.902
16.499
9
14.164
14.776
15.416
16.085
16.786
17.518
18.285
19.086
19.923
20.799
10
16.722
17.549
18.420
19.337
20.304
21.321
22.393
23.521
24.709
25.959
11
19.561
20.655
21.814
23.044
24.349
25.733
27.200
28.755
30.403
32.150
12
22.713
24.133
25.650
27.271
29.001
30.850
32.824
34.931
37.180
39.580
13
26.211
28.029
29.984
32.088
34.352
36.786
39.404
42.218
45.244
48.496
14
30.095
32.392
34.882
37.581
40.504
43.672
47.102
50.818
54.841
59.196
15
34.405
37.280
40.417
43.842
47.580
51.659
56.109
60.965
66.260
72.035
16
39.190
42.753
46.671
50.980
55.717
60.925
66.648
72.938
79.850
87.442
17
44.500
48.883
53.738
59.117
65.075
71.673
78.978
87.067
96.021
105.930
18
50.396
55.749
61.724
68.393
75.836
84.140
93.404
103.739
115.265
128.116
19
56.939
63.439
70.748
78.968
88.211
98.603
110.283
123.412
138.165
154.739
20
64.202
72.052
80.946
91.024
102.443
115.379
130.031
146.626
165.417
186.687
21
72.264
81.968
92.468
104.767
118.809
134.840
153.136
174.019
197.846
225.024
22
81.213
92.502
105.489
120.434
137.630
157.414
180.169
206.342
236.436
217.028
23
91.147
104.602
120.203
138.295
159.274
183.600
211.798
244.483
282.359
326.234
24
102.173
118.154
136.829
158.656
184.166
213.976
248.803
289.490
337.007
392.480
25
114.412
133.333
155.616
181.867
212.790
249.212
292.099
342.598
402.038
471.976
30
199.018
241.330
293.192
356.778
434.738
530.306
647.423
790.932
966.698
1181.865
35
341.583
431.658
546.663
693.552
881.152
1120.699
1426.448
1816.607
2314.173
2948.294
40
581.812
767.080
1013.667
1341.979
1779.048
2360.724
3134.412
4163.094
5529.711
7343.715
45
986.613
1358.208
1874.000
2590.464
3585.031
4965.191
6879.008
9531.258
13203.105
18280.091
50
1668.732
2399.975
3459.344
4994.301
7217.4808
10435.449
15088.805
21812.273
31514.492
45496.094
Year
21%
22%
23%
24%
25%
26%
27%
28%
29%
30%
1
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
2
2.210
2.220
2.230
2.240
2.250
2.260
2.270
2.280
2.290
2.300
3
3.674
3.708
3.743
3.778
3.813
3.848
3.883
3.918
3.954
3.990
4
5.446
5.524
5.604
5.684
5.766
5.848
5.931
6.016
6.101
6.187
5
7.589
7.740
7.893
8.048
8.207
8.368
8.533
8.700
8.870
9.043
6
10.183
10.442
10.708
10.980
11.259
11.544
11.837
12.136
12.442
12.756
7
13.321
13.740
14.171
14.615
15.073
15.546
16.032
16.534
17.051
17.583
8
17.119
17.762
18.430
19.123
19.842
20.588
21.361
22.163
22.995
23.858
9
21.714
22.670
23.669
24.712
25.802
26.940
28.129
29.369
30.664
32.015
10
27.274
28.657
30.113
31.643
33.253
34.945
36.723
38.592
40.556
42.619
11
34.001
35.962
38.039
40.238
42.566
45.030
47.639
50.398
53.318
56.405
12
42.141
44.873
47.787
50.895
54.208
57.738
61.501
65.510
69.780
74.326
13
51.991
55.745
59.778
64.109
68.760
73.750
79.106
84.853
91.016
97.624
14
63.909
69.009
74.528
80.496
86.949
93.925
101.465
109.611
118.411
127.912
15
76.330
85.191
92.669
100.815
109.687
119.346
129.860
141.302
153.750
167.285
16
95.779
104.933
114.983
126.010
138.109
151.375
165.922
181.867
199.337
218.470
17
116.892
129.019
142.428
157.252
173.636
191.733
211.721
233.790
258.145
285.011
18
142.439
158.403
176.187
195.993
218.045
242.583
269.885
300.250
334.006
371.514
19
173.351
194.251
217.710
244.031
273.556
306.654
343.754
385.321
431.868
483.968
20
210.755
237.986
268.783
303.598
342.945
387.384
437.568
494.210
558.110
630.157
21
256.013
291.343
331.603
337.461
429.681
489.104
556.710
633.589
720.962
820.204
PRESENT
22
310.775
356.438
408.871
469.052
538.101
617.270
708.022
811.993
931.040
1067.265
23
377.038
435.854
503.911
582.624
673.626
778.760
900.187
1040.351
1202.042
1388.443
24
457.215
523.741
620.810
732.453
843.032
982.237
1144.237
1332.649
1551.634
1805.975
VALUE
25
554.230
650.944
764.596
898.082
1054.791
1238.617
1454.180
1706.790
2002.608
2348.765
30
1445.111
1767.044
2160.459
2640.881
3227.172
3941.953
4812.891
5873.172
7162.785
8729.805
35
3755.314
4783.520
6090.227
7750.094
9856.746
12527.160
15909.480
20188.742
25596.512
32422.090
TABLES
40
9749.141
12936.141
17153.691
22728.167
30088.621
39791.957
52570.707
69376.562
91447.375 120389.375
45
25294.223
34970.230
48300.660
66638.937
91831.312 126378.937 173692.875 238384.312 326686.376 447005.062
561
562
PRESENT
Year
31%
32%
33%
34%
35%
36%
37%
38%
39%
40%
VALUE
1
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
2
2.310
2.320
2.330
2.340
2.350
2.360
2.370
2.380
2.390
2.400
TABLES
3
4.026
4.062
4.099
4.136
4.172
4.210
4.247
4.284
4.322
4.360
4
6.274
6.362
6.452
6.542
6.633
6.725
6.818
6.912
7.008
7.104
5
9.219
9.398
9.581
9.766
9.954
10.146
10.341
10.539
10.741
10.946
6
13.077
13.406
13.742
14.086
14.438
14.799
15.167
15.544
15.930
16.324
7
18.131
18.696
19.277
19.876
20.492
21.126
21.779
22.451
23.142
23.853
8
24.752
25.678
26.638
27.633
28.664
29.732
30.837
31.982
33.167
34.395
9
33.425
34.895
36.429
38.028
39.696
41.435
43.247
45.135
47.103
49.152
10
44.786
47.062
49.451
51.958
54.590
57.351
60.248
63.287
66.473
69.813
11
59.670
63.121
66.769
70.624
74.696
78.998
83.540
88.335
98.397
98.739
12
79.167
84.320
89.803
95.636
101.840
108.437
115.450
122.903
130.882
139.234
13
104.709
112.302
120.438
129.152
138.484
148.474
159.166
170.606
182.842
195.928
14
138.169
149.239
161.183
174.063
187.953
202.925
219.058
236.435
255.151
275.299
15
182.001
197.996
215.373
234.245
254.737
276.978
301.109
327.281
355.659
386.418
16
239.421
262.354
287.446
314.888
344.895
377.690
413.520
452.647
495.366
541.985
17
314.642
347.307
383.303
422.949
466.608
514.658
567.521
625.652
689.558
759.778
18
413.180
459.445
510.792
567.751
630.920
700.935
778.504
864.399
959.485
1064.689
19
542.266
607.467
680.354
761.786
852.741
954.271
1067.551
1193.870
1334.683
1491.563
20
711.368
802.856
905.870
1021.792
1152.220
1298.809
1463.544
1648.539
1856.208
2089.188
21
932.891
1060.769
1205.807
1370.201
1556.470
1767.380
2006.055
2275.982
2581.128
2925.862
22
1223.087
1401.215
1604.724
1837.068
2102.234
2404.636
2749.294
3141.852
3588.765
4097.203
23
1603.243
1850.603
2135.282
2462.669
2839.014
3271.304
3767.532
4336.750
4989.379
5737.078
24
2101.247
2443.795
2840.924
3300.974
3833.667
4449.969
5162.516
5985.711
6936.230
8032.906
25
2753.631
3226.808
3779.428
4424.301
5176.445
6052.957
7073.645
8261.273
9642.352
11247.062
30
10632.543
12940.672
15737.945
19124.434
23221.258
28172.016
34148.906
41357.227
50043.625
60500.207
Table A.3 The Present Value of One Rupee
Year
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1
.990
.980
.971
.962
.952
.943
.935
.926
.917
.909
2
.980
.961
.943
.925
.907
.890
.873
.857
.842
.826
3
.971
.942
.915
.889
.864
.840
.816
.794
.772
.751
4
.961
.924
.888
.855
.823
.792
.763
.735
.708
.683
5
.951
.906
.863
.822
.784
.747
.713
.681
.650
.621
6
.942
.888
.837
.790
.746
.705
.666
.630
.596
.564
7
.933
.871
.813
.760
.711
.665
.623
.583
.547
.513
8
.923
.853
.789
.731
.677
.627
.582
.540
.502
.467
9
.914
.837
.766
.703
.645
.592
.544
.500
.460
.424
10
.905
.820
.744
.676
.614
.558
.508
.463
.422
.386
11
.896
.804
.722
.650
.585
.527
.475
.429
.388
.350
12
.887
.789
.701
.625
.557
.497
.444
.397
.356
.319
13
.879
.773
.681
.601
.530
.469
.415
.368
.326
.290
14
.870
.758
.661
.577
.505
.442
.388
.340
.299
.263
15
.861
.743
.642
.555
.481
.417
.362
.315
.275
.239
16
.853
.728
.623
.534
.458
.394
.339
.292
.252
.218
17
844
.714
.605
.513
.436
.371
.317
270
.231
.198
18
.836
.700
.587
.494
.416
.350
.296
.250
.212
.180
19
.828
.686
.570
.475
.396
.331
.227
.232
.194
.164
20
.820
.673
.554
.456
.377
.312
.258
.215
.178
.149
21
.811
.660
.538
.439
.359
.294
.242
.199
.164
.135
PRESENT
22
.803
.647
.522
.422
.342
278
.226
.184
.150
.123
23
.795
.634
.507
.406
.326
.262
.211
.170
.138
.112
24
.788
.622
.492
.390
.310
.247
.197
.158
.126
.102
VALUE
25
.780
.610
.478
.375
.295
.233
.184
.146
.116
.092
30
.742
.552
.412
.308
.231
.174
.131
.099
.075
.057
35
.706
.500
.355
.253
.181
.130
.094
.068
.049
.036
TABLES
40
.672
.453
.307
.208
.142
.097
.067
.046
.032
.022
45
.639
.410
.264
.171
.111
.073
.048
.031
.021
.014
50
.806
.372
.228
.141
.087
.054
.034
.021
.013
.009
563
564
Table A.3 The Present Value of One Rupee (Contd.)
PRESENT
Year
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1
.901
.893
.885
.877
.870
.862
.855
.847
.840
.833
VALUE
2
.812
.797
.783
.769
.756
.743
.731
.718
.700
.694
3
.731
.712
.693
.675
.658
.641
.624
.609
.593
.579
TABLES
4
.659
.636
.613
.592
.572
.552
.534
.516
.499
.482
5
.593
.567
.543
.519
.497
.476
.456
.437
.419
.402
6
.535
.507
.480
.456
.432
.410
.390
.370
.352
.335
7
.482
.452
.425
.400
.376
.354
.333
.314
.296
.279
8
.434
.404
.376
.351
.327
.305
.285
.266
.249
.233
9
.391
.361
.333
.308
.284
.263
.243
.225
.209
.194
10
.352
.322
.295
.270
.247
.227
.208
.191
.176
.162
11
.317
.287
.261
.237
.215
.195
.178
.162
.148
.135
12
.286
.257
.231
.208
.187
.168
.152
.137
.124
.112
13
.258
.229
.204
.182
.163
.145
.130
.116
.104
.093
14
.232
.205
.181
.160
.141
.125
.111
.099
.088
.078
15
.209
.183
.160
.140
.123
.108
.095
.084
.074
.065
16
.188
.163
.141
.123
.107
.093
.081
.071
.062
.054
17
.170
.146
.125
.108
.093
.080
.069
.060
.052
.045
18
.153
.130
.111
.095
.081
.069
.059
.051
.044
.038
19
.138
.116
.098
.083
.070
.060
.051
.043
.037
.031
20
.124
.104
.087
.073
.061
.051
.043
.037
.031
.026
21
.112
.093
.077
.064
.053
.044
.037
.031
.026
.022
22
.101
.083
.068
.056
.046
.038
.032
.026
.022
.018
23
.091
.074
.060
.049
.040
.033
.027
.022
.018
.015
24
.082
.006
.053
.043
.035
.028
.023
.019
.015
.013
25
.074
.059
.047
.038
.030
.024
.020
,016
.013
.010
30
.044
.033
.026
.020
.015
.012
.009
,007
.005
.004
35
.026
.019
.014
.010
.008
.006
.004
.003
.002
,002
40
.015
.011
.008
.005
.004
.003
.002
.001
.001
.001
45
.009
.006
.004
.003
.002
.001
.001
.001
.000
.000
50
.005
.003
.002
.001
.001
.001
.000
.000
.000
.000
Year
21%
22%
23%
24%
25%
26%
27%
28%
29%
30%
1
.826
.820
.813
.806
.800
.794
.787
.781
.775
.769
2
.683
.672
.661
.650
.640
.630
.620
.610
.601
.592
3
.564
.551
.537
.524
.512
.500
.488
.477
.466
.455
4
.467
.451
.437
.423
.410
.397
.384
.373
.361
.350
5
.386
.370
.355
.341
.328
.315
.303
.291
.280
.269
6
.319
.303
.289
.275
.262
.250
.238
.227
.217
.207
7
.263
.249
.235
.222
.210
.198
.188
.178
.168
.159
8
.218
.204
.191
.179
.168
.157
.148
.139
.130
.123
9
.180
.167
.155
.144
.134
.125
.116
.108
.101
.094
10
.149
.137
.126
.116
.107
.099
.092
.085
.078
.073
11
.123
.112
.103
.094
.086
.079
.072
.066
.061
.056
12
.102
.092
.083
.076
.069
.062
.057
.052
.047
.043
13
.084
.075
.068
.061
.055
.050
.045
.040
.037
.033
14
.069
.062
.055
.049
.044
.039
.035
.032
.028
.025
15
.057
.051
.045
.040
.035
.031
.028
.025
.022
.020
16
.047
.042
.036
032
.028
.025
.022
.019
.017
.015
17
.039
.034
.030
.026
.023
.020
.017
.015
.013
.012
18
.032
.028
.024
.021
.018
.016
.014
.012
.010
.000
19
.027
.023
.020
.017
.014
.012
.011
.009
.008
.007
20
.022
.019
.016
.014
.012
.010
.008
.007
.006
.005
21
.018
.015
.013
.011
.009
.008
.007
.006
.005
.004
PRESENT
22
.015
.013
.011
.009
.007
.006
.005
.004
.004
.003
23
.012
.010
.009
.007
.006
.005
.004
.003
.003
.002
24
.010
.008
.007
.006
.005
.004
.003
.003
.002
.002
VALUE
25
.009
.007
.006
.005
.004
.003
.003
.002
.002
.001
30
.003
.003
.002
.002
.001
.001
.001
.001
.000
.000
35
.001
.001
.001
.001
.000
.000
.000
.000
.000
.000
TABLES
40
.000
.000
.000
.000
.000
.000
.000
.000
.000
.000
45
.000
.000
.000
.000
.000
.000
.000
.000
.000
.000
50
.000
.000
.000
.000
.000
.000
.000
.000
.000
.000
565
566
PRESENT
Year
31%
32%
33%
34%
35%
36%
37%
38%
39%
40%
1
.763
.758
.752
.746
.741
.735
.730
.725
.719
.714
VALUE
2
.583
.574
.565
.557
.549
.541
.533
.525
.518
.510
3
.445
.435
.425
.416
.406
.398
.389
.381
.372
.364
TABLES
4
.340
.329
.320
.310
.301
.292
.284
.276
.268
.260
5
.259
.250
.240
.231
.223
.215
.207
.200
.193
.186
6
.198
.189
.181
.173
.165
.158
.151
.145
.139
.133
7
.151
.143
.136
.129
.122
.116
.110
.105
.100
.095
8
.115
.108
.102
.096
.091
.085
.081
.076
.072
.068
9
.088
.082
.077
.072
.067
.063
.059
.055
.052
,048
10
.067
.062
.058
.054
.050
.046
.043
.040
.037
.035
11
.051
.047
.043
.040
.037
.034
031
.029
.027
.025
12
.039
.036
.033
.030
.027
.025
.023
.021
.019
.018
13
.030
.027
.025
.022
.020
.018
.017
.015
.014
.013
14
.023
.021
.018
.017
.015
.014
.012
.011
.010
.009
15
.017
.016
.014
.012
.011
.010
.009
.008
.007
.006
16
.013
.012
.010
.009
.008
.007
.006
.006
.005
.005
17
.010
.009
.008
.007
.006
.005
.005
.004
.004
.003
18
.008
.007
.006
.005
.005
.004
.003
.003
.003
.002
19
.006
.005
.004
.004
.003
.003
.003
.002
.002
.002
20
.005
.004
.003
.003
.002
.002
.002
.002
.001
.001
21
.003
.003
.003
.002
.002
.002
.001
.001
.001
.001
22
.003
.002
.002
.002
.001
.001
.001
.001
.001
.001
23
.002
.002
.001
.001
.001
.001
.001
.001
.001
.000
24
.002
.001
.001
.001
.001
.001
.001
.000
.000
.000
25
.001
.001
.001
.001
.001
.000
.000
.000
.000
.000
30
.000
.000
.000
.000
.000
.000
.000
.000
.000
.000
35
.000
.000
.000
.000
.000
.000
.000
.000
.000
.000
40
.000
.000
.000
.000
.000
.000
.000
.000
.000
.000
45
.000
.000
.000
.000
.000
.000
.000
.000
.000
.000
50
.000
.000
.000
.000
.000
.000
.000
.000
.000
.000
Table A.4 The Present Value of an Annuity of One Rupee
Year
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1
.990
.980
.971
.962
.952
.943
.935
.926
.917
.909
2
1.970
1.942
1.913
1.886
1.859
1.833
1.808
1.783
1.759
1.736
3
2.941
2.884
2.829
2.775
2.723
2.673
2.624
2.577
2.531
2.487
4
3.902
3.808
3.717
3.630
3.546
3.465
3.387
3.312
3.240
3.170
5
4.853
4.713
4.580
4.452
4.329
4.212
4.100
3.993
3.890
3.791
6
5.795
5.601
5.417
5.242
5.076
4.917
4.767
4.623
4.486
4.355
7
6.728
6.472
6.230
6.002
5.786
5.582
5.389
5.206
5.033
4.868
8
7.652
7.326
7.020
6.733
6.463
6.210
5.971
5.747
5.535
5.335
9
8.566
8.162
7.786
7.435
7.108
6.802
6.515
6.247
5.995
5.759
10
9.471
8.983
8.530
8.111
7.722
7.360
7.024
6.710
6.418
6.145
11
10.368
9.787
9.253
8.760
8.306
7.887
7.499
7.139
6.805
6.495
12
11.255
10.575
9.954
9.385
8.863
8.384
7.943
7.536
7.161
6.814
13
12.134
11.348
10.635
9.986
9.394
8.853
8.358
7.904
7.487
7.103
14
13.004
12.106
11.296
10.563
9.899
9.295
8.746
8.244
7.786
7.367
15
13.865
12.849
11.938
11.118
10.380
9.712
9.108
8.560
8.061
7.606
16
14.718
13.578
12.561
11.652
10.838
10.106
9.447
8.851
8.313
7.824
17
15.562
14.292
13.166
12.166
11.274
10.477
9.763
9.122
8.544
8.022
18
16.398
14.992
13.754
12.659
11.690
10.828
10.059
9.372
8.756
8.201
19
17.226
15.679
14.324
13.134
12.085
11.158
10.336
9.604
8.950
8.365
20
18.046
16.352
14.878
13.590
12.462
11.470
10.594
9.818
9.129
8.514
21
18.857
17.011
15.415
14.029
12.821
11.764
10.836
10.017
9.292
8.649
PRESENT
22
19.661
17.658
15.937
14.451
13.163
12.042
11.061
10.201
9.442
8.772
23
20.456
18.292
16.444
14.857
13.489
12.303
11.272
10.371
9.580
8.883
24
21.244
18.914
16.936
15.247
13.799
12.550
11.469
10.529
9.707
8.985
VALUE
25
22.023
19.524
17.413
15.622
14.094
12.783
11.654
10.675
9.823
9.077
30
25.808
22.397
19.601
17.292
15.373
13.765
12.409
11.258
10.274
9.427
35
29.409
24.999
21.487
18.665
16.374
14.498
12.948
11.655
10.567
9.644
TABLES
40
32.835
27.356
23.115
19.793
17.159
15.046
12.332
11.925
10.757
9.779
45
36.095
29.490
24.519
20.720
17.774
15.456
13.606
12.108
10.881
9.863
50
39.197
31.424
25.730
21.482
18.256
15.762
13.801
12.234
10.962
9.915
567
568
Table A.4 The Present Value of an Annuity of One Rupee (Contd.)
PRESENT
Year
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1
.901
.893
.885
.877
.870
.862
.855
.847
.850
.833
2
1.713
1.690
1.668
1.647
1.626
1.605
1.585
1.566
1.547
1.528
VALUE
3
2.444
2.402
2.361
2.322
2.283
2.246
2.210
2.174
2.140
2.106
4
3.102
3.037
2.974
2.914
2.855
2.798
2.743
2.690
2.639
2.589
TABLES
5
3.696
3.605
3.517
3.433
3.352
3.274
3.199
3.127
3.058
2.991
6
4.231
4.111
3.998
3.889
3.784
3.685
3.589
3.496
3.410
3.326
7
4.712
4.564
4.423
4.288
4.160
4.039
3.922
3.812
3.706
3.605
8
5.146
4.968
4.799
4.639
4.487
4.344
4.207
4.078
3.954
3.837
9
5.537
5.328
5.132
4.946
4.772
4.607
4.451
4.303
4.163
4.031
10
5.889
5.650
5.426
5.216
5.019
4.833
4.659
4.494
4.339
4.192
11
6.207
5.938
5.687
5.453
5.234
5.029
4.836
4.656
4.487
4.327
12
6.492
6.194
5.918
5.660
5.421
5.197
4.988
4.793
4.611
4.439
13
6.750
6.424
6.122
5.842
5.583
5.342
5.118
4.910
4.715
4.533
14
6.982
6.628
5.303
6.002
5.724
5.468
5.229
5.008
4.802
4.611
15
7.191
6.811
6.462
6.142
5.847
5.575
5.324
5.092
4.876
4.675
16
7.379
6.974
6.604
6.265
5.954
5.669
5.405
5.162
4.938
4.730
17
7.549
7.120
6.729
6.373
6.047
5.749
5.475
5.222
4.990
4.775
18
7.702
7.250
6.840
6.467
6.128
5.818
5.534
5.273
5.033
4.812
19
7.839
7.366
6.938
6.550
6.198
5.877
5.585
5.316
5.070
4.843
20
7.963
7.469
7.024
6.623
6.259
5.929
5.628
5.353
5.101
4.870
21
8.075
7.562
7.102
6.687
6.312
5.973
5.665
5.384
5.127
4.891
22
8.176
7.645
7.170
6.743
6.359
6.011
5.696
5.410
5.149
4.909
23
8.266
7.718
7.230
6.792
6.399
6.044
6.723
5.432
5.167
4.925
24
8.348
7.784
7.283
6.835
6.434
6.073
5.747
5.451
5.182
4.937
25
8.422
7.843
7.330
6.873
6.464
6.097
5.766
5.467
5.195
4.948
30
8.694
8.055
7.496
7.003
6.566
6.177
5.829
5.517
5.235
4.979
35
8.855
8.176
7.586
7.070
6.617
6.215
5.858
5.539
5.251
4.992
40
8.951
8.244
7.634
7.105
6.642
6.233
5.871
5.548
5.258
4.997
45
9.008
8.283
7.661
7.123
6.654
6.242
5.877
5.552
5.261
4.999
50
9.042
8.305
7.675
7.133
6.661
6.246
5.880
5.554
5.262
4.999
Year
21%
22%
23%
24%
25%
26%
27%
28%
29%
30%
1
.826
.820
.813
.806
.800
.794
.787
.781
.775
.769
2
1.509
1.492
1.474
1.457
1.440
1.424
1.407
1.392
1.376
1.361
3
2.074
2.042
2.011
1.981
1.952
1.923
1.896
1.868
1.842
1.816
4
2.540
2.494
2.448
2.404
2.362
2.320
2.280
2.241
2.203
2.166
5
2.926
2.864
2.803
2.745
2.689
2.635
2.583
2.532
2.483
2.436
6
3.245
3.167
3.092
3.020
2.951
2.885
2.821
2.759
2.700
2.643
7
3.508
3.416
3.327
3.242
3.161
3.083
3.009
2.937
2.868
2.802
8
3.726
3.619
3.518
3.421
3.329
3.241
3.156
3.076
2.999
2.925
9
3.905
3.786
3.673
3.566
3.463
3.366
3.273
3.184
3.100
3.019
10
4.054
3.923
3.799
3.682
3.570
3.465
3.364
3.269
3.178
3.092
11
4.177
4.035
4.902
3.776
3.656
3.544
3.437
3.335
3.239
3.147
12
4.278
4.127
3.985
3.851
3.752
3.606
3.493
3.387
3.286
3.190
13
4.362
4.203
4.053
3.912
3.780
3.656
3.538
3.427
3.322
3.223
14
4.432
4.265
4.108
3.962
3.824
3.695
3.573
3.459
3.351
3.249
15
4.489
4.315
4.153
4.001
3.859
3.726
3.601
3.483
3.373
3.268
16
4.536
4.357
4.189
4.033
3.887
3.751
3.623
3.503
3.390
3.283
17
4.576
4.391
4.219
4.059
3.910
3.771
3.640
3.518
3.403
3.295
18
4.608
4.419
4.243
4.080
3.928
3.786
3.654
3.529
3.413
3.304
19
4.635
4.442
4.263
4.097
3.942
3.799
3.664
3.539
3.421
3.311
20
4.657
4.460
4.279
4.110
3.954
3.808
3.673
3.546
3.427
3.316
21
4.675
4.476
4.292
4.121
3.963
3.816
3.679
3.551
3.432
3.320
PRESENT
22
4.690
4.488
4.302
4.130
3.970
3.822
3.684
3.556
3.436
3.323
23
4.703
4.499
4.311
4.137
3.976
3.827
3.689
3.559
3.438
3.325
24
4.713
4.507
4.318
4.143
3.981
3.831
3.692
3.562
3.441
3.327
VALUE
25
4.721
4.514
4.323
4.147
3.985
3.834
3.694
3.564
3.442
3.329
30
4.746
4.534
4.339
4.160
3.995
3.842
3.701
3.569
3.447
3.332
35
4.756
4.541
4.345
4.164
3.998
3.845
3.703
3.571
3.448
3.333
TABLES
40
4.760
4.544
4.347
4.166
3.999
3.846
3.703
3.571
3.448
3.333
45
4.761
4.545
4.347
4.166
4.000
3.646
3.704
3.571
3.448
3.333
50
4.762
4.545
4.348
4.167
4.000
3.846
3.704
3.571
3.448
3.333
569
570

PRESENT
Year
31%
32%
33%
34%
35%
36%
37%
38%
39%
40%
1
.763
.758
.752
.746
.741
.735
.730
.725
.719
.714
VALUE
2
1.346
1.331
1.317
1.303
1.289
1.276
1.263
1.250
1.237
1.224
3
1.791
1.766
1.742
1.719
1.696
1.673
1.652
1.630
1.609
1.589
TABLES
4
2.130
2.096
2.062
2.029
1.997
1.966
1.935
1.906
1.877
1.849
5
2.390
2.345
2.302
2.260
2.220
2.181
2.143
2.106
2.070
2.035
6
2.588
2.534
2.483
2.433
2.385
2.339
2.294
2.251
2.209
2.168
7
2.739
2.677
2.619
2.582
2.508
2.455
2.404
2.355
2.308
2.263
8
2.854
2.786
2.721
2.658
2.598
2.540
2.485
2.432
2.380
2.331
9
2.942
2.868
2.798
2.730
2.665
2.603
2.544
2.487
2.432
2.379
10
3.009
2.930
2.855
2.784
2.715
2.649
2.587
2.527
2.469
2.414
11
3.060
2.978
2.899
2.824
2.752
2.683
2.618
2.555
2.496
2.438
12
3.100
3.013
2.931
2.853
2.779
2.708
2.641
2.576
2.515
2.456
13
3.129
3.040
2.956
2.876
2.799
2.727
2.658
2.592
2.529
2.469
14
3.152
3.061
2.974
2.892
2.814
2.740
2.670
2.603
2.539
2.477
15
3.170
3.076
2.988
2.905
2.825
2.750
2.679
2.611
2.546
2.484
16
3.183
3.088
2.999
2.914
2.834
2.757
2.685
2.616
2.551
2.489
17
3.193
3.097
3.007
2.921
2.840
2.763
2.690
2.621
2.555
2.492
18
3.201
3.104
3.012
2.926
2.844
2.767
2.693
2.624
2.557
2.494
19
3.207
3.109
3.017
2.930
2.848
2.770
2.696
2.626
2.559
2.496
20
3.211
3.113
3.020
2.933
2.850
2.772
2.698
2.627
2.561
2.497
21
3.215
3.116
3.023
2.935
2.852
2.773
2.699
2.629
2.562
2.498
22
3.217
3.118
3.025
2.936
2.853
2.775
2.700
2.629
2.562
2.498
23
3.219
3.120
3.026
2.938
2.854
2.775
2.701
2.630
2.563
2.499
24
3.221
3.121
3.027
2.939
2.855
2.776
2.701
2.630
2.563
2.499
25
3.222
3.122
3.028
2.939
2.856
2.776
2.702
2.631
2.563
2.499
30
3.225
3.124
3.030
2.941
2.857
2.777
2.702
2.631
2.564
2.500
35
3.226
3.125
3.030
2.941
2.857
2.178
2.703
2.632
2.564
2.500
40
3.226
3.125
3.030
2.941
2.857
2.778
2.703
2.632
2.564
2.500
45
3.226
3.125
3.030
2.941
2.857
2.778
2.703
2.632
2.564
2.500
50
3.226
3.125
3.030
2.941
2.857
2.778
2.703
2.632
2.564
2.500
Index
Ability, 48
Bad debts, 386, 405
Account, 301
Balance sheet, 391
Accountancy, 288
Bank
management, 23
overdrafts, 219, 368
Accounting, 286
reconciliation statement, 362
cost, 291
Barometric techniques, 107
cycle, 294
Bill of exchange, 338
errors, 345
Board of directors, 479
financial, 291
Book
management, 291
bills payable, 338
period, 298
bills receivable, 338
process, 294
cash, 327, 347
Accrued income, 402
double-column, 350
Active forecasts, 95
petty, 360
Adjusting entries, 342, 401
simple, 347
Advertisement, 385
three-column or triple-column, 354
Advertising, 372
purchases, 327
Angle of incidence, 199
sales
Apprentice premium, 385
day, 339
Arc elasticity, 89
returns, 336
ARIMA method, 107
subsidiary, 326
Articles of partnership, 467
Book-keeping, 288
Artificial
Break-even
person, 474
analysis, 191
personal accounts, 303
chart, 194
Assets, 393
point, 191
Autonomous demand, 62
volume, 192
Average collection period, 419
Business
Average product (AP), 164
environment, 30
Average rate of return (ARR), 247
operations, 30
571
572
INDEX
Capital, 159, 214, 404
objective evidence, 298
budgeting, 233
realisation, 298
employed, 422
Conspicuous consumption, 69
expenditure, 232, 371
Constant, 129
profit, 373
Consumable stores, 377
receipts, 373
Consumer
Carriage and freight, 372
behaviour, 39
Carriage, cartage or freight, 376
goods, 63
Cash and bank balance, 219
surveys, 99
Cash
Consumption, 70
cycle, 225
Contingent
discount, 349
assets, 394
Ceteris paribus, 66
dependent proposals, 234
Change in quantity demanded, 71
liabilities, 394
Chartered company, 476
Contra entry, 355
Classical stage, 5
Contraction of demand, 72
Closing
Contribution, 193
entries, 342, 378
margin of (or gross margin), 193, 195
stock, 375, 377
Conventions, 299
Co-operation, 484
of conservatism or prudence, 300
Co-operative society, 483
of consistency, 299
consumers, 484
of full disclosure, 300
credit, 484
of materiality, 299
farming, 485
Convex iso-quant, 170

housing, 485
Correlation, 108
marketing, 484
coefficient of, 109
producers, 484
Cost-output relationship, 184
Cobb-Douglas production function, 173
Cost
Coincident series, 107
abandonment, 183
Commercial banks, 270
actual, 179
Commission, 385
average
Common seal, 474
fixed, 184
Companies
total, 185
limited by guarantee, 477
variable, 185
limited by shares, 477
book, 182
Complementary goods, 58
escapable, 183
Complements, 74
explicit, 180
Complete enumeration survey method, 99
fixed, 182
Compound journal entry, 306
future, 181
Concepts
historical, 183
accounting, 296
implicit or imputed, 181
accounting period, 297
incremental, 27, 180
accrual, 299
long-run, 182
business entity, 296
marginal, 116, 187
cost, 296
opportunity, 26
dual aspect, 297
paid-out, 180
going concern, 296
past, 181
incremental, 27
postponable, 183
matching, 298
production, 178, 381
money measurement, 296
replacement, 183
INDEX
573
semi-variable, 182
Douglas production function, 173
short-run, 181
Drawee, 338
shutdown, 183
Drawer, 338
sunk, 180, 183
Drawings, 404
unavoidable, 184
Duopoly, 140
urgent, 183
Durable/non-perishable/repeated-use goods, 63
variable, 182
Coverage ratios, 414, 416
Credit, 301
Earnings per share (EPS), 424
cross-elasticity of demand, 77, 92
Econometric models, 111

note, 336
Econometrics, 25
Cumulative preference shares, 267
Economics, 1, 4
Current
Economies, 174
assets, 218, 393
of vertical integration, 176
liabilities, 219, 394
Efficiency, 2
Cyclical variations, 103
Elastic demand, 77
Elasticity, 75
End-use method, 100
Debenture, 268
Equal utility curve, 44
holders, 268
Equilibrium, 116
Debit, 301
amount, 121
note, 333
price, 121
Decision-making, 13
Equity shares, 268

Decrease in demand, 72
Exceptional demand curve, 69
Decreasing cost industry, 128
Expansion, 232
Deferred revenue expenditure, 371, 407
Expenses, 420
Demand, 47, 64
Experimentation in laboratory, 102
curve, 49, 51
Expert opinion method, 101
derived, 62
Exponential smoothing, 107
determinants of, 54
Extension of demand, 72
function, 49, 53
External
schedule, 49
diseconomies, 178
shifters, 54
economies, 174
Departmental organisation, 492
factors, 30
Depreciation, 385, 403
Desire, 48
Development expenditure, 372
Direct expenses, 376
Factors of production, 158
wages, 376
Fictitious assets, 393
Directors, 475
Final accounts, 370
Discounted cash flow (DCF) method, 238
Financial economies, 176
Discounted payback period, 246
statement, 413
Discriminating monopoly or price discrimination,
Firm, 459
138
demand, 64
Diseconomies of scale, 177
name, 459
Diversification, 232
Fixed
Division of labour, 176
assets, 393
Dock charges, 376
capital, 215
Domestic and household expenses, 386

costs, 182
Double entry, 295, 301
liabilities, 394
system, 301
Forecasting, 94
574
INDEX
Foreign companies, 479
Inelastic demand, 77
Fuel, power, lighting and heating expenses, 376
Inferior
commodity, 56
(goods or Giffen goods), 69
General firm, 464
Input, 157
Generally Accepted Accounting Principles (GAAP),
Intangible
295
fixed asset, 393
Giffens paradox, 69
real accounts, 304
Goods in transit, 408
Interest, 385
Government companies, 477, 495

on capital, 372, 404
Gross
Internal
margin, 420
diseconomies, 177
profit, 374
economies, 175
working capital, 216
factors, 30
Grouping, 391
rate of return, 255
Inventories, 218
Investment, 219, 394, 422
Holding companies, 477
Invoice, 327
Irredeemable preference shares, 267
Irregular forces, 104
Imperfect
Iso-cost line, 172
competition, 130
Iso-product, 167
market, 114
curve, 166
oligopoly, 141
map, 172
Import duty, 376
Iso-quant, 166
Imprest system, 360
Iso-utility curve, 44
Income
effect, 55, 68
elasticity of demand, 77, 89
Joint
received in advance, 403
Hindu family business, 471
statement, 370
sector enterprise, 454
tax, 386
stock company, 473
Increase in demand, 72
Journal, 305
Increasing cost industry, 128
entries, 306
Incremental revenue, 27
proper, 341
Independent proposals, 234
Journalising, 306
Indian companies, 479

Indifference
analysis, 44
Karta (or Manager), 471
curve, 44
Kinked
map, 45
demand, 141
schedule, 44
iso-quant, 170
Indirect expenses, 384
wages, 376
Individual demand, 48
Labour, 158
curve, 51
Lagging series, 107
function, 53
Land, 158
schedule, 49
Laws
Industry, 64
of demand, 65
demand, 64
assumptions of, 67
INDEX
575
of diminishing marginal utility, 40
curve, 52
assumptions of, 67
function, 53
of equimarginal utility, 43
schedule, 50
of production, 163
experiments, 101
of returns to scale, 163
segment demand, 65
of substitution, 43
structure, 112
of variable proportions (or Laws of Retu), 163
supply, 121
Leading series, 107
Marketing economies, 176
Least squares method, 104
Marshalling, 391
Ledger, 316
Mathematics, 23
folio, 306
Mechanical extrapolations (or trend projection),
expenses, 372
103
Leverage or capital structure ratios, 414
Medium-term funds, 266
Liabilities, 394
Microeconomics, 10
Life insurance premium, 386
Modern stage, 9
Limited
Monopolistic competition, 143
firm, 464
Monopoly, 130
monopoly or a relative monopoly, 130
absolute or pure, 130
Linear iso-quant, 168
Movement along the demand curve, 71
Liquidity order, 391
Moving averages, 106
Loans and advances, 218
Multiple
Long run, 184
correlation, 109
demand, 65, 84
regression, 110
Long-term
Mutually exclusive proposals, 234
funds, 266
liabilities, 394
Losses
Naive forecasting, 108
abnormal, 386
Narration, 306
capital, 373
Natural personal accounts, 303
grass, 374
Necessity goods, 90
revenue, 373, 374
Negative
Luxury goods, 90
income elasticity, 92
Negotiable instruments, 338
Macroeconomics, 10
Neo-classical stage, 6
Managerial
Net
diseconomies, 177
present value (NPV), 251
economics, 9, 176
profit margin, 420
Managers commission, 407
Manufacturing
worth, 424
account, 380
New
expenses, 376
demand, 64
Margin of safety, 198
stage, 7
Marginal
Non-cumulative preference shares, 267
product (MP), 164
Non-discounted cash flow methods, 238
rate of technical substitution (MRTS), 168
Non-durable goods, 63
revenue, 116
Non-participating preference shareholders,
utility, 40
267
Market, 112
Normal goods, 57
demand, 48
Normative economics, 18 ( see also Positive
analysis, 38
economics)
576
INDEX
Octroi, 376
Preference shares, 267
Oligopoly, 140
Preliminary or formation expenses, 372
Opening
Prepaid expenses, 218, 402
entry, 312, 342
Price elasticity of demand, 77
stock, 375
Principles
Operating
accounting, 295
assets, 422
double entry, 301
cycle, 225, 230
discounting, 28
Operations, 24
equimarginal, 28
Organisation, 160
time perspective, 27
Output, 157
Private companies, 477
Outstanding expenses, 402
Private undertakings, 454
Producers goods, 63
Production, 157
Packing charges, 376
function, 160
Partial correlation, 109
Profit and loss account, 383
Participating preference shares, 267
Profit margin, 420
Partners, 459
Profitability, 419
active, 464
Index (PI) method, 262
by estoppel, 465
ratios, 419
by holding out, 466
Project, 236
minors as, 465
Promotional elasticity of demand, 77, 94
nominal, 465
Proportional method, 85
in profits, 465
Provision
rights and obligations of, 466
for discount on debtors, 406
secret, 466
for doubtful debts, 405
sleeping (or dormant), 464
Public
working, 464
companies, 477
Partnership, 459
corporation, 493
agreement or deed, 467
enterprises, 488
Passive forecasts, 95
or state undertakings, 454
Payback period, 238
Purchases, 375
Payee, 338
Pure oligopoly, 141
Percentage method, 85
Perfect
markets, 114, 121

Qualitative method, 98
competition, 114
Quantitative
Perfectly
method, 98
elastic demand, 79
techniques, 103
inelastic demand, 80
Perishable/non-durable/single-use goods, 63
Permanent working capital, 219
Rate of return
Perpetual succession, 475
average, 247
Personal accounts, 300
internal, 255
Point elasticity method, 88
Ratio, 414
Positive
activity, 417
economics, 18
analysis of, 414
income elasticity of demand, 91
capital employed turnover, 478

current assets turnover, 418
Posting, 317
debt-quity (D/E), 414
INDEX
577
debt-to-net worth, 415
Risk, 235
debt-to-total capital, 416
Risk-bearing economies, 176
debtors turnover, 419
Royalties, 376
devidend coverage, 417
dividend coverage, 417
dividend payout, 424
Salaries, 385
efficiency, 417
Sales, 377
expenses (or operating), 420
day book or sales journal ( see under Book)
fixed assets turnover, 418
force opinion method, 101
interest coverage, 416
returns, 377
profit-to-assets, 422
Sample survey, 100
profit-volume, 195
Samples, 385
profitability, 419
Scarcity, 2
sales net worth, 418
Seasonal
stock or inventory turnover, 418
variations, 103
total coverage, 417
turnover, 417
Self-evident adjustments, 409
working capital turnover, 418
Shares, 266, 474
Raw materials and stores, 372
capital, 474
Real or property accounts, 300
Shareholders, 267, 474
Rectifying entries, 342
equity of, 415
Redeemable preference shares, 267
Shift in the demand curve, 72
Registered companies, 476

Short run, 117, 184
Regression, 110
demand, 84
Regular working capital, 220
Short-term
Relatively
demand, 65
elastic demand, 81
financial management, 215
inelastic demand, 82
funds, 266
Rent, rates and taxes, 385
loans, 219, 270
Repairs, 372
Simple
Replacement, 232
correlation (or partial correlation), 109
demand, 64
regression, 110
Representative personal accounts, 303
Simultaneous equations model, 111
Research, 24
Single entry, 295
Reserve
Smoothing techniques, 106
for discount on creditors, 406
Sole proprietorship, 455
fund, 409
Special working capital, 220
Statistics, 24
Retained earnings, 270
Statutory companies, 476
Returns
Stock, 375
on assets, 422
Sub-partner, 466
on equity shareholders funds, 424
Subsidiary company, 477
inwards, 336
Substitute goods, 57
outwards, 333
Substitutes, 74
on shareholders equity, 424
Substitution effect, 55, 68
Revenue expenditure, 371
Sundry creditors, 219
losses, 373, 374

profit, 373
receipt, 373
Tangible fixed assets, 393
Right-angle iso-quant, 169
real accounts, 303
578
INDEX
Technical economies, 175
Trend, 103
Temporary or variable working capital, 220
Trial balance, 343
Term loans, 271
Test marketing, 102
Theories
decision, 25
Uncertainty, 235
of demand, 39
Unitary price elasticity, 81
of income and unemployment, 10
Unlimited companies, 477
price, 10
Utility, 39
of production, 157
Time value of money, 251

Total
Variable factors, 163
market demand, 65
Veblen goods, 70
outlay method, 86
product (TP), 164
utility, 40
Trade
Wages, 372, 376
credit, 270
Wasting assets, 394
debtors, 218
Willingness, 48
discount, 328, 349
Working capital, 215
expenses, 385
management, 215
Trading account, 374
Transfer entries, 342
Transport charges, 372
Zero income elasticity, 92
Document Outline
Eco-Contents
Eco-01
Eco-02
Eco-03
Eco-04
Eco-05
Eco-06
Eco-Glossary
Eco-Bibliography
Eco-Model Questions
Eco-Index
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MANAGERIAL ECONOMICS

Role of a Managerial Economist

(Change in Quantity Demanded)

Criteria for the Choice of a Good Forecasting Method

Cash Flows and Accounting Flows

Types of Business Organisation

Three Problems of Economic Organization

MANAGERIAL ECONOMICS AND FINANCIAL ACCOUNTING

scarcity of it, whereas Economics, according to Robbins, studies the problem of

It may be emphasised that neither of

Units of the study

It is concerned with small adjustments It deals with complex, dynamic

Economics applied in business decision-making). Managerial Economics may be viewed as

5. Managerial Economics is goal-oriented and prescriptive. It deals with how decisions

It deals with a firm and its industry.

Pricing Decisions, Policies and Practices

(a) Market research

Macroeconomics. Microeconomics examines individual decision-making, at the level of firms and

10. The author of The Wealth of Nations is ___________.

(b) Income theory

(c) Staffing and directing

Essay Type Questions

Why does Marginal Utility Decrease?

If income increases, marginal utility of money may decrease. If

Superior goods are most common goods

not be able to buy homes.

Less population of females leads to low demand for female-used products

salt, sweets, bread, milk, drinks, etc.

expectations. Real wealth effect influences demand for consumer durables.

Fig. 2.8 Law of demand.

8. There is no change in weather conditions.

(Extension and Contraction in Demand)

The volume of industrial output depends upon the nature of

4. Relatively elastic demand

Fig. 2.15 Perefectly inelastic demand.

The various types of price elasticity are shown in Table 2.10.

not respond to changes

Greater percentage of income spent More elastic

(b) Greater than unity

Price per unit

Point elasticity = Upper portion of tangent

Necessities have an income elasticity of demand of between 0 and +1. In

Demand for inferior goods

Quantity demanded of good X

of products more accurately than it will be able to forecast individual stock-keeping

Step 4: Gather and analyze data

Table 2.14 Types of business decisions

Selecting a Forecasting Method

(a) Fitting trend line by observation

a risk that the data may have been wrongly

tedious and costly the survey is.

3. It requires every industry to furnish its

A market experiment is performed under actual market conditions.

be fully representing the actual market

along with the price change.

1. Based on the assumption that past rate of

Actual demand (000s)

1. It is simple to use and easy to understand.

(ii) Coincident series, and

variables might be related to another variable and the form of the

explanatory (causal) variables in the

1. It explains past economic activity and predicts

2. The values of exogenous variables are

MANAGERIAL ECONOMICS AND FINANCIAL ACCOUNTING