Basic economic concepts essential in business decisions

1. Unit 3
Fundamental Economic
Concepts Used In Business
Decisions
By: Zainul Lamak

2. Why Study Economic Principles ?
• Modern business conditions are changing
so fast and becoming so competitive and
complex that personal business sense,
intuition and experience alone are not
sufficient to make appropriate business
decisions. It is in this area of decision
making that economic analysis contribute
a great goal

3. Process of decision making
i. Determining and Defining the Objective
ii. Collection and analysis of the information
regarding the objective
iii. Inventing, developing and analyzing possible
course of action
iv. Selecting the best available alternative

4. Levels of Business Decisions
 Simple Business Decisions
i. ‘Rule of Thumb’
ii. Used for simple day to day decision making
 Managerial Business Decisions
i. Sophisticated approach
ii. Used for tackling complex business issues

5. Table Of Contents
Sr. No. Principles
1 Opportunity Cost
2 Marginal Principle and Decision Rule
3 Incremental Principle and Decision Rule
4 Contribution Analysis
5 The Equi-Marginal Principle
6 Time perspective in Business decision

6. Basic Types of
Costs
Fixed Costs Variable Costs
• Plant and machinery
• Salaries
• Utility Services
• Leases
• Wages
• Electricity Charges
• Transport Charges
• Raw material cost

7. 1. The Opportunity Cost
• The cost involved in any decision consists of the
sacrifices of alternatives required by that
decision.
• The opportunity cost of a choice is the value of
the alternative forgone.
• Expresses basic relationship between ‘scarcity’
and ‘choice’

8. 20 M
18 M
16 M
Expansion New Production
Unit
Buying Shares in
another firm
Expected Revenues from Investment Options
Option 1
Option 2
Option 3

9. 20 M
18 M
16 M
Expansion New Production
Unit
Buying Shares in
another firm
Expected Revenues from Investment Options
Option 1
Option 2
Option 3
To achieve option 1,
Option 2 becomes
the OPPORTUNITY
COST

10. 18 M 18 M
Expansion New Production
Unit
Option1
Option2
Economic Gain/Profit
The difference between actual
earning and its opportunity cost is
called economic gain/profit
16 M
Buying Shares in
another firm
Option3
2 M

11. Parameters
• Opportunity costs are not restricted to monetary
or financial costs
• Other aspects such as pleasure, time lost and
output forgone are considered too
• For example, Appointing a new manager in the
business

12. Appointing a new Manager
Option A Option B
• Promotion of an internal
employee to a managerial
position with experience but
without qualification
• the opportunity cost for
promoting an internal
employee to a managerial post
is the lack of required
qualification
• Appointing a new employee
with the required qualification
• The opportunity cost for
recruiting a new employee is
the experience and
commitment of the present
internal employee towards the
business

13. 2. Marginal Principle
• Widely used term in Economics
• The term ‘Marginal’ refers to the change in total
quantity or value due to one-unit change in its
determinant
• This could be an increasing or a decreasing
change

14. Elements of Marginal Principle
• Total Cost of Production (TCn)
• Total Revenue (TRn)
• Marginal Cost (MC)
• Marginal Revenue (MR)
• Total Cost for producing an additional unit of
the commodity (TCn-1)
• Total Revenue by selling an additional unit of
the commodity (TRn-1)

15. • Total Cost of Production (TCn)
- The total cost of production of a commodity
depends on the number of units produced.
example, if 300 units are produced at Rs.20
each then the Total Cost amounts to Rs.6000
• Total Revenue (TRn)
- The total revenue of the firm depends on the
total number of units it sells.
example, 300 units sold at Rs.35 each amounts
to a Total Revenue of Rs.10,500

16. • Marginal Cost (MC)
- The marginal cost is the change in the total
cost as a result in producing an additional unit.
example, Total cost of producing 300 units is
Rs.6000 and the total cost of producing an
additional unit is 6020.
[ MC = TCn – TCn-1 ]
MC = 6020 – 6000
MC = 20

17. • Marginal Revenue
- The Marginal revenue is the revenue collected
due to a sale of an additional unit.
Example, Total Revenue earned by selling 350
units is Rs.10,500 and the Total revenue earned
by selling and additional unit is 10,535
[ MR = TRn – TRn-1 ]
MR = 10535 – 10500
MR = 35

18. Limitations
1. It can only be applied where the management has the Total Cost
(TC) and Total Revenue (TR) data for each and every unit of
output is recorded or where the management is fully aware of the
cost of producing one additional unit and the price expected to be
received from the sale of that unit.
Business that manufactures large units:
i . Airplanes
ii . Ships
iii . Buildings
iv . Turbines … etc.

19. 2. The concept of ‘Marginal’ value, when used in
cost analysis, reduces the value of MC to the
change in variable cost only. Therefore,
marginal analysis can only be applied to a
situation in which only the variable cost
changes

20. 3. Incremental Principle
• Incremental principle is the opposite of marginal
principle
• Incremental principle is applied to business decision that
involves bulk production and constant change in total
cost and the total revenue
• Data is easily available
• Combination of fixed and variable cost

21. Elements of Incremental Principle
• Incremental Cost
- The total change in cost is called the
incremental cost
- Incremental cost can be defined as the cost
that arises due to a business decision

22. Current Production Cost 100 M
Incremental Cost

23. Incremental Cost
New Production Cost 115 M

24. 100 M 15 M
15 Million is the Incremental cost
Incremental Cost

25. Elements of Incremental Principle
• Incremental Revenue
- When a business decision is successfully
implemented, it results in a significant increase in
the total revenue
- This increase in the revenue is termed as
incremental revenue

26. Current Revenue 130 M
Incremental Revenue

27. Incremental Revenue
Revenue after successful implementation of Incremental
cost - 150 M

28. 130 M 20 M
20 Million is the Incremental
revenue
Incremental Revenue

29. Incremental Reasoning
• Conclusions based on incremental concept
(Incremental Cost + Incremental Revenue) in
business decision is termed as Incremental
reasoning
• Incremental Reasoning is used in accepting or
rejecting a business proposition

30. Incremental Reasoning for setting up a
new plant

31. Incremental Reasoning
20 M 15 M
Incremental CostIncremental Revenue
5 M
Excess Incremental revenue
5 million/15 million = 33.33 % gross profit on investment
According to the incremental reasoning the firm should immediately
accept the proposition

32. Close Study
Marginal Principle Incremental Principle
• Marginal Value is calculated
for an additional unit
produced
• Fixed cost must remain the
same
• A theoretical concept and
difficult to calculate in real life
• Incremental Value is
calculated for bulk production
and large total cost
• Fixed cost is tentative to
change
• Used in Business decision
more frequently and easy to
calculate

33. 4. Contribution Analysis
• The analysis of a business decision between
Incremental Revenue and Incremental Cost
• Generally applied to analyze the contribution
made by overheads costs and revenue

34. It is a useful technique for taking business
decision on:
• Whether or not to accept a project ?
• Whether or not to introduce a new product ?
• Whether or not to accept a new order ?
• Whether or not to add an additional plant ?
• Whether to make or buy ?

35. Costs taken into consideration for
Contribution Analysis
• Incremental Costs
i. Present Explicit Costs
a. Explicit variable costs
. Direct labour cost
. Direct material cost
. Direct variable overheads
b. Fixed Costs
. New additional equipment
. New additional personnel

36. ii. Opportunity Cost
iii. Future Incremental Costs
. Depreciation
. Reserves
. Advertising

37. Costs NOT taken into consideration for
Contribution Analysis
i. Committed Costs
. Payments of old debts
. Committed raise in salaries
ii. Sunk Costs
. Building
. Plant and Machinery
. Non-recoverable advance payments

38. Revenues taken into consideration for
Contribution Analysis
Incremental Revenues
i. Present Explicit Revenue
ii. Possible Opportunity Revenue
iii. Possible future revenue

39. 5. The Equi-Marginal Principle
• Allocation of available resources amongst the
alternative activities
• An input should be so allocated that the value
added by the last unit is the same in all cases
• Goal of maximizing profits

40. Consumer point of view
• Every commodity will have different utility for
different consumer.
• The consumer will want to purchase both
commodities and will want to reap highest
possible marginal utility
• This is possible when the consumer complies his
purchase of commodities in a way that gives
maximum value

41. Units Marginal utility of
Apples
Marginal Utility of
Oranges
1 10 8
2 8 6
3 6 4
4 4 2
5 2 0
6 0 -2
7 -2 -4
8 -4 -6
Example

42. Business point of view
• When a business intends to start a new project
and get and faces problems of resource
allocation between its alternatives
• Equi-Marginal principle helps in deciding how
much resources to allocate in which project by
studying the marginal utility of each project.

43. Units of expenditure
(Rs. 10 Million)
Marginal Productivity
Project A Project B Project C
1st 50 40 35
2nd 45 30 30
3rd 35 20 20
4th 20 10 15
5th 10 0 12

44. 6. Time Perspective
• All business decision are taken within a certain
time limit
• Time perspective
i. Short run
ii. Long run
• Determination of time perspective is of great
significance specially where projects are
involved

45. • Short Run
A decision to buy explosive materials for
manufacturing crackers involves short run
demand prospect
• Long Run
Spending on labor welfare.
i. Will result in expense initially
ii. Will increase productivity in long run

46. Thank You