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E C O N O M I C S

INTRODUCTION

The English word economics is derived from the ancient Greek word
oikonomikos—meaning the management of a family or a household. Economics
is the study of how individuals and societies make decisions about way to use
scarce resources to fulfil wants and needs. Economics deals with individual
choice, money and borrowing, production and consumption, trade and markets,
employment and occupations, asset pricing, taxes and much more.
As an individual, for example, you constantly face the problem of having limited
resources with which to fulfil your wants and needs. As a result, you must make
certain choices with your money – what to spend it on, what not to spend it on,
and how much to save for the future. You'll probably spend part of your money
on relative necessities such as rent, electricity, clothing and food. Then you
might use the rest to go to the movies, dine out or buy a smart phone.
Economists are interested in the choices you make, and investigate why, for
instance, you might choose to spend your money on a new mobile phone instead
of replacing your old pair of shoes. The underlying essence of economics is
trying to understand how individuals, companies, and nations as a whole behave
in response to certain material constraints.

DEFINITIONS

1. Adam Smith‟s Definition:- Adam Smith, considered to be the founding

father of modern Economics, defines Economics as “the study of the
nature and causes of nations‟ wealth or simply as the study of
wealth”. The central point in Smith‘s definition is wealth creation. He
assumed that, the wealthier a nation becomes the happier are its citizens.
Thus, it is important to find out, how a nation can be wealthy. Economics is
the subject that tells us how to make a nation wealthy. Adam Smith‘s
definition is a wealth-centred definition of Economics.

2. Alfred Marshall‟s Definition:- Alfred Marshall also stressed the importance

of wealth. But he also emphasised the role of the individual in the creation
and the use of wealth. He defines: “Economics is a study of man in the
ordinary business of life. It enquires how he gets his income and how

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he uses it. Thus, it is on the one side, the study of wealth and on the
other and more important side, a part of the study of man”.

3. Lionel Robbins‟ Definition:- In his book „Essays on the Nature and

Significance of the Economic Science‟, published in 1932, Robbins gave
a definition which has become one of the most popular definitions of
Economics. According to Robbins, “Economics is a science which studies
human behaviour as a relationship between ends and scarce means
which have alternative uses”.

SIGNIFICANCE OF ECONOMICS

1. Allows to know the basics of human needs, production, distribution, reuse

and better use of resources.

2. It provides the basis for exchange of goods and services between

individuals, organizations and even countries.

3. Generates systems, techniques and public policies to improve social

welfare.

4. Help to set target prices of goods and services.

5. Adjust political, financial and even social imbalances.

6. Provides knowledge and techniques that prevent crises and help them out.

7. It uses econometric techniques to predict future economic conditions that

could harm or benefit certain situations in ascertain place, and how to
maximize the benefits and problems mystify.

8. As you can see, economics is a science that encompasses us completely.

9. To be an expert in this field you can study a university degree in

economics, in this course the student will learn how the economy moves
and how to generate the best social conditions.

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MICRO AND MACRO ECONOMICS
The whole economic theory is broadly divided into two parts –

Micro economics and Macro economics.

These two terms were at first used by Ragner Frisch in 1933. But these two
words became popular worldwide and most of the economist using nowadays.
The term ‗micro‘ and ‗macro‘ were derived from Greek words ‗Mikros‘ and
‗Makros‘ meaning ‗small‘ and ‗large‘ respectively. So micro economics deals with
the analysis of an individual unit and macro economics with economy as a
whole. For example, in micro economics we study how price of goods or factors
of production are determined. In macro economics we study what are the causes
of high or low level of employment.

So, according to Edwin Mansfield – ―Micro economics deals with the economic
behaviour of individual units such as consumers, firms, and resource owners;
while macro economics deals with behaviour of economic aggregates such as
gross national product and the level of employment.

Meaning of Micro – economics

The term micro was originated from Greek word ‗Mikros‘ which means small.
Hence, microeconomics is concerned on small economic units like as individual
consumer, households, firms, industry etc.

Microeconomics may be defined as the branch of economic analysis which

studies about the economic behaviour of individual economic unit may be a
person, a particular households, a particular firm and an industry. The main
objective of micro – economics is to explain the principles, problems and policies
related to the optimum allocation of resources. According to K. E. Boulding,
―Microeconomics is the study of particular firm, particular households, individual
price, wage, income of the industry and particular commodity‖ .

It is the study of individual tree not a whole forest. Hence, microeconomics tries
to explain how an individual allocates his money income among various needs as
well as how an individual maximize satisfaction level from the consumption of
available limited resources. Microeconomics also explains about the process of
determination of individual price with interaction of demand and supply. It helps

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to determine the price of the product and factor inputs. Therefore, it is also
called as price theory or demand and supply theory. Simply microeconomics is
microscopic study of the economy.

Meaning of Macro - economics

The term macro- economics is derived from Greek word ― Makros‖ , which means
― big‖ . Hence, macro- economics studies not individual units but all the units
combined together or the economy as a whole. Since it studies the economy in
aggregate. It studies national income, national output, general price level, total
employment, total savings, total investment and so on. It is also called
―aggregate economics‖ or the ―income theory‖ .

According to K.E. Boulding –‖ Macro- economics deals not with individual

quantities but with aggregate of these quantities, not with individual incomes,
but with national income, not with individual prices but with price level, not with
individual output but with national output.‖

J.M. Keynes made and outstanding contribution in the development of macro-

economics. It is also known as Keynesian Phenomenon.

NATIONAL INCOME

In every country goods and services are produced in agriculture sector,

industrial sector and service sector. The total value of final goods and services
produced in a country in a year is called national income. National income was
first calculated in India by Dadabai Noaroji in 1876. In our country national
income is calculated every year by Central Statistical Organization (CSO).It
includes payments made to all resources in the form of wages, interest, rent and
profits.

According to Marshall: ―The labour and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material
and immaterial including services of all kinds. This is the true net annual income
or revenue of the country or national dividend.‖ In this definition, the word ‗net‘
refers to deductions from the gross national income in respect of depreciation
and wearing out of machines. And to this, must be added income from abroad.

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Land, Labour, Capital, Organization

Rent, Wages, Interest, Profits

HOUSEHOLDS BUSINESS
FIRMS
Goods and Services

Payment for goods and services

Circular Flow of National Income :-

National income is a flow of money payments resulting from the productive
resources of a country during a year. It has the concept of circular flow in this
sense that the economic transactions which are made in a country during a
particular year appears in different ways. The expenditure of one person is the
income of another person, and his expenditure is also equal to value of goods
and services. To explain this idea we assume that there is economy where are
only two sectors in the economy.
1. Firms.
2. Households.
Firms are required to produce goods. Households own the various factors of
production. Firms require the services of households to produce goods. The firms
hire the services of households to produce goods. These goods are again
supplied to the households. When households sector purchases the goods it
makes the payments. Similarly firms make the payment in the shape of rent,
wages, and interest to the households against their services.
In this way the sum of prices of the goods and services must be equal to the
sum of the reward for the services of factors of production.
So income flows from firms to households in exchange for these services and
again the expenditure flows from households to firms. The goods which are
produced by the firms these are purchased by the household. The flow of income
flows from firms to household and flow of expenditure from household to firms
will be equal. This is called circular flow of national income.

National income can be calculated on the basis of:

1. Flow of goods and services

2. Flow of income
3. Flow of expenditure on goods and services

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CONCEPTS OF NATIONAL INCOME

There are various concepts of National Income. The main concepts of NI are:
GDP, GNP, NNP, NI, PI, DI, and PCI. These different concepts explain about the
phenomenon of economic activities of the various sectors of the economy.

1. Gross Domestic Product (GDP)

Gross domestic product- the market value of all final goods and services
produced in a country during a specific period of time which is usually one year.

GDP is measured using market values, and not quantities. Production is

measured in quantities, but then those quantities have to be changed to account
for their value. In economics we use prices to place values on the final goods,
so total production times price will give us the total value.

Final goods and services vs intermediate goods or services. A product is a final

good or service when it is purchased by the final user. Intermediate products
are used as an input to produce another good or service such as sugar being
purchased to make soda. Sugar is an intermediate good, while soda is a final
good.

GDP only includes the value of final goods, intermediate goods are not
included. GDP only includes current production, and ignores the sale of used
goods. If you purchase a bike in 2011, then that purchase is included in 2011
GDP measure, not 2010 or 2012. Also, if you sell that bike at any time in the
future, the sale of that bike is not included in GDP.

An equation for GDP and some actual values:

GDP = C + I + G + NX

The GDP equation shows us that GDP is equal to consumption expenditure (C)
plus investment expenditure (I) plus government expenditure (G) plus net
exports (NX = Exports - Imports).

2. Gross National Product (GNP)

Gross National Product is the total market value of all final goods and services
produced annually in a country plus net factor income from abroad. Thus, GNP is
the total measure of the flow of goods and services at market value resulting
from current production during a year in a country including net factor income
from abroad. The GNP can be expressed as the following equation:

GNP=GDP+NFIA (Net Factor Income from Abroad)

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NFIA = Income earned by Indians in abroad through jobs or businesses –
Income earned by foreigners in India by jobs or businesses.

3. Net National Product (NNP)

Net National Product is the market value of all final goods and services after
allowing for depreciation. It is also called National Income at market price. When
charges for depreciation are deducted from the gross national product, we get it.
Thus,

NNP=GNP-Depreciation

4. National Income (NI)

National Income is also known as National Income at factor cost. National

income at factor cost means the sum of all incomes earned by resources
suppliers for their contribution of land, labor, capital and organizational ability
which go into the years net production. Hence, the sum of the income received
by factors of production in the form of rent, wages, interest and profit is called
National Income. Symbolically,

NI=NNP + Subsidies given by Govt. - Indirect Taxes

5. Personal Income (PI)

Personal Income is the total money income received by individuals and

households of a country from all possible sources before direct taxes. Therefore,
personal income can be expressed as follows:

PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-Social Security

Contribution + Transfer Payments

6. Disposable Income (DI)

The income left after the payment of direct taxes from personal income is called
Disposable Income. Disposable income means actual income which can be spent
on consumption by individuals and families. Thus, it can be expressed as:

DI=PI-Direct Taxes

7. Per Capita Income (PCI)

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Per Capita Income (average income) of a country is derived by dividing the
national income of the country by the total population of a country. Thus,

PCI=Total National Income/Total National Population

IMPORTANCE OF NATIONAL INCOME

The following points highlight the top eleven reasons for growing
importance of national income studies in recent years.

1. Economic Policy:

Economic policy refers to the actions which Govt. Takes in the economic feild
such as Tax policy, Money supply policy, Interest rate policy etc. National income
figures are an important tool of macroeconomic analysis and policy.

National income estimates are the most comprehensive measures of aggregate

economic activity in an economy. It is through such estimates that we know the
aggregate yield of the economy and can lay down future economic policy for
development.

2. Economic Planning:

National income statistics are the most important tools for long-term and short-
term economic planning. A country cannot possibly frame a plan without having
a prior knowledge of the trends in national income. The Planning Commission in
India also kept in view the national income estimates before formulating the
five-year plans.

3. Economy‟s Structure:

National income statistics enable us to have clear idea about the structure of the
economy. It enables us to know the relative importance of the various sectors of
the economy and their contribution towards national income. From these studies
we learn how income is produced, how it is distributed, how much is spent,
saved or taxed.

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4. Inflationary and Deflationary Gaps:

Inflationary gap means the amount by which the total demand is higher than the
total supply. Deflationary gap means the amount by which the total demand is
less than the total supply. National income and national product figures enable
us to have an idea of the inflationary and deflationary gaps. For accurate and
timely anti- inflationary and deflationary policies, we need regular estimates of
national income.

5. Budgetary Policies:

Modern governments try to prepare their budgets within the framework of

national income data and try to formulate anti-cyclical policies according to the
facts revealed by the national income estimates. Even the taxation and
borrowing policies are so framed as to avoid fluctuations in national income.

6. National Expenditure:

National income studies show how national expenditure is divided between

consumption expenditure and investment expenditure. It enables us to provide
for reasonable depreciation to maintain the capital stock of a community. Too
liberal allowance of depreciation may prove harmful as it may unnecessarily lead
to a reduction in consumption.

7. Distribution of Grants-in-aid:

National income estimates help a fair distribution of grants-in-aid by the federal

governments to the state governments and other constituent units.

8. Standard of Living Comparison:

National income studies help us to compare the standards of living of people in

different countries and of people living in the same country at different times.

9. International Sphere:

National income studies are important even in the international sphere as these
estimates not only help us to fix the burden of international payments equitably
amongst different nations but also enable us to determine the subscriptions and

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quotas of different countries to international organisations like the UNO, IMF,
IBRD. etc.

10. Defense and Development:

National income estimates help us to divide the national product between

defence and development purposes. From such figures we can easily know how
much can be spared for war by the civilian population.

11. Public Sector:

National income figures enable us to know the relative roles of public and private
sectors in the economy. If most of the activities are performed by the state, we
can easily conclude that public sector is playing a dominant role.

INFLATION

Inflation is defined as a sustained increase in the general level of prices for

goods and services in a county, and is measured as an annual percentage
change. Under conditions of inflation, the prices of things rise over time. Put
differently, as inflation rises, every rupee you own buys a smaller percentage of
a good or service. When prices rise, and alternatively when the value of money
falls you have inflation.

The value of a rupee (or any unit of money) is expressed in terms of

its purchasing power, which is the amount of real, tangible goods or actual
services that money can buy at a moment in time. When inflation goes up, there
is a decline in the purchasing power of money. For example, if the inflation rate
is 2% annually, then theoretically a Rs.1 chocolate will cost Rs.1.02 in a year.
After inflation, your rupee does not go as far as it did in the past.

FEATURES OF INFLATION

Following are the main features of inflation:

1. Inflation is always accompanied by a rise in the price level. It is a process

of uninterrupted increase in prices.

2. Inflation is a monetary phenomenon and it is generally caused by

excessive money supply.

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3. Inflation is essentially an economic phenomenon as it originates in the
economic system and is the result of action and interaction of economic
forces.

4. Inflation is a dynamic process as observed over the long period.

5. A cyclical movement of prices is not inflation.

6. Pure inflation starts after full employment.

7. Inflation may be demand-pull or cost-push.

TYPES OF INFLATION

1. Creeping Inflation: This is also known as mild inflation or moderate

inflation. This type of inflation occurs when the price level persistently
rises over a period of time at a mild rate. When the rate of inflation is less
than 10 per cent annually, or it is a single digit inflation rate, it is
considered to be a moderate inflation.

2. Galloping Inflation: If mild inflation is not checked and if it is

uncontrollable, it may assume the character of galloping inflation. Inflation
in the double or triple digit range of 20, 100 or 200 percent a year is called
galloping inflation . Many Latin American countries such as Argentina,
Brazil had inflation rates of 50 to 700 percent per year in the 1970s and
1980s.

3. Hyperinflation: It is a stage of very high rate of inflation. While

economies seem to survive under galloping inflation, a third and deadly
strain takes hold when the cancer of hyperinflation strikes. Nothing good
can be said about a market economy in which prices are rising a million or
even a trillion percent per year . Hyperinflation occurs when the prices go
out of control and the monetary authorities are unable to impose any
check on it. Germany had witnessed hyperinflation in 1920‘s.

4. Stagflation: It is an economic situation in which unemployment increases

along with rising inflation causing demand to remain stagnant in a given
period. In fact, it is an indication of an inefficient market, as traditionally,
there is an inverse relationship between unemployment rates and inflationary

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pressures. Stagflation was witnessed by developed countries in 1970s,
when world oil prices rose dramatically.

5. Deflation: Deflation is the reverse of inflation. It refers to a sustained

decline in the price level of goods and services. It occurs when the annual
inflation rate falls below zero percent (a negative inflation rate), resulting
in an increase in the real value of money. Japan suffered from deflation for
almost a decade in 1990s.

MANAGERIAL E C O N O M I C S

INTRODUCTION

Managerial Economics, is the application of economic theory and methodology to

business. Business involves decision- making. Decision making means the
process of selecting one out of two or more alternative courses of action. The
question of choice arises because the basic resources such as capital, land, labor
and management are limited and can be employed in alternative uses. The
decision-making function thus becomes one of making choice and taking
decisions that will provide the most efficient means of attaining a desired end,
say, profit maximization. Different aspects of business need attention of the
chief executive. He may be called upon to choose a single option among the
many that may be available to him. It would be in the interest of the business to
reach an optimal decision- the one that promotes the goal of the business firm.
A scientific formulation of the business problem and finding its optimal solution
requires that the business firm is he equipped with a rational methodology and
appropriate tools.

Economic theory underscores the fact that each firm in the industry operates under
competitive conditions and hence tries to operate more efficiently to withstand the
competition. The indicator of efficiency is profits. The assumption here is that each firm has
one man as the owner and entrepreneur, and that his sole aim is to maximize profits. As
time passed, one man firms were replaced by partnerships and giant companies and the
structure of the firm changed to include the owner/entrepreneur/shareholders on the one
hand and that managers on the other. The responsibility of the
owners/entrepreneur/shareholders got bifurcated. The day to day affairs of the firm were
looked after by the managers and owners/entrepreneur/shareholders took organizational
decisions aimed at maximizing profits. The goals of the owners/entrepreneurs/shareholders
are called organizational goals while the goals of the managers are referred to as

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Business goals also known as operational goals.

DEFINITIONS

According to E. F. Brigham and J. L. Pappas, "Managerial Economics is the

application of Economic theory and methodology to business administration
practise."

According to McNair and Meriam, "Managerial Economics consists of the use of

Economic modes of thought to analyse business situations."

According to M. H. Spencer and L. Siegelman, "Managerial Economics is the

integration of economic theory with business practise for the purpose of
facilitating decision making and forward planning."

According to Hauge, "Managerial Economics is concerned with using logic of

economics, mathematics & statistics to provide effective ways of thinking about
business decision problems."

According to Joel Dean, "The purpose of Managerial Economics is to show how

economic analysis can be used in formulating business policies."

NATURE OF MANAGERIAL ECONOMICS

Managerial economics is, perhaps, the youngest of all the social sciences. Since
it originates from Economics, it has the basis features of economics, such as
assuming that other things remaining the same. This assumption is made to
simplify the complexity of the Business phenomenon under study in a dynamic
business environment so many things are changing simultaneously. This set a
limitation that we cannot really hold other things remaining the same. In such a
case, the observations made out of such a study will have a limited purpose or
value. Managerial economics also has inherited this problem from economics.

The other features of managerial economics are explained as below:

(a) Microeconomics in nature: Business economics is concerned with finding

the solutions for different managerial problems of a particular firm. Thus, it is
more close to microeconomics.

(b) Operates against the backdrop of macroeconomics: The

macroeconomics conditions of the economy are also seen as limiting factors for
the firm to operate. In other words, the managerial economist has to be aware

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of the limits set by the macroeconomics conditions such as government
industrial policy, inflation and so on.

(c) Normative economics: Economics can be classified into two broad

categories normally. Positive Economics and Normative Economics. Positive

economics describes ― what is, i.e., observed economic phenomenon. The

statement ― Poverty in India is very high‖ is an example of positive economics.
Normative economics describes ―what ought to be, i.e., it differentiates the
ideals form the actual. Ex: People who earn high incomes ought to pay more
income tax than those who earn low incomes. A normative statement usually
includes or implies the words ‗ought‘ or ‗should‘. They reflect people‘s moral
attitudes and are expressions of what a team of people ought to do.

(d) Prescriptive actions: Prescriptive action is goal oriented. Given a problem

and the objectives of the firm, it suggests the course of action from the available
alternatives for optimal solution. It does not merely mention the concept, it also
explains whether the concept can be applied in a given context on not. For
instance, the fact that variable costs as marginal costs can be used to judge the
feasibility of an export order.

(e) Applied in nature: ‗Models‘ are built to reflect the real life complex
business situations and these models are of immense help to managers for
decision-making. The different areas where models are extensively used include
inventory control, optimization, project management etc. In Business economics,
we also employ case study methods to conceptualize the problem, identify that
alternative and determine the best course of action.

(f) Offers scope to evaluate each alternative: Business economics provides

an opportunity to evaluate each alternative in terms of its costs and revenue.
The Business economist can decide which is the better alternative to maximize
the profits for the firm.

(g) Interdisciplinary: The contents, tools and techniques of Business

economics are drawn from different subjects such as economics, management,
mathematics, statistics, accountancy, psychology, organizational behavior,
sociology and etc.

(h) Assumptions and limitations: Every concept and theory of Business

economics is based on certain assumption and as such their validity is not
universal. Where there is change in assumptions, the theory may not hold good
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at all.

SCOPE OF MANAGERIAL ECONOMICS

The main focus of Business economics is to find the solution to Business

problems for which the Business economist makes use of the concepts, tools and
techniques of economics and other related disciplines.

1. Demand Analyses and Forecasting:

A firm can survive only if it is able to the demand for its product at the right
time, within the right quantity. Understanding the basic concepts of demand is
essential for demand forecasting. Demand analysis should be a basic activity of
the firm because many of the other activities of the firms depend upon the
outcome of the demand forecast. Demand analysis provides:

a) The basis for analyzing market influences on the firms; products and thus
helps in the adaptation to those influences.
b) Demand analysis also highlights for factors, which influence the demand
for a product. This helps to manipulate demand. Thus demand analysis
studies not only the price elasticity but also income elasticity, cross
elasticity as well as the influence of advertising expenditure. With the
advent of computers, demand forecasting has become an increasingly
important function of Business economics.

2. Price determination:

Pricing decisions have been always within the preview of Business economics.
Pricing policies are merely a subset of broader class of Business economic
problems. Price theory helps to explain how prices are determined under
different types of market conditions. Competition analysis includes the
anticipation of the response of competing firms‘ pricing, advertising and

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marketing strategies. Product line pricing and price forecasting occupy an
important place here.

3. Production and cost analysis:

Production analysis is in physical terms. While the cost analysis is in monetary

terms. Cost concepts and classifications, cost-out-put relationships, economies
and diseconomies of scale and production functions are some of the points
constituting cost and production analysis.

4. Resource Allocation:

Business Economics is the traditional economic theory that is concerned with the
problem of optimum allocation of scarce resources. Marginal analysis is applied
to the problem of determining the level of output, which maximizes profit. In this
respect, linear programming techniques are used to solve optimization
problems. In fact, linear programming is one of the most practical and powerful
managerial decision making tools currently available.

5. Profit analysis:

Profit making is the major goal of firms. There are several constraints here on
account of competition from other products, changing input prices and changing
business environment hence in spite of careful planning, there is always certain
risk involved. Business economics deals with techniques of averting of
minimizing risks. Profit theory guides in the measurement and management of
profit, in calculating the pure return on capital, besides future profit planning.

6. Investment decisions:

Capital is the foundation of business. Lack of capital may result in small size of
operations. Availability of capital from various sources like equity capital,
institutional finance etc. may help to undertake large-scale operations. Hence
efficient allocation and management of capital is one of the most important tasks
of the managers. The major issues related to capital analysis are:

1. The choice of investment project

2. Evaluation of the efficiency of capital

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3. Most efficient allocation of capital

Knowledge of capital theory can help very much in taking investment decisions. This involves,
capital budgeting, feasibility studies, analysis of cost of capital etc.

7. Forward planning:

Strategic planning provides management with a framework on which long-term decisions can be
made which has an impact on the behavior of the firm. The firm sets certain long-term goals and
objectives and selects the strategies to achieve the same. Strategic planning is now a new
addition to the scope of Business economics with the emergence of multinational corporations.
The perspective of strategic planning is global.

MULTI-DISCIPLINARY NATURE OF MANAGERIAL ECONOMICS

Many new subjects have evolved in recent years due to the interaction among basic disciplines.
While there are many such new subjects in natural and social sciences, Business economics can
be taken as the best example of such a phenomenon among social sciences. Hence it is necessary
to trace its roots and relationship with other disciplines.

1. Relationship with economics:

The relationship between Managerial economics and economics theory may be viewed from the
point of view of the two approaches to the subject Viz. Micro Economics and Marco Economics.
Microeconomics is the study of the economic behavior of individuals, firms and other such micro
organizations. Managerial economics is rooted in Micro Economic theory. Managerial Economics
makes use to several Micro Economic concepts such as marginal cost, marginal revenue, elasticity
of demand as well as price theory and theories of market structure to name only a few. Macro
theory on the other hand is the study of the economy as a whole. It deals with the analysis of
national income, the level of employment, general price level, consumption and investment in the
economy and even matters related to international trade, Money, public finance, etc.

2. Relationship with accounting:

Managerial economics has been influenced by the developments in management theory and
accounting techniques. A proper knowledge of accounting techniques is very essential for the
success of the firm because profit maximization is the major objective of the firm. Managerial

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Economist requires a proper knowledge of cost and revenue information and their classification.

3. Relationship with mathematics:

The use of mathematics is significant for Managerial economics in view of its profit maximization
goal long with optional use of resources. The major problem of the firm is how to minimize cost,
how to maximize profit or how to optimize sales. Mathematical concepts and techniques are
widely used in economic logic to solve these problems. Geometry, Algebra and calculus are the
major branches of mathematics which are of use in Managerial economics.

4. Relationship with Statistics:

A successful businessman must correctly estimate the demand for his product. Statistical methods
provide and sure base for decision-making. Thus statistical tools are used in collecting data and
analyzing them to help in the decision making process. Statistical tools like the theory of
probability and forecasting techniques help the firm to predict the future course of events.
Managerial Economics also make use of correlation and multiple regressions in related variables
like price and demand to estimate the extent of dependence of one variable on the other.

5. Relationship with Operations Research:

The development of techniques and concepts such as linear programming, inventory models and
game theory is due to the development of this new subject of operations research in the post-
war years. Operations research is concerned with the complex problems arising out of the
management of men, machines, materials and money.

Operation research provides a scientific model of the system and it helps Managerial economists
in the field of product development, material management, and inventory control, quality control,
marketing and demand analysis.

7. Relationship with Computer Science:

Computers are used in data and accounts maintenance, inventory and stock controls and supply
and demand predictions. What used to take days and months is done in a few minutes or hours
by the computers. In fact computerization of business activities on a large scale has reduced the
workload of Business personnel.

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DEMAND ANALYSIS
In common, demand means the desire for an object. But in economics demand is something more than
this. According to Stonier and Hague, ―Demand in economics means demand backed up by enough
money to pay for the goods demanded‖. This means that the demand becomes effective only it if is
backed by the purchasing power. In addition to this, there must be willingness to buy a commodity.
Thus demand in economics means the desire backed by the willingness to buy a commodity and the
purchasing power to pay.
In the words of ―Benham‖ ―The demand for anything at a given price is the amount of it which will be
bought per unit of time at that Price‖.
Hence, demand refers to the amount of commodity which an individual consumer is willing to purchase at
given price in a given period. The demand is said to exist when the following three conditions are
fulfilled.
1. Desire to purchase
2. Ability to pay
3. Willing to pay
Ex: A beggar may have desire to purchase a car but he cannot pay money for it.
Ex: A miser does not purchase a car but he can pay money for it.

DEMAND FUNCTION
Demand function is a function which describes a relationship between one variable and its determinants.
The demand function for a good relates the quantity of good which consumers demand during a given
period to the factors which influence the demand. Quantity demanded is dependent variable and all the
factors are independent variables. The factors can be built up into a demand function. The demand
function can be mathematically expressed as follows: Q = Quantity demanded
Q = f(P, I, T, P1..Pn, EP, EI, S, D, A, O) f = Function of
P = Price of goods itself
I = Income of consumers
T = Taster and preferences
P1..Pn = Price of related goods
EP = Expectation about future price
EI = Expectation about future income
S = Size of the Population
D = Distribution of Customers
A = Advertisement
O = Other factors
LAW OF DEMAND:
Law of demand shows the relationship between price and quantity demanded of a commodity in the
market. In the words of Marshall, ―the amount demand increases with a fall in price and diminishes with a
rise in price‖.

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The law of demand states that “ other things remaining constant, the higher the price of the
commodity, the lower is the demand and lower the price, higher is the demand”. It is called as
ceteris paribus (Latin phrase meaning other things constant.)
The law of demand may be explained with the help of the following demand schedule.

Demand Schedule: Demand Curve:

Price of Apple Quantity

(In. Rs.) Demanded
2 6
3 4
4 3
5 2
6 1

When the price falls from Rs. 6 to 5, quantity demand increases from 1 to 2. In the same way as price
falls, quantity demanded increases. On the basis of the demand schedule, we can draw the demand curve.
The above demand curve shows the inverse relationship between price and quantity demanded of apple.
It is downward sloping.
Assumptions:
Law of demand is based on certain assumptions:
1. There is no change in consumers taste and preferences.
2. Income should remain constant.
3. Prices of other goods should not change.
4. There should be no substitute for the commodity
5. The commodity should not confer at any distinction
6. The demand for the commodity should be continuous
7. People should not expect any change in the price of the commodity

EXCEPTIONS TO LAW OF DEMAND

According to law of demand, other things being constant, as the price increases, the demand for the
commodity decreases and vice-versa. But this is not true all the time. In some cases, as the price
increases, the demand for the commodity will also increase and the demand decreases when the price
decreases. All these cases are considered as exceptions to the law of demand.

When price increases from OP to Op1, quantity demanded also increases from OQ to OQ1 and vice versa.
The following are the exceptions to the law of demand.
1. Giffen goods or Giffen paradox:
The Giffen good or inferior good or cheap good is an exception to the law of demand. The demand for
these goods varies directly with the variations in prices i.e., there exists direct relation between the
quantity demanded and the price of the commodity. Giffen goods may or may not exist in the real world.

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Giffen goods are named after
Sir Robert Giffen. He has conducted a survey on American laboring families who consume bread and
meat. The survey revealed that they spend more of their income on bread because it is their staple food or
main food and less of their income on meat. When price of bread increases, after purchasing bread, they
don‘t have surplus money to buy meat. So, the rise in the price of bread forced the people to buy more
bread by reducing the consumption of meat and thus raised the demand for bread. The goods like bajra,
barley, gram, millets, vegetables fall under the category of Giffen goods.
2. Goods of status
In some situations, certain commodities are demanded just because they are expensive or prestige goods
and are usually used as status symbols to display one‘s wealth in the society. Examples of such
commodities are diamonds, air conditioned car, duplex houses etc. as the price of these commodities
increase, they are more considered as status symbols and hence their demand gets raised. This goes
against the law of demand.

3. Ignorance:
Sometimes, the quality of the commodity is Judged by its price. Consumers think that the product is
superior if the price is high. As such they buy more at a higher price.
4.consumer expectations of future prices
If the price of the commodity is increasing, the consumers will buy more of it because of the fear that it
increase still further. Similarly, if the consumer expects the future prices to decrease, he may not purchase
the commodity thinking that the good may be of bad quality. This violates the law of demand.
5. Fear of shortage:
During the times of emergency of war, People may expect shortage of a commodity. At that time, they
may buy more at a higher price to keep stocks for the future.
6. Necessaries:
In the case of necessaries like rice, vegetables etc. people buy more even at a higher price.

DETERMINANTS OF DEMAND
There are several factors or determinants that affect the individual demand and market demand for a
product. These factors are economic, social as well as political factors. The effect of all the factors on the
amount demanded for the commodity is called Demand Function. These factors
are as follows:
1. Price of the Commodity:
The most important factor-affecting amount demanded is the price of the
commodity. The amount of a commodity demanded at a particular price is more
properly called price demand. The relation between price and demand is called the
Law of Demand. The demand for a commodity varies inversely with its price. A
decrease in price increases the purchasing power of consumers and an increase in
the price decreases the purchasing power of the consumers.
2. Income of the Consumer:

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The second most important factor influencing demand is consumer income. Individual consumer‘s
income determines his purchasing ability. When other things remaining constant, if income increases,
demand increases and vice-versa. An increase in income makes an individual to buy many commodities.
The effect of income on demand can be analysed for normal goods, perishable goods and inferior goods.
a) Normal goods: Usually, the demand for a normal good goes
in the same direction with consumer‘s income i.e., demand
for normal goods is directly related to consumer‘s income.
Income Demand
1000 1
2000 2

b) Perishable goods: For perishable goods like foods, fruits, meat, vegetables, milk etc., whose
life is very short, the quantity demanded raises with an increase in income, but after a certain
level it remains constant even though the income raises.
Demand for
Income
milk in Kg.
1000 1
2000 2
3000 3
4000 4
5000 4

c) Inferior goods: The goods for which the demand decreases even though the income level
increases are inferior goods or cheap good or ordinary goods.
Demand for
Income (Rs.)
ordinary ice-cream
100 1
200 2
300 3
400 1

3. Prices of related goods:

In a given market, if the price of one good influences the quantity demanded
of another good, these two goods are said to be related goods. Two commodities in a given market are
related to each other either as Substitutes or Complementary goods.
a. Substitutes: When a want can be satisfied by alternative similar
goods, they are said to be substitutes to each other. Ex: Tea and
Coffee, Santhoor soap and Lux soap etc. The below graph
indicates that as the price of coffee increases, the demand for tea
increases.

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Price of Coffee (Rs.) Demand for Tea
5 50
6 80

There is direct relation between price of coffee and demand for Tea.

b. Complementary goods: When a want can be satisfied by two

or more goods in a combination. These goods are termed as
complementary goods. In other words, if the price of one good
increases, the demand for another good will decrease. Ex:
Bread and Butter, Pen and Ink, Car and Petrol, Sugar and Tea
and Shoe and Socks etc. The below table and graph indicate the
indirect relationship between price of one good and demand for
one good.
Price of Sugar (Rs.) Demand for Tea
30 50
50 20

4. Tastes and habits of the Consumers:

Irrespective of price of good and income levels of consumers, demand for many goods depends on
consumers‘ tastes and habits. For example, the demand for ice-creams, chocolates, alcohol, tea, cigarettes
etc depend on individual tastes and habits. In cases like, a strict vegetarian does not demand for meant at
any price, whereas a non-vegetarian will buy meat at any price.
5. Wealth:
The amount demanded of commodity is also affected by the amount of wealth as well as its distribution.
The wealthier are the people; higher is the demand for normal commodities. If wealth is more equally
distributed, the demand for necessaries and comforts is more. On the other hand, if some people are rich,
while the majorities are poor, the demand for luxuries is generally higher.
6. Population:
Increase in population increases demand for necessaries of life. The composition of population also
affects demand. Composition of population means the proportion of young and old and children as well as
the ratio of men to women. A change in composition of population has an effect on the nature of demand
for different commodities.
7. Government Policy:
Government policy affects the demands for commodities through taxation. Taxing a commodity increases
its price and the demand goes down. Similarly, financial help from the government increases the demand
for a commodity while lowering its price.
8. Expectations regarding the future prices and incomes:

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If consumers expect changes in price of commodity in future, they will change the demand at present
even when the present price remains the same. Similarly, if consumers expect their incomes to rise in the
near future they may increase the demand for a commodity just now.
9. Climate and weather:
The climate of an area and the weather prevailing there has a decisive effect on consumer‘s demand. In
cold areas woolen cloth is demanded. During hot summer days, ice is very much in demand. On a rainy
day, ice cream is not so much demanded.
10. State of business:
The level of demand for different commodities also depends upon the business conditions in the country.
If the country is passing through boom conditions, there will be a marked increase in demand. On the
other hand, the level of demand goes down during depression.
ELASTICITY OF DEMAND

Elasticity of demand explains the relationship between a change in price and consequent change in
amount demanded. ―Marshall‖ introduced the concept of elasticity of demand. Elasticity of demand
shows the extent of change in quantity demanded to a change in price.

Definition Of Elasticity Of Demand:

In the words of ―Marshall‖, ―The elasticity of demand in a market is great or small according as the
amount demanded increases much or little for a given fall in the price and diminishes much or little for a
given rise in Price‖

Elastic demand: A small change in price may lead to a great change in quantity demanded. In this case,
demand is elastic.

In-elastic demand: If a big change in price is followed by a small change in demanded then the demand
in ―inelastic‖.

TYPES OF ELASTICITY OF DEMAND:

There are four types of elasticity of demand:

1. Price elasticity of demand

2. Income elasticity of demand
3. Cross elasticity of demand
4. Advertisement elasticity of demand

I. Price elasticity of demand:

Marshall was the first economist to define price elasticity of demand. Price elasticity of demand measures
changes in quantity demand to a change in Price. It is the ratio of percentage change in quantity
demanded to a percentage change in price.

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Proportionate change in the quantity demand of commodity
Ep = Price elasticity =
Proportionate change in the price of commodity

Q2 − Q1 Q1 = Old demand
Q1 Q2 = New demand
E
P
= p1 = Old price
P2 − P1
P1 p2 = New price

There are five cases of price elasticity of demand

A. Perfectly elastic demand:

When small change in price leads to an infinitely large change is quantity demand, it is called perfectly or
infinitely elastic demand. In this case E=∞. Sometimes, even there is no change in the price, the demand
changes in huge quantity. In case of perfect elastic demand, the demand for a commodity changes even
though there is no change in price. This elasticity is very rarely found in practice. We can see a straight
line demand curve parallel to the X- axis.
Price Demand
10 100
10 1000

Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝑝 = (1000 − 100)/100 /(10 − 10)/10 = ∞

The demand curve is horizontal straight line. It shows the at Rs. 10 price
any quantity is demanded and if price increases, the consumer will not
purchase the commodity.

B. Perfectly Inelastic Demand

A commodity is said to have perfectly inelastic demand, when even a

large change in price of the commodity causes no change in the quantity
demanded. The elasticity coefficient of perfectly in elastic demand is E p =
0.

The shape of the demand curve for perfectly inelastic is vertical as shown below.

Price Demand
10 100
20 100
Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝑝 = (100 − 100)/100 /(20 − 10)/10 = 0

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When price increases from Rs. 10 to Rs.20, the quantity demanded remains the same. In other words the
response of demand to a change in Price is nil. In this case ‗E‘=0.

C. Relatively elastic demand:

Demand changes more than proportionately to a change in price. i.e. a

small change in price leads to a very big change in the quantity
demanded. In this case E > 1. This demand curve will be flatter.

Price Demand
10 300
15 100

Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝑝 = (100 − 300)/300 /(15 − 10)/10 = −1.34

When price increases from Rs.10 to Rs.15, quantity demanded decreases from 300units to 100units which
is larger than the change in price.

D. Relatively in-elastic demand.

Quantity demanded changes less than proportional to a change in price. A large change in price leads to
small change in quantity demanded. Here E < 1. Demanded carve will be
steeper.

Price Demand
10 100
15 80

Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝑝 = (80 − 100)/100 /(15 − 10)/10 = −0.40

When price increases from Rs.10 to Rs.15 quantity demanded decreases from
100units to units, which is smaller than the change in price.

E. Unitary elasticity of demand:

The change in demand is exactly equal to the change in price. When both
are equal, E=1 and elasticity is said to be unitary.

Price Demand
10 200
15 100

Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

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𝐸𝑝 = (100 − 200)/200 /(15 − 10)/10 = −1

When price increases from Rs.10 to Rs.15, quantity demanded decreases from 200units to 100units. Thus
a change in price has resulted in an equal change in quantity demanded so price elasticity of demand is
equal to unity.

II. Income elasticity of demand:

Income elasticity of demand shows the change in quantity demanded as a result of a change in income.
Income elasticity of demand may be slated in the form of a formula.

Proportionate change in the quantity demand of commodity

EI = Income Elasticity =
Proportionate change in the income of the people

Q2 − Q1
Q1
E
I
=
I2 − I1
I1
Q1 = Old demand Q2 = New demandI1 = Old income
I2 = New income

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III. Cross elasticity of Demand:

A change in the price of one commodity leads to a change in the quantity demanded of another
commodity. This is called a cross elasticity of demand. The formula for cross elasticity of demand is:

Proportionate change in the quantity demand of commodity ―X”

EC = Cross elasticity =
Proportionate change in the price of commodity ―Y”

a. In case of substitutes, cross elasticity of demand is positive. Eg: Coffee

and Tea

When the price of coffee increases, Quantity demanded of tea increases. Both
are substitutes.

b. In case of compliments, cross elasticity is negative. If an increase in the

price of one commodity leads to a decrease in the quantity demanded of another
and vice versa.

When price of car goes up, the quantity demanded of petrol decreases. The cross-
demanded curve has negative slope.

IV. Advertisement elasticity of demand:

It refers to increase in the sakes revenue because of change in the advertising expenditure. In other words,
there is a direct relationship between the amount of money spent on advertising and its impact on sales.
Advertising elasticity is always positive.

Proportionate change in the quantity demand of commodity

EA = Advertisement elasticity =

Proportionate change in advertisement costs

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SIGNIFICANCE / IMPORTANCE OF ELASTICITY OF DEMAND

(or)

ELASTICITY OF DEMAND IN DECISION-MAKING

The concept of elasticity is very useful to the producers and policy makers alike. It is very valuable tool to
decide the extent of increase or decrease in price for a desired change in the quantity demanded for the
products and services in the firm or the economy. The practical importance of this concept will be clear
from the following application.

1. Price fixation:

A knowledge of elasticity of demand may help the businessman to make a decision whether to cut or
increase, the price of his product or to shift the burden of any additional cost of production on to the
consumers by charging high price. Each seller under monopoly and imperfect competition has to take into
account elasticity of demand while fixing the price for his product. If the demand for the product is
inelastic, he can fix a higher price.

2. Production:

The elasticity of demand helps the businessman to decide about production. A businessman choose the
optimum product mix on the basis of elasticity of demand for various products. The products having more
elastic demand are preferred by the businessman. The sale of such products can be increased with a little
reduction in their prices. Hence elasticity of demand helps the producers to take correct decision
regarding the level of output to be produced.

3. prices of factors of production:

A factor with an inelastic demand can always command a higher price as compared to a factor relatively
elastic demand. This helps the trade unions in knowing that where they can easily get the wage rate
increased. Bargaining capacity of trade unions depend upon elasticity of demand for workers services.
Elasticity of demand also helps in the determination of rewards for factors of production. For example, if
the demand for labour is inelastic, trade unions will be successful in raising wages. It is applicable to
other factors of production.

4. International Trade:

Elasticity of demand helps in finding out the terms of trade between two countries. Terms of trade refers
to the rate at which domestic commodity is exchanged for foreign commodities. Terms of trade depends
upon the elasticity of demand of the two countries for each other goods. A country will benefit from
international trade when it fixes lower price for exports items whose demand is price elastic and high
price for those exports whose demand is inelastic. The demand for imports should be elastic for a fall in
price and inelastic for raise in price. The terms of trade between the two countries also depends upon the

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elasticity of demand of exports and imports. If the demand is inelastic, the terms of trade will be in favour
of the seller country. If the demand is elastic, the terms of trade will be in favour of the buyer country.

5. Tax policies:

The government can impose higher taxes and collect more revenue if the demand for the commodity on
which a tax is to be levied is inelastic. On the other hand, in case of a commodity with elastic demand
high tax rates may fail to bring in the required revenue for the government. Elasticity of demand helps the
government in formulating tax policies. For example, for imposing tax on a commodity, the Finance
Minister has to take into account the elasticity of demand.

6. Nationalization of public utilities:

The nationalization of public utility services can also be justified with the help of elasticity of demand.
Demand for public utilities such as electricity, water supply, post and telegraph, public transportation etc.,
is generally inelastic in nature. If the operation of such utilities is left in the hands of private individuals,
they may exploit the consumers by charging high prices. Therefore, in the interest of general public, the
government owns and runs such services.

DEMAND FORECASTING

Forecasting is predicting or expecting the needs of the consumers in future. Forecasting the demand for its
products is the essential function for an organization irrespective of its nature. Forecasting customer
demand for products and services is a proactive process of determining what products are needed, where,
when and in what quantities. So, demand forecasting is a customer focused activity. It supports other
planning activities such as capacity planning, inventory planning and even overall business planning.
Many organizations follow it as a custom to completely and accurately forecast the demand of its
products regularly. Demand forecasting is not helpful at the firm level but also at national level. The need
for demand forecasting arises due to the following purposes.

 It serves as a road map for production plans.

 It plays a significant role in situations of uncertain production or demand.
 It facilitates the managers to line up their business activities.
 It is a basis for export and import policy and fiscal policy.
 It can help businessman to take decisions regarding inputs of production process such as labor,
capital etc.

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METHODS OF FORECASTING:

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Several methods are employed for forecasting demand. All these methods can be grouped under survey
method, statistical method and other methods. Survey methods and statistical methods are further
subdivided in to different categories.

I. Survey Method:
A. Survey of buyers intention:

To anticipate what buyers are likely to do under a given set of circumstances, a most useful source of
information would be the buyers themselves. It is better to draw a list of potential buyers. Approach each
buyer to ask how much does he plans to buy of the given product at a given point of time under particular
conditions.

1. Census method:

If the company wishes to elicit the opinion of all the buyers, this method is called census method. This
method is not only time-consuming but also costly. Suppose there are 10,000 buyers for a particular
product. if the company gets the opinion of all these ten thousand customers, this method is known as
census method.

2. Sample method:

If the company selects a group of buyers who can represent the whole population, this method is called
the sample method. A survey of buyers based on sample basis can be completed faster with relatively
lower cost. Normally a questionnaire is designed to elicit the information. There are specialized
organizations to collect the information from the potential buyers, ex: ORG-Marg. Etc.

B. Sales force opinions:

The sales people are those who are in constant touch with the main and large buyers of a particular
market, and hence they constitute anther valid source of information about the likely sales of a product.
the sales force is capable of assessing the likely reactions of the customers of their territories quickly,
given the company‘s strategy. It is less costly as the survey can be conducted instantaneously through
telephone, fax or video-conference, and so on. The data thus collected, forms another valid source of
reliable information.

II. Statistical Methods:

Statistical method is used for long run forecasting. In this method, statistical and mathematical techniques
are used to forecast demand. This method relies on post data.

A. Trend projection methods

1. Trend line by observation:

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This method of forecasting trend is elementary, easy and quick as it involves merely the plotting the
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 read from the graph.

2. Least squares method:

Here, certain statistical formulas are used to find the trend line which best fits the available data. It is
assumed that there is a proportional change in sales over period of time. In such a case, the trend line
equation is in linear form.

The estimating linear trend equation of sales is written as: S = x + y(T), where x and y have been
calculated form past data, S is sales and T is the year number for which the forecast is made. To find the
values of x and y, the following equations have to be used.

ΣS = Nx + yΣT
ΣST = xΣT + yΣT2
Where S is the sales; T is the year number, N= number of years.

3. Times series analysis:

Time series forecasting is the use of a model to predict future values based on previously observed values.
The first step in making estimates for the future consists of gathering information from the past. In this
connection one usually deals with statistical data which are collected, observed or recorded at successive
intervals of time. Such data are generally referred to as time series. Thus when we observe numerical data
at different points of time the set of observations is known as time series. It may be noted that any or all
of the components may be present in any particular series. The components are Secular trend(Long term
trend), Seasonal trend , Cyclical trend (periods in the business cycle such as prosperity, decline,
depression, improvement), Irregular trend(also called as erratic or accidental or random variations in
business). From the following equation future sales can be measured. The constants T,S,C,I. are
calculated from past data.
Y = Future sales
T = Secular trend
Y=T+ S+ C+ I S = Seasonal trend
C = Cyclical trend
4. Moving average method: I = Irregular trend

This method considers that the average of past events determine the future events. As the name itself
suggests, under this method, the average keeps on moving depending up on the number of years selected.
This method is easy to compute.

5. Exponential Smoothing

It is the most popular technique used for short-run forecasts. Unlike in moving average method, in this
method, all time periods are given varying weights. Recent values are given higher weights and distance
past values are given lower values. The reason is that the recent past reflects more in nearest future.

The following formula is used for exponential smoothing.

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If α is higher, higher weight is given to the most recent information. α is calculated on the basis of
past data. If there were fluctuations in past data, the α value is high.
C. Barometric techniques:

Under the barometric technique, one set of data is used to predict another set. In other words, to forecast
demand for a particular product or service, use some other relevant indicator (which is known as
barometer) of future demand. Ex: The demand for cable TV may be linked to the number of new houses
occupied in a given area or demand for new houses in a particular area.

D. Correlation and Regression method:

Correlation and regression methods are statistical techniques. 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
independent. If the high values of one variable are associated with the high values of another, they are
said to be 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. Correlation coefficient ranges between
+1 and -1. When the correlation coefficient is zero, it indicates that the variables under study are not
related at all.

In regression analysis, an equation is estimated which ‗best fits‘ in the sets of observations of dependent
variables and independent variables. The best estimate if the true underlying relationship between these
variables is thus generated. The dependent (unknown) variable is then forecast based on this estimated
equation, for a given value of the independent (known) variable. With the help of the following equation
future sales can be calculated. Y = Dependent variable
X = Independent variable
Y = a + bX a & b = Constants

a & b values can be calculated with the following equations.

ΣY = Na + bΣX
ΣXY = aΣX + bΣX2
III. Other Methods
a) Experts opinion:

Well-informed persons are called experts. Experts constitute yet another source of information. These
persons are generally the outside experts and they do not have any vested interests in the results of a
particular survey.

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 b) Test marketing:

It is likely that opinions given by buyers, salesmen or other experts may be, at times, misleading. This is
the reason why most of the manufacturers favour to test their product or service in a limited market as
test-run before they launch their products nationwide. Based on the results of test marketing, valuable
lessons can be learnt on how consumers react to the given product and necessary changes can be
introduced to gain wider acceptability. To forecast the sales of a new product or the likely sales of an
established product in a new channel of distribution or territory, it is customary to find test marketing in
practice.

c) Controlled experiments:

Controlled experiments refer to such exercises where some of the major determinants of demand are
manipulated to suit to the customers with different tastes and preferences, income groups, and such
others. It is further assumed that all other factors remain the same. In this method, the product is
introduced with different packages, different prices in different markets or same markets to assess which
combination appeals to the customer most.

d) Judgment approach:

When none of the above methods are directly related to the given products or services, the management
has no alternative other than using its own judgment.

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 UNIT - III
MARKET
Market is a place where buyer and seller meet, goods and services are offered for the sale and transfer of
ownership occurs. A market may be also defined as the demand made by a certain group of potential buyers for
a good or service. The former one is a narrow concept and later one is a broader concept. Economists describe a
market as a collection of buyers and sellers who transact over a particular product or product class (the housing
market, the clothing market, the grain market etc.). For business purpose we define a market as people or
organizations with wants (needs) to satisfy, money to spend, and the willingness to spend it. Broadly, market
represents the structure and nature of buyers and sellers for a commodity/service and the process by which the
price of the commodity or service is established. In this sense, we are referring to the structure of competition
and the process of price determination for a commodity or service. The determination of price for a commodity
or service depends upon the structure of the market for that commodity or service (i.e., competitive structure of
the market). Hence the understanding on the market structure and the nature of competition are a pre-requisite
in price determination.
Different Market Structures
Market structure describes the competitive environment in the market for any good or service. A market
consists of all firms and individuals who are willing and able to buy or sell a particular product. This includes
firms and individuals currently engaged in buying and selling a particular product, as well as potential entrants.
The determination of price is affected by the competitive structure of the market. This is because the firm
operates in a market and not in isolation. In making decisions concerning economic variables it is affected, as
are all institutions in society by its environment.

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 PERFECT COMPETITION
Perfect competition refers to a market structure where competition among the sellers and buyers prevails in its
most perfect form. In a perfectly competitive market, a single market price prevails for the commodity, which is
determined by the forces of total demand and total supply in the market.
Characteristics Of Perfect Competition
The following features characterize a perfectly competitive market:
a) A large number of buyers and sellers: The number of buyers and sellers is large and the share of each
one of them in the market is so small that none has any influence on the market price.
b) Homogeneous product: The product of each seller is totally undifferentiated from those of the others.
c) Free entry and exit: Any buyer and seller is free to enter or leave the market of the commodity.
d) Perfect knowledge: All buyers and sellers have perfect knowledge about the market for the
commodity.
e) Indifference: No buyer has a preference to buy from a particular seller and no seller to sell to a
particular buyer.
f) Non-existence of transport costs: Perfectly competitive market also assumes the non-existence of
transport costs.
g) Perfect mobility of factors of production: Factors of production must be in a position to move freely
into or out of industry and from one firm to the other.
Perfect competition: The individual firm
AR(Average revenue) curve and MR(Marginal Revenue) curve under perfect competition becomes equal to
D(Demand) curve and it would be a horizontal line or parallel to the X-axis. The curve simply implies that a
firm under perfect competition can sell as much quantity as it likes at the given price determined by the industry
i.e. a perfectly elastic demand curve.

Perfect competition: The firm and the industry

Price is determined by the market forces, that is, demand and supply for a given product or service. As
discussed above, firms have no control over the prices they charge for their products. The ultimate price that
determines the quantity demanded is equal to the quantity supplied. This price is also called equilibrium price,
as it balances the forces of demand and supply. The figure shows how the price is determines. DD is the
demand curve and SS is the supply curve. Rs. 6 is the price at which DD and SS intersect each other. At Rs. 6,
60 units are supplied and demanded.
If the price increases to Rs.8, supply will also increase and hence the price is likely to fall down.

37
If the price decreases to Rs. 4, supply will decrease and hence the price is likely to go up.

Price-Output Determination Under Perfect Competition

In this market, the price is determined by supply and demand forces. Marshal who propounded the theory says
that the price is determined by the equilibrium between demand and supply.
The pricing of commodity under perfect competition can be determined
in three periods of time.
a) Very short period (Market Period)
Market period is too short period to increase the supply. The market
period is so short that supply of the commodity is limited to existing stock.
During the market period, say a single day, the supply of a commodity is
perfectly inelastic.
In this figure quantity is represented along X-axis and price is
represented along Y-axis. MS is the very short period supply curve. DD is
demand curve. It intersects supply curve at E. The price is OP. The quantity is OM. D1 D1 represents increased
demand. This curve cuts the supply curve at E1. Even at the new equilibrium, supply is OM only. But price
increases to OP1. So, when demand increases, the price will increase but not the supply. If demand decreases
new demand curve will be D2 D2. This curve cuts the supply curve at E2. Even at this new equilibrium, the
supply is OM only. But price falls to OP2. Hence in very short period, given the supply, it is the change in
demand that influences price. The price determined in a very short period is called Market Price.
b) Short Period
Short period is not too long period to install new capital
equipments. It is also not sufficient period to permit the new firms to enter
the industry to increase the supply of the commodity in the market. Hence
the firm can increase the supply of a commodity in the short period only
by making intensive use of the given plants and equipments and
increasing the units of variable factors.
As a result of this, the short period supply of a commodity will be
relatively less elastic.

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In the diagram MS is the market period supply curve. DD is the initial demand curve. It intersects MS curve at
E. The price is OP and output OM. Suppose demand increases, the demand curve shifts upwards and becomes
D1D1. In the very short period, supply remains fixed on OM. The new demand curve D1D1 intersects MS at
E1. The price will rise to OP1. This is what happened in the very short-period.
As the price rises from OP to OP1, firms expand output. As firms can vary some factors but not all, the law of
variable proportions operates. This results in new short-run supply curve SS. It interests D1 D1 curve at E2. The
price will fall from OP1 to OP2.
c) Long Period
In Long run, the Firm‟s output (supply) can be changed by both the
variable factors and fixed factors i.e. all factors become variable.
There is enough time for new Firms to enter the Industry. Further, if
the demand is increased, the supply can be increased or decreased
according to the demand. For Long run equilibrium, long run marginal
cost (LMC) is equal to MR and LMC curve cut the MR curve from
below. In case of long run equilibrium, all the firms will earn only
normal profits.
Take the case when the Firm earn super-normal profit-Then the existing Firm will increase their production and
new Firm will enter the Industry. Consequently, the total supply will increase and price fall down and further
results in normal profit for the firm
On the contrary, if the firm is incurring losses, Then some Firm will leave the Industry which will reduce the
total supply. And due to decrease in supply, price will rise and once again Firm will begin to earn normal profit.
Firm equilibrium is at the minimum point of its LAC and at this point the Firm will get the normal profits. If
AR (price) rises to OP1, then Firm‟s LMC cuts its MR1 at E1 and the firm gets super-normal profit but again
come to OP yielding normal profits as stated before. And at price OP 2, firm incurs losses but again rise to level
OP to maintain the equilibrium at normal profit
Firm‟s equilibrium: MC=MR=AR= min LAC
MONOPOLY
„mono‟ means single and „poly‟ means seller. The term monopoly refers to that market in which a single firm
controls the whole supply of a particular product which has no close substitutes. Monopoly emerges in firms
such as transport, water and electricity supply etc.
Features:
1. Single person or a firm: A single person or a firm controls the total supply of the commodity. There
will be no competition for monopoly firm. The monopolist firm is the only firm in the whole industry.
2. No close substitute: The goods sold by the monopolist shall not have close substitutes. Even if price of
monopoly product increases, people will not go in far substitute. For example: If the price of electric
bulb increases slightly, consumer will not go in for kerosene lamp.
3. Large number of Buyers: Under monopoly, there may be a large number of buyers in the market who
compete among themselves.
4. Price Maker: Since the monopolist controls the whole supply of a commodity, he is a price-maker, and
then he can alter the price.

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 5. Supply and Price: The monopolist can fix either the supply or the price. He cannot fix both. If he
charges a very high price, he can sell a small amount. If he wants to sell more, he has to charge a low
price. He cannot sell as much as he wishes for any price he pleases.
6. Downward Sloping Demand Curve: The demand curve (average revenue curve) of monopolist slopes
downward from left to right. It means that he can sell more only by lowering price.

Monopoly refers to a market situation where there is only one seller. He has complete control over the supply of
a commodity. He is therefore in a position to fix any price. Under monopoly there is no distinction between a
firm and an industry. This is because the entire industry consists of a single firm.
Being the sole producer, the monopolist has complete control over the supply of the commodity. He has also the
power to influence the market price. He can raise the price by reducing his output and lower the price by
increasing his output. Thus he is a price-maker. He can fix the price to his maximum advantages. But he cannot
fix both the supply and the price, simultaneously. He can do one thing at a time. If he fixes the price, his output
will be determined by the market demand for his commodity. On the other hand, if he fixes the output to be
sold, its market will determine the price for the commodity. Thus his decision to fix either the price or the
output is determined by the market demand.
The market demand curve of the monopolist (the average revenue curve) is downward sloping. Its
corresponding marginal revenue curve is also downward sloping. But the marginal revenue curve lies below the
average revenue curve as shown in the figure. The monopolist faces the down-sloping demand curve because to
sell more output, he must reduce the price of his product. The firm‟s demand curve and industry‟s demand
curve are one and the same. The average cost and marginal cost curve are U shaped curve. Marginal cost falls
and rises steeply when compared to average cost.
Under monopoly, demand curve is average revenue curve.

Price-Output Determination Under Monopoly

The monopolistic firm attains equilibrium when its marginal cost becomes
equal to the marginal revenue. The monopolist always desires to make
maximum profits. He makes maximum profits when MC=MR. He does not
increasing his output if his revenue exceeds his costs. But when the costs
exceed the revenue, the monopolist firm incur loses. Hence the monopolist
curtails his production. He produces up to that point where marginal cost is
equal to the marginal revenue (MR=MC). Thus, the point is called equilibrium
point. The price output determination under monopoly may be explained with
the help of a diagram.

40
In the diagram, the quantity supplied or demanded is shown along X-axis. The cost or revenue is shown along
Y-axis. AC and MC are the average cost and marginal cost curves respectively. AR and MR curves slope
downwards from left to right. AC and MC are U shaped curves. The monopolistic firm attains equilibrium
when its marginal cost is equal to marginal revenue (MC=MR). Under monopoly, the MC curve may cut the
MR curve from below or from a side. In the diagram, the above condition is satisfied at point E. At point E,
MC=MR. The firm is in equilibrium. The equilibrium output is OM. Up to OM output, MR is greater than MC
and beyond OM, MR is less than MC. Therefore, the monopolist is will be in equilibrium at output OM where
MR=MC and profits are maximized.
The above diagram (Average revenue) = MQ or OP
Average cost = MR
Profit per unit = Average Revenue-Average cost=MQ-MR=QR
Total Profit = QR x SR=PQRS
If AR > AC; Abnormal or super normal profits.
If AR = AC; Normal Profit
If AR < AC ; Loss
MONOPOLISTIC COMPETITION
Perfect competition and pure monopoly are rare phenomena in the real world. Instead, almost every market
seems to exhibit characteristics of both perfect competition and monopoly. Hence, in the real world, it is the
state of imperfect competition lying between these two extreme limits that work. Edward. H. Chamberlain
developed the theory of monopolistic competition, which presents a more realistic picture of the actual market
structure and the nature of competition.
Features/Characteristics
The important characteristics of monopolistic competition are:
1. Existence of Many firms: Industry consists of a large number of sellers, each one of whom does not
feel dependent upon others. Every firm acts independently without bothering about the reactions of its
rivals. The size is so large that an individual firm has only a relatively small part in the total market, so
that each firm has very limited control over the price of the product. As the number is relatively large, it
is difficult for these firms to determine its price- output policies without considering the possible
reactions of the rival forms. A monopolistically competitive firm follows an independent price policy.
2. Product Differentiation: product differentiation is the essential feature of monopolistic competition.
Products can be differentiated by means of unique facilities, advertising, brand loyalty, packing,
pricing, terms of credit, superior maintenance service, convenient location and so on. Through heavy
advertisement budgets, Pepsi and Coca-Cola make it very expensive for a third competitor to enter the
cola market on such a big scale. The following example illustrate how the firms differentiate
themselves from others in a monopolistic environment.
 In hotel industry, some hotels have spacious swimming pools, gyms, cultural programs etc. The
customers who value these facilities don‟t bother about price changes.
 The colleges who provide best infrastructure and placements in various reputed companies
have demand from the student community irrespective of an increase in tuition fee.
 Cell phones which have unique features have demand from the public even price increases.

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 3. Large Number of Buyers: There are large number of buyers in the market. But the buyers have their
own brand preferences. So, the sellers are able to exercise a certain degree of monopoly over them.
Each seller has to plan various incentive schemes to retain the customers who patronize his products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the monopolistic competition too,
there is freedom of entry and exit. That is, there is no barrier as found under monopoly.
5. Selling costs: Since the products are close substitutes, much effort is needed to retain the existing
consumers and to create new demand. So, each firm has to spend a lot on selling cost, which includes
cost on advertising and other sale promotion activities.
6. Imperfect Knowledge: Imperfect knowledge about the product leads to monopolistic competition. If
the buyers are fully aware of the quality of the product, they cannot be influenced much by
advertisement or other sales promotion techniques.
7. The Group: Under perfect competition, the term industry refers to all collection of firms producing a
homogenous product. But under monopolistic competition, the products of various firms are not
identical though they are close substitutes.
Price – Output Determination Under Monopolistic Competition
Under monopolistic competition, Since different firms produce different varieties of products, different
prices for them will be determined in the market depending upon the demand and cost conditions. Each firm
will set the price and output of its own product. Here also the profit will be maximized when marginal revenue
is equal to marginal costMR=MC. The demand curve for the firm in case of monopolistic competition is just
similar to that of monopoly.
The degree of elasticity of demand of a firm in monopolistic competition depends upon the extent to
which the firm can resorts to product differentiation. The greater the ability of the firm to differentiate the
product, the less elastic the demand is. The firm‟s influence to increase the price depends upon the extent to
which it can differentiate the product.
a) Short-run
In the short-run, the firm is in equilibrium when marginal Revenue =
Marginal Cost. In the figure, AR is the average revenue curve. MR
marginal revenue curve, MC marginal cost curve, AC average cost curve,
MR and MC interest at point E where output is OM and price MQ (i.e.
OP). Thus, the equilibrium output is OM and the price is MQ or OP. When
the price (average revenue) is above average cost, a firm will be making
supernormal profit. From the figure it can be seen that AR is above AC in
the equilibrium point. As AR is above AC, this firm is making abnormal
profits in the short-run. The abnormal profit per unit is QR, i.e., the
difference between AR and AC at equilibrium point and the total supernormal profit is OR x OM. This total
abnormal profits is represented by the rectangle PQRS. The firm may make supernormal profits in the short-run
if it satisfies the following two conditions.
a) MR = MC
b) AR > AC
b Long–run

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More and more firms will be entering the market having been attracted by
supernormal profits enjoyed by the existing firms in the industry. As a result,
competition become s intensive on one hand, forms will compete with one
another for acquiring scare inputs pushing up the prices of factor inputs. On
the other hand, on the entry of several firms, the supply in the market will
increase, pulling down the selling price of the products. In order to cope with
the competition, the firms will have to increase the budget on advertising. The
entry of new firms continue till the supernormal profits of the firms completely eroded and ultimately firms in
the industry will earn only normal profits. Those firms which are not able to earn at least normal profits will get
closed. Thus in the long-run, every firm in the monopolistic competitive industry will earn only normal profits,
which are just sufficient to stay in the business. It is be noted that normal profits are part of average costs.
In the long-run, in order to achieve equilibrium position, the firm has to fulfill the following conditions:
a) MR = MC
b) AR = AC at the level of equilibrium level of output.
OLIGOPOLY
The term oligopoly is derived from two Greek words, oligos meaning a few, and pollen meaning to sell.
Oligopoly is the form of imperfect competition where there are a few sellers in the market, producing either a
homogeneous product or producing products, which are close but not perfect substitute of each other.
Features
1. Monopoly Power:
There is a clement of monopoly power in oligopoly. Since there are only a few firms and each firm has
a large share of the market. In its share of the market, it controls the price and output. Thus an
oligopoly has some monopoly power.

2. Interdependence of Firms:
Under oligopoly, there are only a few firms, each producing a homogeneous or slightly differentiated
product. Since the number of firms is small, each firm enjoys a large share of the market and has a
significant influence on the price and output decisions. Thus, there is interdependence of firms. No firm
can ignore the actions and reactions of rival firms under oligopoly.

3. Conflicting Attitude of Firms:

Under oligopoly, two types of conflicting attitudes are found in the firms. On the one hand, firms
realize the disadvantages of mutual competition and desire to combine to maximize their joint profits.
This tendency leads to the formation of collusion. On the other hand, the desire to maximize one‟s
individual profit may lead to conflict and antagonism; the firms come into clash with one another on
the question of distribution of profits and allocation of markets. Thus, there is an existence of two
opposing attitudes among the firms.

4. Few firms. In this market, only few sellers are found:

For example, the market for automobiles in India exhibits oligopolistic structure as there are only few
producers of automobiles. If there are only two firms, it is called „duopoly‟.

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 5. Nature of product:
If the firms product homogeneous product, it becomes pure oligopoly. The firms with product
differentiation constitute impure oligopoly.

6. Interdependence among firms:

In oligopoly market, each firm treats the other as its rival firm. It is for this reason that each firm while
determining price of its product, takes into account the reaction of the other firms to its own action.

7. Large number of consumers:

In this market, there are large numbers of consumers to demand the product.

TYPES OF PRICING
Firms set prices for their products through several alternative means. The important pricing methods followed
in practice are shown in the chart.

A. Cost Based Pricing

1. Full cost pricing:-Under this method, price is just equal to the average cost.
2. Cost plus pricing:- Here, the average cost is ascertained and then a conventional margin added to the
cost to arrive at the price. In other words, find out the product unit‟s total cost and add a percentage of
profit to arrive at the selling price. It is commonly followed in departmental stores and other retail
shops. This method is simple to be administered. It may be very difficult to find the selling price in
advance due to complexity of the nature of the project.
3. Marginal cost pricingBreak even pricing or Target profit pricing:- In this method, selling price is
fixed in such a way that it covers full variable or marginal cost and contributes towards recovery of
fixed costs. in the stiff competition, marginal cost offers a guidelines as to how far the selling price can
be lowered.
B. Competition based pricing
Here the price of product is set based on what the competitor charges for a similar product. In other words, a
reduction in the price of products by the competitor will force us to follow suit. In such a case, how far we can
go on reducing the price?. Here the marginal cost concept comes handy. As long as the price covers the
marginal cost, continue to sell. If not, better stop selling. It is because, every unit sold at less than marginal cost
results in loss.

44
 1. Sealed bid pricing:- This method is more popular in tenders and contracts. Each contracting firm
quotes its price in a sealed cover called “tender”. All the tenders are opened on a scheduled date and the
person who quotes the lowest price is awarded the contract.
2. Going rate pricing:- Here the prevailing market price is charged. Suppose, when one wants to buy or
sell gold, the prevailing market rate at a given point of time is taken as the basis to determine the price.
C. Demand Based Pricing
1. Perceived value pricing:- This method considers the buyer‟s perception of the value of the product as
the basis of pricing. Here the pricing rule is that the firm must develop procedures for measuring the
relative value of the product as perceived by consumers.
2. Price discriminationDifferential pricing:- Price discrimination refers to the practice of charging
different prices to customers for the same good. In involves selling a product or service for different
prices in different market segments. Price differentiation depends on geographical location of the
consumers, type of consumer, purchasing quantity, season, time of the service etc. E.g. Telephone
charges, APSRTC charges.
D. Strategy based pricing
1. Skimming pricing:- The company follows this method when the product is for the first time
introduced in the market. Under this method, the company fixes a very high price for the product. this
strategy is mostly found in case of technology products. When Samsung introduces a new cell phone
model, it fixes a high price because of the uniqueness of the product.
2. Penetration pricing:- This is exactly opposite to the market skimming method. Here, a low price is
fixed for the product in order to catch the attention of consumers, once the product image and
credibility is established, the seller slowly starts jacking up the price to reap good profits in future. The
Rin washing soap perhaps falls into this category. This soap was sold at a rather low price in the
beginning and the firm even distributed free samples. Today, it is quite an expensive brand and yet it is
selling very well.
3. Two-part pricing:- Under this strategy, a firm charges a fixed fee for the right to purchase its goods,
plus a per unit charge for each unit purchased. Entertainment houses such as country clubs, athletic
clubs, etc, usually adopt this strategy. They charge a fixed initiation fee or membership fee plus a
charge, per month or per visit, to use the facilities.
4. Block pricing:- We see block pricing in our day-to-day life very frequently. Four Santhoor soaps in a
single pack with nice looking soap box or five Maggi packets in a single pack with an attractive bowl
indicate this pricing method. The total value of the goods includes consumer‟s surplus as the consumer
is given soap box and bowl along with the products freely. By selling certain number of units of a
product as one package, the firm earns more than by selling unit wise.
5. Commodity bundling:- Commodity bundling means the practice of bundling two or more different
products together and selling them at single „bundle price‟. For example tourist companies offer the
package that includes the travelling charges, hotel, meals and sight-seeing etc, at a bundle price instead
of pricing each of these services separately.

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 6. Peak load pricing:- Under this method, high price is charged during the peak times than off-peak
times. RTC increases charges during festivals, Railways charge more fares during tatkal time. During
seasonal period when demand is likely to be higher, a firm may increase profits by peak load pricing.
7. Cross subsidization:- The process of charging high price for one group of customers in order to
subsidize another group.
8. Transfer pricing:- Transfer pricing means a price at which one process forwards their outputwork-in-
progress to the next process for further processing. It is an internal pricing technique.

PRODUCT LIFE CYCLE BASED PRICING

Companies must adapt to the stages of the product life cycle to effectively sell and promote their products.
Depending on the product life cycle stage, a company will develop branding techniques and an appropriate
pricing model. Understanding each stage helps businesses increase profits.

The stages of a product life cycle govern how a product is priced, distributed, and promoted. A new product
goes through multiple stages during the course of its life cycle, including an introduction stage, growth stage,
maturity stage and a decline stage. As a product ages, companies look for new ways to brand it, and
also explore pricing changes. Market and competitor research help businesses assess the proper course of action
to maintain product profitability.

Introduction Stage
A new product may simply be either another brand name added to the existing ones or an altogether new
product. Pricing a new brand for which there are many substitutes available in market is not a big problem as
pricing a new product for which close substitutes are not available.
There are two type of pricing strategies for new product.
1. Skimming price policy:- Selling a product at a high price, sacrificing high sales to gain a high profit,
therefore „skimming‟ the market. Usually employed to reimburse the cost of investment of the original
research into the product - commonly used in electronic markets when a new range, such as DVD players,
are firstly dispatched into the market at a high price.
2. Penetration price policy:- This pricing policy is adopted generally in the case of new product for which
substitutes are available. This policy requires fixing a lower initial price designed to penetrate the market as
quickly as possible.

Growth Stage

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During the growth stage, a company aims to develop brand recognition and increase their customer base. The quality
of their product is often improved based on early reviews, and technical support is usually enhanced. Pricing remains
generally stable as demand continues with minimal competition. A larger distribution network is formed to keep up
with the pace of demand.
Maturity Stage
In the maturity stage, the steady sales start to decline and companies face greater challenges in the marketplace.
Competitors will often introduce rival products with the intent of grabbing some of the market share. This is the
product life cycle stage in which the customer base is heavily fought over and price decreases most often occur.
Additional features are added to distinguish a product from its competitors. Companies run promotions during this
stage that highlight the primary differences between their product and their competitor‟s products.

Decline Stage
In the decline stage, a company will make important decisions regarding the future of their product. They can choose
to create new iterations of the product with new features, or they can reduce the price and offer it at a discount. A
company may choose to discontinue the product altogether, either disposing of their inventory or selling it to another
company who is willing to manufacture and market it. Promotion at this stage will depend on whether a company
chooses to continue its product, and how they plan to re-market it.

INTRODUCTION TO ACCOUNTING

The purpose of any business is to make profits for that some business activities are to be conducted.
You may involve in transactions daily. Any human activity directed at making profit is called business.
Business is of different types. It may be trading activity or manufacturing activity. Business may require
capital which may be owner‟s capital and borrowed capital. Transactions involve exchange of value like
purchase of goods, sale of goods for cash or credit and payment of expenses in the course of production
and distribution.

History of Accounting:

Accounting is as old as civilization itself. From the ancient relics of Babylon, it can be will
proved that accounting did exist as long as 2600 B.C. However, in modern form accounting based on
the principles of Double Entry System came into existence in 17th Century. Fra Luka Paciolo, a
mathematician published a book De computic et scripturies in 1494 at Venice in Italy. This book was
translated into English in 1543. In this book he covered a brief section on „book-keeping‟.

Origin of Accounting in India:

Accounting was practiced in India thousand years ago and there is a clear evidence for this. In

47
his famous book Arthashastra Kautilya dealt with not only politics and economics but also the art of
proper keeping of accounts. However, the accounting on modern lines was introduced in India after
1850 with the formation joint stock companies in India.

Accounting in India is now a fast developing discipline. The two premier Accounting Institutes in India
viz., chartered Accountants of India and the Institute of Cost and Works Accountants of India are
making continuous and substantial contributions. The international Accounts Standards Committee
(IASC) was established as on 29th June. In India the „Accounting Standards Board (ASB) is formulating
„Accounting Standards‟ on the lines of standards framed by International Accounting Standards
Committee.\

BOOK-KEEPING AND ACCOUNTING

Book – Keeping: Book – Keeping involves the chronological recording of financial transactions in a
set of books in a systematic manner.

48
Accounting: Accounting is concerned with the maintenance of accounts giving stress to the design of
the system of records, the preparation of reports based on the recorded date and the interpretation of the
reports.

DIFFERENCE BETWEEN BOOK-KEEPING AND ACCOUNTING:

BOOK-KEEPING ACCOUNTING

Concerned with recording of Concerned with classifying, summarizing, analyzing and

1
transactions interpreting the data and communicating to the end users

Book-keeper maintains the

2 Accountant maintains the accounts of whole organization
accounts of particular section

He works under an accountant 3 He directs and reviews the work of book-keeper

He has higher level of knowledge, conceptual

He has limited knowledge 4
understanding, analytical skills

His work is clerical in nature 5 His work is executive in nature

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 SYSTEMS OF BOOK-KEEPING:

1. Single entry system

 It is incomplete system of double entry system.
 Only cash and personal accounts are maintained.
2. Double entry system
 It is only the system that records two aspects of a transaction.
 In this system, the transactions are recorded with the help of “Debit-Credit rules”.

Definition of Accounting:

American Institute of Certified Public Accountants (AICPA): “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.”

Thus, accounting is an art of identifying, recording, summarizing and interpreting business transactions
of financial nature. Hence accounting is the Language of Business.

1. Cash system: Only cash related transactions are recorded. Usually, Government and some
professionals use this type of accounting system. Receipts and payments account is prepared. It does not
present true picture of the financial position of a company.

2. Accrual system: It is also known as mercantile system of accounting. It considers outstanding

expenses and incomes It provides clear picture of financial position of a firm. Company‟s Act
recommended this system to all companies.

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 BRANCHES OF ACCOUNTING

The important branches of accounting are:

1. Financial Accounting: The purpose of Accounting is to ascertain the financial results i.e. profit or
loass in the operations during a specific period. It is also aimed at knowing the financial position, i.e.
assets, liabilities and equity position at the end of the period. It also provides other relevant information
to the management as a basic for decision-making for planning and controlling the operations of the
business.

2. Cost Accounting: The purpose of this branch of accounting is to ascertain the cost of a product /
operation / project and the costs incurred for carrying out various activities. It also assist the
management in controlling the costs. The necessary data and information are gatherr4ed form financial
and other sources.

3. Management Accounting : Its aim to assist the management in taking correct policy decision and to
evaluate the impact of its decisions and actions. The data required for this purpose are drawn accounting
and cost-accounting.

FUNCTIONS OF AN ACCOUNTANT

The job of an accountant involves the following types of accounting works :

1. Designing Work : It includes the designing of the accounting system, basis for identification and
classification of financial transactions and events, forms, methods, procedures, etc.

2. Recording Work : The financial transactions are identified, classified and recorded in appropriate
books of accounts according to principles. This is “Book Keeping”. The recording of transactions tends
to be mechanical and repetitive.

3. Summarizing Work : The recorded transactions are summarized into significant form according to
generally accepted accounting principles. The work includes the preparation of profit and loss account,
balance sheet. This phase is called „preparation of final accounts‟

4. Analysis and Interpretation Work: The financial statements are analysed by using ratio analysis,
break-even analysis, funds flow and cash flow analysis.

5. Reporting Work: The summarized statements along with analysis and interpretation are
communicated to the interested parties or whoever has the right to receive them. For Ex. Share holders.

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 In addition, the accou8nting departments has to prepare and send regular reports so as to assist the
management in decision making. This is „Reporting‟.

6. Preparation of Budget : The management must be able to reasonably estimate the future
requirements and opportunities. As an aid to this process, the accountant has to prepare budgets, like
cash budget, capital budget, purchase budget, sales budget etc. this is „Budgeting‟.

7. Taxation Work : The accountant has to prepare various statements and returns pertaining to income-
tax, sales-tax, excise or customs duties etc., and file the returns with the authorities concerned.

8. Auditing : It involves a critical review and verification of the books of accounts statements and reports
with a view to verifying their accuracy. This is „Auditing‟.

USERS OF ACCOUNTING INFORMATION

1. Managers : These are the persons who manage the business, i.e. management at the top, middle and
lower levels. Their requirements of information are different because they make different types of
decisions.

Accounting information also helps the managers in appraising the performance of subordinates.
As such Accounting is termed as “ the eyes and ears of management.”

2. Investors : Those who are interested in buying the shares of company are naturally interested in the
financial statements to know how safe the investment already made is and how safe the proposed
investments will be.

3. Creditors : Lenders are interested to know whether their load, principal and interest, will be paid when
due. Suppliers and other creditors are also interested to know the ability of the firm to pay their dues in
time.

4. Workers : In our country, workers are entitled to payment of bonus which depends on the size of
profit earned. Hence, they would like to be satisfied that he bonus being paid to them is correct. This
knowledge also helps them in conducting negotiations for wages.

5. Customers : They are also concerned with the stability and profitability of the enterprise. They may be
interested in knowing the financial strength of the company to rent it for further decisions relating to
purchase of goods.

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6. Government: Governments all over the world are using financial statements for compiling statistics
concerning business which, in turn, helps in compiling national accounts. The financial statements are
useful for tax authorities for calculating taxes.

7. Public : The public at large interested in the functioning of the enterprises because it may make a
substantial contribution to the local economy in many ways including the number of people employed
and their patronage to local suppliers.

8. Researchers: The financial statements, being a mirror of business conditions, is of great interest to
scholars undertaking research in accounting theory as well as business affairs and practices.

ADVANTAGES OF ACCOUNTING

1. Provides for systematic records: Since all the financial transactions are recorded in the books, one
need not rely on memory. Any information required is readily available from these records.

2. Facilitates the preparation of financial statements: Profit and loss accountant and balance sheet can
be easily prepared with the help of the information in the records. This enables the trader to know the
net result of business operations (i.e. profit / loss) during the accounting period and the financial
position of the business at the end of the accounting period.

3. Provides control over assets: Book-keeping provides information regarding cash in had, cash at bank,
stock of goods, accounts receivables from various parties and the amounts invested in various other
assets. As the trader knows the values of the assets he will have control over them.

4. Provides the required information: Interested parties such as owners, lenders, creditors etc., get
necessary information at frequent intervals.

5. Comparative study: One can compare the present performance of the organization with that of its
past. This enables the managers to draw useful conclusion and make proper decisions.

6. Less Scope for fraud or theft: It is difficult to conceal fraud or theft etc., because of the balancing of
the books of accounts periodically. As the work is divided among many persons, there will be check and
counter check.

7. Tax matters: Properly maintained book-keeping records will help in the settlement of all tax matters
with the tax authorities.

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8. Ascertaining Value of Business: The accounting records will help in ascertaining the correct value of
the business. This helps in the event of sale or purchase of a business.

9. Documentary evidence: Accounting records can also be used as an evidence in the court to substantiate
the claim of the business. These records are based on documentary proof. Every entry is supported by
authentic vouchers. As such, Courts accept these records as evidence.

10. Helpful to management: Accounting is useful to the management in various ways. It enables the
management to assess the achievement of its performance. The weakness of the business can be
identified and corrective measures can be applied to remove them with the helps accounting.

LIMITATIONS OF ACCOUNTING

1. Does not record all events: Only the transactions of a financial character will be recorded under
book-keeping. So it does not reveal a complete picture about the quality of human resources, location
advantage, business contacts etc.

2. Does not reflect current values: The data available under book-keeping is historical in nature. So
they do not reflect current values. For instance, we record the value of stock at cost price or market
price, whichever is less. In case of, building, machinery etc., we adopt historical cost as the basis. In
fact, the current values of buildings, plant and machinery may be much more than what is recorded in
the balance sheet.

3. Estimates based on Personal Judgment: The estimate used for determining the values of various
items may not be correct. For example, debtor are estimated in terms of collectability, inventories are
based on marketability, and fixed assets are based on useful working life. These estimates are based
on personal judgment and hence sometimes may not be correct.

4. Inadequate information on costs and Profits: Book-keeping only provides information about the
overall profitability of the business. No information is given about the cost and profitability of
different activities of products or divisions.

ACCOUNTING PRINCIPLES

Accounting principles are the rules and regulations which are followed by the accountants at the time of
recording the accounting transactions. They help in measuring, recording and summarizing the
transactions. These principles are termed as “ Generally Accepted Accounting Principles (GAAP) “ which
are basic assumptions.

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Accounting Concepts:

1. Business Entity Concept: In this concept “Business is treated as separate from the proprietor”. All
the Transactions recorded in the book of Business and not in the books of proprietor. The proprietor is
also treated as a creditor for the Business.

2. Going Concern Concept: This concept relates with the long life of Business. The assumption is that
business will continue to exist for unlimited period unless it is dissolved due to some reasons or the
other.

3. Money Measurement Concept: In this concept “Only those transactions are recorded in accounting
which can be expressed in terms of money, those transactions which cannot be expressed in terms of
money are not recorded in the books of accounting”.

4. Cost Concept: Accounting to this concept, can asset is recorded at its cost in the books of account. i.e.,
the price, which is paid at the time of acquiring it. In balance sheet, these assets appear not at cost price
every year, but depreciation is deducted and they appear at the amount, which is cost, less
classification.

5. Accounting Period Concept: every Businessman wants to know the result of his investment and
efforts after a certain period. Usually one-year period is regarded as an ideal for this purpose. This
period is called Accounting Period. It depends on the nature of the business and object of the proprietor
of business.

6. Dual Aspect Concept: According to this concept “Every business transactions has two aspects”, one
is the receiving benefit aspect another one is giving benefit aspect. The receiving benefit aspect is
termed as “DEBIT”, where as the giving benefit aspect is termed as “CREDIT”. Therefore, for every
debit, there will be corresponding credit.

7. Matching Cost Concept: According to this concept “The expenses incurred during an accounting
period, e.g., if revenue is recognized on all goods sold during a period, cost of those good sole should
also be charged to that period.

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8. Realization Concept: According to this concept revenue is recognized when a sale is made. Sale is
considered to be made at the point when the property in goods posses to the buyer and he becomes
legally liable to pay.

Accounting Conventions:

1. Full Disclosure: According to this convention accounting reports should disclose fully and fairly the
information. They purport to represent. They should be prepared honestly and sufficiently disclose
information which is if material interest to proprietors, present and potential creditors and investors.
The companies ACT, 1956 makes it compulsory to provide all the information in the prescribed form.

2. Materiality: Under this convention the trader records important factor about the commercial activities.
In the form of financial statements if any unimportant information is to be given for the sake of clarity
it will be given as footnotes.

3. Consistency: It means that accounting method adopted should not be changed from year to year. It
means that there should be consistent in the methods or principles followed. Or else the results of a
year Cannot be conveniently compared with that of another.

4. Conservatism: This convention warns the trader not to take unrealized income in to account. That is
why the practice of valuing stock at cost or market price, whichever is lower is in vague. This is the
policy of “playing safe”; it takes in to consideration all prospective losses but leaves all prospective
profits.

ELEMENTS OF FINANCIAL STATEMMENTS

Entity:- An entity is an economic unit which performs economic activities. Ex: Tata Steel, H.M.T. Ltd.

Business transaction:- A transaction is an exchange of goods or services for cash or credit. It involves
transfer of money or money‟s worth that brings about change in the financial position of a business.

Trade debtors:- Trade debtors are the persons from whom the amount are due for goods sold or services
rendered on credit basis.

Trade creditors:- Trade creditors are those to whom the amounts are due for goods purchased or services
rendered on credit basis.

Goods:- Goods are those with which the business firm trades. They are meant for resale.

Assets:- Assets are those which yield future economic benefits.

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Current Assets:- current assets are those assets which are held in cash or which are likely to be converted
into cash during the financial year.

Fixed Assets:- Fixed assets are those assets which are not held for resale in normal course of business.

Tangible Fixed Assets:- The assets that can be visible, seen and touched are called as “ Tangible Fixed
Assets”.

Intangible fixed assets:- The assets that cannot be visible, seen and touched are called as “ Intangible
Fixed Assets”.

Liabilities:- The financial obligations of the firm are called liabilities.

Current Liabilities:- The liabilities which fall due in a short period are known as “ Current Liabilities”.

Long term liabilities:- The liabilities which fall due for payment in a relatively short period are called as
long term liabilities.

Purchases:- The total amount of goods obtained by an enterprise for resale either for cash or credit.

Sales:- The amount for which goods are sold or services are rendered either for cash or credit is called as
sales.

Expenditure:- The amount incurred in the process of acquiring goods, assets or services.

Revenue:- The amount charged for the goods sold or services rendered by an enterprise.

Capital: Capital is the amount invested by the owner/propietor in the firm. It is a liability to the firm.

Drawings: cash or goods withdrawn by the proprietor from the Business for his personal or Household is
termed to as “drawing”.

Reserve: An amount set aside out of profits or other surplus and designed to meet contingencies.

Account: A summarized statements of transactions relating to a particular person, thing, Expense or

income.

Discount: There are two types of discounts..

cash discount: An allowable made to encourage frame payment or before the expiration of the period
allowed for credit.

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Trade discount: A deduction from the gross or catalogue price allowed to traders who buys them for
resale.

CLASSIFICATION OF ACCOUNTS

All business transactions are classified into three categories:

1.Those relating to persons(Natural persons, artificial persons and representative persons)

2.Those relating to property(Assets)

3.Those relating to income & expenses

Thus, three classes of accounts are maintained for recording all business transactions. They are:

1.Personal accounts

2.Real accounts

3.Nominal accounts

1. Personal Accounts :Accounts which are transactions with persons are called “Personal Accounts” . In
accounting, all natural persons and all the firms are considered as persons.

A separate account is kept on the name of each person for recording the benefits received from ,or given
to the person in the course of dealings with him.

E.g.: Krishna‟s A/C, Gopal‟s A/C, SBI A/C, Nagarjuna Finanace Ltd.A/C, Obul Reddy & Sons A/C ,
HMT Ltd. A/C, Capital A/C, Drawings A/C etc.

2. Real Accounts: The accounts relating to properties or assets are known as “Real Accounts” .Every
business needs assets such as machinery , furniture etc, for running its activities .A separate account is
maintained for each asset owned by the business .

E.g.: cash A/C, furniture A/C, building A/C, machinery A/C etc.

3. NominalAccounts:Accounts relating to expenses, losses, incomes and gains are known as “Nominal
Accounts”. A separate account is maintained for each item of expenses, losses, income or gain.

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E.g.: Salaries A/C, stationery A/C, wages A/C, postage A/C, commission A/C, interest A/C, purchases
A/C, rent A/C, discount A/C, commission received A/C, interest received A/C, rent received A/C,
discount received A/C.

Before recording a transaction, it is necessary to find out which of the accounts is to be debited and which
is to be credited. The following three different rules have been laid down for the three classes of
accounts….

DEBIT, CREDIT RULES

Debit the receiver

Personal Accounts

Credit the giver

Debit what comes in

Real Accounts

Credit what goes out

Debit all expenses/losses

Nominal Accounts

Credit all incomes/gains

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Identification of the accounts involved in each transaction:

1. Consider that the transaction is committed by the firm and it is being recorded in the books of the
firm.

2. see whether it is cash transaction or credit transaction.

a. A transaction that refers to a person and doesn‟t refer to the term “ cash “ is called credit transaction

b. A transaction which is not credit transaction is called cash transaction

3. If the transaction is credit one, first find whether the „ personal A/C‟ is to be debited or credited and
next find which account is to be credited or debited.

4. If it is a cash transaction, first find whether the „ cash A/C‟ is to be debited or credited and next find
which account is to be credited or debited.

5. Debit means entering the amount on the left side of an account.

6. Credit means entering the amount on the right side of account.

ACCOUNTING EQUATION

The basic accounting equation, also called the balance sheet equation, represents the relationship between
the assets, liabilities, and owner's equity of a business. It is the foundation for the double-entry
bookkeeping system. For each transaction, the total debits equal the total credits. It can be expressed as
further more.

Assets = Liabilities + Equity

In a company, capital represents the shareholders' equity. Since every business transaction affects at least
two of a company‟s accounts, the accounting equation will always be “in balance,” meaning the left side
should always equal the right side. Thus, the accounting formula essentially shows that what the firm
owns (its assets) is purchased by either what it owes (its liabilities) or by what its owners invest (its
shareholders equity or capital).

For example: A student buys a computer for Rs.1000. To pay for the computer, the student uses Rs.400
in cash and borrows Rs.600 for the remainder. Now his assets are worth Rs.1000, liabilities are Rs.600,
and equity Rs.400.

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The formula can be rewritten:

Assets - Liabilities = (Shareholders' or Owners' Equity)

Sometimes we expand the Accounting Equation to show all the Equity components. This is called the

Expanded Accounting Equation.

Now it shows owners' interest is equal to property (assets) minus debts (liabilities). Since in a company,
owners are shareholders, owner's interest is called shareholders' equity.
Every accounting transaction affects at least one element of the equation, but always balances. Simplest
transactions also include:

Example 1: Prepare the Accounting Equation on the basis of following:

1. Mr. Shiraz Khan started business and introduced capital Rs. 1,00,000 in cash.

2. Purchased goods in cash Rs. 50,000.

3. Purchased from Bismillah Furnitures Rs. 20,000.

4. Sold goods costing Rs. 25,000 for Rs. 35,000.

5. Paid Bismillah Furnitures in cash.

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Example 2: Prepare the Accounting Equation on the basis of following:

1. Issuing shares for cash or other assets Rs.6000

2. Buying assets by borrowing money Rs.10000
3. Selling assets for cash Rs. 900
4. Buying assets by paying cash Rs.600 and by borrowing money 400.
5. Earning revenues Rs.700

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 JOURNAL

The first step in accounting therefore is the record of all the transactions in the books of original entry
viz., Journal and then posting into ledges.

The word Journal is derived from the Latin word „journ‟ which means a day. Therefore, journal means a
„day Book‟ in day-to-day business transactions are recorded in chronological order.

Journal is treated as the book of original entry or first entry or prime entry. All the business transactions
are recorded in this book before they are posted in the ledges. The journal is a complete and
chronological(in order of dates) record of business transactions. It is recorded in a systematic manner. The
process of recording a transaction in the journal is called “JOURNALISING”. The entries made in the
book are called “Journal Entries”.

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 The proforma of Journal is given below.

Date Particulars L.F Debit Amount Credit Amount

Journalize the following examples:

Example 1. Journalize the following transactions in the books of Mr. Ram

2015 Jan 1 Business started with Rs. 10,000
“ 2 Cash deposited in the bank Rs. 5,000
“ 5 Purchases Rs. 3,000
“ 8 Sales Rs. 4,000
“ 10 Cash drawn from the bank Rs. 1,000

Solution: Journal entries in the book of Mr.Ram

Dr Cr
Date Particulars LF
Amount Amount
Cash A/C 10000
Dr
2015 Jan 1 10000
To Capital A/C
(Being the business started)
Bank A/C Dr 5000
“2 To Cash A/C 5000
(Being Cash deposited in the bank)
Purchases A/C 3000
Dr
“5 3000
To Cash A/C
(Being purchases made on the cash basis)

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 Cash A/C 4000
Dr
“8 4000
To Sales A/C
(Being sales made on the cash basis)
Cash A/C 1000
Dr
“ 10 1000
To Bank A/C
(Being cash withdrawn from the bank)

Example 2. Journalize the following transactions in the books of Sri Laxmi & Co.
2015 Jan 1 Business started with Rs. 10,000 Cash and Furniture Rs. 5,000
“ 2 Goods purchased from Mr. Sathish Rs. 2,000
“ 5 Rent paid Rs. 1,000
“ 8 Goods sold to Mr. Ramya Rs. 4,000
“ 10 Goods sold and cheque received Rs. 1,000

Example 3. Enter the following transactions in Journal

2015 Jan 1 Purchased office furniture Rs. 2000 and paid through cheque.
“ 2 Cash sales Rs. 3000
“ 5 Wages paid Rs. 1000
“ 8 Telephone bill paid Rs. 500
“ 10 Cash sales Rs. 2000 and credit sales Rs. 2000 to Sunil.

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Example 4. Journalize the following transactions.
2015 Jan 1 Salaries paid Rs. 2000
“ 2 Paid for advertisement Rs. 3000
“ 5 Purchased a car for office use Rs. 100000
“ 8 Paid insurance premium Rs. 500
“ 10 Returned goods to Suresh Rs. 100

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Example 5. Journalize the following transactions.
2015 Jan 1 Goods returned from Ram Rs. 200
“ 2 Cash withdrawn for personal use Rs. 3000
“ 5 Loan borrowed from SBH Rs. 100000
“ 8 Interest received Rs. 500
“ 10 Discount paid Rs. 100

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 SUBDIVISION OF JOURNAL

Small businesses record all transactions in a single journal but large companies record their transactions in
different journals according to their nature. The journal is sub-divided into eight parts. They are;

1. Purchase book (where all credit purchases are recorded)

2. Sales book (where all credit sales are recorded)

3. Purchase returns book (where the particulars of goods returned to suppliers are recorded)

4. Sales returns book (where the particulars of goods returned from customers are recorded)

5. Bills receivable book (where the details of bills received are recorded)

6. Bills payable book (where the details of bills payable are recorded)

7. Cash book (where all the cash transaction are recorded)

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 8. Proper journal (where the transactions which are not recorded in the above books are recorded)

Record the following transactions in the three columnar (cash, Bank, Discount columns) cash book.

Example 1. Prepare a three columnar cash book.

2015 Jan 1 Manmohan started a business with cash balance of Rs. 10,000 and paid into bank Rs.
8,000.

3 Bought office furniture by cheque Rs. 3000

5 Sold goods for cash Rs. 1000

8 Anand paid Rs. 600 and was allowed a discount of Rs.60

12 A cheque received from Mani for Rs. 690 and allowed him a discount of Rs. 10; the cheque
was deposited into bank.

18 Cash withdrawn from bank for office use Rs. 1000

24 Received a cheque for sales Rs. 1200

20 Drew cash for personal use Rs. 100; Salaries paid Rs. 500.

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Example 2.

2015 Jan 1 ABC firms has cash in hand Rs. 4,000 and balance at bank Rs. 5,000.

2 Deposited cash Rs. 3,500 into bank.

8 Bought goods worth Rs. 8000 from Ram.

10 Sold goods worth Rs. 15000 for cash.

12 Sold goods to Suresh for Rs. 5000

15 Paid Rs. 2000 to Ram on account

18 Withdrew Rs. 1000 from bank for personal use

20 Settled Ram account; he allows a discount of Rs. 200

23 Suresh paid Rs. 4900 in full settlement of account

25 Withdrew Rs. 2000 from bank for office use

Prepare a three columnar cash book.

LEDGER

All the transactions in a journal are recorded in a chronological order. After a certain period, if we want to
know whether a particular account is showing a debit or credit balance it becomes very difficult. So, the

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ledger is designed to accommodate the various accounts maintained the trader. It contains the final or
permanent record of all the transactions in duly classified form. “A ledger is a book which contains
various accounts.” The process of transferring entries from journal to ledger is called “POSTING”.

Posting is the process of entering in the ledger the entries given in the journal. Posting into ledger is done
periodically, may be weekly or fortnightly as per the convenience of the business. The following are the
guidelines for posting transactions in the ledger.

1. After the completion of Journal entries only posting is to be made in the ledger.

2. For each item in the Journal a separate account is to be opened. Further, for each new item a new
account is to be opened.

3. Depending upon the number of transactions space for each account is to be determined in the
ledger.

4. For each account there must be a name. This should be written in the top of the table. At the end
of the name, the word “Account” is to be added.

5. The debit side of the Journal entry is to be posted on the debit side of the account, by starting
with “TO”.

6. The credit side of the Journal entry is to be posted on the debit side of the account, by starting
with “BY”.

Proforma for ledger: LEDGER BOOK ------------- Account

Date Particulars JF Amount Date Particulars JF amount

To By

Example:

Enter the following transactions in journal and post them into ledger:

2017 Jan. 1 Mr. Rameh started business with cash Rs.100,000

2 He purchased furniture for Rs.20,000

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 3 He purchased goods for Rs.60,000
5 He sold goods for cash Rs.80,000
6 He paid salaries Rs.10,000
Solution:

Journal Entries

Date Particular L.F Amount Amount

2017
Jan. 1 Cash A/C ................................................... Dr. 100,000
To Capital 100,000
(Being capital brought in)
2 Furniture A/C. ............................................. Dr. 20,000
To Cash A/C 20,000
(Being furniture purchased for cash)
3 Purchases A/C ............................................ Dr. 60,000
To Cash A/C 60,000
(Goods purchased for cash)
5 Cash A/C ................................................... Dr. 80,000
To Sales A/C 80,000
(Sold goods for cash)
6 Salaries A/C ............................................... Dr. 10,000
To Cash A/C 10,000
(Salaries paid)

Ledger

Cash Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.1 To Capital A/C 100,000 Jan.2 By Furniture A/C 20,000
Jan.5 To Sales A/C 80,000 Jan.3 By Purchases A/C 60,000
Jan.6 By Salaries A/C 10,000
By Balance c/d 90,000
180,000 180,000

Capital Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.6 To Balance c/d 100,000 Jan.1 By Cash A/C 100,000
100,000 100,000

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 Furniture Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.2 To Cash A/C 20,000 Jan.6 By Balance c/d 20,000
20,000 20,000

Purchases Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.3 To Cash A/C 60,000 Jan.6 By Balance c/d 60,000
60,000 60,000

Sales Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.6 To Balance c/d 80,000 Jan.5 By Cash A/C 80,000
80,000 80,000

Salaries Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.6 To Cash A/C 10,000 Jan.6 By Balance c/d 10,000
10,000 10,000

TRIAL BALANCE

According to double entry system every debit has corresponding credit. All the debit balances are equal to
credit balances. If they don‟t agree, it is understood that some mistakes are committed somewhere. Trial
Balance is a statement in which debit and credit balances of all ledger accounts are shown to list the
arithmetical accuracy of the books of accounts.

Features of trial balance

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  It is not account.
 It contains debit and credit balances of accounts.
 It helps in preparation of final accounts.
 Both debit and credit side of a trial balances are always equal.
Format of the trial balance

Debit Credit
Particulars Particulars
Amount Amount

Balances of all assets, Balances of all liabilities,

xxxx xxxx
Expenses, Losses Incomes, Gains, Reserves

(Or)

Debit Credit
Particulars
Amount Amount

Format of Trial Balance as on December 31st, 201X

Debit balances Rs Credit balances Rs

Debtors xxxx Creditors xxxx
All assets xxxx All liabilities xxxx
All expenses xxxx All incomes and gains xxxx
All losses xxxx Profits account xxxx
Purchases xxxx Loan account xxxx
Sales returns xxxx Bank over draft xxxx
Drawings xxxx Sales xxxx
stock xxxx Purchase returns xxxx
Bills receivables xxxx Provision for doubtful debts xxxx
Prepaid expenses xxxx Provision for discount on debtors xxxx
Incomes receivables xxxx All reserves and surpluses xxxx
All intangible assets xxxx Bills payables xxxx
Outstanding expenses xxxx
Incomes received in advance xxxx
Capital xxxx
xxxx xxxx

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Prepare the Trial Balances for the following examples:

Example 1. Prepare a trial balance as on 31-12-2014 from the below information.

Particulars Rs Particulars Rs
Sundry debtors 32000 Bills payable 7500
Stock 22000 Purchases 218870
Cash in hand 35 Cash at bank 1545
Plant and machinery 17500 Sundry creditors 10650
Trade expenses 1075 Sales 234500
Salaries 2225 Carriage outward 400
Rent 900 Discounts Dr 1100
Capital 79500 Premises 34500

Example 2. Make a trial balance from the below balances of accounts.

Particulars Rs Particulars Rs
Capital 100000 Machinery 30000
Stock 16000 Wages 50000
Carriage inward 500 Salaries 5000
Factory rent 2400 Repairs 400
Fuel and power 2500 Buildings 40000
Sundry debtors 20000 Sales 203600
Purchases 122000 Creditors 12500
Returns outwards 2000 Returns inwards 3600
Drawings 2000 Discount allowed 750

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 Discount received 250 Office expenses 1000
Manufacturing expenses 600 Bills payable 3000
Bills receivable 5000 Cash in hand 2400
Cash at bank 15400 Office rent 1800

FINAL ACCOUNTS

In every business, the business man is interested in knowing whether the business has resulted in
profit or loss and what the financial position of the business is at a given time. In brief, he wants to know
(i)The profitability of the business and (ii) The soundness of the business.

The trader can ascertain this by preparing the final accounts. The final accounts are prepared from
the trial balance. Hence the trial balance is said to be the link between the ledger accounts and the final
accounts. The final accounts of a firm can be divided into two stages. The first stage is preparing the
trading and profit and loss account and the second stage is preparing the balance sheet.

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 TRADING ACCOUNT

The first step in the preparation of final account is the preparation of trading account. The main
purpose of preparing the trading account is to ascertain gross profit or gross loss as a result of buying and
selling the goods.

Finally, a ledger 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. The up-to-date state of
any account can be easily known by referring to the ledger.

PROFIT AND LOSS ACCOUNT:

The business man is always interested in knowing his net income or net profit.Net profit represents the
excess of gross profit plus the other revenue incomes over administrative, sales, Financial and other
expenses. The debit side of profit and loss account shows the expenses and the credit side the incomes. If
the total of the credit side is more, it will be the net profit. And if the debit side is more, it will be net loss.

Format of Trading and Profit & Loss A/C of ……….for the year ending ……………..
Particulars Amount Particulars Amount
To Opening stock xxxx By Sales xxxx
To Purchases xxxx Less: Returns xxxx xxxx
Less: Returns xxxx xxxx By Closing stock xxxx
To Carriage inwards xxxx By Gross loss (c/d) xxxx
To Freight, cartage xxxx
To Customs duty xxxx
To Clearing charges xxxx
To Octroi xxxx
To Wages xxxx
To Gas, water, coal, light xxxx
To Factory rent xxxx
To Works manager salary xxxx
To Factory supervision xxxx
To consumable stores xxxx
To Plant depreciation xxxx
To Gross profit (c/d) xxxx
xxxx xxxx
To Gross loss(b/d) xxxx By Gross profit(b/d) xxxx
To Salaries xxxx By Discount received xxxx
To Rent, Taxes xxxx By Interest received xxxx
To Insurance xxxx By Dividend received xxxx
To Printing stationery xxxx By Rent received xxxx

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To Advertisement xxxx By Commission received xxxx
To Carriage outward xxxx By Net loss (c/d) xxxx
To Bad debts xxxx xxxx
To Repairs xxxx xxxx
To Depreciation xxxx xxxx
To Discount allowed xxxx xxxx
To Commission allowed xxxx xxxx
To Interest paid xxxx xxxx
To Provision for doubtful debts xxxx xxxx
To Postage xxxx xxxx
To General expenses xxxx xxxx
To Net profit (c/d) xxxx xxxx
xxxx xxxx
BALANCE SHEET:

The second point of final accounts is the preparation of balance sheet. It is prepared often in the trading
and profit, loss accounts have been compiled and closed. A balance sheet may be considered as a
statement of the financial position of the concern at a given date.

A balance sheet is an item wise list of assets, liabilities and proprietorship of a business at a certain state.

Balance Sheet of……………....company as on ……………..

Capital & Liabilities Amount Assets Amount
Capital xxxx Land and buildings xxxx
Add: Net profit xxxx Furniture xxxx
xxxx Plant and machinery xxxx
Less: Drawings xxxx xxxx Land xxxx
Loans xxxx Vehicles xxxx
Bank Over Draft xxxx Debtors xxxx
Bills payable xxxx Investments xxxx
Creditors xxxx Bills receivables xxxx
Outstanding expenses xxxx Goodwill xxxx
Incomes received in advance xxxx Patents xxxx
All reserves xxxx Copyright xxxx
Trade marks xxxx
Prepaid expenses xxxx
Incomes receivables xxxx
Securities xxxx
Closing stock xxxx
Cash in hand xxxx
Cash at bank xxxx
xxxx xxxx

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 IMPORTANT ADJUSTMENTS:

1. Outstanding expenses

a) Add to respective expense account in Trading & Profit & Loss account

b) Show as a liability in Balance Sheet

Note:- If it is given only in trial balance, show as a liability in the balance sheet

2. Prepaid expenses

a) Deduct from the respective expenses account in Trading and P/L account

b) Show as an asset in Balance Sheet

Note:- If it is given only in trial balance, show only as an asset in B/S

3. Accrued incomes or incomes receivables

a) Add to the respective income A/C in P/L Account

b) Show as an asset in B/S

Note:- If it is only given in trial balance, show as an asset in B/S

4. Incomes received in advance

a) Deduct from the respective income A/C in P/L Account

b) Show as a liability in B/S

Note:- It is given only in trial balance, show as a liability in B/S

5. Closing stock

a) Show on the credit side of trading A/C

b) Show as an asset in B/S

Note:- If it is given only in trial balance, show as an asset in B/S

6. Interest on capital

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 a) Show on the debit side of P/L A/C

b) Add to capital in B/S

Note:- If it is given only in trial balance, show only in P/L A/C

7. Depreciation

a) Show on the debit side of P/L A/C

b) Deduct from respective asset in B/S

Note:- If it is given only in trial balance, show only on the debit side of P/L A/C)

8. I) Bad debts ( when given only in adjustments)

a) Show on the debit side of P/L A/C

b) Deduct from debtors in B/S

II) Bad debts ( when given only in trial balance )

Show on the debit side of P/L A/C only

III) Bad debts ( when given in both trial balance and adjustments)

a) Add “ Bad debts given in adjustments” to “ Bad debts in trial balance” on the debit side of P/L
A/C

b) Deduct “ Bad debts in adjustments” from the debtors in B/S

9. Provision/Reserve for bad debts (RBD)

A) When RBD is given only in trial balance

a) Deduct from the debtors in B/S

B) When RBD is given only in adjustments

a) Show on the debit side of P/L A/C

b) Deduct from the debtors in B/S

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 C) When RBDs are given in both trial balance (RBD old) and adjustments (RBD New)

a) Compare both RBDs, show the difference on the debit side of P/L A/C if RBD new is excess
than RBD old. Show the difference on the credit side of P/L A/C in RBD old is excess than
RBD new.

b) Deduct always only RBD new from debtors in B/S

PROCEDURE FOR PREPARING TRADING ACCOUNT

1. Show opening stock and net purchases ( purchases less purchase returns) on the debit side.

2. Show net sales (sales – sales returns) and the closing stock given in the adjustments on the credit
side.

3. Show all the direct expenses with adjustments on the debit side.

4. Balance the account and carry forward the balance to P/L A/C

PROCEDURE FOR PREPARING PROFIT AND LOSS ACCOUNT

1. Show all the remaining expenses with adjustments on the debit side.

2. Show all the remaining incomes with adjustments on the credit side

3. See whether all adjustments are taken once in any of the Trading Account and Profit & Loss
Account

4. Balance the P/L A/C and transfer the balance to capital in B/S

PROCEDURE FOR PREPARING BALANCE SHEET

1. Show all the assets with adjustments on the assets side.

2. Show all the liabilities with adjustments on the liabilities side.

3. See whether all items of trial balance are taken once and whether all adjustments are taken twice.

4. Add both the columns of assets and liabilities.

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 Example 1: From the following trial balance and additional
information of Mr. Arun, prepare his final accounts for the year ending
31-3-2015.
Particulars Rs Particulars Rs
Building 280000 Capital 250000
Furniture 60000 Sales 265000
Opening stock 25000 Bank loan 100000
Advertising 5000 Commission 6000
Salaries 14000 Creditors 8000
Wages 3000
Purchases 190000
Discount 4000
Bad debts 2000
Interest on loan 6000
Returns inwards 10000
Debtors 30000
629000 629000
Adjustments:
1. Stock on 31-3-2015 was Rs. 35000.
2. Wages outstanding Rs. 1000.

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 Example 2: From the following data and additional information of Mr.
Kiran, prepare his final accounts for the year ending 31-3-2015.
Building 70000 Carriage inwards 1291
Furniture 1640 Establishment expenses 2135
Debtors 15600 Carriage outwards 800
Creditors 18852 Insurance 783
Stock 15040 Interest (Cr) 340
Cash in hand 988 Bad debts 613
Cash at bank 24534 Audit fee 400
Bills receivables 5844 General expenses 3050
Purchases 85522 Discount (Dr) 945
Sales 121850 Investments 8922
Capital 92000 Returns inwards 285
Bills payable 6250 Rent 900
Adjustments:
1. Stock on 31-3-2015 was Rs. 35000.
2. Prepaid insurance Rs. 100.
3. Depreciation on furniture Rs. 10%
4. Interest accrued but not received Rs. 100

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Example 3: From the following trial balance and additional information,
prepare final accounts for the year ending 31-12-2014.
Particulars Rs Particulars Rs
Sundry debtors 64000 Discount received 9000
Stock (1-1-2014) 44000 Bank over draft 15000
Cash in hand 3160 Long term loan 25300
Wages 35000 Sales 365000
Trade expenses 2150 Capital 150000
Gas, water, power 4450
Sales returns 800
Bank charges 1800
Purchases 237740
Advertisements 2200
Premises 160000
Drawings 9000
564300 564300
Adjustments:
1. Bank charges outstanding Rs.150,
2.Write off bad debts Rs. 500
3. Provide 5% for doubtful debts.

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 Example 4: From the following data prepare final accounts for the year ending 31-12-
2014.

Particulars Rs Rs
Drawings and capital 12000 80000
Opening stock 12000
Investments 30600
Stationery 12000
Carriage 3000
Returns 6000 2600
Purchases and sales 120000 160000
Loans 2400 10000
Debtors and creditors 60000 25000
Discount allowed 2200
Freight in 10400
Freight out 6000
Charity 28000
Reserve for doubtful debts 2000
Bills payables 25000
304600 304600
Adjustments:
1. Closing stock Rs. 20000
2. Appreciate investment by 10%
3. Maintain reserve for doubtful debts at the rate of 5%
4. Provide 5% as interest on capital

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 ACCOUNTING PROCESS/CYCLE

Accounting process involves a sequence of activities which are repeated in every accounting period. So it
is known as accounting cycle.

Journalizing

Final Ledger
Accounts Posting

Trial
Balance

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