UNIT I

Micro and Macro Economics and its applications; Nature and scope of economics science; micro
economics, Macro economics concept of equilibrium; Economic efficiency, Technical efficiency;
Demand and Supply concepts; elasticity of demand and supply, Determination of demand, fixed
cost, variable cost, average cost, marginal cost, opportunity cost; standard cost; concept of iso-
quant; price of products, Break even analysis, Nature and functions of Money, National Income,
GNP and savings, Inflation and deflation, Business cycles. Types and principles of management,
Elements of Management; Planning, organizing, staffing, co-ordinating, etc Types of firm

Economics:
Economics is the science that deals with the production and consumption of goods and services
and the distribution and rendering of these for human welfare. The following are the economic
goals;
 A high level of employment
 Price stability

 Efficiency

 An equitable distribution of income

 Growth

The field of economics is divided into two broad subfields: macroeconomics and
microeconomics.

Macro Economics;
Macroeconomics is the study of aggregate economic behavior. Macroeconomists are
concerned with such issues as national income, employment, inflation, national output, economic
growth, interest rates, and international trade.
Macroeconomics is the study of entire economies and economic systems and specifically
considers such broad economic aggregates as gross domestic product, economic growth, national
income, employment, unemployment, inflation, and international trade. In general, the topics
covered in macroeconomics are concerned with the economic environment within which firm
managers operate. For the most part, macroeconomics focuses on the variables over which the
managerial decision maker has little or no control but may be of considerable importance in the
making of economic decisions at the micro level of the individual, firm, or industry.

Micro Economics;
Microeconomics is the study of individual economic behavior. Micro economists are
concerned with output and input markets, product pricing, input utilization, production costs,
market structure, capital budgeting, profit maximization, production technology, and so on.
By contrast, microeconomics is the study of the behavior and interaction of individual
economic agents. These economic agents represent individual firms, consumers, and
governments. Microeconomics deals with such topics as profit maximization, utility
maximization, revenue or sales maximization, production efficiency, market structure, capital
budgeting, environmental protection, and governmental regulation.

CONCEPT OF ENGINEERING ECONOMICS

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

It is clear that price has a major role in deciding the demand and supply of the product. Hence
from the organizations point of view, efficient and effective functioning of the organization
would certainly help it to provide goods/services at a lowe cost which in turn will enable it to fix
a lower price for its goods or services.

The following discusses the different types of efficiency and their impact on the operation of
businesses and the definition and scope of engineering economics.

Types of Efficiency

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

Technical Efficiency

It is the ratio of the output to input of a physical system. The physical system may be a diesel
engine, a machine working in a shop floor, furnance etc,
The technical efficiency of a diesel engine is as follows

In practice technical efficiency can never be more than 100% . This is mainly due to frictional
loss and incomplete combustion of fuel, which are considered to be unavoiadable phenomena in
the working of a diesel engine.

Economic efficiency

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

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

Economic efficiency is also called productivity. There are several wazs of improving
productivity.

 Increased output for the same input

 Decreased output for the same output

 By a proporionate increase in the output which is more than the proportionate increase in
the input

 By a proportionate decrease in the input which is more than the proportionate decrease in
the output

 Through simultaneous increase in the output with decrease in the input.

Increased output for the same input. In this strategy, the output is increased while keeping the
input constant. Let us assume that in a steel plant, the layout of the existing facilities is not
proper. By, slightly altering the location of the billet-making section., and bringing it closer to
the furance which produces hot metal , the scale formation at the top of ladles will be
considerably reduced. The molten metal is usually carried in ladles to the billet-making section.
In the lng run, this would give more yield in terms of tonnes of billet produced. In this exercise,
there is no extra cost involved. The only task is the relocation of the billet-making facility wich
involves an insignficant cost.

Decreased input for the same out put. In this strategy, the input is decreased to produce the same
output . let us assume that there exists a substitue raw material to manfacture a product and it is
available at a lower price. If we can identify such a material and use it for manfacturing the
product then certainly it will reduce the input. In this excerise, the job of the purchase department
is to identify an alternate subsitute material. The process of identification does not involve any
extra cost. So, the productivity ratio will increase because of the decreased input by way of using
cheaper raw materials to produce the same output.

Less proportionate increase in output is more than that of the input. consider the example of
introducing a new product into the existing product mix of an organization. Let us assume that
the existing facilities are not fully utilized an the R&D wing of the company has identified a new
product which has a very good market and which can be manfactured with the surplus facilities
of the organization. If the new product is taken up for production, it will lead to

 An increase in the revenus of the organiyation by way of selling the new product in
addition to the existing product mix and

 An increase in the material cost and operation and maintenance cost of machineries
because of producing the new product.

If we examine these these two increase closely, the proportionate increase in the revenue will be
more than the proprotionate increase in the input cost. Hence, there will be a net increase in the
productivity ratio.

When proprotionate decrease in input is more than that of the output.let us consider the converse
of the pervious example, i.e dropping an uneconomical product from the existing product mix.
This will result in the following:

 A decrease in the revenue of the organization

 A decrease in the material cost, and operation and maintenance cost of machinery

If we closely examine these two decreases, we will se that the proportionate decrease in the input
cost will more than the proportionate decrease in the revenue. Hence, there will be net increase in
the productivity ratio.
Simultaneous increase in output and decrease in input. let us asume that there are advanced
automated technologies like robots and automated guided vechile system (AGVS, available in
the market which can be empolyed in the organization we are interested in. If we employ these
modern tools, then:

 There will be drastic reduction in the operation cost, initiallly, the cost on equipment
would be very high. But in the long run, the reduction in the operation cost would break-
even the high intial investment and offer more savings on the input.

 These advanced facilities would help in producing more products because they do not
experience fatigue. The increased production will yield more revenue.

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

1.2.2 Definition and scope of engineering economics

As stated earlier, efficient functioning of any business organization would enable it to provide
goods/services at a lower price. In the process of managing organizations, the managers at
different levels should take appropriate economic decisions which will help in minimizing
investment, operating and maintenance expenditures besides increasing the revenue, savings and
other related gains of the organization.

Definition

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

Scope

The issues that covered in this book are elementary economic analysis, intrest formulae, bases
for comparing alternatives, present worth method, future worth method, annual equilant method,
rate of return method,replacement analysis, depreciation, evaluationof public alternatives,
inflation adjusted investment decisions, make or buy decisions, inventory control, project
management, value engineering and linear programming
CIRCULAR FLOW OF ECONOMIC ACTIVITY

The individuals own or control resources which are necessary inputs for the firms in the
production process. These resources (factors of production) are classified into four types.

Land: It includes all natural resources on the earth and below the earth. Non renewable
resources such as oil, coal etc once used will never be replaced. It will not be available for our
children. Renewable resources can be used and replaced and is not depleted with use.

Labor: is the work force of an economy. The value of the worker is called as human capital.

Capital: It is classified as working capital and fixed capital (not transformed into final products)

Entrepreneurship: It refers to the individuals who organize production and take risks.

All these resources are allocated in an effective manner to achieve the objectives of
consumers (to maximize satisfaction), workers (to maximize wages), firms (to maximize the
output and profit) and government (to maximize the welfare of the society).

The fundamental economic activities between households and firms are shown in the
diagram. The circular flows of economic activities are explained in a clockwise and
counterclockwise flow of goods and services.

The four sectors namely households, business, government and the rest of the world can
also be considered to see the flow of economic activities. The circular flow of activity is a chain
in which production creates income, income generates spending and spending in turn induces
production.

The major four sectors of the economy are engaged in three economic activities of
production, consumption and exchange of goods and services. These sectors are as follows:

Households: Households fulfill their needs and wants through purchase of goods and services
from the firms. They are owners and suppliers of factors of production and in turn they receive
income in the form of rent, wages and interest.
Firms: Firms employ the input factors to produce various goods and services and make
payments to the households.

Government: The government purchases goods and services from firms and also factors of
production from households by making payments.

Foreign sector: Households, firms and government of India purchase goods and services
(import) from abroad and make payments. On the other hand all these sectors sell goods and
services to various countries (export) and in turn receive payments from abroad

Chart - 1

Circular Flow Of Economic Activity

 The above said four agents take economic decisions to produce goods and services and to
exchange them and to consume them for satisfying the wants of the economy as a whole.
Understanding the opportunities and constraints in the exchange is essential to take better
decision in business. This is discussed in the forthcoming chapters in detail.

The economy comprises of the interaction of households, firms, government and other
nations. Households own resources and supply factor services like land, raw material, labour and
capital to the firms which helps them to produce goods and services.

In turn, firms pay rent for land, wages for their labour and interest against the capital
invested by the households. The earnings of the household are used to purchase goods and
services from the firms to fulfill their needs and wants, the remaining is saved and it goes to the
capital market and is converted as investments in various businesses.

The household and business firms have to pay taxes to the government for enjoying the
services provided. On the other hand firms and households purchase goods and services (import)
from various countries of the world. Firms tend to sell their products to the foreign customers
(export) who earn income for the firm and foreign exchange for the country.

Therefore, it is clear that households supply input factors, which flow to firms. Goods and
services produced by firms flow to households

Flow in an Economy;

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

Consumer goods, Services

Business Households

Provide goods and services to Consume final goods and services

consumers. produced by business and services

Use resources, inputs provided by Provide productive inputs to

households businesses

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

Economics Resources; Land, Labour, Capital

Law of supply and Demand

An interesting aspect of the economy is that the demand and supply of a product are
interdependent and they are sensitive with the respect to the price of that product. The
interrelationships between them are shown in above diagram.

And also it is clear that when there is a decrease in the price of a product, the demand for
product increases and its supply decreases. Also, the product is more in demand for the product
increases. At the same time, lowering of the price of the product makes the producers restrain
from releasing more quantities of the product in the market. Hence the supply of the product is
decreased. The point of intersection of the supply curve and the demand curve is known as the
equilibrium point. At the price corresponding to this point, the quantity of supply is equal to the
quantity of demand. Hence this point is called equilibrium point.
Factors influencing demand

The shape of the demand curve is influenced by the following factors;

o Income of the people

o Prices of related goods
o Tastes of consumers
If the income level of the people increases significantly, then their purchasing power will
naturally improve. This would definitely shift the demand curve to the north east direction. A
converse situation will shift the demand curve to the south west direction.
If, for instance the price of television sets is lowered drastically its demand would naturally go
up. As a result, the demand for its associated product, namely VCDs, would also increase. Hence
the prices of related foods influence the demand of products.
Over a period of time, the preferences of the people for a particular product may increase,
which in turn, will affect the demand. For instance diabetic people prefer to have sugar free
products. If the incidence of diabetes rises naturally there will be increased demand for sugar free
products.

Factors influencing supply

The shape of the supply curve is affected by the following factors:

1) Cost of the inputs 2) Technology 3) Weather 4) Prices of related goods

If the cost of inputs increases, then naturally, the cost of the product will go up. In such a
situation, at the prevailing price of the product the profit margin per unit will be less. The
producers will then reduce the production quantity, which in turn will affect the supply of the
product. For instance if the prices of fertilizers and cost of labor are increased significantly in
agriculture the profit margin per bag of paddy will be reduced. So, the farmers will reduce the
area of cultivation, and hence the quantity of supply of paddy will be reduced at the prevailing
prices of the paddy.

If there is advancement in technology used in manufacture of the product in the long run, there
will be a reduction in the production cost per unit. This will enable the manufacturer to have a
greater profit margin per unit at the prevailing price of the product. Hence, the producer will be
tempted to supply more quantity to the market.

Weather also has a direct bearing on the supply of products. For example demand for woolen
products will increase during winter. This means the prices of woolen goods will be increased in
winter. So, naturally, manufacturers will supply more volume of woolen goods during winter.

Again take the case of television sets. If the price of TV sets is lowered significantly then its
demand would naturally go up. As a result, the demand for associated products like VCDs would
also go up. Over a period of time, this will lead to an increase in the price of VCDs, which would
result in more supply of VCD’s

DETERMINANTS OF DEMAND:

There are various factors affecting the demand for a commodity. They are:

1.Price of the good: The price of a commodity is an important determinant of demand. Price and
demand are inversely related. Higher the price less is the demand and vice versa.

2.Price of related goods: The price of related goods like substitutes and complementary goods
also affect the demand. In the case of substitutes, rise in price of one commodity lead to increase
in demand for its substitute. In the case of complementary goods, fall in the price of one
commodity lead to rise in demand for both the goods.

3.Consumer’s Income: This is directly related to demand. A change in the income of the
consumer significantly influences his demand for most commodities. If the disposable income
increases, demand will be more.

4.Taste, preference, fashions and habits: These are very effective factors affecting demand for
a commodity. When there is a change in taste, habits or preferences of the consumer, his demand
will change. Fashions and customs in society determine many of our demands.
5.Population: If the size of the population is more, demand for goods will be more . The market
demand for a commodity substantially changes when there is change in the total population.

6.Money Circulation: More the money in circulation, higher the demand and vice versa.

7.Value of money: The value of money determines the demand for a commodity in the market.
When there is a rise or fall in the value of money there may be changes in the relative prices of
different goods and their demand.

8.Weather Condition: Weather is also an important factor that determines the demand for
certain goods.

9.Advertisement and Salesmanship: If the advertisement is very attractive for a commodity,

demand will be more. Similarly if the salesmanship and publicity is effective then the demand
for the commodity will be more.

10.Consumer’s future price expectation: If the consumers expect that there will be a rise in
prices in future, he may buy more at the present price and so his demand increases.

11.Government policy (taxation): High taxes will increase the price and reduce demand, while
low taxes will reduce the price and extend the demand.

12.Credit facilities: Depending on the availability of credit facilities the demand for
commodities will change. More the facilities higher the demand.

13.Multiplicity of uses of goods: if the commodity has multiple uses then the demand will be
more than if the commodity is used for a single purpose.

DEMAND DISTINCTIONS: TYPES OF DEMAND

Demand may be defined as the quantity of goods or services desired by an individual,

backed by the ability and willingness to pay.
1.Direct and indirect demand: (or) Producers’ goods and consumers’ goods: demand for
goods that are directly used for consumption by the ultimate consumer is known as direct
demand (example: Demand for T shirts). On the other hand demand for goods that are used by
producers for producing goods and services. (example: Demand for cotton by a textile mill)

2.Derived demand and autonomous demand: when a produce derives its usage from the use of
some primary product it is known as derived demand. (example: demand for tyres derived from
demand for car) Autonomous demand is the demand for a product that can be independently
used. (example: demand for a washing machine)

3.Durable and non durable goods demand: durable goods are those that can be used more than
once, over a period of time (example: Microwave oven) Non durable goods can be used only
once (example: Band-aid)

4.Firm and industry demand: firm demand is the demand for the product of a particular firm.
(example: Dove soap) The demand for the product of a particular industry is industry demand
(example: demand for steel in India )

5.Total market and market segment demand: a particular segment of the markets demand is
called as segment demand (example: demand for laptops by engineering students) the sum total
of the demand for laptops by various segments in India is the total market demand. (example:
demand for laptops in India)

6.Short run and long run demand: short run demand refers to demand with its immediate
reaction to price changes and income fluctuations. Long run demand is that which will ultimately
exist as a result of the changes in pricing, promotion or product improvement after market
adjustment with sufficient time.

7.Joint demand and Composite demand: when two goods are demanded in conjunction with
one another at the same time to satisfy a single want, it is called as joint or complementary
demand. (example: demand for petrol and two wheelers) A composite demand is one in which a
good is wanted for several different uses. ( example: demand for iron rods for various purposes)

8.Price demand, income demand and cross demand: demand for commodities by the
consumers at alternative prices are called as price demand. Quantity demanded by the consumers
at alternative levels of income is income demand. Cross demand refers to the quantity demanded
of commodity ‘X’ at a price of a related commodity ‘Y’ which may be a substitute or
complementary to X.

Price Demand: The ability and willingness to buy specific quantities of a good at the prevailing
price in a given time period.

Income Demand: The ability and willingness to buy a commodity at the available income in a
given period of time.

Market Demand: The total quantity of a good or service that people are willing and able to buy
at prevailing prices in a given time period. It is the sum of individual demands.

Cross Demand: The ability and willingness to buy a commodity or service at the prevailing
price of the related commodity i.e. substitutes or complementary products. For example, people
buy more of wheat when the price of rice increases.

EXCEPTIONAL DEMAND CURVE:

The demand curve slopes from left to right upward if despite the increase in price of the
commodity, people tend to buy more due to reasons like fear of shortages or it may be an
absolutely essential good.

The law of demand does not apply in every case and situation. The circumstances when
the law of demand becomes ineffective are known as exceptions of the law. Some of these
important exceptions are as under

1. Giffen Goods:

Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties
millets like bajra, cheaper vegetables like potato etc come under this category. Sir Robert Giffen
of Ireland first observed that people used to spend more of their income on inferior goods like
potato and less of their income on meat. After purchasing potato the staple food, they did not
have staple food potato surplus to buy meat. So the rise in price of potato compelled people to
buy more potato and thus raised the demand for potato. This is against the law of demand. This is
also known as Giffen paradox.
2. Conspicuous Consumption / Veblen Effect:

This exception to the law of demand is associated with the doctrine propounded by
Thorsten Veblen. A few goods like diamonds etc are purchased by the rich and wealthy sections
of society. The prices of these goods are so high that they are beyond the reach of the common
man. The higher the price of the diamond, the higher its prestige value. So when price of these
goods falls, the consumers think that the prestige value of these goods comes down. So quantity
demanded of these goods falls with fall in their price. So the law of demand does not hold good
here.

3. Conspicuous Necessities:

Certain things become the necessities of modern life. So we have to purchase them
despite their high price. The demand for T.V. sets, automobiles and refrigerators etc. has not
gone down in spite of the increase in their price. These things have become the symbol of status.
So they are purchased despite their rising price.

4. Ignorance:

A consumer’s ignorance is another factor that at times induces him to purchase more of
the commodity at a higher price. This is especially true, when the consumer believes that a high-
priced and branded commodity is better in quality than a low-priced one.

5. Emergencies:

During emergencies like war, famine etc, households behave in an abnormal way.
Households accentuate scarcities and induce further price rise by making increased purchases
even at higher prices because of the apprehension that they may not be available. . On the other
hand during depression, , fall in prices is not a sufficient condition for consumers to demand
more if they are needed.

6. Future Changes In Prices:

Households also act as speculators. When the prices are rising households tend to
purchase large quantities of the commodity out of the apprehension that prices may still go up.
When prices are expected to fall further, they wait to buy goods in future at still lower prices. So
quantity demanded falls when prices are falling.

7. Change In Fashion:

A change in fashion and tastes affects the market for a commodity. When a digital
camera replaces a normal manual camera, no amount of reduction in the price of the latter is
sufficient to clear the stocks. Digital cameras on the other hand, will have more customers even
though its price may be going up. The law of demand becomes ineffective.
8. Demonstration Effect:

It refers to a tendency of low income groups to imitate the consumption pattern of high
income groups. They will buy a commodity to imitate the consumption of their neighbors even if
they do not have the purchasing power.

9. Snob Effect:

Some buyers have a desire to own unusual or unique products to show that they are
different from others. In this situation even when the price rises the demand for the commodity
will be more.

10. Speculative Goods/ Outdated Goods:

Speculative goods such as shares do not follow the law of demand. Whenever the prices
rise, the traders expect the prices to rise further so they buy more.

Goods that go out of use due to advancement in the underlying technology are called
outdated goods. The demand for such goods does not rise even with fall in prices

11. Seasonal Goods:

Goods which are not used during the off-season (seasonal goods) will also be subject to
similar demand behaviour.

12. Goods In Short Supply:

Goods that are available in limited quantity or whose future availability is uncertain also
violate the law of demand.

ELASTICITY OF DEMAND

In economics, the term elasticity means a proportionate (percentage) change in one

variable relative to a proportionate (percentage) change in another variable. The quantity
demanded of a good is affected by changes in the price of the good, changes in price of other
goods, changes in income and changes in other factors. Elasticity is a measure of just how much
of the quantity demanded will be affected due to a change in price or income.

Elasticity of Demand is a technical term used by economists to describe the degree of

responsiveness of the demand for a commodity due to a fall in its price. A fall in price leads to an
increase in quantity demanded and vice versa.
The elasticity of demand may be as follows:

 Price Elasticity
 Income Elasticity and
 Cross Elasticity

PRICE ELASTICITY

The response of the consumers to a change in the price of a commodity is measured by

the price elasticity of the commodity demand. The responsiveness of changes in quantity
demanded due to changes in price is referred to as price elasticity of demand. The price elasticity
of demand is measured by dividing the percentage change in quantity demanded by the
percentage change in price.

Price Elasticity= Proportionate change in the Quantity Demanded/Proportionate change in

price

Percentage change in quantity demanded

= ----------------------------------------------

Percentage change in price

ΔQ / Q 10

= ---------= ------= 0.5 ΔQ = change in quantity demanded

ΔP / P 20 ΔP = change in price

P = price
Q = quantity demanded
For example:

Quantity demanded is 20 units at a price of Rs.500. When there is a fall in price to Rs.
400 it results in a rise in demand to 32 units. Therefore the change in quantity demanded is12
units resulting from the change in price of Rs.100.

The Price Elasticity of Demand is = 500 / 20 x 12/100 = 3

The Determinants Of Price Elasticity Of Demand

The exact value of price elasticity for a commodity is determined by a wide variety of
factors. The two factors considered by economists are the availability of substitutes and time.
The better the substitutes for a product, the higher the price elasticity of demand.. The longer the
period of time, the more the price elasticity of demand for that product. The price elasticity of
necessary goods will have lower elasticity than luxuries.

The elasticity of demand depends on the following factors:

1. Nature of the commodity: The demand for necessities is inelastic because the demand does
not change much with a change in price. But the demand for luxuries is elastic in nature.
2. Extent of use: A commodity having a variety of uses has a comparatively elastic demand.
3. Range of substitutes: The commodity which has more number of substitutes has relatively
elastic demand. A commodity with fewer substitutes has relatively inelastic demand.
4. Income level: People with high incomes are less affected by price changes than people with
low incomes.
5. Proportion of income spent on the commodity: When a small part of income is spent on the
commodity, the price change does not affect the demand therefore the demand is inelastic
in nature.
6. Urgency of demand / postponement of purchase: The demand for certain commodities are
highly inelastic because you cannot postpone its purchase. For example medicines for any
sickness should be purchased and consumed immediately.
7. Durability of a commodity: If the commodity is durable then it is used it for a long period.
Therefore elasticity of demand is high. Price changes highly influences the demand for
durables in the market.
8. Purchase frequency of a product/ recurrence of demand: The demand for frequently
purchased goods are highly elastic than rarely purchased goods.
9. Time: In the short run demand will be less elastic but in the long run the demand for
commodities are more elastic.

The following are the possible combination of changes in Price and Quantity demanded. The
slope of each combination is depicted in the following graphs.

1. Relatively Elastic Demand (Ed >1) a small percentage change in price leading to a larger
change in Quantity demanded.
2. Perfectly Elastic Demand (Ed = ∞) a small change in price will change the quantity demanded
by an infinite amount.

3. Relatively Inelastic Demand (Ed < 1) a change in price leads to a smaller percentage change in
quantity demanded.

4. Perfectly Inelastic Demand (Ed = 0) the quantity demanded does not change regardless of the
percentage change in price.
5. Unit Elasticity of Demand (Ed =1) the percentage change in quantity demanded is the same as
the percentage change in price that caused it.

INCOME ELASTICITY

Income elasticity of demand measures the responsiveness of quantity demanded to a

change in income. It is measured by dividing the percentage change in quantity demanded by the
percentage change in income. If the demand for a commodity increases by 20% when income
increases by 10% then the income elasticity of that commodity is said to be positive and
relatively high. If the demand for food were unchanged when income increases, the income
elasticity would be zero. A fall in demand for a commodity when income rises results in a
negative income elasticity of demand.

The following are the various types of income elasticity:

Zero Income Elasticity: The increase in income of the individual does not make any difference
in the demand for that commodity. ( Ei = 0)

Negative Income Elasticity: The increase in the income of consumers leads to less purchase of
those goods. ( Ei < 0).

Unitary Income Elasticity: The change in income leads to the same percentage of change in the
demand for the good. ( Ei = 1).

Income Elasticity is Greater than 1: The change in income increases the demand for that
commodity more than the change in the income. ( Ei > 1).

Income Elasticity is Less than 1: The change in income increases the demand for the
commodity but at a lesser percentage than the change in the Income. ( Ei < 1).
 The positive income elasticity of demand can be classified as unity, more than unity and
less than unity. We can understand from the above graphs that the product which is highly elastic
in nature will grow faster when the economy is expanding. The performance of firms having low
income elasticity on the other hand will be less affected by the economic changes of the country.
With a rise in consumer’s income, the demand increases for superior goods and decreases for
inferior goods and vice versa.

The income elasticity of demand is positive for superior goods or normal goods and negative for
inferior goods since a person may shift from inferior to superior goods with a rise in income.
CROSS ELASTICITY

The quantity demanded of a particular commodity varies according to the price of other
commodities. Cross elasticity measures the responsiveness of the quantity demanded of a
commodity due to changes in the price of another commodity.

For example the demand for tea increases when the price of coffee goes up. Here the
cross elasticity of demand for tea is high. If two goods are substitutes then they will have a
positive cross elasticity of demand. In other words if two goods are complementary to each other
then negative income elasticity may arise.

The responsiveness of the quantity of one commodity demanded to a change in the price
of another good is calculated with the following formula.

% change in demand for commodity A Ec

= -------------------------------------------------

% change in price of commodity B

If two commodities are unrelated goods, the increase in the price of one good does not
result in any change in the demand for the other goods. For example the price fall in Tata salt
does not make any change in the demand for Tata Nano.

Significance Of Elasticity Of Demand:

The concept of elasticity is useful for the managers for the following decision making
activities

1. In production i.e. in deciding the quantity of goods to be produced

2. Price fixation i.e. in fixing the prices not only on the cost basis but also on the basis of prices
of related goods.
3. In distribution i.e. to decide as to where, when, and how much etc.
4. In international trade i.e. what to export, where to export
5. In foreign exchange
6. For nationalizing an industry
7. In public finance

ELEMENTS OF COSTS

Cost can be broadly classfied into variable cost and overhead cost. Variable cost varies with the
volume of production while overhead cost is fixed, irrespective of the production volume.

Variable cost can be futher classfied into direct material cost, direct labour cost, and direct
expenses. The overhead cost can be classfied into factory overhead, adminstration overhead,
selling overhead, and distribution overhead.

Direct material costs are those costs of materials that are used to produce the product. Direct
labour cost is the amount of wages paid to the direct labour involved in the production activities.
Direct expenses are those expenses that vary in relation to the production volume, other than the
direct material costs and direct labour costs.

Overall cost is the aggregate of indirect material costs, indirect labour costs and indirect
expenses. Administration overhead includes all the costs that are incurred in administering the
business. Selling overhead is the total expense that is incurred in the promotional activities and
the expenses relating to sales force. Distribution overhead is the total cost of shipping the items
from the factory site to the customer sites

The selling price of a product is derived as shown below:

a) Direct material costs + Direct labour costs+ Direct expenses= Prime cost

b) Prime cost+ Factory overhead = Factory cost.

c) Factory cost+ office and administrative overhead = cost of production.

d) cost of production +opening finished stock- Closing finished stock = cost of goods sold.

e) cost of goods sold + selling and distribution overhead = cost of sales

f) cost of sales + profit = sales

g) sales/ Quantity sold = selling price per unit

 in the above calculations, if the opening finished stock is equal to the closing finished
stock, then the cost of production is equal to the cost of goods sold.

1.4 OTHER COSTS/ REVENUES

The following are the costs/revenue other than the costs which are presented in the previous
section:

 Marginal cost

 Marginal revenue

 Sunk cost

 Opportunity cost

Marginal cost:

Marginal cost of a product is the cost of producing an additional unit of that product. Let the
cost of producing 20 units of a product be Rs.10,000, and the cost of producing 21 units of the
same product be Rs. 10045. Then the marginal cost of producing the 21 units is Rs.45.

Marginal revenue:

Marginal revenue of a product is the incremental revenue of selling an additional unit of that
product. Let the revenue of selling 20 units of a product be Rs.15,000 and the revenue selling 21
units of the same product be Rs.15085. then, the marginal revenue of selling the 21st unit is Rs.
85.

Sunk Cost:

This is known as the past cost of an equipment/asset. Let us assume that an equipment has
been purchased for Rs 1,00,000 about three years back. If it is considered for replacement, then
its present value is not Rs. 100000. Instead, its present market value should be taken as the
present value of the equipment for further analysis. So, the purchase value of the equipment in
the past is known as its sunk cost. The sunk cost should not be considered for any analysis done
from nowonwards.

Opportunity Cost

In practice, if an alternative (X) is selected from a set of competing alternatives(X, Y), then
the corresponding investment in the selected alternative is not available for any other purpose. If
the same money is invested in some other alternative (Y), it may fetch some return. Since the
money is invested in the selected alternative(X), one has to forego the return form the other
alternative (Y). The amount that is foregone by not investing in the other alternative(Y) is known
as opportunity cost of the selected alternative(X). So the opportunity cost of an alternative is the
return that will be foregone by not investing the same money in another alternative.

Consider that a person has invested a sum of Rs 50, 000 in shares. Let the expected annual
return by this alternative be rs 7500. If the same amount is invested in fixed deposit, a bank will
pay a return of 18%. Then, the corresponding total return per year for the investment in the bank
is rs 9000. This return is greater than the return from shares. The foregone excess return of rs
1500 by way of not investing in the bank is the opportunity cost of investing in shares.

BREAK EVEN ANALYSIS

The main objective of break even analysis is to find the cutt off production volume from
where a firm will make profit. Let

, s = selling price per unit

, v = variable cost per unit

FC = fixed cost per period

Q = volume of production

The total sales revenue (s) of the firm is given by the following formula;

S = sxQ

The total cost of the firm for a given production volume is given as

TC = Total variable cost + Fixed cost

= v x Q + FC

The linear plots of the above two equations are shows in below diagram. The intersection point
of the total sales revenue line and the total cost line is called the break even point. The
corresponding volume of production on the X axis us known as break even sales quantity. At the
intersection point, the total cost is equal to the total revenue. This point is also called as no loss
or no gain situation. For any production quantity which is less than the break even quantity, the
total cost is more than the total revenue. Hence, the firm will be making loss. For any production
quantity which is more thatn the break even quantity, the total revenue will be more than the total
cost. Hence, the firm will be making profit.

Profit = Sales - (Fixed cost + Variable cost)

 = s x Q - (FC + v x Q )

The formulae to find the break even quantity and break even sales quantity

The contribution is the difference between the sales and the variable costs. The margin of safty
is the sales over and above the break even sales. The formulae to compute these values are

Contribution = Sales – Variable costs

Contribution /unit = Selling Price/ unit - Variable cost/unit

M. S = Actual Sales – Break even sales

M.S as a per cent of sales = (M.S/ Sales) x 100

EXAMPLE 1.1 Alpha Associates has the following details:

Fixed cost = Rs. 20,00,000; Variable cost per unit = Rs. 100; Selling price per unit = Rs. 200
Find
(a) The break-even sales quantity,
(b) The break-even sales
(c) If the actual production quantity is 60,000, find (i) contribution; and
(ii) margin of safety by all methods.

Solution
Fixed cost (FC) = Rs. 20,00,000
Variable cost per unit (v) = Rs. 100
Selling price per unit (s) = Rs. 200.
PROFIT/VOLUME RATIO (P/V RATIO)

P/V ratio is a valid ratio which is useful for further analysis. The different formulae for the P/V
ratio are as follows:

The relationship between BEP and P/V ratio is as follows:

The following formula helps us find the M.S. using the P/V ratio:

EXAMPLE 1.2 Consider the following data of a company for the year 1997:

Sales = Rs. 1,20,000 Fixed cost = Rs. 25,000 Variable cost = Rs. 45,000
Find the following:
(a) Contribution (b) Profit (c) BEP (d) M.S.

Solution
EXAMPLE 1.3 Consider the following data of a company for the year 1998:
Sales = Rs. 80,000; Fixed cost = Rs. 15,000; Variable cost = 35,000
Find the following:
(a) Contribution (b) Profit (c) BEP (d) M.S.
Solution;

ISO-Quants:

Definitions:
“The Iso-product curves show the different combinations of two resources with which a firm can
produce equal amount of product.” Bilas

“Iso-product curve shows the different input combinations that will produce a given output.”
Samuelson

“An Iso-quant curve may be defined as a curve showing the possible combinations of two
variable factors that can be used to produce the same total product.” Peterson

“An Iso-quant is a curve showing all possible combinations of inputs physically capable of
producing a given level of output.” Ferguson
 To understand the production function with two variable inputs, iso-quant curve is used.
These curves show the various combinations of two variable inputs resulting in the same level of
output. The shape of an Iso-quant reflects the ease with which a producer can substitute among
inputs while maintaining the same level of output.

From the graph we can understand that the iso-quant curve indicates various
combinations of capital and labour usage to produce 100 units of motor pumps. The points a, b
or any point in the curve indicates the same quantum of production. If the production increases to
200 or 300 units definitely the input usage will also increase therefore the new iso-quant curve
for 200 units (Q1) is shifted upwards. Various iso-quant curves presented in a graph is called as
iso- quant map.

Iso-cost: different combination of inputs that can be purchased at a given expenditure level.

Optimal input combination:

The above graph explains clearly that the iso quant curve for 100 units of motor consists of ‘n’
number of input combinations to produce the same quantity. For example at ‘a’ to produce 100
units of motors the firm uses OC amount of capital and OL amount of labour ie., more capital
and less labour force. At ’b’ OC1 amount of capital and OL1 labour force is used to produce the
same that means more labour and less capital.

Optimal input combination: (the above graph) the points of tangency between iso quant and iso
cost curves depict optimal input combination at different activity levels.

Expansion path: Optimal input combinations as the scale of production expand. From the graph
it is clear that the optimum combination is selected based on the tangency point of iso cost
(budget line) and iso- quant ie., a, b respectively. The point ‘a’ indicates that to produce 100
units of motor the best combination of capital and labour are OC and OM which is within the
budget. Over a period of time a firm will face various optimum levels if we connect all points we
derive expansion path of a firm.

The Law of Returns to Scale

In the long run the fixed inputs like machinery, building and other factors will change
along with the variable factors like labor, raw material etc. With the equal percentage of increase
in input factors various combinations of returns occur in an organization.

Returns to scale: the change in percentage output resulting from a percentage change in
all the factors of production. They are increasing, constant and diminishing returns to scale.

Increasing returns to scale may arise: if the output of a firm increases more than in
proportionate to an increase in all inputs. For example the input factors are increased by 50% but
the output has doubled (100%).

Constant returns to scale: when all inputs are increased by a certain percentage the
output increases by the same percentage.

For example input factors are increased by 50% then the output has also increased by 50
percentages. Let us assume that a laptop consists of 50 components we call it as a set. In case the
firm purchases 100 sets they can assemble 100 laptops but it is not possible to produce more than
100 units.

Diminishing returns to scale: when output increases in a smaller proportion than the
increase in inputs it is known as diminishing return to scale. For example 50% increment in input
factors lead to only 20% increment in the output.

Managerial Uses Of Production Function:

Production functions are logical and useful. Production analysis can be used as aids in decision
making because they can give guidance to obtain the maximum output from a given set of inputs
and how to obtain a given output from the minimum aggregation of inputs. The complex
production functions with large numbers of inputs and outputs are analyzed with the help of
computer based programmes.
 UNIT – II

Production Management & Marketing Management:Types of Production; process of

planning, scheduling, Routing, material control; product concept concepts of productivity,
Core concepts of Marketing- Needs, Wants, Demand- Marketing Vs Selling- Products and
Markets- Pricing and its related factors- Channels of Distribution- Promotion-
Advertising- Market Research- Sales Forecasting.

Production

Production Management

According to Buffa “production is the process by which goods and services are created.”

Schematic representation of production system

Input Process Output

Men conversion of raw material finished goods

Machine

Money

Methods

Materials

Types of Production

Production

On the basis of Output On the basis of Flow On the basis of specification

Product Projects Customized

Services Job Shop Standardized

Flow shop

Continuous production
Product: Produced goods which can be seen are called as product. E.g. Consumer goods like
furniture, T.V, radio.

Services: Goods which cannot be seen and only can be felt are called as services. E.g.
Transportation, health, services, education system etc.

Project: It is complex non-routine one time effort limited by time, budget and resources. E.g.
dam constructions, starting new industries, fabricating boilers etc.

Job shop: This is a conversion process in which units of different types follow different
sequences through different shops. E.g. Hospitals, auto repair, machine shop etc

Flow shop: This is a conversion process in which successive units of output undergo the same
sequence of operations. E.g.T.V factory, auto factory.

Customized: A goods produced vary from person to person. E.g. production of shirts.

Standardized: A goods produced remains the same for all. E.g. insurance whole sale services.

Productivity

It is a relationship between output and the input of a business system.

Productivity = output

Input

There are several strategies for improving the productivity which are :

 Increased output for the same input.

 Decreased input for the same output.

 Proportionate increase in output with increase in input.

 Proportionate decrease in input with decrease in output

 Simultaneous increase in output with decrease in input.

Increased output for the same input: In this strategy the output in increased while keeping the
input constant. Let us assume that in a steel plant layout of the existing shops is not proper. By
altering the location of the billet-making section, i.e bringing it more closely produces hot metal
this would give more yields in terms of tons of billet gets produced. So this is an example where
the output is increased without any increase in input.

Decreased input for the same output. In this strategy, the input is decreased to produce the
same output. Let us assume that there exists a substitute of raw material to manufacture a product
which has the required properties and it is available at lower prices. If we identify such material
and use it for manufacturing the product then certainly it will reduce the input cost. The process
of identification does not involve any extra cost. So naturally, the productivity ratio will increase
because of the decreased input by using the cheaper raw material to produce the same input.

Proportionate increase in output with increase in input: consider the example of introducing
a new product into the existing product mix of an organization. The company gas identified a
new product which has a very good market and which can be manufactured with the surplus
facilities of the organization. If the new product is taken for production then the following will
be the result

There will be an increase in the revenue of the organization by way of selling new product hence
we find that proportionate increase in the revenue will be more than a proportionate increase in
the input cost.

Proportionate decrease in input with decrease in output: consider the reverse case of
previous example i.e. dropping an uneconomical product from the existing market. This will
result in the following:

There will be a decrease in the revenue of the organization because of dropping a product from
the existing market. Hence we find that proportionate decrease in input will be more than a
proportionate decrease in output.

Increase in output with decrease in input: let us assume that advanced automated technologies
like robot, automated guided vehicle system are available in the market which can be employed
in the organization of our interest. The outcome of these modern tools can be summarized as
following:

These advanced facilities would help in producing more number of goods because the machine
works faster than a human and it never gets tired. Hence the productivity ratio will increase at a
faster rate.

PROCESS PLANNING:

It is the systematic determination of the goods by which a product is to be manufactured

economically and competitively.

In a nutshell process planning is the preparation of detailed work plan.

Process planning procedure:

 It develops the broad plan of manufacturing a product or a component.

 Information required for Process planning:
 Quality of work to be performed
  Detailed specification of the product
 Availability of equipments, tools, and manpower
 Sequence of operations to be performed
 Standard time for each operation.

Steps involved in process planning:

1. Current production commitments, delivery date, and quality to be produced

2. Selection of materials: right quality, shape and size of raw material
3. Selection of jigs, fixtures and special attachment
4. Selection of cutting tools
5. Selection of inspection gauges
6. Documentation of process.

SCHEDULING

Concept. In brief, scheduling means-when and in what sequence the work will be done. It
involves deciding as to when the work will start and in certain duration of time how much work
will be finished. Scheduling deals with orders and machines, i:e., it determines which order will
be taken up on which machine and in which department by which operator. While doing so, the
aim is to schedule as large amount of work as the plant facilities can conveniently handle by
maintaining a free flow of material along the production line.
Scheduling may be called the time phase of Loading. Loading means the assignment of task or
work load facility whereas scheduling includes in addition, the specification of time and
sequence in which the order/Work will be taken up.
A production schedule is similar to a railway time table and shows which machine is doing what
and when.
Factors Affecting Scheduling.
The following factors affect production scheduling and are considered before establishing the
scheduling plan.
(a) External factors:
1. Customer's demand,
2. Customer's delivery dates, and
3. Stock of goods already lying with the dealers and retailers.
(b) Internal factors:
1. Stock of finished goods with the firm,
2. Time interval to process finished goods from raw material. In other words - how much time
will be required to manufacture each component, subassembly and then assembly (i.e., the final
Product),
3. Availability of equipment and machinery; their total capacity and specifications,
4. Availability of materials; their quantity and specifications,
5. Availability of manpower (number, type and kind of skills),
6. Additional manufacturing facilities if required, and
7. Feasibility of economic production runs.
Scheduling Procedure - and Techniques.(Refer Notes for the diagrams)
Scheduling normally starts with the Master Schedule. Figure 7.18 shows the master
schedule for a foundry shop.
A master schedule resembles central office which possesses information about all the
orders in hand. Master schedule, in Fig. 7.18, is a weekly breakdown of the production
requirements. The total capacity in any week is of 100 hours of work in the foundry shop.
As the orders are received, depending upon their delivery dates (or priorities, if any) they are
marked on the master schedule. When the shop capacity is full for the present week the newly
acquired orders are carried over to the next week and so on. A master schedule is thus updated
continuously; it depicts a running total of the production requirements and shows the work ahead
–yet to be completed. Master schedule is actually the 'basis for all subsequent scheduling
techniques.
Advantages
1. It is simple and easy to understand,
2. It can be kept running (i.e., current),
3. It involves less cost to make it and maintain,
4. It can be maintained by non-technical staff, and
5. A certain percentage of total weekly capacity can be allocated for rush orders.
Disadvantages
1. It provides only overall picture, and
2. It does not give detailed information.
Applications
It finds applications:
1. In big firms, for the purpose of loading the entire plant,
2. In Research and Development organizations, and
3. For the overall planning in foundries, computer centres, repair shops, etc.
Perpetual Scheduling.
Like master scheduling, it is also simple and easy to understand, is kept Current, involves less
cost and can be maintained by clerical staff. But, the information which it provides is very gross
and at the same time it is not clear from the chart -when the work will take place.
Making of perpetual schedule involves two steps ':

(i) Preparation of Load Analysis sheet from the orders in hand.

(ii) The total load against each section is added up and knowing the weekly capacity of a section
(Department), the number of weeks load against each department is calculated and plotted on a
Gantt load chart.
Order Scheduling.
It is a most elaborate technique. Fig. 7.21 shows an order schedule chart.
Time is marked horizontally and the vertical axis shows the particular facility (say a machine),
the information required to generate an order schedule is, regarding the number of parts to be
manufactured, name of the machines, their set-up times, total production time and the date of
completion of the order.
The scheduling is started by placing the last operation at the date of completion and then working
backwards. For example, if order X takes 3 days to complete and it is to be delivered to the
customer on 7th of January, the work will be started on 5th of January.
Order schedule chart has the following advantages and limitations.
Advantages
(1) It is very detailed.
(2) The earliest possible completion dates can be met.
Limitations
(1) It is very costly.
(2) It requires accurate (production) time standards and good communication system.
(3) It is difficult to maintain effectively if there are many active orders.

MANUFACTURING SCHEDULE
A master schedule is too general to permit adequate day-to-day planning by line supervision is
usually unnecessary in a small organisation.
Weekly departmental manufacturing schedules supplement the master schedule and must be
made to reflect immediate factors, some of which are
(1) Tool downtime due to broken and worn tools,
(2) Equipment downtime for repair and maintenance,
(3) Shortages and defects in materials,
(4) Absenteeism and
(5) Cancellations and rush orders.

ROUTING

Meaning:

 Defined as the selection of path, which part of the product will follow while being
transformed from raw materials to finished products.
 Path to be followed by department to department and machine to machine till raw
materials get its final shape.

Routing in industries:

A) Continuous Industry:
 Such industries are almost automatic therefore their routing is simple.
 Raw material enters the plant and automatically moves through different
process till it gets final shape.
 Once the route is decided in the beginning no further control is needed.
B) Assembly Industry:
  Such industries require various components to be assembled at a particular
time.
 The component should reach at the proper time and proper place to avoid
wastage of time and production delay.
 Eg: industries producing cycle, scooter, car, Radio, Typewriter, watch etc

C) Job Order Industry:

 Such industries always handle different products, therefore after receiving
manufacturing orders; the planning department has to prepare detailed
drawing and planning each time.
 The planning can be made after receiving manufacturing order.
MATERIAL MANAGEMENT

Meaning and Scope:

It includes several aspects connected with materials like

 Materials planning and programming
 Store keeping
 Purchasing, Transportation
 Inventory control, Materials handling
 Simplification, Codification and standardization in stores
 Disposal of scrap and surplus

Objectives of material management:

 Maintaining continuous production by ensuring a uniform flow of materials

 Reducing working costs by systematic use of scientific techniques

 Releasing working capital for productive purpose

 Increasing the competitiveness by ensuring right quality at right prices, especially in

foreign market

 Establishing good buyer-seller relations.

 Ensuring low departmental cost and high efficiency.

Function of material management:

 Material planning

 Procurement and purchasing of material

  Receiving and Warehousing

 Storage and store administration

 Inventory control

 Standardization, simplification and value analysis

 Disposal of scrap and surplus

STORES AND MATERIAL CONTROL

Introduction:

Materials and supplies are the most important assets in the majority of business. The success of
business depends to a large extent on the efficient storage and material control.

Materials pilferage, deterioration of material and careless handling of stores leads to reduce
profits.

STORES MANAGEMENT:

 Required material is never out of stock

 No material is available in excess

 Purchasing materials on the basis of economic order quantity

 Protect stores against damage, theft.

 This can be achieved through:

 Proper purchasing practice

 Proper methods of storing materials

 Effective system of physical control materials

 Proper method of keeping store records.

Definition for Market

An actual or nominal place where forces of demand and supply operate, and where buyers and
sellers interact (directly or through intermediaries) to trade goods, services, or contracts or
instruments, for money or barter.
Markets include mechanisms or means for (1) determining price of the traded item, (2)
communicating the price information, (3) facilitating deals and transactions, and (4) effecting
distribution. The market for a particular item is made up of existing and potential customers who
need it and have the ability and willingness to pay for it.

Dr. Philip Kotler defines marketing as “the science and art of exploring, creating, and
delivering value to satisfy the needs of a target market at a profit. Marketing identifies
unfulfilled needs and desires. ... Marketing are activities of a company associated with buying
and selling a product or service. It includes advertising, selling and delivering products to people.

It includes the coordination of four elements called the 4 P's of marketing:

(1)identification, selection and development of a product,
(2)determination of its price,
(3)selection of a distribution channel to reach the customer's place, and
(4)development and implementation of a promotional strategy.

Definition of Marketing

According to American marketing association “it is the process of planning and

executing the conception, pricing, promotion and distribution of ideas, goods and services to
create exchanges that will satisfy individual and organizational objectives”.

Marketing = Market +Consumer Satisfaction

Concepts of marketing

 Production concept :
It says that customers will favor those products which are widely available at low cost.
Hence such firms concentrate on reducing the cost of production and develop wide distribution
net work. Under this concept price and availability are the major influencing factors on the
customers while purchasing a product.

 Product concept :
It suggests that customers will favor those products which offer the best quality or
performance. The managers of such organization focus their energy on improving the quality of
products produced by them.

 Selling concept :

Customers will not buy enough of the products of an organization. The focus on this concept
is to somehow sell what the company manufactures. Hence the company must take an
aggressive selling effort to push its products like heavy advertising, large scale sales promotion,
heavy price discounts and public relations are the tools used by organizations that rely on this
concept.

 Marketing concept:
The marketing concept holds that the key to achieve organizational goals consists in
determining the needs and wants of target markets and delivering the desired satisfactions more
effectively and efficiently than competitors.

CONCEPT OF NEEDS, WANTS AND DEMAND

NEED is the unsatisfactory condition which get arise in human being.
Types of Needs
 Stated needs: The customer expects the particular product.
 Unstated needs: The customer expects to buy the particular brand in the product.
 Delight needs: The customer would like the dealer to include the additional service.
 Secret needs: the customer wants to be seen by friends as a savvy consumer.
WANTS deals with need for a specifying the particular object or event.
DEMAND it deals with the ability and willingness of the person to buy the particular product.
For example: many people want a Mercedes or BMW but only few are willing and able to buy one.
Types of Demand
 Latent demand: consumer may have a strong need to purchase the product but may not
have the ability to buy it.
 Full demand: Consumers buy the product adequately.
 Over full demand more consumers want the product than supply can meet.
 Negative demand: consumers dislike the product.
 Seasonal demand: consumer buys the product for the particular time period.
 Declining demand: consumer buy less frequently.
 Nonexistent demand: consumers are unaware or uninterested in a product.
PRODUCT

Definition: Alderson defines “a product is a bundle of utilities consisting of various product

features for satisfying the customers.”

Important features of a product:

Tangibility: It should be perceptible by the touch. An item to be called as product should have a
tangibility character touch, seen or feeling, for instance: car shirt, book etc.

Intangible Attributes: The product may be intangible, in the form of services, for instance
banking insurance services; repairing etc. it is an associated feature. For instance: scooter is a
tangible product and when free servicing is offered by the seller, then the product is not only a
tangible item but also an intangible one.

Associated Attributes: Such attributes may be brand, package, warranty etc.For instance,
Hindustan lever’s vanaspathi ghee has a brand name DALDA and with its package it can be
identified by the consumers.

Exchange value: Whether the product is tangible or intangible, it should have exchange value
and must be capable of being exchanged between seller and buyer for mutually agreed price.

Consumer satisfaction: Products should have the ability to offer value satisfaction to the
consumer. The satisfaction may be either real or psychological.

Classifications of products or services:

Goods may also be called as product. They are tangible. They are:

A. CONSUMER‘S GOODS: These types of goods are purchased by ultimate users or

consumers for their personal use. For example: food, biscuits, toys, clothes etc. are purchased by
consumers to satisfy their non-business wants. These goods may be further classifies as:

Convenience goods: Consumers or purchasers get commodities such as bread, drug, soap, sugar,
toothpaste, newspapers, petrol, cool drinks, at minimum effort and at low cost. They are often
required by the consumers. These types of goods are available at places, where consumers need.
The purchase of such goods cannot be postponed because they are daily necessities of life.

Shopping goods: Before marking final selection, the consumers make an enquiry as to the
products .comparative prices, durability, style etc. from different shops. Goods like furniture,
readymade garments etc. are mostly costly than convenience goods.

Speciality goods: Certain products possess special attention to the customers. As such the
consumer may wait or suffer inconveniences to get the desired needs. These types of goods are
of high value and manufactured by reputed firms. For example: cars, diamond.
B. INDUSTRIAL GOODS: Goods are those which are used for further production of goods and
services.

Raw Materials: These are goods that enter physically into the final products. For example:
building stones, raw cotton. Raw jute etc.

Fabricated materials: Materials of this category will enter into the final products but some type
of processing is already undergone .for example: bricks, copper sheets, leather, yarn etc.

Installation: Machines, buildings equipments etc. do not enter into final products and are
durable for a long period. They are essential for production .for example: gas, power installation
etc. they need heavy expenses for installation and sometimes decide the nature, scope and
efficiency of an organization.

Accessories: They are light machines or tolls which are used for the operation of a business. This
is not used for manufacturing a product. For example: typewriters, calculators, accounting
machine etc

C.SERVICES: Services are intangible activities which are offered for sale as such or in
connection with sale of goods. For example: banking, consultation etc.

PRODUCT LIFE CYCLE (PLC)

When a Product is commercialized it enters into the market and competes with the rival products
for making sale and earning profit. Like human beings, products also have a length of life and
they pass through different stages in this life period. These stages are termed as product life cycle
of that product.

Stages of product life cycle

 Introductory stage
 Growth stage
  Maturity stage or saturation stage
 Decline stage

Introduction stage:

 The information on product acceptance, product image and distribution system are
needed.
 The new product means “a product that opens up an entirely new market, replaces an
existing product or significantly broadens the market for an existing product.
 Product is new one, awareness in market is low, cost of marketing is high, and profits are
low.
 In this stage, the product is introduced into market and made available to the customers
with a slow rise in sales
 The profit may be low, because of heavy advertising and sales promotion in order to
stimulate the demand.
Growth stage:

 During the growth stage the products start yielding very good profits but there is a threat
from the competitors who try to enter the market and take the market share
 The product given first satisfaction to the first buyers. Others follow: sales increases
rapidly and product start generates profits.
 This is the stage where competitors appear along with substitute products in large
numbers.
 The success of firms depends upon the efficient manufacturing and distributing system of
the product.
Maturity stage:

 In this stage, the product’s sales reach the highest point but the profits starts declining
slowly thereafter.
 The product reaching its maturity and sales are good. But battle for market share is about
begin.
 At this stage, keen competition increases. Market expenses increase, even after mark-
down price, which enable to face competition.
 Profit is thinned. Additional expenses are involved in product modification and
improvement in the marketing mix to attract the customer and retain the market.
Saturation stage:

 The sales are at peak and further increase is not possible.

 The demand for the product is stable. But battle for market share is about to begin.
 At this stage, a replacement of product is needed, because the sale of the existing product
cannot be increased.
Decline stage:

 When sales start declining buyers go for newer and better product.
  This is because of many reasons technological advances, consumers shifts in taste,
increased competition etc.
 It exhibits a sharp decline in sales of the product.
 The firm has to decide whether to drop the product or continue with it.

Classification of Markets

Markets have been classified, on the basis of different approaches, in various ways. They are
given below.

A. On the Basis of Geographical Area:

1. Family Market: When exchanges are confined within a family or close members of the
family, such a market can be called as family members.

2. Local market: When people –buyers and sellers, belong to a local area or areas, say a town or
village, participate in market it is called local market. The demands are limited. For example,
perishable goods like fruits, fish, vegetables etc…

3. National Market: For a certain type of commodities, a country may be regarded as a market,
through the fast development of industrialization; it is called as national market. At the present
stage, in India, the goods of one corner can reach another corner because of the efficient systems
of communications and transportation facilities.

4. World Market: international market comes up when the buyers and sellers of goods evolve
on world level. That is involvement of buyers and sellers beyond the boundaries of a nation.

B. On the Basis of Commodities /Goods:

Commodity markets are subdivided into:

Produce Exchange Market: One market deals in one commodity only. Generally sellers and
buyers of a particular commodity set up such markets and run them regulated and controlled by
certain rules. Ex: the cotton exchange market of Bombay.

Manufactured Goods Market: such type of markets deals with manufactured goods. Ex:
leather goods, machinery etc.

Bullion market: This type of market deals with the purchase or sale of gold, silver etc. Bullion
markets of Bombay, Calcutta, Kanpur etc, are examples of such markets.

C. On the Basis of Economics:

Perfect market: A market is said to be perfect if it satisfies the following conditions:

  Large number of buyers and sellers
 Prices should be uniform throughout the market
 Buyers and sellers have a perfect knowledge of market
 Goods can be moved from one place to another without restrictions.
Imperfect market: A Market is said to be imperfect when

 Products are similar but not identical

 Prices are not uniform
 There is a lack of communications
 There are restrictions on the movement of goods.

D. On the Basis of Transaction:

Spot Market: In such a market goods are exchanged and the physical delivery of goods takes
place immediately.

Future Market: In such a market contracts are made over the price for future delivery. The
dealing and settlement takes place on different dates.

E. On the basis of regulation:

Regulated market: These are types of markets which are organized, controlled and regulated by
statutory measures. Example: stock exchange of Mumbai, Chennai, Kolkata etc…

Unregulated market: This is free market. There is no control with regard to price, quality;
commission etc. demand and supply determine the price of goods.

F. On the Basis of Time:

Very short period market: Markets which deal in perishable goods like, fruits, milk, vegetables
etc., are for a very short period. There is no change in the supply of goods. Price is determined
on the basis of demand.

Short period market: In certain goods, supply is adjusted to meet the demand. The demand is
greater than supply. Such markets are known as short period.

Long period market: This type of market deals in durable goods.

G. On the Basis of Volume of Business:

Wholesale Market: In wholesale market goods are supplied in bulky quantity to dealers.

Retail Market: In retail market goods are sold in small quantities directly to the users or
consumers. The consumer gets the goods for consumption and not for profit making.
Pricing

Method adopted by a firm to set its selling price. It usually depends on the firm's average costs,
and on the customer's perceived value of the product in comparison to his or her perceived value
of the competing products. Different pricing methods place varying degree of emphasis on
selection, estimation, and evaluation of costs, comparative analysis, and market situation.

Factors affecting price fixation

1. Fair trade laws. Manufacturers make agreement, with dealers who retail their products, on
the price it can be sold to the public.
2. Nationally advertised prices and government restricted prices of different products.
3. Desired customer clientele. Pricing policy depends upon the buying habits of the customers
who buy the products and whether, they (i.e., customers) are price conscious people.
4. Company monopoly. Whether the company has a monopoly or it is in a competitive position.
5. Manufacturer’s suggested prices, depending upon the cost of manufacture and selling the
product.
6. Type of Merchandises, i.e., whether they are novelties or special interest items, etc.
7. Nature of sales. Whether the product sells seasonally, (e.g., refrigerators) or throughout the
year
(e.g., televisions and transistor radios).
8. Price lining is a policy of keeping merchandise in fairly well defined price range, e.g., selling
shoes at Rs. 139.95 Rs. 254.95 and Rs. 371.95, etc.
9, .Whether large volume with low unit profit or relatively small volume with high unit profit is
desired. .
10.. Suitable channels of distribution.
11. Sales promotional strategy.
PRICING PRACTICES

 Administered pricing:
Administered prices are those prices, which are statutorily fixed by the government,
taking into account the cost and the stipulated profit per unit .steel, fertilizer, coal etc are
generally fixed by the Government.

 Dual pricing:
 Under this dual pricing system, a producer is required compulsorily to sell a part of his
production to the government or its authorized agency at a substantially low price. The rest of
the product may be sold in the open market at a price fixed by the producer.

Sugar open market

Ration system

 Discriminatory pricing:

It occurs when company sells a products or services at two or more prices these
variations in price are not proportionate to the cost incurred. There are several forms of
discriminatory pricing:

 Customer segment pricing:

Here different customer groups are charged at different prices for the same product or
services. E.g.: Museums, entertainment, parks charge different admission fee from students and
others.

 Time price differentials:

In these case price may vary within 24 hours period. Example: gold rate.

 Calendar use pricing:

In these case prices may fixed on season basis or time of the usage. Example: in a tourist
place a hotel may charge different prices during season and off season.

 Product form pricing:

Here different versions of the same products are charged differently. For e.g.: liquid soap,
soap bar.

 Geographical pricing:
In this approach the company takes the location of manufacturing and buyers place into
consideration while fixing prices. Cost of transportation is a major component in this pricing
method.

CHANNELS OF DISTRIBUTION

DEFINITION

A set of independent organization involved in the process of making a product or service

available to the final customers for consumption.

Different Types of Channel Level

 Zero Level Channel or Direct marketing

 In this case company does not depend upon any channel member to reach the customer. It
directly sells the product to the end consumer. Hence these level is also knows direct
marketing or direct selling. The manufacturer in this case directly interacts with the customer.
Different method of direct marketing includes door to door selling, mail order, telephonic
order and selling through company owned shops.

Manufactures Customers

 One –level channels or single

When there is a single intermediary in between the producer and the buyer it is known as a
one level channel for eg. A company sells the product through a retailer to the customer.

Manufacturers Retailers Customers

 Two level channels or Double level channel

Here there are two intermediaries between the manufacturers as the customer eg. A
manufacturer sells the product to a wholesaler who sells it again to retailers who in turn
passes the product to the final customers
Manufacturers Wholesalers
Retailers Agents

 Three level channels or Triple Level channel

In these cases the product passes through the hands of three intermediaries before reaching
the final customers.

Manufacturers Agent Wholesalers Retailers Customers

SALES PROMOTION-Introduction

All the activities that go into the development of sales or those that are intended to raise
the demand level for a product very quickly can be grouped under the title Sales Promotion.
Sales promotion includes those marketing activities, other than personal selling, advertising, and
publicity, that stimulate consumer purchasing and dealer effectiveness, such as displays, shows
and exhibitions, demonstrations, and various non-recurrent selling efforts not in the ordinary
routine.
 Sales promotion focuses the attention of the customer at the actual point of sales in the
shops with such effectiveness that both the advertiser and the dealer are benefited. The main
purpose is to increase sales.
Sales promotion plays a critical role in introductory and maturity stages of the product
life cycle and also appears to be especially effective during periods of rapid inflation.
Sales promotion, intended to educate the consumers better and to bring about an increase
in sales is used more extensively in highly competitive businesses.
The whole idea behind sales promotion is to bring the name of product and that of the
manufacturer constantly before wholesalers, retailers and the consumers in order to stimulate
their interest in the product.
TYPES OF SALES PROMOTION

SALES PROMOTION

Consumer Sales Promotion Dealer’s Sales Promotion Sales Man Promotion

Coupons Price off Bonus

Samples Price Deal Meetings &conference

Premium Dealers’ Gift Sales contest

 Mail Premium Sales Contest

 Reusable Premium
 Direct premium

Sweepstakes

Money refund offer

Price off
Consumer Sales Promotion

Samples: Free samples are given to consumers to increase their interest in the product. It is an
effective device when the product is purchased often. Examples: soaps, detergent, tea and expand.

Coupons: certificated entitling the bearer to a stated saving on the purchase of a specific product
mailed enclosed in other products or attached to them. The coupons are used to

 Introduce new products.

 To sell new and larger size of a product
 To encourage repeated sale.

Premium: Merchandise offered at a relatively low cost or free as an incentive to purchase a

particular product.

Direct Premium: Premium accompanies the product inside or outside the package. Example:
one bowl for good day biscuit.

Free in mail premium: The Company sends these items by mail to consumers who are
requested to send the proof of their purchase.

Reusable Premium: It is a container which can be reused after the product is used. Example:
plastic jar.

Sweepstakes: Consumers submit their names for inclusion in a list of prizes –winning contest.

Price off: It stimulates sales during a slump season. It gives a temporary discount to the
consumer’s i.e. goods are offered at a rate less than the labeled rate.

Money Refund Offer: if the purchaser is not satisfied with the product, a part or all of the
purchaser’s money will be refund. It is stated on the package.

Dealer’s Sales Promotion

Price off: A straight discount off the list price on each case purchased during a stated time
period.
Price deal: Apart from the regular discounts special discounts are also allowed to the dealers for
a specified quantity of purchase.

Dealers Gift: manufacturers give attractive and useful articles to dealers against their orders.
The articles are radio, T.V, clock, watch etc.

Salesman Promotion

Bonus: The manufacturer sets a target of sales for a year. If the sales force sell the students
above the targeted sales bonus is offered to them.

Meetings &conference: The idea behind these is to educate, inspire and reward the salesman.
New selling techniques are described to them and discussed in the conference.

Sales contest: A sales contest aims at inducing the sales force or dealers to increase their sales
over a stated period, with prizes going to those who succeed.

Objectives of sales promotion

 To increase buying response at the consumers level.

 To attract new customers.
 To capture the major market share
 To meet the competition of other firms.
 To create brand image
 To stimulate the demand by popularizing the product.

ADVERTISING
Introduction and Definition

 Advertising can become an established essential of a country's economy. It contributes to

broad Geographic system of distribution; to the volume sales, an essential corollary of
mass production ;and to the pricing of many products within the economic means of the
average man .
 Just as communication is vital to good internal management, so is advertising vital to the
earning of profit.
 Running a business without advertising is just like winking at a beautiful girl in the dark-
you know what you are doing but she does not know it.
 Advertising is generally regarded as a form of communication the purpose of which is to
convey concepts about companies, goods and services by means of words, pictures,
 diagrams, sound, music, color, shapes and symbol on two levels of significance-the
national and the emotional.
 Advertising is any paid form of non-personal presentation and promotion of ideas, goods
or services by an indentified sponsor.
 Advertising may be defined as commercial messages to the public, designed to inform
potential and established consumers and to encourage sales for the advertiser.
 Advertising can stimulate demand and, where necessary, can even create demand where
none exists.
 Advertising arouses public interest, fosters a buying attitude and raises consumer demand
for the products of a company.
Functions and Objectives of Advertising
1. Advertising introduces existing and new company products to the public.
2. Advertising enhances potential buyer's responses to the company and its offerings.
3. Advertising tells that a product which the customers want exists and from where it can be
procured and at what price.
4. Advertising is undertaken to reduce selling costs; because large volume of production will
lead to economies, if, through advertising, it can be supported by mass distribution.
5. Advertising makes a product stand against its competitor products.
6. Advertising
 finds new users
 supports salesmen
 increases profit
 reaches customers who would otherwise be inaccessible to sales staff,
 tells the public, the good qualities of the product, i.e.,why people should purchase only
this brand'
7. Advertising convinces retailers that they should keep the products of that company.
8. Advertising creates a confidence in the minds of buyers regarding quality of those goods or
products.
9. Advertising builds ,up reputation for the company goods and services.
Types of Advertisements

Advertisements

Product Advertising Institutional Advertising

Selective advertising Informative

Comparative advertising Persuasive

Competitive advertising Remainder

Primary demand advertising

Commercial advertising

Product Advertising: The Company tries to sell its product or services through advertising. It
may be referred to as product advertising.

Selective Advertising: The goal of advertisement is to influence demand for a specific product
on the particular period of time.

Comparative Advertising: It stresses on comparative features of two or more specific brands in

terms of product or services.

Competitive Advertising: Advertising may begin to stress subtle differences in brands, with
heavy emphasis on brand name recall.

Primary demand advertising: It is intended to stimulate primary demand for a new product or
product category.

Industrial advertising: It is also termed as business advertising, as the name suggests such
advertising is solely meant for effecting increase in sales. Usually the following forms of
commercial advertising are recognized.
  Trade advertisement: Advertisement relates to trade is trade advertisement.
 Professional advertising: Advertisements undertaken by professional people is
professional advertising.
 Farmers Advertising: advertisements exclusively used for selling farm products such as
fertilizers, insecticides, farm implements etc.

Institutional advertising: where the objective of advertising is to promote the image of a

company or its services it is called institutional advertising.

Informative Advertising: It is designed to inform about the product information to the targeted
customers.

Persuasive Advertising: It is designed to make the customers to buy the products.

Remainder Advertising: It is designed to make the customers to recall the products which is
existing in the market.

MEANING OF MARKET RESEARCH

“The systematic gathering, recording and analyzing of data about problems relating to the
marketing of goods and services”.

Objectives of market research:

 To define the probable market for a particular product

 To assess competitive strength and policies.
 To understand customer acceptance.
 To assess the probable volume of future sales.

Types of market research

Market research: it covers the aspects regarding size and nature of market including export
market, dividing the consumers in terms of their age, sex, income. It may include market trends,
market share, and market potential.

Sales research: it relates to the problem of regional variations in sales, fixing sales territories,
measurement of the effectiveness of a salesman, evaluation and impact of sales methods and
incentives.

Product research: it relates to the analysis of the strength and weakness of the existing product,
product testing problems related to diversification.
Packaging research: to know the impact and its response in the market has become as
independent research field.

Advertising research: it undertakes a study relating to the preparation of the advertisement copy.

Business economic research : Problems relating to input – output analysis forecasting ,price and
profit analysis and preparation of break even charts are the main fields of this research .\

Process of market research

Define the problem:

In this step the problem is clearly and accurately stated to determine what issues are involved in
the research. What questions to ask and what types of solutions are needed. This is the crucial
step that should not be rushed.

Make a preliminary investigation:

The objective of preliminary investigation is to develop both a sharper definition of the problem
and a set of tentative answers. The tentative answers are developed by examining internal
information and published data and by talking with persons who have some experience with the
problem. Theses answers will be tested by future research.

Plan the research:

At this stage researchers know what facts are needed to resolve the identified problem and what
facts are available. They make plans on how together needed but missing data.

Gather factual information:

Once the basic research plan has been completed, the needed information can be collected by
mail, telephone or personal interviews, by observation or form commercial or government data
sources. The choice depends on the plan and the available sources of information.

Interpret the information:

Facts by themselves do not always provide a sound solution to a marketing problem. They must
be interpreted and analyzed to determine the choices available to management.

Report preparation:

The finals step in marketing research is summarizing the result and making a report. The findings
and recommendations are put in such a manner that the recipient of the report can understand
them clearly enough to use them effectively.

Market information system

 It consists of people, equipment and procedures to gather, sort, analyze, evaluate and distribute
needed timely and accurate information to market decision makers.

Market Research Techniques

Some of the techniques used by persons engaged in market research for collecting the
data are as follows:
1. Desk research. The data is collected from the information published by the company
or outside sources, e.g. government agencies, trade associations, etc. Desk research is done on :
(a) Sales analysis, i.e. past sales, fluctuations sales and promotional expenditures, economics of
order size,etc.
(b) Correlation studies, concerned with finding the relationship between two or more variables,
e.g., number of new cars produced and number of car batteries sold.’
(c) Ratios, such as stock-turn (the relationship between sales and stocks), profit per rupee
invested (earnings/capital)etc.
2. Postal Questionnaire carefully prepared questionnaires, consisting of questions -short,
specific and statistical or open minded are posted to a selected sample of respondents for
collecting specific data from them.
3. Telephone interviews Telephone interviews are conducted at a personal level with a
selected sample of people for collecting their views.
4. Personal Interviews Personal interviews are conducted on a simple question and
answer basis. Such interviews give best lt Suits with greater reliability.
5. Observational Method The marketing research personnel silently observe others and
collect the desired information, e.g., ~standing outside or in a wine shop, the brands more
frequently purchased can be found out. 6. Statistical Methods – Statistical methods make use of
large precollected data and logically conclude the market investigations. – Bar chart, histogram,
frequency polygon, frequency distribution curve and the concepts of average, median, and
standard deviation help serve the purpose.
SALES FORECASTING:

Forecasting is essentially the art of anticipating what buyers are likely to do under a given
set of conditions. – The market research conducted by a firm plus the analyses of current sales
experience and trends form the basis for the construction of a sales forecast. – The sales forecast
is a commitment on the part of the-sales department and each of its division’s of the expected
sales likely to be achieved in a given period at stated prices. – Sales forecasting should be very
accurate because production and stock holding plans and the whole train of events following
from these are based on them.

Sales Forecasting Techniques

 Forecasting is the formal process of predicting future events that will significantly affect th
functioning of the enterprise. Sales forecasting techniques may be categorized as
follows:

(a) Historic estimate,

(b) Sales force estimate,
(c) Trend line (or Time series analysis) technique,
(d) Market survey,
(e) Delphi method,
(f) Judgmental techniques,
(g) Prior knowledge,
(h) Forecasting by past average,
(i) Forecasting from last period's sales,
(j) Forecasting by Moving average,
(k) Forecasting by Weighted Moving average,
(l) Forecasting by Exponential Smoothing,
(m) Correlation Analysis,
(n) Linear Regression Analysis.
Historic estimate

This technique makes use of the assumption that what happened in past will happen in

future. example if a concern has sold 5000 blankets in winter last year, it will be able to
sell the sales quantity in winter this year also.
 Historic estimate is useful if the activity is affected by pattern of seasonality.
 It is useful for determining model, size and colour distribution.
 Manager in consultation with other related factory executives formulates the final
estimate of sales.
 This technique is useful when an industry is making a limited number of products (e.g.,
commercial power generating equipment) and there are a few large customers.
Trend line technique
- Trend line technique is employed when there is an appreciable amount of historical
data. - This technique is more reliable than the historic estimate (a) above.
- This technique involves plotting historical data, i.e., a diagram between activity
indicator,e.g., tons of material (say past sales) on Y-axis and time on X-axis
- A single best fitting line (using statistical technique) is drawn and projected to show sales
estimate for future.

- This technique is more accurate as it makes use of a large past data and possesses scientific
validity.
Market Survey, ie: Market Research Technique
 - This technique finds application when a concern introduces a new product in the market
and is interested to estimate its sales forecast. For a new product, naturally, no historic or
past data regarding sales will be available.

- This technique may be very informal, utilizing the sales force to feel out the potential
customer’s inorder to establish the extent of the market or it may be a systematically
conducted survey using special mathematical tools.
Delphi Method
A panel of experts is interrogated by a sequence of questionnaires in which the response
to one questionnaire is used to produce the next questionnaire. Any set of information available
to some experts and not others is thus passed on to the others, enabling all the experts to have
access to all the information for forecasting. The method solicits and collates opinion from
experts to arrive at a reliable consensus.
Judgmental techniques.
They involve 1. Opinions of consumers and customers. Questionnaires related to
buying the product may be sent to selected group of consumers and to the customers who have
already purchased the product. The information thus received can be very useful in estimating
product performance and its probable demand in future. 2. Retail and wholesale dealers can
provide some insight into the pace of current and future sales. 3. The opinion of area sales
managers can also be quite useful.

Prior knowledge

This is used by ancillary units which are more or less a part of the large organisation. The large
organisation informs each ancillary unit how many component parts to make. The forecast
estimate is needed only to establish the material and tool requirements, etc.

Econometric Forecasting –

In econometric forecasting the analyst tries to uncover the cause-and-effect relationship between
sales and some other phenomena that are related to sales. For example, an appliance
manufacturer might discover that the sales of television sets respond to the disposable income of
customers with a I-month lag. That is, 1 month after a change in disposable income, there a
proportionate change in the sales of T.V. sets, this process is called econometric forecasting.
Here, the analyst tries to identify those factors that best explain the level of sales for a product. -
Econometric forecasting utilizes correlation and Regression techniques. The objective is to
establish a cause-and-effect relationship between changes in the sales level of the product and a
set of relevant explanatory variables.
 UNIT III

Financial management: Sources of finance (Internal and External) - Preparation of Balance

Sheet and Profit and Loss Statements, Types of Accounting and significance of each types,
interest formulas and their applications.

MEANING OF FINANCE

Finance also is referred as the provision of money at the time when it is needed. Finance
is the science that describes the management, creation and study of money, banking, credit,
investments, assets and liabilities. Finance consists of financial systems, which include the public,
private and government spaces, and the study of finance and financial instruments, which can
relate to countless assets and liabilities.

Objectives of Financial Management

Profit maximization
Wealth maximization

SOURCES OF FINANCE

There are two main sources of finance; these are internal sources and external sources.

Internal sources include:

 Retained profit - profit made is reinvested into the business.
 Controlling working capital - reducing costs, delaying outflows and speeding up inflows.
 Sale of assets - Assets the company owns can be sold and then leased back which frees
up a large amount of capital in the short term.
External sources of finance:
 Increasing trade credit - delaying payments on purchases for as long as possible.
 Factoring - use a company to collect all debts.
 Overdraft - an agreement with a bank to be allowed to overdraw a certain amount.
 Grants - an agreed amount of money given for a special reason by government or other
organisation.
 Venture capital - people invest in the company when it is unable to float on the stock
market.
 Debentures - business equivalent of a mortgage. Loan for a set length of time at a set
interest rate.
 Share issues - selling of new shares to raise capital.
 Owner’s savings - the owners investing money into the business.
 Bank loans - medium or long term loans but interest is charged.
 Leasing - instead of buying.
 Accounting
It is a systematic process of identifying, recording, measuring, classifying, verifying,
summarizing, interpreting and communicating financial information. It reveals profit or loss for a
given period, and the value and nature of a firm's assets, liabilities and owners' equity.
Accounting provides information on the
1. resources available to a firm,
2. The means employed to finance those resources, and
3. The results achieved through their use.

TYPES OF ACCOUNTING

The financial literature classifies accounting into two broad categories, viz, Financial
Accounting and Management Accounting. Financial accounting is primarily concerned with the
preparation of financial statements whereas management accounting covers areas such as
interpretation of financial statements, cost accounting, etc. Both these types of accounting are
examined in the following paragraphs.

Financial accounting

As mentioned earlier, financial accounting deals with the preparation of financial

statements for the basic purpose of providing information to various interested groups like
creditors, banks, shareholders, financial institutions, government, consumers, etc. Financial
statements, i.e. the income statement and the balance sheet indicate the way in which the
activities of the business have been conducted during a given period of time.

Financial accounting is charged with the primary responsibility of external reporting. The
users of information generated by financial accounting, like bankers, financial institutions,
regulatory authorities, government, investors, etc. want the accounting information to be
consistent so as to facilitate comparison. Therefore, financial accounting is based on certain
concepts and conventions which include separate business entity, going concern concept, money
measurement concept, cost concept, dual aspect concept, accounting period concept, matching
concept, realization concept and conventions of conservatism, disclosure, consistency, etc. All
such concepts and conventions would be dealt with detail in subsequent lessons.

The significance of financial accounting lies in the fact that it aids the management in
directing and controlling the activities of the firm and to frame relevant managerial policies
related to areas like production, sales, financing, etc. However, it suffers from certain drawbacks
which are discussed in the following paragraphs.

The information provided by financial accounting is consolidated in nature. It does

not indicate a break-up for different departments, processes, products and jobs. As
such, it becomes difficult to evaluate the performance of different sub-units of the
organisation.
 Financial accounting does not help in knowing the cost behaviour as it does not
distinguish between fixed and variable costs.

The information provided by financial accounting is historical in nature and as

such the predictability of such information is limited.
The management of a company has to solve certain ticklish questions like expansion of
business, making or buying a component, adding or deleting a product line, deciding on
alternative methods of production, etc. The financial accounting information is of little help in
answering these questions.

The limitations of financial accounting, however, should not lead one to believe that it is
of no use. It is the basic foundation on which other branches and tools of accounting analysis are
based. It is the source of information, which can be further analyzed and interpreted according to
the tailor-made requirements of decision-makers.

Management accounting

Management accounting is ‘tailor-made’ accounting. It facilitates the management by providing

accounting information in such a way so that it is conducive for policy making and running the
day-to-day operations of the business. Its basic purpose is to communicate the facts according to
the specific needs of decision-makers by presenting the information in a systematic and
meaningful manner. Management accounting, therefore, specifically helps in planning and
control. It helps in setting standards and in case of variances between planned and actual
performances, it helps in deciding the corrective action.

An important characteristic of management accounting is that it is forward looking. Its

basic focus is one future activity to be performed and not what has already happened in the past.

Since management accounting caters to the specific decision needs, it does not rest upon
any well-defined and set principles. The reports generated by a management accountant can be
of any duration– short or long, depending on purpose. Further, the reports can be prepared for the
organisation as a whole as well as its segments.

Cost accounting

One important variant of management accounting is the cost analysis. Cost accounting
makes elaborate cost records regarding various products, operations and functions. It is the
process of determining and accumulating the cost of a particular product or activity. Any product,
function, job or process for which costs are determined and accumulated, are called cost centres.

The basic purpose of cost accounting is to provide a detailed break-up of cost of different
departments, processes, jobs, products, sales territories, etc., so that effective cost control can be
exercised.
 Cost accounting also helps in making revenue decisions such as those related to pricing,
product-mix, profit-volume decisions, expansion of business, replacement decisions, etc.

The objectives of cost accounting, therefore, can be summarized in the form of three
important statements, viz, to determine costs, to facilitate planning and control of business
activities and to supply information for short- and long-term decision.

Cost accounting has certain distinct advantages over financial accounting. Some of them
have been discussed succeedingly. The cost accounting system provides data about profitable
and non-profitable products and activities, thus prompting corrective measures. It is easier to
segregate and analyse individual cost items and to minimize losses and wastages arising from the
manufacturing process. Production methods can be varied so as to minimize costs and increase
profits. Cost accounting helps in making realistic pricing decisions in times of low demand,
competitive conditions, technology changes, etc.

Various alternative courses of action can be properly evaluated with the help of data
generated by cost accounting. It would not be an exaggeration if it is said that a cost accounting
system ensures maximum utilization of physical and human resources. It checks frauds and
manipulations and directs the employer and employees towards achieving the organisational goal.

Governmental Accounting, also known as public accounting or federal accounting, refers to

the type of accounting information system used in the public sector. This is a slight deviation
from the financial accounting system used in the private sector. The need to have a separate
accounting system for the public sector arises because of the different aims and objectives of the
state owned and privately owned institutions. Governmental accounting ensures the financial
position and performance of the public sector institutions are set in budgetary context since
financial constraints are often a major concern of many governments. Separate rules are followed
in many jurisdictions to account for the transactions and events of public entities.

Tax Accounting refers to accounting for the tax related matters. It is governed by the tax rules
prescribed by the tax laws of a jurisdiction. Often these rules are different from the rules that
govern the preparation of financial statements for public use (i.e. GAAP). Tax accountants
therefore adjust the financial statements prepared under financial accounting principles to
account for the differences with rules prescribed by the tax laws. Information is then used by tax
professionals to estimate tax liability of a company and for tax planning purposes.
Forensic Accounting is the use of accounting, auditing and investigative techniques in cases of
litigation or disputes. Forensic accountants act as expert witnesses in courts of law in civil and
criminal disputes that require an assessment of the financial effects of a loss or the detection of a
financial fraud. Common litigations where forensic accountants are hired include insurance
claims, personal injury claims, suspected fraud and claims of professional negligence in a
financial matter (e.g. business valuation).
Project Accounting refers to the use of accounting system to track the financial progress of a
project through frequent financial reports. Project accounting is a vital component of project
management. It is a specialized branch of management accounting with a prime focus on
ensuring the financial success of company projects such as the launch of a new product. Project
accounting can be a source of competitive advantage for project-oriented businesses such as
construction firms.
Social Accounting, also known as Corporate Social Responsibility Reporting and Sustainability
Accounting, refers to the process of reporting implications of an organization's activities on its
ecological and social environment. Social Accounting is primarily reported in the form of
Environmental Reports accompanying the annual reports of companies. Social Accounting is still
in the early stages of development and is considered to be a response to the growing
environmental consciousness amongst the public at large.

Balance Sheet

A statement of the assets, liabilities, and capital of a business or other organization at a particular
point in time, detailing the balance of income and expenditure over the preceding period. A
balance sheet is a financial statement that summarizes a company's assets, liabilities and
shareholders' equity at a specific point in time. These three balance sheet segments give investors
an idea as to what the company owns and owes, as well as the amount invested by shareholders.

The balance sheet adheres to the following formula:

Assets = Liabilities + Shareholders' Equity

Profit & Loss Statement

A profit and loss statement (P&L) is a financial statement that summarizes the revenues, costs
and expenses incurred during a specific period of time, usually a fiscal quarter or year. These
records provide information about a company's ability – or lack thereof – to generate profit by
increasing revenue, reducing costs, or both. The P&L statement is also referred to as "statement
of profit and loss", "income statement," "statement of operations," "statement of financial
results," and "income and expense statement."It is prepared to ascertain the net profit or net loss
made by the company during the accounting period.

INTEREST FORMULAS

While making investment decisions, computations will be done in many ways. To simplify all
these computations, it is extremely important to know how to use interest formulas more
effectively. Before discussing the effective application of the interest formulas for investment-
decision making, the various interest formulas are presented first.

Interest rate can be classified into simple interest rate and compound interest rate.

In simple interest, the interest is calculated, based on the initial deposit for every interest
period. In this case, calculation of interest on interest is not applicable. In compound interest, the
interest for the current period is computed based on the amount (principal plus interest up to the
end of the previous period) at the beginning of the current period.
The notations which are used in various interest formulae are as follows:
P = principal amount
n = No. of interest periods
i = interest rate (It may be compounded monthly, quarterly, semiannually or annually)
F = future amount at the end of year n
A = equal amount deposited at the end of every interest period
G = uniform amount which will be added/subtracted period after period to/
from the amount of deposit A1 at the end of period 1
Single-Payment Compound Amount
Here, the objective is to find the single future sum (F) of the initial payment (P) made at time 0
after n periods at an interest rate i compounded every period. The cash flow diagram of this
situation is shown in Fig. 3.2

The formula to obtain the single-payment compound amount is

F = P(1 + i)n = P(F/P, i, n)
where
(F/P, i, n) is called as single-payment compound amount factor
EXAMPLE 3.1 A person deposits a sum of Rs. 20,000 at the interest rate of
18% compounded annually for 10 years. Find the maturity value after 10 years.
Solution
P = Rs. 20,000 i = 18% compounded annually n = 10 years
F = P(1 + i)n = P(F/P, i, n)
= 20,000 (F/P, 18%, 10)
= 20,000 x 5.234
= Rs. 1,04,680
The maturity value of Rs. 20,000 invested now at 18% compounded yearly
is equal to Rs. 1,04,680 after 10 years.
Single-Payment Present Worth Amount
Here, the objective is to find the present worth amount (P) of a single future sum (F) which will
be received after n periods at an interest rate of i compounded at the end of every interest period.
The corresponding cash flow diagram is shown in Fig. 3.3.

Cash flow diagram of single-payment present worth amount.

The formula to obtain the present worth is

Where
(P/F, i, n) is termed as single-payment present worth factor.
EXAMPLE 3.2 A person wishes to have a future sum of Rs. 1,00,000 for his
son’s education after 10 years from now. What is the single-payment that he
should deposit now so that he gets the desired amount after 10 years? The bank
gives 15% interest rate compounded annually.

Solution
F = Rs. 1,00,000
i = 15%, compounded annually
n = 10 years
P = F/(1 + i)n = F(P/F, i, n)
= 1,00,000 (P/F, 15%, 10)
= 1,00,000 x 0.2472
= Rs. 24,720
The person has to invest Rs. 24,720 now so that he will get a sum of Rs. 1,00,000 after 10 years
at 15% interest rate compounded annually.
Equal-Payment Series Compound Amount
In this type of investment mode, the objective is to find the future worth of n equal payments
which are made at the end of every interest period till the end of the nth interest period at an
interest rate of i compounded at the end of each interest period. The corresponding cash flow
diagram is shown in Fig. 3.4.

Fig. 3.4 Cash flow diagram of equal-payment series compound amount.

In Fig. 3.4,
A = equal amount deposited at the end of each interest period
n = No. of interest periods
i = rate of interest
F = single future amount

The formula to get F is

where (F/A, i, n) is termed as equal-payment series compound amount factor.
EXAMPLE 3.3 A person who is now 35 years old is planning for his retired life. He plans to
invest an equal sum of Rs. 10,000 at the end of every year forthe next 25 years starting from the
end of the next year. The bank gives 20% interest rate, compounded annually. Find the maturity
value of his account when he is 60 years old.
Solution
A = Rs. 10,000
n = 25 years
i = 20%
F=?

= A(F/A, i, n)
= 10,000(F/A, 20%, 25)
= 10,000 x 471.981
= Rs. 47,19,810
The future sum of the annual equal payments after 25 years is equal to Rs. 47,19,810.
Equal-Payment Series Sinking Fund
In this type of investment mode, the objective is to find the equivalent amount (A) that should be
deposited at the end of every interest period for n interest periods to realize a future sum (F) at
the end of the nth interest period at an interest rate of i. The corresponding cash flow diagram is shown in
Fig. 3.6.

In Fig. 3.6,
A = equal amount to be deposited at the end of each interest period
n = No. of interest periods
i = rate of interest
F = single future amount at the end of the nth period

Where (A/F, i, n) is called as equal-payment series sinking fund factor.

EXAMPLE 3.4 A company has to replace a present facility after 15 years at an outlay of Rs.
5,00,000. It plans to deposit an equal amount at the end of every year for the next 15 years at an
interest rate of 18% compounded annually. Find the equivalent amount that must be deposited at
the end of every year for the next 15 years.
Solution
F = Rs. 5,00,000, n = 15 years i = 18% A = ?

The corresponding cash flow diagram is shown in Fig. 3.7.

= 5,00,000(A/F, 18%, 15)

= 5,00,000 x 0.0164
= Rs. 8,200
The annual equal amount which must be deposited for 15 years is Rs. 8,200
Equal-Payment Series Present Worth Amount
The objective of this mode of investment is to find the present worth of an equal payment made
at the end of every interest period for n interest periods at an interest rate of i compounded at the
end of every interest period.
The corresponding cash flow diagram is shown in Fig. 3.8. Here
P = present worth
A = annual equivalent payment
i = interest rate
n = No. of interest periods
The formula to compute P is

EXAMPLE 3.5 A company wants to set up a reserve which will help the company to have an
annual equivalent amount of Rs. 10,00,000 for the next 20 years towards its employees welfare
measures. The reserve is assumed to grow at the rate of 15% annually. Find the single-payment
that must be made now as the reserve amount.

Solution
A = Rs. 10,00,000, i = 15%, n = 20 years P=?

The corresponding cash flow diagram is illustrated in Fig. 3.9.

= 10,00,000 x (P/A, 15%, 20)
= 10,00,000 x 6.2593
= Rs. 62,59,300

The amount of reserve which must be set-up now is equal to Rs. 62,59,300.

Equal-Payment Series Capital Recovery Amount

The objective of this mode of investment is to find the annual equivalent amount (A) which is to
be recovered at the end of every interest period for n interest periods for a loan (P) which is
sanctioned now at an interest rate of i compounded at the end of every interest period (see Fig.
3.10).

Cash flow diagram of equal-payment series capital recovery amount

In Fig. 3.10,
P = present worth (loan amount)
A = annual equivalent payment (recovery amount)
i = interest rate
n = No. of interest periods
The formula to compute P is as follows:

where,
(A/P, i, n) is called equal-payment series capital recovery factor.

EXAMPLE 3.6 A bank gives a loan to a company to purchase an equipment worth Rs. 10,00,000
at an interest rate of 18% compounded annually. This amount should be repaid in 15 yearly
equal installments. Find the installment amount that the company has to pay to the bank.
Solution
P = Rs. 10,00,000, i = 18% n = 15 years A = ?
The corresponding cash flow diagram is shown in Fig. 3.11.

Fig. 3.11 Cash flow diagram of equal-payment series capital recovery amount.

= 10,00,000 _ (A/P, 18%, 15)

= 10,00,000 _ (0.1964)
= Rs. 1,96,400
The annual equivalent installment to be paid by the company to the bank is
Rs. 1,96,400.
Uniform Gradient Series Annual Equivalent Amount

The objective of this mode of investment is to find the annual equivalent amount of a series with
an amount A1 at the end of the first year and with an equal increment (G) at the end of each of
the following n – 1 years with an interest rate i compounded annually.

The corresponding cash flow diagram is shown in Fig. 3.12.

Fig. 3.12 Cash flow diagram of uniform gradient series annual equivalent amount.

The formula to compute A under this situation is

where
(A/G, i, n) is called uniform gradient series factor.

EXAMPLE 3.7 A person is planning for his retired life. He has 10 more years of service. He
would like to deposit 20% of his salary, which is Rs. 4,000, at the end of the first year, and
thereafter he wishes to deposit the amount with an annual increase of Rs. 500 for the next 9 years
with an interest rate of 15%. Find the total amount at the end of the 10th year of the above series.

Solution

Here, A1 = Rs. 4,000 G = Rs. 500 i = 15% n = 10 years A = ? & F = ?

The cash flow diagram is shown in Fig. 3.13.

Cash flow diagram of uniform gradient series annual equivalent amount.

= 4,000 + 500(A/G, 15%, 10)

= 4,000 + 500 x 3.3832
= Rs. 5,691.60

This is equivalent to paying an equivalent amount of Rs. 5,691.60 at the end of every year for the
next 10 years. The future worth sum of this revised series at the end of the 10th year is obtained
as follows:

F = A(F/A, i, n)
= A(F/A, 15%, 10)
= 5,691.60(20.304)
= Rs. 1,15,562.25
At the end of the 10th year, the compound amount of all his payments will be Rs. 1,15,562.25.

EXAMPLE 3.8 A person is planning for his retired life. He has 10 more years of service. He
would like to deposit Rs. 8,500 at the end of the first year and thereafter he wishes to deposit the
amount with an annual decrease of Rs. 500for the next 9 years with an interest rate of 15%. Find
the total amount at the end of the 10th year of the above series.

Solution Here,
A1 = Rs. 8,500, G = –Rs. 500, i = 15% , n = 10 years, A = ? & F = ?

The cash flow diagram is shown in Fig. 3.14.

Fig. 3.14 Cash flow diagram of uniform gradient series annual equivalent amount.

This is equivalent to paying an equivalent amount of Rs. 6,808.40 at the end of every year for the
next 10 years.
The future worth sum of this revised series at the end of the 10th year is obtained as follows:

F = A(F/A, i, n)
= A(F/A, 15%, 10)

= 6,808.40(20.304)
= Rs. 1,38,237.75

At the end of the 10th year, the compound amount of all his payments is
Rs. 1,38,237.75.

3.3.8 Effective Interest Rate

Let i be the nominal interest rate compounded annually. But, in practice, the compounding may
occur less than a year. For example, compounding may be monthly, quarterly, or semi-annually.
Compounding monthly means that the interest is computed at the end of every month. There are
12 interest periods in a year if the interest is compounded monthly. Under such situations, the
formula to compute the effective interest rate, which is compounded annually, is where,
i = the nominal interest rate
C = the number of interest periods in a year.

EXAMPLE 3.9 A person invests a sum of Rs. 5,000 in a bank at a nominal interest rate of 12%
for 10 years. The compounding is quarterly. Find the maturity amount of the deposit after 10
years.
Solution
P = Rs. 5,000, n = 10 years, i = 12% (Nominal interest rate), F = ?

METHOD 1
No. of interest periods per year = 4
No. of interest periods in 10 years = 10 _ 4 = 40
Revised No. of periods (No. of quarters), N = 40
Interest rate per quarter, r = 12%/4
= 3%, compounded quarterly.

F = P(1 + r)N = 5,000(1 + 0.03)40

= Rs. 16,310.19

METHOD 2

No. of interest periods per year, C = 4

Effective interest rate, R = (1 + i/C)C – 1
= (1 + 12%/4)4 – 1
= 12.55%, compounded annually.

F = P(1 + R)n = 5,000(1 + 0.1255)10

= Rs. 16,308.91
 UNIT – IV

Method of Depreciation: Straight Line Method of Depreciation-Declining Balance Method

of Depreciation -Sum-of-the-Years-Digits Method of Depreciation-Sinking Fund Method of
Depreciation- Service Output Method of Depreciation.

DEPRECIATION
INTRODUCTION

Any equipment which is purchased today will not work for ever. This may be due to wear and
tear of the equipment or obsolescence of technology. Hence, it is to be replaced at the proper
time for continuance of any business. The replacement of the equipment at the end of its life
involves money. This must be internally generated from the earnings of the equipment. The
recovery of money from the earnings of an equipment for its replacement purpose is called
depreciation fund since we make an assumption that the value of the equipment decreases with
the passage of time. Thus, the word “depreciation” means decrease in value of any physical asset
with the passage of time.
METHODS OF DEPRECIATION
There are several methods of accounting depreciation fund. These are as follows:
1. Straight line method of depreciation
2. Declining balance method of depreciation
3. Sum of the years—digits method of depreciation
4. Sinking-fund method of depreciation
5. Service output method of depreciation
Straight Line Method of Depreciation
In this method of depreciation, a fixed sum is charged as the depreciation amount throughout the
lifetime of an asset such that the accumulated sum at the end of the life of the asset is exactly
equal to the purchase value of the asset. Here, we make an important assumption that inflation is
absent.
 UNIT – V
Methods of Comparison of Alternatives–Present Worth Method of Comparison ( Revenue
Dominated Cash flow Diagram, Cost Dominated Cash Flow Diagram),Future Worth Method
Comparison (Revenue Dominated Cash Flow Diagram, Cost Dominated Cash Flow Diagram),
Annual Equivalent Method of Comparison (Revenue Dominated Cash Flow Diagram, Cost
Dominated Cash Flow Diagram), Rate of Return Method, Examples in all the methods.

BASES FOR COMPARISON OF ALTERNATIVES

In most of the practical decision environments, executives will be forced to select the best
alternative from a set of competing alternatives. Let us assume that an organization has a huge
sum of money for potential investment and there are three different projects whose initial
outlay and annual revenues during their lives are known. The executive has to select the best
alternative among these three competing projects
There are several bases for comparing the worthiness of the projects. These bases
are:

1. Present worth method

2. Future worth method
3. Annual equivalent method
4. Rate of return method
PRESENT WORTH METHOD OF COMPARISON
INTRODUCTION
In this method of comparison, the cash flows of each alternative will be reduced to time zero
by assuming an interest rate i. Then, depending on the type of decision, the best alternative
will be selected by comparing the present worth amounts of the alternatives.

The sign of various amounts at different points in time in a cash flow diagram is to be decided
based on the type of the decision problem. In a cost dominated cash flow diagram, the costs
(outflows) will be assigned with positive sign and the profit, revenue, salvage value (all
inflows), etc. will be assigned with negative sign. In a revenue/profit-dominated cash flow
diagram, the profit, revenue, salvage value (all inflows to an organization) will be assigned
with positive sign. The costs (outflows) will be assigned with negative sign.

In case the decision is to select the alternative with the minimum cost, then the alternative with
the least present worth amount will be selected. On the other hand, if the decision is to select
the alternative with the maximum profit, then the alternative with the maximum present worth
will be selected.
 REVENUE-DOMINATED CASH FLOW DIAGRAM
A generalized revenue-dominated cash flow diagram to demonstrate the present worth
method of comparison is presented in Fig. 4.1.

In Fig. 4.1, P represents an initial investment and Rj the net revenue at the end of the jth year.
The interest rate is i, compounded annually. S is the salvagevalue at the end of the nth year.
To find the present worth of the above cash flow diagram for a given Interest rate, the formula is

PW(i) = – P + R1[1/(1 + i)1] + R2[1/(1 + i)2] + ...

+ Rj[1/(1 + i) j] + Rn[1/(1 + i)n] + S[1/(1 + i)n]
In this formula, expenditure is assigned a negative sign and revenues are assigned a positive
sign.
If we have some more alternatives which are to be compared with this alternative, then the
corresponding present worth amounts are to be computed and compared. Finally the alternative
with the maximum present worth amount should be selected as the best alternative.
COST-DOMINATED CASH FLOW DIAGRAM
A generalized cost-dominated cash flow diagram to demonstrate the present worth method of
comparison is presented in Fig. 4.2.
In Fig. 4.2, P represents an initial investment, Cj the net cost of operation and
maintenance at the end of the jth year, and S the salvage value at the end of the nth year.

To compute the present worth amount of the above cash flow diagram for a
given interest rate i, we have the formula

PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)2] + ... + Cj[1/(1 + i) j] +

Cn[1/(1 + i)n] – S[1/(1 + i)n]

In the above formula, the expenditure is assigned a positive sign and the revenue a negative
sign. If we have some more alternatives which are to be compared with this alternative, then
the corresponding present worth amounts are to be computed and compared. Finally, the
alternative with the minimum present worth amount should be selected as the best alternative.

EXAMPLE 4.1 Alpha Industry is planning to expand its production operation.It has identified
three different technologies for meeting the goal. The initialoutlay and annual revenues with
respect to each of the technologies aresummarized in Table 4.1. Suggest the best technology
which is to be implemented based on the present worth method of comparison assuming 20%
interest rate, compounded annually.

Solution In all the technologies, the initial outlay is assigned a negative sign and the
annual revenues are assigned a positive sign.
TECHNOLOGY 1
Initial outlay, P = Rs. 12,00,000

Annual revenue, A = Rs. 4,00,000

Interest rate, i = 20%,

compounded annually Life of this technology, n =
10 years
The cash flow diagram of this technology is as
shown in Fig. 4.3.

The present worth expression for this technology is

PW(20%)1 = –12,00,000 + 4,00,000 x (P/A, 20%, 10)
= –12,00,000 + 4,00,000 x (4.1925)

= –12,00,000 + 16,77,000

= Rs. 4,77,000
TECHNOLOGY 2
Initial outlay, P = Rs. 20,00,000
Annual revenue, A = Rs. 6,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years
The cash flow diagram of this technology is shown in Fig. 4.4.
 The present worth expression for this technology is
PW(20%)2 = – 20,00,000 + 6,00,000 x (P/A, 20%, 10)
= – 20,00,000 + 6,00,000 x (4.1925)
= – 20,00,000 + 6,00,000 x(4.1925)
= – 20,00,000 + 25,15,500
= Rs. 5,15,500

TECHNOLOGY 3
Initial outlay, P = Rs. 18,00,000
Annual revenue, A = Rs. 5,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years

The cash flow diagram of this technology is shown in Fig. 4.5

The present worth expression for this technology is

PW(20%)3 = –18,00,000 + 5,00,000 x (P/A, 20%, 10)
= –18,00,000 + 5,00,000 x(4.1925)
= –18,00,000 + 20,96,250
= Rs. 2,96,250

From the above calculations, it is clear that the present worth of technology 2 is the highest
among all the technologies. Therefore, technology 2 is suggested for implementation to
expand the production.
EXAMPLE 4.2 An engineer has two bids for an elevator to be installed in a new
building. The details of the bids for the elevators are as follows:

Determine which bid should be accepted, based on the present worth method of
comparison assuming 15% interest rate, compounded annually.
Solution
Bid 1: Alpha Elevator Inc.
Initial cost, P = Rs. 4,50,000
Annual operation and maintenance cost, A = Rs. 27,000
Life = 15 years
Interest rate, i = 15%, compounded annually
The cash flow diagram of bid 1 is shown in Fig. 4.6.

The present worth of the above cash flow diagram is computed as follows:

PW(15%) = 4,50,000 + 27,000(P/A, 15%, 15)

= 4,50,000 + 27,000 x 5.8474
= 4,50,000 + 1,57,879.80
= Rs. 6,07,879.80
=
Bid 2: Beta Elevator Inc.
Initial cost, P = Rs. 5,40,000
Annual operation and maintenance cost, A = Rs. 28,500
Life = 15 years
Interest rate, i = 15%, compounded annually.

The present worth of the above cash flow diagram is computed as follows:
PW(15%) = 5,40,000 + 28,500(P/A, 15%, 15)
= 5,40,000 + 28,500 x 5.8474

= 5,40,000 + 1,66,650.90

= Rs. 7,06,650.90
The total present worth cost of bid 1 is less than that of bid 2. Hence, bid 1 is to be selected for
implementation. That is, the elevator from Alpha Elevator Inc. is to be purchased and installed
in the new building.

EXAMPLE 4.3 Investment proposals A and B have the net cash flows as follows:
 Compare the present worth of A with that of B at i = 18%. Which proposal should be
selected?
Solution

Present worth of A at i = 18%. The cash flow diagram of proposal A is shown in Fig. 4.8.

The present worth of the above cash flow diagram is computed as

PWA(18%) = –10,000 + 3,000(P/F, 18%, 1) + 3,000(P/F, 18%, 2)
+ 7,000(P/F, 18%, 3) + 6,000(P/F, 18%, 4)
= –10,000 + 3,000 (0.8475) + 3,000(0.7182) + 7,000(0.6086)
+ 6,000(0.5158)
= Rs. 2,052.10

Present worth of B at i = 18%. The cash flow diagram of the proposal B is shown in Fig.
4.9.

The present worth of the above cash flow diagram is calculated as

PWB(18%) = –10,000 + 6,000(P/F, 18%, 1) + 6,000(P/F, 18%, 2) +3,000(P/F, 18%, 3) +
3,000(P/F, 18%, 4)
= –10,000 + 6,000(0.8475) + 6,000(0.7182) + 3,000(0.6086) +3,000(0.5158)
= Rs. 2,767.40
At i = 18%, the present worth of proposal B is higher than that of proposal A.
Therefore, select proposal B.
EXAMPLE 4.4 A granite company is planning to buy a fully automated granite cutting
machine. If it is purchased under down payment, the cost of the machine is Rs. 16,00,000. If it
is purchased under installment basis, the company has to pay 25% of the cost at the time of
purchase and the remaining amount in 10 annual equal installments of Rs. 2,00,000 each.
Suggest the best alternative for the company using the present worth basis at i = 18%,
compounded annually.
Solution There are two alternatives available for the company:
1. Down payment of Rs. 16,00,000

2. Down payment of Rs. 4,00,000 and 10 annual equal installments of Rs. 2,00,000 each

Present worth calculation of the second alternative. The cash flow diagram of the
second alternative is shown in Fig. 4.10.

The present worth of the above cash flow diagram is computed as

PW(18%) = 4,00,000 + 2,00,000(P/A, 18%, 10)

= 4,00,000 + 2,00,000 x 4.4941

= Rs. 12,98,820
The present worth of this option is Rs. 12,98,820, which is less than the first option of
complete down payment of Rs. 16,00,000. Hence, the company should select the second
alternative to buy the fully automated granite cutting machine.

EXAMPLE 4.5 A finance company advertises two investment plans. In plan 1, the company
pays Rs. 12,000 after 15 years for every Rs. 1,000 invested now. In plan 2, for every Rs. 1,000
invested, the company pays Rs. 4,000 at the end of the 10th year and Rs. 4,000 at the end of
15th year. Select the best investment plan from the investor‘s point of view at i = 12%,
compounded annually.
Solution Plan 1. The cash flow diagram for plan 1 is illustrated in Fig. 4.11.

The present worth of the above cash flow diagram is calculated as

PW(12%) = –1,000 + 12,000(P/F, 12%, 15)

= –1,000 + 12,000(0.1827)

= Rs. 1,192.40
Plan 2. The cash flow diagram for plan 2 is shown in Fig. 4.12.

The present worth of the above cash flow diagram is computed as

PW(12%) = –1,000 + 4,000(P/F, 12%, 10) + 4,000(P/F, 12%, 15)
= –1,000 + 4,000(0.3220) + 4,000(0.1827)

= Rs. 1,018.80
The present worth of plan 1 is more than that of plan 2. Therefore, plan 1 is the best plan
from the investor‘s point of view.

EXAMPLE 4.6 Novel Investment Ltd. accepts Rs. 10,000 at the end of every year for 20 years
and pays the investor Rs. 8,00,000 at the end of the 20th year. Innovative Investment Ltd.
accepts Rs. 10,000 at the end of every year for 20 years and pays the investor Rs. 15,00,000 at
the end of the 25th year. Which is the best investment alternative? Use present worth base with
i = 12%

Solution

Novel Investment Ltd’s plan.

The cash flow diagram of Novel Investment Ltd‘s plan is shown in Fig. 4.13.

The present worth of the above cash flow diagram is computed as

PW(12%) = –10,000(P/A, 12%, 20) + 8,00,000(P/F, 12%, 20)
= –10,000(7.4694) + 8,00,000(0.1037)
= Rs. 8,266
Innovative Investment Ltd’s plan. The cash flow diagram of the Innovative Investment
Ltd‘s plan is illustrated in Fig. 4.14.
The present worth of the above cash flow diagram is calculated as

PW(12%) = –10,000(P/A, 12%, 20) + 15,00,000(P/F, 12%, 25)

= –10,000(7.4694) + 15,00,000(0.0588)

= Rs. 13,506

The present worth of Innovative Investment Ltd‘s plan is more than that of Novel Investment
Ltd‘s plan. Therefore, Innovative Investment Ltd‘s plan is the best from investor‘s point of
view.
EXAMPLE 4.7 A small business with an initial outlay of Rs. 12,000 yields Rs. 10,000 during
the first year of its operation and the yield increases by Rs. 1,000 from its second year of
operation up to its 10th year of operation. At the end of the life of the business, the salvage
value is zero. Find the present worth of the business by assuming an interest rate of 18%,
compounded annually.

Solution
Initial investment, P = Rs. 12,000
Income during the first year, A = Rs. 10,000
Annual increase in income, G = Rs. 1,000 n = 10
years

i = 18%, compounded annually

The cash flow diagram for the small business is depicted in Fig. 4.15.

The equation for the present worth is

PW(18%) = –12,000 + (10,000 + 1,000 x (A/G, 18%, 10)) x (P/A, 18%, 10)
= –12,000 + (10,000 + 1,000 x 3.1936) x4.4941

= –12,000 + 59,293.36

= Rs. 47,293.36

The present worth of the small business is Rs. 47,293.36.

FUTURE WORTH METHOD

INTRODUCTION
In the future worth method of comparison of alternatives, the future worth of various
alternatives will be computed. Then, the alternative with the maximum future worth of net
revenue or with the minimum future worth of net cost will be selected as the best alternative
for implementation.

REVENUE-DOMINATED CASH FLOW DIAGRAM

A generalized revenue-dominated cash flow diagram to demonstrate the future worth
method of comparison is presented in Fig. 5.1.

In Fig. 5.1, P represents an initial investment, Rj the net-revenue at the end of the
jth year, and S the salvage value at the end of the nth year.

The formula for the future worth of the above cash flow diagram for a given
interest rate, i is

FW(i) = –P(1 + i)n + R1(1 + i)n–1 + R2(1 + i)n–2 + ...+ Rj(1 + i)n–j + ... + Rn + S
 In the above formula, the expenditure is assigned with negative sign and the revenues are
assigned with positive sign. If we have some more alternatives which are to be compared with
this alternative, then the corresponding future worth amounts are to be computed and compared.
Finally, the alternative with the maximum future worth amount should be selected as the best
alternative.
COST-DOMINATED CASH FLOW DIAGRAM
A generalized cost-dominated cash flow diagram to demonstrate the future worth
method of comparison is given in Fig. 5.2.

In Fig. 5.2, P represents an initial investment, Cj the net cost of operation and maintenance at
the end of the jth year, and S the salvage value at the end of the nth year.The formula for the
future worth of the above cash flow diagram for a given interest rate, i is

FW(i) = P(1 + i)n + C1(1 + i )n–1 + C2(1 + i)n–2 + ...+ Cj(1 + i)n–j + ... + Cn – S
In this formula, the expenditures are assigned with positive sign and revenues with negative
sign. If we have some more alternatives which are to be compared with this alternative, then
the corresponding future worth amounts are to be computed and compared. Finally, the
alternative with the minimum future worth amount should be selected as the best alternative.

5.4 EXAMPLES
In this section, several examples highlighting the applications of the future worth
method of comparison are presented.

At i = 18%, select the best alternative based on future worth method of comparison.
Solution Alternative A
Initial investment, P = Rs. 50,00,000
Annual equivalent revenue, A = Rs. 20,00,000
Interest rate, i = 18%, compounded annually
Life of alternative A = 4 years
The cash flow diagram of alternative A is shown in Fig. 5.3.

The future worth amount of alternative B is computed as

FWA(18%) = –50,00,000(F/P, 18%, 4) + 20,00,000(F/A, 18%, 4) = –
50,00,000(1.939) + 20,00,000(5.215)

= Rs. 7,35,000

Alternative 2—Build soft ice-cream stand

First cost = Rs. 36,00,000
Net annual income = Annual income – Annual property tax
= Rs. 9,80,000 – Rs. 1,50,000
= Rs. 8,30,000
Life = 20 years
Interest rate = 12%, compounded annually
The cash flow diagram for this alternative is shown in Fig. 5.6.
The future worth of alternative 2 is calculated as
FW2(12%) = – 36,00,000(F/P, 12%, 20) + 8,30,000 (F/A, 12%, 20)
= –36,00,000 (9.646) + 8,30,000 (72.052)
= Rs. 2,50,77,560

The future worth of alternative 1 is greater than that of alternative 2. Thus, building the gas
station is the best alternative.

EXAMPLE 5.3 The cash flow diagram of two mutually exclusive alternatives are given in
Figs. 5.7 and 5.8.
(a) Select the best alternative based on future worth method at i = 8%.

(b) Rework part (a) with i = 9% and 20%

(a) Evaluation at i = 8%
Alternative 1—This comes under equal payment gradient series.
P = Rs. 5,00,000
A1 = Rs. 50,000
G = Rs. 50,000
i = 8% n = 6 years
 The formula for the future worth of alternative 1 is
FW1(8%) = –P(F/P, 8%, 6) + [A1 + G(A/G, 8%, 6)] x (F/A, 8%, 6)

= – 5,00,000(1.587) + [50,000 + 50,000(2.2764)] x 7.336

= – 79,35,000 + 1,63,820 x 7.336
= –79,35,000 + 12,01,784
= Rs. 4,08,283.52
Alternative 2—This comes under equal payment gradient series.
P = Rs. 7,00,000
A1 = Rs. 70,000
G = Rs. 70,000

i = 8%

n = 6 years

The formula for the future worth of alternative 2 is

FW2(8%) = –P(F/P, 8%, 6) + [A1 + G(A/G, 8%, 6)] x (F/A, 8%, 6)
FW2(8%) = –7,00,000 x 1.587 + [70,000 + 70,000 x2.2764] x7.336
= –11,10,900 + 16,82,497
= Rs. 5,71,596.93
The future worth of alternative 2 is more than that of alternative 1. Therefore,
alternative 2 must be selected.

(b) (i) Evaluation at i = 9%:

Alternative 1
P = Rs. 5,00,000 A1 = Rs. 50,000 G = Rs. 50,000 n = 6 years
The formula for the future worth of alternative 1 is as follows:
FW1(9%) = – P(F/P, 9%, 6) + [A1 + G(A/G, 9%, 6)] x (F/A, 9%, 6)
= – 5,00,000 (1.677) + [50,000 + 50,000 (2.2498)] x7.523

= – 8,38,500 + 12,22,412.27

= Rs. 3,83,912.27
Alternative 2
P = Rs. 7,00,000 A1 = Rs. 70,000 G = Rs. 70,000 n = 6 years
The formula for the future worth of the alternative 2 is
FW2(9%) = –P(F/P, 9%, 6) + [A1 + G(A/G, 9%, 6)] x(F/A, 9%, 6)
= –7,00,000 x 1.677 + [70,000 + 70,000 x 2.2498] x 7.523
= –11,73,900 + 17,11,377.18
= Rs. 5,37,477.18
The future worth of alternative 2 is more than that of alternative 1. Therefore,
alternative 2 must be selected
(ii) Evaluation at i = 20%: Alternative 1
P = Rs. 5,00,000 A1 = Rs. 50,000 G = Rs. 50,000 n = 6 years
The formula for the future worth of alternative 1 is
FW1(20%) = –P(F/P, 20%, 6) + [A1 + G(A/G, 20%, 6)] x(F/A, 20%, 6)
= –5,00,000(2.986) + [50,000 + 50,000 (1.9788)] x 9.93
= –14,93,000 + 14,78,974.20
= Rs. –14,025.80

The negative sign of the future worth amount indicates that alternative 1 incurs loss.
Alternative 2
P = Rs. 7,00,000 A1 = Rs. 70,000 G = Rs. 70,000 n = 6 years

The formula for the future worth of alternative 2 is

FW2(20%) = – P(F/P, 20%, 6) + [A1 + G(A/G, 20%, 6)] _ (F/A, 20%, 6)

= –7,00,000 _ 2.986 + [70,000 + 70,000 _ 1.9788] _ 9.93

= –20,90,200 + 20,70,563.88

= Rs. –19,636.12

The negative sign of the above future worth amount indicates that alternative 2 incurs loss.
Thus, none of the two alternatives should be selected.
 EXAMPLE 5.4 M/S Krishna Castings Ltd. is planning to replace its annealing furnace.
It has received tenders from three different original manufacturers of annealing furnace.
The details are as follows.

Solution Alternative 1—Manufacturer 1

First cost, P = Rs. 80,00,000 Life, n = 12 years
Annual operating and maintenance cost, A = Rs. 8,00,000
Salvage value at the end of furnace life = Rs. 5,00,000
The cash flow diagram for this alternative is shown in Fig. 5.9.

The future worth amount of alternative 1 is computed as

FW1(20%) = 80,00,000 (F/P, 20%, 12) + 8,00,000 (F/A, 20%, 12) – 5,00,000
= 80,00,000(8.916) + 8,00,000 (39.581) – 5,00,000
= Rs. 10,24,92,800
Alternative 2— Manufacturer 2
First cost, P = Rs. 70,00,000
Life, n = 12 years
Annual operating and maintenance cost, A = Rs. 9,00,000
Salvage value at the end of furnace life = Rs. 4,00,000

The future worth amount of alternative 2 is computed as

FW2(20%) = 70,00,000(F/P, 20%, 12) + 9,00,000(F/A, 20%, 12) – 4,00,000

= 70,00,000(8.916) + 9,00,000 (39.581) – 4,00,000
= Rs. 9,76,34,900
Alternative 3—Manufacturer 3
First cost, P = Rs. 90,00,000
Life, n = 12 years
Annual operating and maintenance cost, A = Rs. 8,50,000
Salvage value at the end of furnace life = Rs. 7,00,000
The future worth amount of alternative 3 is calculated as
FW3(20%) = 90,00,000(F/P, 20%, 12) + 8,50,000(F/A, 20%, 12) – 7,00,000
= 90,00,000(8.916) + 8,50,000 (39.581) – 7,00,000
= Rs. 11,31,87,850

The future worth cost of alternative 2 is less than that of the other two alternatives. Therefore,
M/s. Krishna castings should buy the annealing furnace from manufacturer 2.

Solution Machine A
Initial cost of the machine, P = Rs. 4,00,000
Life, n = 4 years
Salvage value at the end of machine life, S = Rs. 2,00,000
Annual maintenance cost, A = Rs. 40,000
Interest rate, i = 12%, compounded annually.
The cash flow diagram of machine A is given in Fig. 5.12.
The future worth function of Fig. 5.12 is
FWA(12%) = 4,00,000 x (F/P, 12%, 4) + 40,000 x (F/A, 12%, 4) – 2,00,000
= 4,00,000 x (1.574) + 40,000 x (4.779) – 2,00,000
= Rs. 6,20,760

Machine B
Initial cost of the machine, P = Rs. 8,00,000
Life, n = 4 years
Salvage value at the end of machine life, S = Rs. 5,50,000
Annual maintenance cost, A = zero.
Interest rate, i = 12%, compounded annually.

The cash flow diagram of the machine B is illustrated in Fig. 5.13.

The future worth function of Fig 5.13 is

FWB(12%) = 8,00,000 x(F/P, 12%, 4) – 5,50,000

= 8,00,000 x (1.574) – 5,50,000

= Rs. 7,09,200

The future worth cost of machine A is less than that of machine B. Therefore, machine A should
be selected.
 ANNUAL EQUIVALENT METHOD
INTRODUCTION
In the annual equivalent method of comparison, first the annual equivalent cost or the revenue of
each alternative will be computed. Then the alternative with the maximum annual equivalent
revenue in the case of revenue-based comparison or with the minimum annual equivalent cost in
the case of costbased comparison will be selected as the best alternative.
REVENUE-DOMINATED CASH FLOW DIAGRAM
A generalized revenue-dominated cash flow diagram to demonstrate the annual equivalent
method of comparison is presented in Fig. 6.1.

In Fig. 6.1, P represents an initial investment, Rj the net revenue at the end
of the jth year, and S the salvage value at the end of the nth year.
The first step is to find the net present worth of the cash flow diagram using
the following expression for a given interest rate, i:
PW(i) = –P + R1/(1 + i)1 + R2/(1 + i)2 + ...
+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n
In the above formula, the expenditure is assigned with a negative sign and
the revenues are assigned with a positive sign.

In the second step, the annual equivalent revenue is computed using the following formula:
where (A/P, i, n) is called equal payment series capital recovery factor.

If we have some more alternatives which are to be compared with this alternative, then the
corresponding annual equivalent revenues are to be computed and compared. Finally, the
alternative with the maximum annual equivalent revenue should be selected as the best
alternative.

COST-DOMINATED CASH FLOW DIAGRAM

A generalized cost-dominated cash flow diagram to demonstrate the annual equivalent method of
comparison is illustrated in Fig. 6.2.

In Fig. 6.2, P represents an initial investment, Cj the net cost of operation and maintenance at the
end of the jth year, and S the salvage value at the end of the nth year.
The first step is to find the net present worth of the cash flow diagram using
the following relation for a given interest rate, i.
PW(i) = P + C1/(1 + i)1 + C2/(1 + i)2 + ...
+ Cj/(1 + i) j + ... + Cn/(1 + i)n – S/(1 + i)n
In the above formula, each expenditure is assigned with positive sign and the salvage value with
negative sign. Then, in the second step, the annual equivalent cost is computed using the
following equation:

where (A/P, i, n) is called as equal-payment series capital recovery factor.

As in the previous case, if we have some more alternatives which are to be compared with this
alternative, then the corresponding annual equivalent costsare to be computed and compared.
Finally, the alternative with the minimum annual equivalent cost should be selected as the best
alternative.
If we have some non-standard cash flow diagram, then we will have to follow the general
procedure for converting each and every transaction to time zero and then convert the net present
worth into an annual equivalent cost/ revenue depending on the type of the cash flow diagram.
Such procedure is tobe applied to all the alternatives and finally, the best alternative is to be
selected.
ALTERNATE APPROACH
Instead of first finding the present worth and then figuring out the annual equivalent cost/revenue,
an alternate method which is as explained below can be used. In each of the cases presented in
Sections 6.2 and 6.3, in the first step, one can find the future worth of the cash flow diagram of
each of the alternatives.
Then, in the second step, the annual equivalent cost/revenue can be obtained by using the
equation:

where (A/F, i, n) is called equal-payment series sinking fund factor.

EXAMPLES
In this section, the application of the annual equivalent method is demonstrated with several
numerical examples.

EXAMPLE 6.1 A company provides a car to its chief executive. The owner of the company is
concerned about the increasing cost of petrol. The cost per litre of petrol for the first year of
operation is Rs. 21. He feels that the cost of petrol will be increasing by Re.1 every year. His
experience with his company car indicates that it averages 9 km per litre of petrol. The executive
expects to drive an average of 20,000 km each year for the next four years. What is the annual
equivalent cost of fuel over this period of time?. If he is offered similar service with the same
quality on rental basis at Rs. 60,000 per year, should the owner continue to provide company car
for his executive or alternatively provide a rental car to his executive? Assume i = 18%. If the
rental car is preferred, then the company car will find some other use within the company
Solution
Average number of km run/year = 20,000 km
Number of km/litre of petrol = 9 km
Therefore,
Petrol consumption/year = 20,000/9 = 2222.2 litre
Cost/litre of petrol for the 1st year = Rs. 21
Cost/litre of petrol for the 2nd year = Rs. 21.00 + Re. 1.00
= Rs. 22.00
Cost/litre of petrol for the 3rd year = Rs. 22.00 + Re. 1.00
= Rs. 23.00
Cost/litre of petrol for the 4th year = Rs. 23.00 + Re. 1.00
= Rs. 24.00
Fuel expenditure for 1st year = 2222.2 _ 21 = Rs. 46,666.20
Fuel expenditure for 2nd year = 2222.2 _ 22 = Rs. 48,888.40
Fuel expenditure for 3rd year = 2222.2 _ 23 = Rs. 51,110.60
Fuel expenditure for 4th year = 2222.2 _ 24 = Rs. 53,332.80

The annual equal increment of the above expenditures is Rs. 2,222.20 (G).
In Fig. 6.3, A1 = Rs. 46,666.20 and G = Rs. 2,222.20
A = A1 + G(A/G, 18%, 4)
= 46,666.20 + 2222.2(1.2947)
= Rs. 49,543.28
The proposal of using the company car by spending for petrol by the company will cost an
annual equivalent amount of Rs. 49,543.28 for four years. This amount is less than the annual
rental value of Rs. 60,000. Therefore, the company should continue to provide its own car to its
executive.
EXAMPLE 6.2 A company is planning to purchase an advanced machine centre. Three original
manufacturers have responded to its tender whose particulars are tabulated as follows:

Determine the best alternative based on the annual equivalent method by assuming i = 20%,
compounded annually.

Solution Alternative 1
Down payment, P = Rs. 5,00,000
Yearly equal installment, A = Rs. 2,00,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for manufacturer 1 is shown in Fig. 6.4.

The annual equivalent cost expression of the above cash flow diagram is
AE1(20%) = 5,00,000(A/P, 20%, 15) + 2,00,000
= 5,00,000(0.2139) + 2,00,000
= 3,06,950
Alternative 2
Down payment, P = Rs. 4,00,000
Yearly equal installment, A = Rs. 3,00,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for the manufacturer 2 is shown in Fig. 6.5.

The annual equivalent cost expression of the above cash flow diagram is
AE2(20%) = 4,00,000(A/P, 20%, 15) + 3,00,000
= 4,00,000(0.2139) + 3,00,000
= Rs. 3,85,560.
Alternative 3
Down payment, P = Rs. 6,00,000
Yearly equal installment, A = Rs. 1,50,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for manufacturer 3 is shown in Fig. 6.6.

The annual equivalent cost expression of the above cash flow diagram is
AE3(20%) = 6,00,000(A/P, 20%, 15) + 1,50,000
= 6,00,000(0.2139) + 1,50,000
= Rs. 2,78,340.
The annual equivalent cost of manufacturer 3 is less than that of manufacturer 1 and
manufacturer 2. Therefore, the company should buy the advanced machine centre from
manufacturer 3.
EXAMPLE 6.3 A company invests in one of the two mutually exclusive alternatives. The life of
both alternatives is estimated to be 5 years with the following investments, annual returns and
salvage values.

Determine the best alternative based on the annual equivalent method by assuming i = 25%.

Solution Alternative A
Initial investment, P = Rs. 1,50,000 , Annual equal return, A = Rs. 60,000
Salvage value at the end of machine life, S = Rs. 15,000
Life = 5 years, Interest rate, i = 25%, compounded annually
The cash flow diagram for alternative A is shown in Fig. 6.7.

The annual equivalent revenue expression of the above cash flow diagram
is as follows:
AEA(25%) = –1,50,000(A/P, 25%, 5) + 60,000 + 15,000(A/F, 25%, 5)
= –1,50,000(0.3718) + 60,000 + 15,000(0.1218)
= Rs. 6,057
Alternative B
Initial investment, P = Rs. 1,75,000
Annual equal return, A = Rs. 70,000
Salvage value at the end of machine life, S = Rs. 35,000
Life = 5 years
Interest rate, i = 25%, compounded annually
The cash flow diagram for alternative B is shown in Fig. 6.8.
The annual equivalent revenue expression of the above cash flow diagram is
AEB(25%) = –1,75,000(A/P, 25%, 5) + 70,000 + 35,000(A/F, 25%, 5)
= –1,75,000(0.3718) + 70,000 + 35,000(0.1218)
= Rs. 9,198
The annual equivalent net return of alternative B is more than that of alternative A. Thus, the
company should select alternative B.

EXAMPLE 6.4 A certain individual firm desires an economic analysis to determine which of the
two machines is attractive in a given interval of time. The minimum attractive rate of return for
the firm is 15%. The following data are to be used in the analysis:

Which machine would you choose? Base your answer on annual equivalent cost.

Solution Machine X
First cost, P = Rs. 1,50,000
Life, n = 12 years
Estimated salvage value at the end of machine life, S = Rs. 0.
Annual maintenance cost, A = Rs. 0.
Interest rate, i = 15%, compounded annually.

The annual equivalent cost expression of the above cash flow diagram is
AEX(15%) = 1,50,000(A/P, 15%, 12)
= 1,50,000(0.1845)
= Rs. 27,675
Machine Y
First cost, P = Rs. 2,40,000
Life, n = 12 years
Estimated salvage value at the end of machine life, S = Rs. 60,000
Annual maintenance cost, A = Rs. 4,500
Interest rate, i = 15%, compounded annually.
The cash flow diagram of machine Y is depicted in Fig. 6.10.
The annual equivalent cost expression of the above cash flow diagram is
AEY(15%) = 2,40,000(A/P, 15%, 12) + 4,500 – 6,000(A/F, 15%, 12)
= 2,40,000(0.1845) + 4,500 – 6,000(0.0345)
= Rs. 48,573
The annual equivalent cost of machine X is less than that of machine Y. So, machine X is the
more cost effective machine.

EXAMPLE 6.5 Two possible routes for laying a power line are under study.Data on the routes
are as follows:

If 15% interest is used, should the power line be routed around the lake or under the lake?
Solution Alternative 1— Around the lake
First cost = 1,50,000 x 15 = Rs. 22,50,000
Maintenance cost/yr = 6,000 x15 = Rs. 90,000
Power loss/yr = 15,000 x 15 = Rs. 2,25,000
Maintenance cost and power loss/yr = Rs. 90,000 + Rs. 2,25,000
= Rs. 3,15,000
Salvage value = 90,000 x 15 = Rs. 13,50,000
The cash flow diagram for this alternative is shown in Fig. 6.11

The annual equivalent cost expression of the above cash flow diagram is
AE1(15%) = 22,50,000(A/P, 15%, 15) + 3,15,000 – 13,50,000(A/F, 15%, 15)
= 22,50,000(0.1710) + 3,15,000 – 13,50,000(0.0210)
= Rs. 6,71,400

Alternative 2—Under the lake

First cost = 7,50,000 x 5 = Rs. 37,50,000
Maintenance cost/yr = 12,000 x5 = Rs. 60,000
Power loss/yr = 15,000 x5 = Rs. 75,000
Maintenance cost and power loss/yr = Rs. 60,000 + Rs. 75,000
= Rs. 1,35,000
Salvage value = 1,50,000 x 5 = Rs. 7,50,000
The cash flow diagram for this alternative is shown in Fig. 6.12.
The annual equivalent cost expression of the above cash flow diagram is
AE2(15%) = 37,50,000(A/P, 15%, 15) + 1,35,000 – 7,50,000(A/F, 15%, 15)
= 37,50,000(0.1710) + 1,35,000 – 7,50,000(0.0210)
= Rs. 7,60,500

The annual equivalent cost of alternative 1 is less than that of alternative 2. Therefore, select the
route around the lake for laying the power line.
EXAMPLE 6.6 A suburban taxi company is analyzing the proposal of buying cars with diesel
engines instead of petrol engines. The cars average 60,000 km a year with a useful life of three
years for the petrol taxi and four years for the diesel taxi. Other comparative details are as
follows:

Determine the more economical choice if interest rate is 20%, compounded annually.
Solution Alternative 1— Purchase of diesel taxi
Vehicle cost = Rs. 3,90,000
Life = 4 years
Number of litres/year 60,000/30 = 2,000 litres
Fuel cost/yr = 2,000 x 8 = Rs. 16,000
Fuel cost, annual repairs and insurance premium/yr
= Rs. 16,000 + Rs. 9,000 + Rs. 15,000 = Rs. 40,000
Salvage value at the end of vehicle life = Rs. 60,000
The annual equivalent cost expression of the above cash flow diagram is
AE(20%) = 3,90,000(A/P, 20%, 4) + 40,000 – 60,000(A/F, 20%, 4)
= 3,90,000(0.3863) + 40,000 – 60,000(0.1863)
= Rs. 1,79,479
Alternative 2— Purchase of petrol taxi
Vehicle cost = Rs. 3,60,000
Life = 3 years, Number of litres/year 60,000/20 = 3,000 litres
Fuel cost/yr = 3,000 x 20 = Rs. 60,000
Fuel cost, annual repairs and insurance premium/yr
= Rs. 60,000 + Rs. 6,000 + Rs. 15,000 = Rs. 81,000
Salvage value at the end of vehicle life = Rs. 90,000

The cash flow diagram for alternative 2 is shown in Fig. 6.14.

The annual equivalent cost expression of the above cash flow diagram is
AE(20%) = 3,60,000(A/P, 20%, 3) + 81,000 – 90,000(A/F, 20%, 3)
= 3,60,000(0.4747) + 81,000 – 90,000(0.2747)
= Rs. 2,27,169
The annual equivalent cost of purchase and operation of the cars with diesel engine is less than
that of the cars with petrol engine. Therefore, the taxi company should buy cars with diesel
engine. (Note: Comparison is done on common multiple lives of 12 years.)

EXAMPLE 6.7 Ramu, a salesman, needs a new car for use in his business. He expects that he
will be promoted to a supervisory job at the end of third year and so his concern now is to have a
car for the three years he expects to be “on the road”. The company will reimburse their
salesman each month the fuel cost and maintenance cost. Ramu has decided to drive a low-priced
automobile. He finds, however, that there are two different ways of obtaining the automobile. In
either case, the fuel cost and maintenance cost are borne by the company.
(a) Purchase for cash at Rs. 3,90,000.
(b) Lease a car. The monthly charge is Rs. 10,500 on a 36-month lease payable at the end of each
month. At the end of the three-year period, the car is returned to the leasing company. Ramu
believes that he should use a 12% interest rate compounded monthly in determining which
alternative to select. If the car could be sold for Rs. 1,20,000 at the end of the third year, which
option should he use to obtain it?
Alternative 1—Purchase car for cash
Purchase price of the car = Rs. 3,90,000
Life = 3 years = 36 months
Salvage value after 3 years = Rs. 1,20,000
Interest rate = 12% (nominal rate, compounded annually)
= 1% compounded monthly
The monthly equivalent cost expression [ME(1%)] of the above cash flow
diagram is
ME(1%) = 3,90,000(A/P, 1%, 36) – 1,20,000(A/F, 1%, 36)
= 3,90,000(0.0332) – 1,20,000(0.0232)
= Rs. 10,164
Alternative 2—Use of car under lease
Monthly lease amount for 36 months = Rs. 10,500

Monthly equivalent cost = Rs.10,500.

The monthly equivalent cost of alternative 1 is less than that of alternative 2. Hence, the
salesman should purchase the car for cash.
EXAMPLE 6.8 A company must decide whether to buy machine A or machine B.

Solution Machine A
Initial cost = Rs. 3,00,000
Useful life (years) = 4
Salvage value at the end of machine life = Rs. 2,00,000
Annual maintenance = Rs. 30,000
Interest rate = 15%, compounded annually
The cash flow diagram of machine A is depicted in Fig. 6.17.

The annual equivalent cost expression of the above cash flow diagram is
AE(15%) = 3,00,000(A/P, 15%, 4) + 30,000 – 2,00,000(A/F, 15%, 4)
= 3,00,000(0.3503) + 30,000 – 2,00,000(0.2003)
= Rs. 95,030
Machine B
Initial cost = Rs. 6,00,000
Useful life (years) = 4
Salvage value at the end of machine life = Rs. 3,00,000
Annual maintenance = Rs. 0.
Interest rate = 15%, compounded annually
The cash flow diagram of machine B is illustrated in Fig. 6.18.

The annual equivalent cost expression of the above cash flow diagram is
AE(15%) = 6,00,000(A/P, 15%, 4) – 3,00,000(A/F, 15%, 4)
= 6,00,000(0.3503) – 3,00,000(0.2003)
= Rs. 1,50,090
Since the annual equivalent cost of machine A is less than that of machine B, it is advisable to
buy machine A.
EXAMPLE 6.9 Jothi Lakshimi has arranged to buy some home recording equipment. She
estimates that it will have a five year useful life and no salvage value at the end of equipment life.
The dealer, who is a friend has offered Jothi Lakshimi two alternative ways to pay for the
equipment.
(a) Pay Rs. 60,000 immediately and Rs. 15,000 at the end of one year.
(b) Pay nothing until the end of fourth year when a single payment of
Rs. 90,000 must be made.
If Jothi Lakshimi believes 12% is a suitable interest rate, which alternative
is the best for her?
Solution Alternative 1
Down payment = Rs. 60,000
Payment after one year = Rs. 15,000
The cash flow diagram for alternative 1 is shown in Fig. 6.19.

The present worth equation of the above cash flow diagram is

PW(12%) = 60,000 + 15,000(P/F, 12%, 1)
= 60,000 + 15,000(0.8929)
= 73,393.50

The annual equivalent expression of the above cash flow diagram is

AE(12%) = 73,393.5(A/P, 12%, 4)
= 73,393.5(0.3292)
= Rs. 24,161.14
Alternative 2
Payment after four years = Rs. 90,000
The annual equivalent cost expression of the above cash flow diagram is
AE(12%) = 90,000(A/F, 12%, 4)
= 90,000(0.2092)
= Rs. 18,828
The annual equivalent cost of alternative 2 is less than that of alternative 1. Hence, Jothi
Lakshimi should select alternative 2 for purchasing the home equipment.

EXAMPLE 6.10 A transport company has been looking for a new tyre for its truck and has
located the following alternatives:

If the company feels that the warranty period is a good estimate of the tyre life and that a
nominal interest rate (compounded annually) of 12% is appropriate, which tyre should it buy?
Solution In all the cases, the interest rate is 12%. This is equivalent to 1% per
month.
Brand A
Tyre warranty = 12 months
Price/tyre = Rs. 1,200
The annual equivalent cost expression of the above cash flow diagram is
AE(1%) = 1,200(A/P, 1%, 12)
= 1,200(0.0888)
= Rs. 106.56
Brand B
Tyre warranty = 24 months
Price/tyre = Rs. 1,800

The annual equivalent cost expression of the above cash flow diagram is
AE(1%) = 1,800(A/P, 1%, 24)
= 1,800(0.0471)
= Rs. 84.78
Brand C
Tyre warranty = 36 months
Price/tyre = Rs. 2,100
The annual equivalent expression of the above cash flow diagram is
AE(1%) = 2,100(A/P, 1%, 36)
= 2,100(0.0332)
= Rs. 69.72

Brand D
Tyre warranty = 48 months
Price/tyre = Rs. 2,700

The annual equivalent cost expression of the above cash flow diagram is
AE(1%) = 2,700(A/P, 1%, 48)
= 2,700 (0.0263)
= Rs. 71.01
Here, minimum common multiple lives of tyres are considered. This is 144 months. Therefore,
the comparison is made on 144 month’s basis. The annual equivalent cost of brand C is less than
that of other brands. Hence, it should be used in the vehicles of the trucking company. It should
be replaced four times during the 144-month period.
 RATE OF RETURN METHOD
INTRODUCTION
The rate of return of a cash flow pattern is the interest rate at which the present worth of that cash
flow pattern reduces to zero. In this method of comparison, the rate of return for each alternative
is computed. Then the alternative which has the highest rate of return is selected as the best
alternative. In this type of analysis, the expenditures are always assigned with a negative sign
and the revenues/inflows are assigned with a positive sign.

A generalized cash flow diagram to demonstrate the rate of return method of comparison is
presented in Fig. 7.1.

In the above cash flow diagram, P represents an initial investment, Rj the

net revenue at the end of the jth year, and S the salvage value at the end of the
nth year.
The first step is to find the net present worth of the cash flow diagram using
the following expression at a given interest rate, i.
PW(i) = – P + R1/(1 + i)1 + R2/(1 + i)2 + ...
+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n

Now, the above function is to be evaluated for different values of i until the present worth
function reduces to zero, as shown in Fig. 7.2.
In the figure, the present worth goes on decreasing when the interest rate is increased. The value
of i at which the present worth curve cuts the X-axis is the rate of return of the given
proposal/project. It will be very difficult to find the exact value of i at which the present worth
function reduces to zero.

So, one has to start with an intuitive value of i and check whether the present worth function is
positive. If so, increase the value of i until PW(i) becomes negative. Then, the rate of return is
determined by interpolation method in the range of values of i for which the sign of the present
worth function changes from positive to negative.
EXAMPLES
In this section, the concept of rate of return calculation is demonstrated with
suitable examples.
EXAMPLE 7.1 A person is planning a new business. The initial outlay and cash flow pattern for
the new business are as listed below. The expected life of the business is five years. Find the rate
of return for the new business.

Solution
Initial investment = Rs. 1,00,000
Annual equal revenue = Rs. 30,000
Life = 5 years

The cash flow diagram for this situation is illustrated in Fig. 7.3.

The present worth function for the business is

PW(i) = –1,00,000 + 30,000(P/A, i, 5)
When i = 10%,
PW(10%) = –1,00,000 + 30,000(P/A, 10%, 5)
= –1,00,000 + 30,000(3.7908)
= Rs. 13,724.
When i = 15%,
PW(15%) = –1,00,000 + 30,000(P/A, 15%, 5)
= –1,00,000 + 30,000(3.3522)
= Rs. 566.
When i = 18%,
PW(18%) = –1,00,000 + 30,000(P/A, 18%, 5)
= –1,00,000 + 30,000(3.1272)
= Rs. – 6,184

Therefore, the rate of return for the new business is 15.252%.

EXAMPLE 7.2 A company is trying to diversify its business in a new product line. The life of
the project is 10 years with no salvage value at the end of its life. The initial outlay of the project
is Rs. 20,00,000. The annual net profit is Rs. 3,50,000. Find the rate of return for the new
business.
Solution
Life of the product line (n) = 10 years
Initial outlay = Rs. 20,00,000
Annual net profit = Rs. 3,50,000
Scrap value after 10 years = 0
The cash flow diagram for this situation is shown in Fig. 7.4.

The formula for the net present worth function of the situation is
PW(i) = –20,00,000 + 3,50,000(P/A, i, 10)
When i = 10%,
PW(10%) = –20,00,000 + 3,50,000(P/A, 10%, 10)
= –20,00,000 + 3,50,000(6.1446)
= Rs. 1,50,610.
When i = 12%,
PW(12%) = –20,00,000 + 3,50,000(P/A, 12%, 10)
= –20,00,000 + 3,50,000(5.6502)
= Rs. –22,430.

= 11.74 %
Therefore, the rate of return of the new product line is 11.74%
EXAMPLE 7.3 A firm has identified three mutually exclusive investment proposals whose
details are given below. The life of all the three alternatives is estimated to be five years with
negligible salvage value. The minimum attractive rate of return for the firm is 12%.

Find the best alternative based on the rate of return method of comparison.
Solution
Calculation of rate of return for alternative A1
Initial outlay = Rs. 1,50,000
Annual profit = Rs. 45,570
Life = 5 years
The cash flow diagram for alternative A1 is shown in Fig. 7.5.

The formula for the net present worth of alternative A1 is given as

PW(i) = –1,50,000 + 45,570(P/A, i, 5)
When i = 10%,
PW(10%) = –1,50,000 + 45,570(P/A, 10%, 5)
= –1,50,000 + 45,570(3.7908)
= Rs. 22,746.76
When i = 12%,
PW(12%) = –1,50,000 + 45,570(P/A, 12%, 5)
= –1,50,000 + 45,570(3.6048)
= Rs. 14,270.74
When i = 15%,
PW(15%) = –1,50,000 + 45,570(P/A, 15%, 5)
= –1,50,000 + 45,570(3.3522)
= Rs. 2,759.75
When i = 18%,
PW(18%) = –1,50,000 + 45,570(P/A, 18%, 5)
= –1,50,000 + 45,570(3.1272)
= Rs. –7,493.50
Therefore, the rate of return of the alternative A1 is

Calculation of rate of return for alternative A2

Initial outlay = Rs. 2,10,000
Annual profit = Rs. 58,260
Life of alternative A2 = 5 years
The cash flow diagram for alternative A2 is shown in Fig. 7.6.

The formula for the net present worth of this alternative is

PW(i) = –2,10,000 + 58,260 (P/A, i, 5)
When i = 12%,
PW(12%) = –2,10,000 + 58,260(P/A, 12%, 5)
= –2,10,000 + 58,260(3.6048)
= Rs. 15.6
When i = 13%,
PW(13%) = –2,10,000 + 58,260(P/A, 13%, 5)
= –2,10,000 + 58,260 (3.5172)
= Rs. –5,087.93
Therefore, the rate of return of alternative A2 is

Calculation of rate of return for alternative A3

Initial outlay = Rs. 2,55,000
Annual profit = Rs. 69,000
Life of alternative A3 = 5 years
The cash flow diagram for alternative A3 is depicted in Fig. 7.7.

The formula for the net present worth of this alternative A3 is

PW(i) = –2,55,000 + 69,000(P/A, i, 5)
When i = 11%,
PW(11%) = – 2,55,000 + 69,000(P/A, 11%, 5)
= –2,55,000 + 69,000 (3.6959)
= Rs. 17.1
When i = 12%,
PW(12%) = – 2,55,000 + 69,000(P/A, 12%, 5)
= –2,55,000 + 69,000 (3.6048)
= Rs. – 6,268.80
Therefore, the rate of return for alternative A3 is

The rates of return for the three alternatives are now tabulated

From the above data, it is clear that the rate of return for alternative A3 is less than the minimum
attractive rate of return of 12%. So, it should not be considered for comparison. The remaining
two alternatives are qualified for consideration. Among the alternatives A1 and A2, the rate of
return of alternative A1 is greater than that of alternative A2. Hence, alternative A1 should be
selected.

EXAMPLE 7.4 For the cash flow diagram shown in Fig. 7.8, compute the rate of return. The

amounts are in rupees.

Solution For the positive cash flows of the problem,

A1 = Rs. 150, G = Rs. 150
The annual equivalent of the positive cash flows of the uniform gradient
series is given by
A = A1 + G(A/G, i, n)
= 150 + 150(A/G, i, 5)
The formula for the present worth of the whole diagram
= –1,275 + [150 + 150(A/G, i, 5)] _ (P/A, i, 5)
PW(10%) = –1,275 + [150 + 150(A/G, 10%, 5)] __ (P/A, 10%, 5)
= –1,275 + [150 + 150(1.8101)] _ (3.7908)
= Rs. 322.88
PW(12%) = –1,275 + [150 + 150(A/G, 12%, 5)] _ (P/A, 12%, 5)
= –1,275 + [150 + 150(1.7746)] _ (3.6048)
= Rs. 225.28
PW(15%) = –1,275 + [150 + 150(A/G, 15%, 5)] _ (P/A, 15%, 5)
= –1,275 + [150 + 150(1.7228)] _ (3.3522)
= Rs. 94.11
PW(18%) = –1,275 + [150 + 150(A/G, 18%, 5)] _ (P/A, 18%, 5)
= –1,275 + [150 + 150(1.6728)] _ (3.1272)
= Rs. –21.24
Therefore, the rate of return for the cash flow diagram is

EXAMPLE 7.5 A company is planning to expand its present business activity. It has two
alternatives for the expansion programme and the corresponding cash flows are tabulated below.
Each alternative has a life of five years and a negligible salvage value. The minimum attractive
rate of return for the company is 12%. Suggest the best alternative to the company.

Solution Alternative 1
Initial outlay = Rs. 5,00,000
Annual revenue = Rs. 1,70,000
Life of alternative 1 = 5 years
The cash flow diagram for alternative 1 is illustrated in Fig. 7.9.

The formulae for the net present worth of alternative 1 are as follows:
PW1(i) = –5,00,000 + 1,70,000(P/A, i, 5)
PW1(15%) = –5,00,000 + 1,70,000(P/A, 15%, 5)
= –5,00,000 + 1,70,000(3.3522)
= Rs. 69,874
PW1(17%) = –5,00,000 + 1,70,000(P/A, 17%, 5)
= –5,00,000 + 1,70,000(3.1993)
= Rs. 43,881
PW1(20%) = –5,00,000 + 1,70,000(P/A, 20%, 5)
= –5,00,000 + 1,70,000(2.9906)
= Rs. 8,402
PW1(22%) = –5,00,000 + 1,70,000(P/A, 22%, 5)
= –5,00,000 + 1,70,000(2.8636)
= Rs. –13,188

Therefore, the rate of return of alternative 1 is

Alternative 2

Initial outlay = Rs. 8,00,000

Annual revenue = Rs. 2,70,000
Life = 5 years
The cash flow diagram for alternative 2 is depicted in Fig. 7.10.

The formula for the net present worth of alternative 2 is:

PW2(i) = – 8,00,000 + 2,70,000(P/A, i, 5)
PW2(20%) = – 8,00,000 + 2,70,000(P/A, 20%, 5)
= – 8,00,000 + 2,70,000(2.9906)
= Rs. 7,462

PW2(22%) = –8,00,000 + 2,70,000 (P/A, 22%, 5)

= – 8,00,000 + 2,70,000 (2.8636)
= Rs. –26,828

Thus, the rate of return of alternative 2 is

Since the rate of return of alternative 1 is greater than that of the alternative 2, select alternative 1.