Fundamental Concepts Used For Decision Making or Managerial Decision Making

 

 

Fundamental Concepts Used In Managerial Economics

OR

Fundamental Concepts Used For Decision Making or Managerial Decision Making

 

Five fundamental concepts that are basic in a study of managerial economics are as follows

(i)  Incremental concept

(ii) The concept of time perspective

(iii) The discounting principle

(iv) The concept of opportunity cost and

(v) The concept of equi-marginalism.

 

(I)  Incremental Concept

Incremental concept is closely related to the Marginal revenues (MR) and Marginal costs (MC) of economic theory. Incremental reasoning involves estimates of an impact of decision alternatives on costs and revenues, stressing the changes in total costs and total revenue that result from changes in prices, products, procedures, investments or whatever may be at stake in the investment decision.

            The two basic concepts involved in this analysis are “Incremental cost” and “Incremental revenue”. Incremental cost is the change in total cost consequent upon a decision. Likewise incremental revenue is the change in total revenue due to decision.

The decision criterion according to this concept is accept a particular decision

• If it increases the revenue more than it increases the cost as assessed for the managerial point of view. **
• If it decreases some costs to a greater extent than it increases others
• If it increases some revenues more than it decreases others; and
• If it reduces costs more than revenues.

 

 

 

 

Implications of Incremental Reasoning

‘Incremental reasoning is significant, for some businessmen hold an erroneous view that to make an overall profit they must make a profit on every job’. The result is that they often refuse orders that do not cover full cost (labour, materials and overhead) plus some provision for profit. But incremental reasoning shows that this rule may be inconsistent with profit maximization in the short run. It can be seen from the following illustration that a refusal to accept business below. Full cost means ‘a rejection of a possibility of adding more to revenue that to cost’. 

           

Illustration

Suppose a new order is estimated to bring in Rs.20, 000 by way of additional revenue. The cost as estimated by the company’s accountant is as follows.

 

            Labour                                                                                     Rs 6, 000

            Material                                                                                   Rs 8, 000

            Overhead (allocated at 120% of labour cost                          RS 7, 200

            Selling and administrative expenses

            (Allocated at 20% of labour and material costs                      Rs. 2, 800

                                                                                                            ------------

            Full cost                                                                                  Rs 24,000

                                                                                                            ------------

 

The order appears to be unprofitable, because, if it accepted, it will result in a loss of

Rs 4,000. But suppose that there exists an idle capacity with which this order could be met. Further suppose the order adds only Rs 2,000 to overhead (the incremental overhead is limited to the added use of heat, power and light the added wear and tear to the machinery, the added costs of supervision etc). The order does not require any selling and administrative costs, as the only requirement is the acceptance of order. In addition, only a part of the labour cost is incremental because some of the idle workers already on the pay roll will be employed without any additional pay.

 

The incremental cost of accepting the above order may be as follows:

 

            Overhead                                            Rs 2,000

            Materials                                             Rs 8,000

            Labour                                                 Rs 4,000

                                                                        -------------

            Total incremental cost                         Rs 14,000

                                                                        -------------

 Therefore, contrary to the accountant’s estimate of a loss of Rs 4,000 the order will result in an addition of Rs 6,000 as profit. The application of the incremental principle maximizes short run profit, but not long-run profit.

 

(II) The Concept of Time Perspective

Economists make a distinction between a short-run and long-run with a precision that is often missed in ordinary discussions. The distinction is not based on the duration of time but on the ability of the business firms to change the use of the different inputs such as raw materials, labour, management, plant and equipment etc.

            If firms can change the ratio in which every input is used, the period is referred to as the long run. On the other hand, if firms can change the use of a few inputs but not all, the period of is referred as the short-run.

            In real life this type of dichotomy between long-run and short-run perspective break down. In many decisions as the time perspective is extended more and likely to change as the time perspective moves out farther. The crucial problem in decision-making is to maintain the right balance between the short run and long run and intermediate run perspectives.

            A decision may be taken on the basis of short run considerations, but may, as time passes, have long run repercussions that make it more or less profitable than it seemed at first. The following illustration may make the matter clear.

           

           

Consider a firm with some temporary idle capacity. Orders for 10,000 units come to the management’s attention. The prospective consumer is willing to pay Rs 4 per unit or Rs 40,000 for the whole lot. The short run incremental cost (which ignores the fixed cost) is only Rs 3. Therefore, the contribution to overhead and profit is Re.1 per unit (or Rs 10,000 for the whole lot). In spite of this favorable position, before accepting this order, the management must take into consideration the following long run consequences.

 

·         Firstly, if the management commits itself to series of repeat orders at the same price the management may be forced to consider the question of expansion of capacity when the so called fixed costs may also become variable.

·         Secondly, the acceptance of an order at a lower price might tarnish the image of the company.

·         Thirdly, some of the present customers may feel that they had been treated unfairly and may opt to resort to firms which follow ‘ethical pricing’.

 

The above considerations lead us to the following conclusion.

A decision should take into account the short run and long run effects on revenues and costs, customer’s reaction and company’s image etc., giving appropriate weight to the most relevant time periods.

 

The Discounting Principle

 

Money has a time value. A certain sum of money, say Rs 1000 to be received today is worth more than Rs 1000 to be received in the future. But bow much more is it worth depends upon two factors (i) the time interval and (ii) the investment pattern.

            The proverb “A bird in the hand is worth two in the bush” is applicable to this concept. Suppose a person is offered a choice whether to receive Rs 1000 today or Rs1000 next year. Naturally, he will choose the first offer for two obvious reasons.

(i) The amount can be invested and made to earn interest.

(ii) A lot of risk and uncertainty is involved in recovering the amount in future.
           

Considering these, business firms always prefer receiving a given amount that day itself to receiving the same amount in future. Investment in business leads to an accrual of benefits over a period of time. The computation of the present value of an amount due in future or a stream of earnings likely to accrue in future, involves discounting of time.

Suppose we have Rs 2,000 at our disposal. We can invest this amount in a bank, say at an interest rate, and ‘r’ of 10%. After one year, we could withdraw from the bank both the original deposit and the accumulated interest; this would be our future receipt in year one or R1.

That is 

 

R1 = Rs 2000 + (0.1) 2000 = Rs 2200

 

        Generally R1 = PV + r (PV) = PV (1+ r)

 

Where PV = Present value

 

Alternatively if we do not withdraw the money but leave it on deposit for a further period of one year, then at the end of the second year we could withdraw the following

 

R2 = R1 + r (R1 (1+r) = PV (1+ r) 2

 

 

 

In this manner, R at the end of year ‘n’

 

Rn = PV (1+ r) n

 

This process is called compounding. The above compound interest formula tells us about the magnitude of a future receipt if we already know its present value and the interest rate.

            The reverse procedure, where the future receipt and interest are known, and the present value can be found out. It is known as discounting.

 

The discounting formula can be stated as:

 

PV= Rn (1+ r) n

 

This gives us the PV of a sum of money to be received ‘n’ years. Hence at a given discount rate of ‘r’. When stream of future receipts is expected, to accrue at annual intervals, then the PV of a stream is the sum of the PVs of each receipt.

That is

R1 / (1+ r) + R2 / (1+ r)2 + R3 / (1+ r)3 + ……….. Rn / (1+ r)n

 

Suppose a firm is going to receive Rs 20000 per year for the next three years at a rate of 10% from its fixed deposit. Then

 

PV = 20,000/ (1+ 0.10)1 + 20,000/ (1+ 0.10)2 + 20,000/ (1+ 0.10)3 =

 

= 20,000/ (1.10) + 20,000/ (1.21) + 20,000/ (1.301)

 

= 18,180.2 + 16, 529.0 + 15, 026.2 = Rs 49,735.4

 

The Concept of Opportunity Cost

The Concept of Opportunity Cost lies at the heart of all managerial decisions; the Opportunity Cost of anything is the alternative that has been foregone. This implies that one commodity can be produced only at the cost of foregoing the production of another commodity. As Adam smith has observed, “If a hunter can bag a deer or a beaver in the course of a single day, the cost of deer is a beaver and the cost of beaver is a deer”.

            In managerial economics, opportunity costs are the costs of displaced alternatives. They represent only sacrificed alternatives. According to Haynes, Mote and Paul

1. The opportunity cost of funds tied up in one’s own business is the interest that could be earned on those funds in other ventures.
2. The opportunity cost of the time one puts in his own business is the sacrifice of earnings that would be possible form producing other products.
3. The opportunity cost of using a machine that is useless for any other purposes is nil, since its use requires no sacrifice of other opportunities.

 

 

 

 

 

 

 

The Principle of Equi-Marginalism

According to this principle, if an input can be used in producing goods or services, the allocation of the input should be such that its marginal contribution is the same in all its uses.

            Let us explain this concept with an example. Suppose a firm is engaged in four activities – A, B, C, and D. all these activities require the services of labor. Imagine that the firm has 100 units of labor at its activities by adding more labor but only at the cost of labour in its other activities. The optimum will be attained when the value of the marginal product of labour is equal in all activities.

 

Symbolically

VMPLLA = VMP B = VMP LC = VMP LD   where

 

VMP = Value of Marginal Product

A, B, C, D = Activities

L = Labour

 

This concept of equi-marginalism is crucial in capital budgeting, where the limited resources of the firm have to be allocated in a rational manner. The equi-marginalism concept holds good only in cases of diminishing returns.