UNIT 1

ENGINEERING ECONOMICS AND FINANCIAL ACCOUNTING

1. Managerial Economics:

Study of economic theories, logic and methodology for solving the practical

problems of business.

To analyze business problems for rational business decisions.

Application of economic concepts and economic analysis to the problems of

formulating rational managerial decisions. ( Mansfield)

Also called Business Economic or Economics for firms.

1.1 Principles of Managerial Economics

Economic principles assist in rational reasoning and defined thinking. They develop

logical ability and strength of a manager. Some important principles of managerial

economics are:

i. Marginal and Incremental Principle

This principle states that a decision is said to be rational and sound if given the firm’s

objective of profit maximization, it leads to increase in profit, which is in either of two

scenarios-

If total revenue increases more than total cost.

If total revenue declines less than total cost.

Marginal analysis implies judging the impact of a unit change in one variable on the

other. Marginal revenue is change in total revenue per unit change in output sold.

Marginal cost refers to change in total costs per unit change in output produced (While

incremental cost refers to change in total costs due to change in total output).The decision

of a firm to change the price would depend upon the resulting impact/change in marginal

revenue and marginal cost. If the marginal revenue is greater than the marginal cost, then

the firm should bring about the change in price. Incremental analysis differs from

marginal analysis only in that it analysis the change in the firm's performance for a given

managerial decision, whereas marginal analysis often is generated by a change in outputs

or inputs. Incremental analysis is generalization of marginal concept. It refers to changes

in cost and revenue due to a policy change. For example - adding a new business, buying

new inputs, processing products, etc. Change in output due to change in process, product

or investment is considered as incremental change. Incremental principle states that a

decision is profitable if revenue increases more than costs; if costs reduce more than

revenues; if increase in some revenues is more than decrease in others; and if decrease in

some costs is greater than increase in others.

ii.Equi-marginal Principle

Marginal Utility is the utility derived from the additional unit of a commodity

consumed. The laws of equi-marginal utility states that a consumer will reach the stage

of equilibrium when the marginal utilities of various commodities he consumes are

equal. According to the modern economists, this law has been formulated in form of

law of proportional marginal utility. It states that the consumer will spend his money-

income on different goods in such a way that the marginal utility of each good is

proportional to its price, i.e.,

MUx / Px = MUy / Py = MUz / Pz

Where, MU represents marginal utility and P is the price of good.

Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the

technique of production which satisfies the following condition:

MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3

Where, MRP is marginal revenue product of inputs and MC represents marginal cost.

Thus, a manager can make rational decision by allocating/hiring resources in a manner

which equalizes the ratio of marginal returns and marginal costs of various use of

resources in a specific use.

iii.Opportunity Cost Principle

By opportunity cost of a decision is meant the sacrifice of alternatives required by that

decision. If there are no sacrifices, there is no cost. According to Opportunity cost

principle, a firm can hire a factor of production if and only if that factor earns a reward

in that occupation/job equal or greater than it’s opportunity cost. Opportunity cost is the

minimum price that would be necessary to retain a factor-service in it’s given use. It is

also defined as the cost of sacrificed alternatives. For instance, a person chooses to

forgo his present lucrative job which offers him Rs.50000 per month, and organizes his

own business. The opportunity lost (earning Rs. 50,000) will be the opportunity cost of

running his own business.

iv.Time Perspective Principle

According to this principle, a manger/decision maker should give due emphasis, both to

short-term and long-term impact of his decisions, giving apt significance to the

different time periods before reaching any decision. Short-run refers to a time period in

which some factors are fixed while others are variable. The production can be increased

by increasing the quantity of variable factors. While long-run is a time period in which

all factors of production can become variable. Entry and exit of seller firms can take

place easily. From consumers point of view, short-run refers to a period in which they

respond to the changes in price, given the taste and preferences of the consumers, while

long-run is a time period in which the consumers have enough time to respond to price

changes by varying their tastes and preferences.

v.Discounting Principle

According to this principle, if a decision affects costs and revenues in long-run, all

those costs and revenues must be discounted to present values before valid

comparison of alternatives is possible. This is essential because a rupee worth of

money at a future date is not worth a rupee today. Money actually has time value.

Discounting can be defined as a process used to transform future dollars into an

equivalent number of present dollars. For instance, $1 invested today at 10% interest

is equivalent to $1.10 next year.

FV = PV*(1+r)t

Where, FV is the future value (time at some future time), PV is the present value

(value at t0, r is the discount (interest) rate, and t is the time between the future value

and present value.

2. Managerial Decisions/ Decision Analysis

Process of selecting the best out of alternative opportunities, open to the firm.

2.1 4 main phases of decision making

1. Determine and define the objective.

2. Collection of information regarding economic, social, political and technological

environment and foreseeing the necessity and occasion for decision.

3. Inventing, developing and analyzing possible courses of action.

4. Selecting a particular course of action from the available alternatives.

2.2 Decision Making Process

• The intelligence phase

– Finding / Identifying / formulating problems

• The design phase

– Develop alternative decisions

• The choice phase

– Chose the best decision from the pool

2.3 Types of Decisions

• Based on convenience

– Structured

• Well defined decision making procedure where every decision is broken down in

distinct stages of evaluation, alternative search, elimination and acceptance criteria.

– Semi Structured

• It is a mixed kind of situation where very limited amount of structuring is maintained at

some areas of operation but otherwise no segmenting and structuring is done.

– Unstructured

• All three phases of decision making are unstructured and clustered. Any one of the

functions (Input, Output or Internal Process) is not readily available because the decision

must be very rare or new so that it was not extensively studied to incorporate procedures

to deal with it within the system.

• Based on criticality

– Strategic

• Affect the entire organization or a major part of it. These are quite long-term decisions

and generally made at upper level of management.

– Tactical

• This is also called management control decisions and affects only a part of the

organization. This is taken by middle level management with the objective to meet the

strategic plan.

– Operational

• Affect only one or two functional areas at a time. These are very short term and made at

lower management levels.

• Based on availability

-Certainty / Uncertainty / Risk

–

• Based on programmability

– Programmed

• All resources for decision making are already available and the system can respond on

the go.

– Non Programmed

• All resources are not available for instant decision making.

2.4 Decision Making Models a. Rational Decision Making Model

Consists of a structured four-step sequence

identifying the problem

generating alternative solutions

selecting a solution

implementing and evaluating the solution

b. Political Decision Making Model

o Assumes that people bring preconceived notions and biases into the

decision-making situation

o Self-interest may block people from making the most rational choice

o Sometimes it is difficult to determine if a decision maker is

operating rationally or politically

c· Normative Model of Decision Making – Simon’s Model

Based on premise that decision making is not rational

Decision making is characterized by

limited information processing

use of judgmental heuristics

sacrificing

Relationship of Managerial Economics with other discipline 1. ME and Economics

Micro economics

Study of economic behaviour of individuals, firms and other such micro

organisations. ME makes use of several micro economic concepts such as

marginal cost, marginal revenue, elasticity of demand etc.

Macroeconomics

Study of economy as a whole. It deals with the analysis of national income, level

of employment, general price level, consumption and investment in the economy

etc.

These are all important issues related to the economic environment. Hence it will

be useful to have a background of these areas for the successful management of a

firm.

ME dealing with national income forecasting is very essential for a managerial

economist in demand forecasting for his products. Business sales is affected by

business conditions which is depended on whether we are in boom or recession.

2. The usefulness of economics to the operations of firm can be seen in 4 different

areas: Marketing and Sales, Production and Finance.

Marketing and sales applications:

Economics can contribute much to marketing through the use of applied demand

theory. Sales function is closely related to an analysis of consumer demand. Size

of market is depended on the size and composition of population, advertisement

cost, price and income elasticity of demand and the supply elasticity of the

competitors.

Economics makes use of demand theory especially price elasticity concept to

measure consumer sensitivity.

Production application:

Managers have to plan for monthly and weekly production schedules. Production

function and input-output relations are very useful concepts here.

Financial applications:

Financial decisions involve the economies of time and uncertainty. A business

firm has to decide whether to invest a large sum of money in new plant and

equipment or whether to spend it on advertisement. Here the economies of time

become an important determinant whether the firm should allocate its resources

for present or future. Planning interest rate structures on loans also require time

value of money considerations.

3. Management theory and accounting

Accounting refers to the recording of financial transactions of the firm. A proper

knowledge of accounting techniques is very essential for the success of the firm.

Because profit maximisation is the major objective of the firm. The firms may

aim at wealth maximisation or growth maximisation or try to maximise provision

of services as in the case of non-profit organisations like Hospitals, Universities,

Govt. etc.

4. ME and Mathematics:

The use of Mathematics is significant in view of its profit maximisation goal

along with optimum use of resources. The major problem of the firm is how to

minimise cost, how to maximise profit or how to optimise sales. Mathematical

concepts and techniques are used in economic logic to solve these problems. Also

mathematical methods help to estimate and predict the economic factors for

decision making and forward planning. Mathematical symbols are more

convenient to handle and understand various concepts like incremental cost,

elasticity of demand etc.

5. ME and Statistics:

Statistical tools are used in collecting data and analysing them to help in decision

making process. Statistical tools like the theory of probability and forecasting

techniques help the firm to predict the future course of events. ME also make use

of correlation and multiple regression in related variables like price and demand

to estimate the extent of dependence of one variable on the other. The theory of

probability is very useful in problems involving uncertainty.

6. ME and Computer science

Computers are used in data and accounts maintenance, inventory and stock

controls, supply and demand predictions. It helps reduce time and workload of

managers.

7. ME and Operations research

Taking effective decisions is the major concern of ME and OR. The development

of techniques and concepts such as linear programming, inventory models and

game theory is due to the development of OR.

OR is concerned with the complex problems arising out of the management of

men, machines, materials and money. OR provides a scientific model of the

system and it helps managerial economists in the field of product development,

materials management, inventory control, quality control, marketing and demand

analysis.

The varied tools of OR are helpful to ME in decision making.

The Linear programming techniques has proved to be a useful tool for the ME in

the matter of reducing transportation costs and allocation of purchases among

different suppliers.

Dynamic programming is useful when a sequence of decisions must be made with

each decision affecting future decisions.

Such uses arise in the matter of investment decisions of funds.

Input output analysis can be used by firms for planning, coordination and

mobilisation of resources in various departments.

Queuing theory is helpful when a firm has to depend upon several allied service

organisations.

Queuing theory is useful to find out ways of reducing the waiting period in

meeting demand.

Theory of games is useful in explaining the behaviour of competitors. Each

competitor aims certain guaranteed minimum gain. Its behaviour with this goal

prevents its opponents from achieving their aim. This theory helps us to solve the

problems of price determination and the indeterminate condition of oligopoly.

Thus statistical tools have helped to bring more accuracy and determinateness to

the decision making process of a firm which operates in an uncertain

environment.

3. FIRMS