ENGINEERING ECONOMICS:-

Engineering economics, previously known as engineering economy, is a subset of economics

concerned with the use and "...application of economic principles" in the analysis of engineering
decisions.
Module :- 1

Meaning of Engineering Economics:

Engineering is the profession in which knowledge of the mathematical and
natural sciences gained by study experience and practice is applied with
judgment to develop ways to utilise economically the material and forces
of nature for the benefit of mankind.

Engineering economics is closely aligned with Conventional Micro-

Economics. It is devoted to problem solving and decision making at the
operational level. Thus “Engineering Economics refers to those aspects
of economics and its tools of analysis most relevant to the Engineer’s
decision making process”.

Nature And Scope of Economics

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Economics is defined as the social science that deals with the production,
distribution, and consumption of goods and services. Evolved in the 19th century,
the economic studies have become one of the most significant studies of modern
days. From a small shop to a country, Economics plays a crucial role in the
efficient running of both. No business can flourish without applying the principles
of economics. The study of economics is extensive and varied. The nature and
scope of economics depend upon the interaction of economic agents and how
economies work. Let’s analyze the nature and scope of economics deeply.
 Nature of Economics
The nature of economics deals with the question that whether economics falls into
the category of science or arts. Various economists have given their arguments in
favour of science while others have their reservations for arts.

Economics as a Science
To consider anything as a science, first, we should know what science is all about?
Science deals with systematic studies that signify the cause and effect relationship.
In science, facts and figures are collected and are analyzed systematically to arrive
at any certain conclusion. For these attributes, economics can be considered as a
science. However, economics is treated as a social science because of the
following features:

 It involves a systematic collection of facts and figures.

 Like in science, it is based on the formulation of theories and laws.
 It deals with the cause and effect relationship.
These points validate that the nature of economics is correlated with science. Just
as in science, various economic theories are also based on logical reasoning.

Economics as an Art
It is said that “knowledge is science, action is art.” Economic theories are used to
solve various economic problems in society. Thus, it can be inferred that besides
being a social science, economics is also an art.

Scope of Economics
Economists use different economic theories to solve various economic problems in
society. Its applicability is very vast. From a small organization to a multinational
firm, economic laws come into play. The scope of economics can be understood
under two subheads: Microeconomics and Macroeconomics. Let’s discuss these in
detail:

Microeconomics
Microeconomics examines individual economic activity, industries, and their
interaction. It has the following characteristics:

 Elasticity: It determines the ratio of change in the proportion of one variable

to another variable. For example- the income elasticity of demand, the price
elasticity of demand, the price elasticity of supply, etc.
 Theory of Production: It involves an efficient conversion of input into output.
For example- packaging, shipping, storing, and manufacturing.
 Cost of Production: With the help of this theory, the object price is evaluated
by the price of resources.
 Monopoly: Under this theory, the dominance of a single entity is studied in a
particular field.
 Oligopoly: It corresponds to the dominance of small entities in a market.
Macroeconomics
It is the study of an economy as a whole. It explains broad aggregates and their
interactions “top down.” Macroeconomics has the following characteristics:

 Growth: It studies the factors which explain economic growth such as the
increase in output per capita of a country over a long period of time.
 Business Cycle: This theory emerged after the Great Depression of the 1930s.
It advocates the involvement of the central bank and the government to
formulate monetary and fiscal policies to monitor the output over the business
cycle.
 Unemployment: It is measured by the unemployment rate. It is caused by
various factors like rising in wages, a shortfall in vacancies, and more.
 Inflation and Deflation: Inflation corresponds to an increase in the price of a
commodity, while deflation corresponds to a decrease in the price of a
commodity. These indicators are valuable to evaluate the status of the
economy of a country.
Difference between Micro and macro economics :-

What are the differences Between Micro and Macro Economics

An economy is primarily divided into two categories - microeconomics and

macroeconomics. Microeconomics is the study of the economy on an individual level.
Contrarily, macroeconomics observes a nation’s economy as a whole, including its
performance, structure, and future direction.

Micro and macroeconomics are interdependent to some extent. Several differences also
exist between these two segments of economics.

What is Microeconomics?

Microeconomics focuses on the choices made by individual consumers as well as

businesses concerning the fluctuating cost of goods and services in an economy.
Microeconomics covers several aspects, such as –

 Supply and demand for goods in different marketplaces.

 Consumer behaviour, as an individual or as a group.
  Demand for service and labour, including individual labour markets, demand,
and determinants like the wage of an employee.

One of the main features of microeconomics is it focuses on casual situations when a

marketplace experiences certain changes in the existing conditions. It takes a bottom-
up approach to analyse the economy.

What is Macroeconomics?

Macroeconomics studies the economic progress and steps taken by a nation. It also
includes the study of policies and other influencing factors that affect the economy as a
whole. Macroeconomics follows a top-down approach, and involves strategies like –

 The overall economic growth of a country.

 Reasons that are likely to influence unemployment and inflation.
 Fiscal policies that are likely to influence factors like interest rates.
 Effect of globalisation and international trade.
 Reasons that affect varying economic growths among countries.

Another feature of macroeconomics is that it focuses on aggregated growth and its

economic correlation.

There are a few differences between these two categories. Here are the primary
dissimilarities –

Microeconomics Vs Macroeconomics
[Link] Microeconomics Macroeconomics
Macroeconomics studies a
Microeconomics studies individual economic
1. nation’s economy, as well as its
units
various aggregates.
Macroeconomics is the study of
Microeconomics primarily deals with aggregates such as national
2.
individual income, output, price of goods, etc. output, income, as well as
general price levels.
Macroeconomics focuses on
Microeconomics focuses on overcoming
upholding issues like
3. issues concerning the allocation of resources
employment and national
and price discrimination.
household income.
 Microeconomics accounts for factors like Macroeconomics account for
4. demand and supply of a particular the aggregated demand and
commodity. supply of a nation’s economy.
Microeconomics offers a picture of the goods
Macroeconomics helps ensure
and services that are required for an efficient
5. optimum utilisation of the
economy. It also shows the goods and services
resources available to a country.
that might grow in demand in future.
Macroeconomics help
Microeconomics helps point
determine the equilibrium
6. how equilibrium can be achieved at a small
levels of employment and
scale.
income of the nation.
Microeconomics also focuses on issues The primary component of
7. arising due to price variation and income macroeconomic problems is
levels. income.

Examples of Microeconomics and Macroeconomics

Example of Microeconomics –

 Price determination of a particular commodity.

 Consumer equilibrium.
 Output generated by an individual organisation.
 Individual income and savings.

Example of Macroeconomics –

 National income and savings.

 General price level.
 Aggregated demand as well as supply.
 Poverty.
 Rate of unemployment.

Similarities Between Micro and Macro Economics

The unique characteristics of microeconomics and macroeconomics form a

corresponding and co-dependent relation between the two schools of economics.
Factors that might directly affect microeconomic factors can also impact
macroeconomics in the long run.

Similarly, State-level policies, a component of macroeconomics, can also affect

individual consumers and businesses. For example, a tax hike (macroeconomics) can
increase the retail price of certain products, affecting the rate of consumption
(microeconomics).

Effect of Micro and Macro Economics

Any changes in these categories have a direct impact on a country’s economy. Several
factors affect it; let’s take a look –

 Decision Making

Uncontrollable external factors such as changes in interest rate, regulations, number of

competitors present in the market, cultural preferences, etc. play a key role influencing
an organisation’s strategies and performance. These can have a cumulative effect on a
nation’s economy as well.

 Economic Cycles

Experts consider macroeconomics as a cyclic design. Higher demand level, personal

income, etc. can influence price levels, which in turn can affect a nation’s economy.
Contrarily, when supply outweighs demand, the cost of daily goods reduces. This
pattern continues until the next cycle of supply and demand.

 Price of Products and Services

The primary goal of an organisation is to keep cost at the minimum and increase
the profit margin. The cost of labour is one of the highest expenses incurring factors in
microeconomics, thereby directly affecting the overall cost of production and retail.

To understand the uses of microeconomics and macroeconomics as well as several other

central components of an economy, visit Vedantu’s official website today.

What is the definition of demand in economics?

Economic demand is the number of consumers willing to purchase goods or services at a
certain price. Supply is the other side of demand. Businesses that accurately meet demand
with their supply of products or services greatly benefit in profits and heightened brand
awareness.

The relationship between supply and demand

If demand is the quantity consumers are willing to buy at a given price, supply is the quantity
producers are willing to offer. The price of goods and services is determined by the supply in
the market and the demand for it. When the supply is low and the demand is high, the price
will increase. When supply is high and the demand is low, the price will decrease. The
equilibrium price is the price where the quantity consumers purchase equals the quantity
producers supply.

Related: Learn About Being a Controller

Types of demand
As a business, you need to understand the different types of demand to be able to best
anticipate how much product you need. Demand characteristics provide a picture of how well
the industry is thriving and offers ideas as to where new service can be introduced. The
following list details seven types of demand in economics:

1. Joint demand
2. Composite demand
3. Short-run and long-run demand
4. Price demand
5. Income demand
6. Competitive demand
7. Direct and derived demand

1. Joint demand

Joint demand is the demand for complementary products and services. These can be products
that are accessories for others or that people commonly purchase together. For example,
cereal and milk or peanut butter and jelly. The two are linked but demand for one is not
necessarily dependent on the demand for the other.

2. Composite demand

Composite demand happens when there are multiple uses for a single product. For example,
corn can be used as animal feed, ethanol and food in its whole form. The rise in demand for
any of these products leads to a shortage in supply for the others. This shortage can lead to a
rise in price.

Related: Learn About Being a Business Analyst

3. Short-run and long-run demand

Short-run demand refers to how people will immediately react to price changes while
elements are fixed. For example, if the demand for a product drastically decreases and a
manufacturer has high overhead costs, they have no choice but to absorb the profits lost. Over
time, or in the long run, companies have a chance to adjust to the new situation by decreasing
labor or increasing price and supplies.
4. Price demand

Price demand relates to the amount a consumer is willing to spend on a product at a given
price. Businesses use this information to determine at what price point a new product should
enter the market. Consumers will buy items based on their perception of that product's value.
Price elasticity refers to how the demand will change with fluctuations in price.

5. Income demand

As consumers make more income, quantity demand increases. This means people will buy
more overall when they earn more income. Tastes and expectations also change with an
increase in income, reducing the size of one market and increasing the size of another.
Consumers will often buy a product or service because it is what they can afford but may
deem lower quality. The demand for those lower-quality products will decrease as income
increases.

Related: Your Guide to Careers in Finance

6. Competitive demand

Competitive demand occurs when there are alternative services or products a customer can
choose from. From a business's perspective, they can use fluctuations in the price of their
competitors to determine how their own will sell. An example of this is between name-brand
and store-brand medicine. If a consumer prefers a name brand but it is out of stock or the
price increases significantly, the store brand will see a rise in sales.

7. Direct and derived demand

Direct demand is the demand for a final good. Food, clothing and cell phones are an example
of this. Also called autonomous demand, it's independent of the demand for other products.

Derived demand is the demand for a product that comes from the usage of others. For
example, the demand for pencils will result in the demand for wood, graphite, paint and
eraser materials. In this example, the demand for wood is dependent on the demand for its
uses.

Derived demand is similar to joint demand because of its connection to other products. It is
different from joint demand because it is dependent on the final product to generate a need.
Without the need for those end products, there is no demand for the intermediate product.

Related: 18 Top Economics Degree Jobs

Factors that influence demand

Demand is influenced by the activities of consumers and businesses. Businesses attempt to
drive demand through marketing efforts. Consumers drive demand through their tastes,
income levels and resistance to price increases.

Here are the most common determinants of demand:

Expectations

People will buy more of something if they suspect the value of it will increase in the future.
Property, stocks and gold are good examples.

Income

The amount of income earned by consumers will determine demand. The more income, the
higher the demand. On an individual basis, consumers who earn more won't necessarily
purchase more of the same. For example, a consumer who can afford an expensive television
won't keep buying them just because they can. This is called the marginal utility principle,
meaning a product loses its usefulness at a certain quantity or price point.

Price

Demand and price have an inverse relationship. This means that when the prices go up, the
demand goes down. The opposite is also true. Price expectation occurs when consumers rush
to purchase an item because they believe the price will increase soon, which increases that
product's demand. When they expect the price will fall, like in the case of a department store
sale, they will wait to purchase. Businesses use these tactics to increase demand for a product
or service.

Availability of alternatives

Substitute products are products that are closely related. Consumers will turn to an alternative
product when the price of one increases.

Complementary products

Products that are accessories for other products fluctuate in demand depending on the price of
the main product. If the price of the main product goes up, the demand for complementary
products goes down.

Consumer preferences

People purchase things based on their lifestyle or how they feel about the brand. For example,
if someone is concerned about the environment, they'll avoid products they see as harmful.

Market size

When there are more buyers available in a market, overall demand increases. For example, if
more people can afford yachts, the market size and demand for yachts will increase. If there
are fewer people able to afford yachts, the market and demand decrease.

Elasticity of Demand :-

A good's price elasticity of demand is a measure of how sensitive the quantity demanded is to its price.
When the price rises, quantity demanded falls for almost any good, but it falls more for some than for
others.
 Supply :-

In economics, supply is the amount of a resource that firms, producers, labourers, providers of
financial assets, or other economic agents are willing and able to provide to the marketplace or to an
individual. Supply can be in produced goods, labor time, raw materials, or any other scarce or
valuable object.
Types of Supply

 Short-term supply explains that the ability of a purchaser to buy goods is

constrained by the available supplies. Buyers cannot purchase beyond the
supplied products.
 Long-term supply explains the factor of time availability whenever the
demand changes – meaning, the availability of time gives the supplier a
leeway to adjust to a sudden shift in demand.
 Joint supply explains the consequential supply. For example, lamb
production affects meat and wool supply. In case farmers reduce farming
lambs, meat and wool supply will go down, too. Similarly, an increase will
result in the opposite effect.
 Market supply explains the overall willingness and ability of all suppliers
to supply the market a particular product on a day-to-day basis. For
example, wheat suppliers A, B, and C may be willing to supply 5, 0, 6 kilos
in the market at $1 per kilo for a total of 11 kilos. If prices rise to $2.50, the
suppliers may increase to 10, 8, and 15 kilos, respectively. In total, the
market supply amounts to 33 kilos.
 Composite supply is used to explain the supply of products that serves
more than one purpose. A perfect illustration is the mining of crude oil. The
production of oil affects the manufacturing of petrol, gas, kerosene, diesel,
etc.
Additional Resources

CFI offers the Capital Markets & Securities Analyst (CMSA)® certification
program for those looking to take their careers to the next level. To keep learning
and developing your knowledge base, please explore the additional relevant
resources below:

 Demand Curve
 Price Elasticity
 Quantity Supplied
 Supplier Power

Elasticity of Supply :-

The price elasticity of supply is a measure used in economics to show the responsiveness, or
elasticity, of the quantity supplied of a good or service to a change in its price.

Elasticity of Supply
The elasticity of supply establishes a quantitative relationship
between the supply of a commodity and it’s price. Hence, we can
express the numeral change in supply with the change in the price of
a commodity using the concept of elasticity. Note that elasticity can
also be calculated with respect to the other determinants of supply.

However, the major factor controlling the supply of a commodity is

its price. Therefore, we generally talk about the price elasticity of
supply. The price elasticity of supply is the ratio of the percentage
change in the price to the percentage change in quantity supplied of a
commodity.

Es= [(Δq/q)×100] ÷ [(Δp/p)×100] = (Δq/q) ÷ (Δp/p)

Δq= The change in quantity supplied

q= The quantity supplied

Δp= The change in price

 p= The price

Elasticity from a Supply Curve

Along with the method mentioned above, there are two more ways to
calculate the price elasticity of supply, both of which make use of the
supply curve. We can either calculate the elasticity at a specific point
on the supply curve, known as point elasticity or between two prices,
known as arc-elasticity.

The formula for calculating the point elasticity of supply is:

Es= (dq/dp)×(p/q)

Here dq/dp is the slope of the supply curve.

The formula for calculating the arc-elasticity of supply is:

Es= [(q1 – q2)/( q1 + q2)] × [( p1 + p2)/(p1 – p2)]

Types of Elasticity of Supply

(Source: economicsonline)
1. Perfectly Inelastic Supply
A service or commodity has a perfectly inelastic supply if a given
quantity of it can be supplied whatever might be the price. The
elasticity of supply for such a service or commodity is zero. A
perfectly inelastic supply curve is a straight line parallel to the Y-
axis. This is representative of the fact that the supply remains the
same irrespective of the price.

The supply of exclusive items, like the painting of Mona Lisa, falls
into this category. Whatever might be the price on offer, there is no
way we can increase its supply.

Browse more Topics under Theory Of Supply

 Meaning And Determinants Of Supply

 Law of Supply
 Equilibrium Price
2. Relatively Less-Elastic Supply
When the change in supply is relatively less when compared to the
change in price, we say that the commodity has a relatively-less
elastic supply. In such a case, the price elasticity of supply assumes a
value less than 1.

3. Relatively Greater-Elastic Supply

When the change in supply is relatively more when compared to the
change in price, we say that the commodity has a relatively greater-
elastic supply. In such a case, the price elasticity of supply assumes a
value greater than 1.

4. Unitary Elastic
For a commodity with a unit elasticity of supply, the change in
quantity supplied of a commodity is exactly equal to the change in its
price. In other words, the change in both price and supply of the
commodity are proportionately equal to each other. To point out, the
elasticity of supply in such a case is equal to one. Further, a unitary
elastic supply curve passes through the origin.

5. Perfectly Elastic supply

A commodity with a perfectly elastic supply has an infinite elasticity.
In such a case the supply becomes zero with even a slight fall in the
price and becomes infinite with a slight rise in price. This is
indicative of the fact that the suppliers of such a commodity are
willing to supply any quantity of the commodity at a higher price. A
perfectly elastic supply curve is a straight line parallel to the X-axis.
 Module :-II

Production in Economics
Production in Economics is sometimes defined as the creation of utility or the
creation of wants – satisfying goods’ and services. It is said that just as a man
cannot destroy matter, he also cannot create matter.
“If consuming means extracting utilities from,” says Fraser, “producing means
putting utility into.”
 Production, therefore, should be defined, not as a creation of utility, but the
creation (or addition) of value. Utilities are created in three forms:

 Form utility
 Time utility
 Place utility.
Production in Economics is a very important economic activity. As we are aware,
the survival of any firm in a competitive market depends upon its ability to
produce goods and services at a competitive cost.

One of the principal concerns of business managers is the achievement of optimum

efficiency in production by minimising the cost of production.

Table of Contents [Hide]

 1 Production in Economics
 2 What is Production?
 3 Production Definition
 4 Concept of Production
 5 Importance of Production
 6 Factors of Production
o 6.1 Land
o 6.2 Labour
o 6.3 Capital
o 6.4 Entrepreneur
 7 Business Economics Tutorial

What is Production?
In economics, Production is a process of transforming tangible and intangible
inputs into goods or services.
Raw materials, land, labour and capital are the tangible inputs, whereas ideas,
information and knowledge are the intangible inputs. These inputs are also known
as factors of production.

Also Read: Production Possibility Curve

Production Definition
Production in Economics can be defined as an organised activity of transforming
physical inputs (resources) into outputs (finished products), which will satisfy the
products’ needs of the society.
James Bates and J.R. Parkinson

Production in Economics is an activity whether physical or mental, which is

directed to the satisfaction of other people’s wants through exchange.
J.R. Hicks

Concept of Production
Production in Economics can be defined as the process of converting the inputs
into outputs. Inputs include land, labour and capital, whereas output includes
finished goods and services.
In other words, Production in Economics is an act of creating value that satisfies
the wants of the individuals.
Organisations engage in production for earning maximum profit, which is the
difference between the cost and revenue. Therefore, their production decisions
depend on the cost and revenue. The main aim of production is to produce
maximum output with given inputs.
Also Read: What is Consumer Demand?

Importance of Production
Production in Economics is considered very important by organisations.
Importance of Production are as follow:
 Helps in creating value by applying labour on land and capital
 Improves welfare as more commodities mean more utility
 Generates employment and income, which develops the economy.
 Helps in understanding the relation between cost and output
Also Read: Production Function

Factors of Production
Factors of Production in Economics are the inputs that are used for producing the
final output with the main aim of earning an economic profit.
Land, labour, capital and entrepreneur are the main factors of production. Eachand
every factor is important and plays a distinctive role in the organisation.
Factors of Production are:
1. Land
2. Labour
3. Capital
4. Entrepreneur

Factors of Production

Land
Land is the gift of nature and includes the dry surface of the earth and the natural
resources on or under the earth’s surface, such as forests, rivers, sunlight, etc.

Land is utilised to produce income called rent. Land is available in fixed quantity;
thus, does not have a supply price. This implies that the change in price of land
does not affect its supply. The return for land is called rent.

Characteristics which would qualify a given factor to be called land

 Land is a free gift of nature

 Land is a free gift of nature
 Land is permanent and has indestructible powers
 Land is a passive factor
 Land is immobile
 Land has multiple uses
 Land is heterogeneous
Labour
Labour is the physical and mental efforts of human beings that undertake
the production process.
It includes unskilled, semi-skilled and highly skilled labour. The supply of labour
is affected by the change in its prices. It increases with an increase in wages. The
return for labour is called wages and salary.

Characteristics of labour:

 Human Effort
 Labour is perishable
 Labour is an active factor
 Labour is inseparable from the labourer
 Labour power differs from labourer to labourer
 All labour may not be productive
 Labour has poor bargaining power
 Labour is mobile
 There is no rapid adjustment of supply of labour to the demand for it
 Choice between hours of labour and hours of leisure
Capital
Capital is the wealth created by human beings. It is one of the important factor of
production of any kind of goods and services, as production cannot take place
without the involvement of capital.
Capital is an output of a production process that goes into another production
process as an input. Capital as a factor of production is divided into two parts,
namely, physical capital and human capital.
Physical capital includes tangible resources, such as buildings, machines, tools
and equipment, etc.
Human capital includes knowledge and skills of human resource, which is gained
by education, training and experience. Return for capital is termed as interest.
Types of Capital

 Fixed capital
 Circulating capital
 Real capital
 Human capital
 Tangible capital
 Individual capital
 Social Capital
Entrepreneur
Entrepreneurship consists of three major functions, viz., coordination, management
and supervision. An entrepreneur is a person who creates an enterprise. The
success or failure depends on the efficiency of the entrepreneur.

An enterprise is an organisation that undertakes commercial purposes or business

ventures and focuses on providing goods and services. An enterprise is composed
of individuals and physical assets with a common goal of generating profits.

Functions of an entrepreneur

Initiating business enterprise and resource co-ordination

Risk bearing or uncertainty bearing
Innovations
What is the Law of Variable Proportion?
The Law of Variable Proportion states that as the quantity of a factor is increased while
keeping other factors constant, the Total Product (TP) first rises at an incremental rate, then at
a decremental rate and lastly the total production begins to fall. In other words, as one of the
factors in production makes some variation in its quantity, keeping all the other factors
constant, the ratio between all the factors starts varying, which further influence the level of
output.
What are the Stages of Law of Variable Proportion?
In order to understand this in detail, let us take an example. Imagine you own a land wherein
you produce rice by employing more and more labour (variable factors). The table given
below explains the situation further:

3 Stages of Law of Variable Proportion

In this above table and graph of the Law of Variable Proportion, you would notice that:

 Up to 3 units of labour employed, the TP is rising at an increasing rate (2,6,12). This

constitutes Stage 1 of the law, which is the Stage of Increasing Returns. Therefore,
during the first stage, the TP curve increases significantly.

 Beyond the 3rd unit of labour, the TP starts rising at a diminishing rate (12,16,18),
which means the TP curve rises at a slower rate. This eventually makes the marginal
product (MP) starting to fall. Constituting the second stage of the Law of Variable
Proportion which is called the Stage of Diminishing Returns.

 After the employment of 6 units of labour, the TP starts to fall, indicating the 3rd
stage which is the Stage of Negative Returns. Even after employing 6 units of
labour, it fails to yield the marginal product, that is when the MP comes to zero.
Eventually, the TP curve starts sloping down and the marginal product goes to
negative in the x-axis.
 cost of revenue concept :-

What is Total Cost?

Definition: Total cost is an economic measure that sums all expenses paid to
produce a product, purchase an investment, or acquire a piece of equipment
including not only the initial cash outlay but also the opportunity cost of their
choices.
Define Total Costs: Total costs means an economic measurement of the entire
amount paid to produce a product.

Example
Jane is the Chief Operating Officer of the largest car manufacturer in the world.
The company has recently been seeing its total costs increase 15% year over year
and Jane has been put in charge of analyzing this trend in an effort to fix it.

She sees that the company’s costs, overall, have risen from $100,000 to $132,250
in only two years, which validates the extreme growth in costs. After looking
through the numbers, she sees, to her surprise, that fixed costs have not actually
increased, but have decreased from $70,000 to $65,000. Additionally, she sees that
the firm’s variable costs, specifically in salary and benefits, have ballooned from
$30,000 to $67,250.
What is a Fixed Cost?
Home » Accounting Dictionary » What is a Fixed Cost?
Definition: A fixed cost is an expense that does not change as production volume
increases or decreases within a relevant range. In other words, fixed costs are
locked in place as long as operations stay within a certain size. Fixed costs are less
controllable than variable costs because they aren’t based on volume or operations.
What Does Fixed Cost Mean?
Instead, management usually sets fixed costs at predetermined rates based on
company necessities. Some examples of fixed costs include rent, insurance, and
property taxes. All of these expenses are completely independent from production
volume.

Example
For example, building rent is a fixed cost that management negotiates with the
landlord based on how much square footage the business needs for its operations.
If management decides to rent 10,000 square feet manufacturing plant at $50 a
square foot, the rent will be $50,000 a month regardless of how many units the
factory actually produces. The plant could produce 10 units or 50,000 units. The
rent will always be same because it’s a fixed cost.
Management often uses fixed costs to base budgets and production schedules on.
Since a business can’t get rid of its set costs, a certain amount of products need to
be created and sold during each period to cover the expenses. Management
typically looks at the break-even point where the revenues for a period equal the
fixed and variable costs. This shows when the company will start producing a
profit.
Total revenue
Total Revenue :-

What Is Total Revenue in Economics?

In business and economics, one of the most important measures for evaluating your success and progress is
looking at the trends in your total revenue. You need to know this important measure so that you can
eventually calculate your total profit for a business.
Total revenue in economics refers to the total receipts from sales of a given quantity of goods or services.
It is the total income of a business and is calculated by multiplying the quantity of goods sold by the price
of the goods. For example, if Company A produces 100 widgets and sells them for $50 each, the total
revenue would be 100 * $50 = $5,000. In economics, total revenue is often represented in a table or as a
curve on a graph.
It is important to note that the concept of revenue in economics usually involves two other key terms. The
first term is average revenue (AR), which refers to the revenue per unit of output sold. It is obtained by
dividing the total revenue by the number of units sold.
The second term is marginal revenue (MR), which is the additional revenue generated from the sale of an
additional unit of output. In other words, it's the change in total revenue from the sale of one more unit of a
good. For example, if Company A sold one more widget and their revenue increased from $5,000 to
$5,050, the marginal revenue would be equal to $50.

Total revenue is the total receipts a seller can obtain from selling goods or services to buyers. It can
be written as P × Q, which is the price of the goods multiplied by the quantity of the sold goods.
The Concept of Average Revenue and
Marginal Revenue
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The Concept of Average Revenue and Marginal Revenue!

A producer or seller of good is also very much concerned with the demand
for a good, because revenue obtained by him from selling the good
depends mainly upon the demand for the good.
He is, therefore, interested in knowing what sort of demand curve faces
him. The demand curve of the consumers for a product is the average
revenue curve from the standpoint of the sellers, since the price paid by the
consumers is revenue of the sellers.

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Average Revenue:
Price paid by the consumer for the product forms the revenue or income of
the seller. The whole income received by the seller from selling a given
amount of the product is called total revenue. If a seller sells 15 units of a
product at price Rs. 10 per unit and obtains Rs. 150 from this sale, then his
total revenue is Rs. 150.

Thus total revenue can be obtained from multiplying the quantity of output
sold by the market price of the product (P.Q). On the other hand, average
revenue is revenue earned per unit of output. Average revenue can be
obtained by dividing the total revenue by the number of units sold. Thus,

Average revenue = total revenue/total output sold

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AR = TR/Q

Where AR stands for average revenue, TR for total revenue and Q for total
output produced and sold. In our above example, when total revenue Q
equal to Rs. 150 is received from selling 15 units of the product, the
average revenue will be equal to Rs. 150/15 = Rs. 10. Rs. 10 is here the
revenue earned per unit of output.
Now the question is whether average revenue is different from price or
these two concepts mean the same thing. If a seller sells various units of a
product at the same price, then average revenue would be the same thing
as price. But when he sells different units of a given product at different
prices, then the average revenue will not be equal to price.

An example will clarify this point. Suppose a seller sells two units of a
product, both at a price of Rs. 10 per unit. Total revenue of the seller will
be Rs. 20 and the average revenue will be 20/2 = Rs. 10. Thus average
revenue is here equal to the price of the product.

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Now suppose that the seller sells the two units of his product, one unit to
the consumer A at price Rs. 12 and one unit to the consumer B at price Rs.
10. His total revenue from the sale of two units of the product will be Rs.
22. Average will be here equal to 22/2 = Rs. 11. Thus in this case when
two units of the product are sold at different prices, average revenue is not
equal to the prices charged for the product.

But in the actual life we find that different units of a product are sold by
the seller at the same price in the market (except when he discriminates
and charges different prices for different units of the good), average
revenue equals price. Thus in economics we use average revenue and price
as synonyms except when we are discussing price discrimination by the
seller.

Since the buyer’s demand curve represents graphically the quantities

demanded or purchased by the buyers at various prices of the good, it also,
therefore, shows the average revenue at which the various amounts of the
good are sold by the seller. This is because the price paid by the buyer is
revenue from seller’s point of view. Hence, average revenue curve of the
firm is really the same thing as the demand curve of the consumers.

Marginal Revenue:
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On the other hand, marginal revenue is the net revenue earned by selling
an additional unit of the product. In other words, marginal revenue is the
addition made to the total revenue by selling one more unit of a
commodity. Putting it in algebraic expression, marginal revenue is the
addition made to total revenue by selling n units of a product instead of n –
1 where n is any given number.

If a producer sells 10 units of a product at price Rs. 15 per unit, he will get
Rs. 150 as the total revenue. If he now increases his sales of the product by
one unit and sells 11 units, suppose the price falls to Rs. 14 per unit. He
will, therefore, obtain total revenue of Rs. 154 from the sale of 11 units of
the good. This means that 11th unit of output has added Rs. 4 to the total
revenue. Hence Rs. 4 is here the marginal revenue.

Total revenue when 10 units are sold at price of Rs. 15 = 10 x 15 =Rs. 150

Total revenue when 11 units are sold at price of Rs. 14 = 11 x 14 = Rs. 154

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Marginal revenue = 154- 150 = Rs. 4

The word net in the first definition of marginal revenue given above is
worth noting. The full understanding of the word ‘net’ in the definition
will reveal why the marginal revenue is not equal to the price. The
question is, taking our above numerical example, why the marginal
revenue due to the 11th unit is not equal to the price of Rs. 14 at which the
11th unit is sold. The answer is that the 10 units which were sold at the
price of Rs. 15 before will now all have to be sold at the reduced price of
Rs. 14 per unit.

This will mean the loss of one rupee on each of the previous 10 units and
total loss on the previous 10 units due to price fall will be equal to Rs. 10.
The loss in revenue incurred on the previous units occurs because the sale
of additional 11th unit reduces the price to Rs. 14 for all.

Thus in order to find out the net addition made to the total revenue by the
11th unit, the loss in revenue (Rs. 10) on previous units should be
deducted from the price of Rs. 14 at which the 11th unit is sold along with
others. The marginal revenue in this case will, therefore, be equal to Rs. 14
– 10 = 4. Marginal revenue is thus less than the price at which the
additional unit is sold.

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It is clear from above that marginal revenue can either be found directly by
taking out the difference between total revenue before and after selling the
additional unit, or it can be obtained by subtracting the loss in revenue on
previous units due to the fall in price from the price at which the additional
unit is sold.

Therefore, marginal revenue = difference in total revenue in increasing

sales from n – 1 units to n units.

= price of the additional unit minus loss in revenue on previous units

resulting from price reduction.
It follows from above that when the price falls as additional unit is sold,
marginal revenue is less than the price. But when the price remains the
same as additional unit is sold, as under perfect competition, the marginal
revenue will be equal to average revenue, since in this case there is no loss
incurred on the previous units due to the fall in price.

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The relationship between average revenue and marginal revenue is the

same as between any other average and marginal values. When average
revenue falls marginal revenue is less than the average revenue. When
average revenue remains the same, marginal revenue is equal to average
revenue.

If TR stands for total revenue and Q stands for output, then marginal
revenue (MR) can also be expressed as follows:
MR = ∆TR/∆Q

∆TR/∆Q indicates the slope of the total revenue curve.

Thus, if the total revenue curve is given to us, we can find out marginal
revenue at various levels of output by measuring the slopes at the
corresponding points on the total revenue curve.

Average and Marginal Revenue under Imperfect Competition:

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The meaning of the concepts of total, average and marginal revenues

under conditions o’ imperfect competition will become clear from Table
21.3. As has been stated above, when imperfect competition prevails in the
market for a product, an individual firm producing that product faces a
downward sloping demand curve. In other words, as a firm working under
conditions of imperfect competition increases production and sale of its
product its price falls.

Now, when all units of a product are sold at the same price, the average
revenue equals price. How marginal revenue can be obtained from the
changes in total revenue and what relation it bears to average revenue will
be easily grasped from looking at Table 21.3.

Table 21.3. Total, Average and Marginal Revenues:

It will be seen from the Col. Ill of the table that price (or average revenue)
is falling as additional units of the product are sold. Marginal revenue can
be found out by taking out the difference between the two successive total
revenues. Thus, when 1 unit is sold, total Y revenue is Rs. 16. When 2
units are sold, price (or AR) falls to Rs. 15 and total revenue increases to
Rs. 30.

Marginal revenue is therefore here equal to 30-16 = 14, which is recorded

in Col. IV. When 3 units of the product are sold, price falls to Rs. 14 and
total revenue increases to Rs. 42. Hence marginal revenue is now equal to
Rs. 42-30 = Rs. 12 which is again recorded in Col. IV.

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Likewise, marginal revenue of further units can be obtained by taking out

the difference between two successive total revenues. Marginal revenue is
positive as long as total revenue is increasing. Marginal revenue becomes
negative when total revenue declines. Thus when in our table 22.3 quantity
sold is increased from 9 units to 10 units the total revenue declines from
Rs. 72 to 70 and therefore the marginal revenue is negative and is equal to
-2.

It may be noted that in all forms of imperfect competition, that is,

monopolistic competition, oligopoly and monopoly, average revenue curve
facing an individual firm slopes downward as in all these market forms
when a firm lowers the price of its product, its quantity demanded and
sales would increase and vice versa.

The case, when average revenue (or price) falls when additional units of
the product are sold in the market is graphically represented in Fig. 21.1.
In Fig. 21.1 it will be observed that average revenue curve (AR) is falling
downward and marginal revenue curve (MR) lies below it.

The fact that MR curve is lying below AR curve indicates that marginal
revenue declines more rapidly than average revenue. When OQ units of
output are sold, AR is equal to QH or OP and MR is equal to QS. When
OM units of the product are sold, marginal revenue is zero. If the quantity
sold is increased beyond OM, marginal revenue becomes negative.
Average and Marginal Revenue under Perfect Competition:
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When there prevails perfect competition in the market for a product,

demand curve facing an individual firm is perfectly elastic and the price is
beyond the control of a firm, average revenue remains constant. If the
price or average revenue remains the same when more units of a product
are sold, the marginal revenue will be equal to average revenue.

This is so because if one more unit is sold and the price does not fall, the
addition made to the total revenue by that unit will be equal to the price at
which it is sold, since no loss in revenue is incurred on the previous units
in this case Consider the following table:

TABLE 21.4. Average and Marginal Revenues under Perfect

Competition:
In the above table, price remains constant at the level of Rs. 16 when more
units of the product are sold. Col. Ill shows the total revenue when various
quantities of the product are sold. Total revenue has been found out by
multiplying the quantity sold by the price.

It will be found from taking out the difference between two successive
total revenues that marginal revenue in this case is equal to the price i.e.,
Rs. 16. Thus, when two units of the good are sold instead of one, the total
revenue rises from Rs. 16 to Rs. 32, the addition made to the total revenue
i.e. marginal revenue will be equal to Rs. 32 -16 = Rs. 16.

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Similarly, when three units of the product are sold, the total revenue
increases to Rs. 48, and the marginal revenue will be equal to Rs. 48 -32 =
Rs. 16 Likewise, it will be found for further units of the product sold that
marginal revenue is equal to price. The case of perfect competition when
for an individual firm average revenue (or price) remains constant and
marginal revenue is equal to average revenue is graphically shown in Fig.
21.2 Average revenue curve in this case is a horizontal straight line (i.e.,
parallel to the X-axis).

Horizontal-straight-line average revenue curve (AR) indicates that price or

average remains the same at OP level when quantity sold is increased.
Marginal revenue (MR) curve coincides with average revenue (AR) curve
since marginal revenue is equal to average revenue.
Cost minimization analysis (CMA) comprises for the least costly
alternatives when the outcomes of two or more therapies are virtually
identical. CMA involves calculating drug costs to analyze the least costly
drug or therapeutic modality. It also reflects the cost of preparing and
administering a dose. This method of cost evaluation is the one used most
often in evaluating the cost of a specific drug. This method can only be
used to compare two products that have been shown to be equivalent in
dose and therapeutic effect.

Module :- III
Market :-
A market is defined as the sum total of all the buyers and sellers in the area or region under
consideration. The area may be the earth, or countries, regions, states, or cities.

The value, cost and price of items traded are as per forces of supply and demand in a market. The
market may be a physical entity, or may be virtual. It may be local or global, perfect and imperfect.

What is Market Structure?

Market structure, in economics, refers to how different industries are classified and
differentiated based on their degree and nature of competition for goods and
services. It is based on the characteristics that influence the behavior and outcomes
of companies working in a specific market.
Some of the factors that determine a market structure include the number of buyers
and sellers, ability to negotiate, degree of concentration, degree of differentiation
of products, and the ease or difficulty of entering and exiting the market.

Summary

 Market structure refers to how different industries are classified and

differentiated based on their degree and nature of competition for
services and goods.
 The four popular types of market structures include perfect
competition, oligopoly market, monopoly market, and monopolistic
competition.
 Market structures show the relations between sellers and other sellers,
sellers to buyers, or more.

Understanding Market Structures

In economics, market structures can be understood well by closely examining an

array of factors or features exhibited by different players. It is common to
differentiate these markets across the following seven distinct features.

1. The industry’s buyer structure

2. The turnover of customers
3. The extent of product differentiation
4. The nature of costs of inputs
5. The number of players in the market
6. Vertical integration extent in the same industry
7. The largest player’s market share
By cross-examining the above features against each other, similar traits can be
established. Therefore, it becomes easier to categorize and differentiate companies
across related industries. Based on the above features, economists have used this
information to describe four distinct types of market structures. They include
perfect competition, oligopoly market, monopoly market, and monopolistic
competition.

Types of Market Structures

1. Perfect Competition

Perfect competition occurs when there is a large number of small companies

competing against each other. They sell similar products (homogeneous), lack
price influence over the commodities, and are free to enter or exit the market.

Consumers in this type of market have full knowledge of the goods being sold.
They are aware of the prices charged on them and the product branding. In the real
world, the pure form of this type of market structure rarely exists. However, it is
useful when comparing companies with similar features. This market is unrealistic
as it faces some significant criticisms described below.

 No incentive for innovation: In the real world, if competition exists and a

company holds a dominant market share, there is a tendency to increase
innovation to beat the competitors and maintain the status quo. However, in
a perfectly competitive market, the profit margin is fixed, and sellers cannot
increase prices, or they will lose their customers.
 There are very few barriers to entry: Any company can enter the market
and start selling the product. Therefore, incumbents must stay proactive to
maintain market share.

2. Monopolistic Competition

Monopolistic competition refers to an imperfectly competitive market with the

traits of both the monopoly and competitive market. Sellers compete among
themselves and can differentiate their goods in terms of quality and branding to
look different. In this type of competition, sellers consider the price charged by
their competitors and ignore the impact of their own prices on their competition.
When comparing monopolistic competition in the short term and long term, there
are two distinct aspects that are observed. In the short term, the monopolistic
company maximizes its profits and enjoys all the benefits as a monopoly.

The company initially produces many products as the demand is high. Therefore,
its Marginal Revenue (MR) corresponds to its Marginal Cost (MC). However, MR
diminishes over time as new companies enter the market with differentiated
products affecting demand, leading to less profit.

3. Oligopoly

An oligopoly market consists of a small number of large companies that sell

differentiated or identical products. Since there are few players in the market, their
competitive strategies are dependent on each other.

For example, if one of the actors decides to reduce the price of its products, the
action will trigger other actors to lower their prices, too. On the other hand, a price
increase may influence others not to take any action in the anticipation consumers
will opt for their products. Therefore, strategic planning by these types of players is
a must.

In a situation where companies mutually compete, they may create agreements to

share the market by restricting production, leading to supernormal profits. This
holds if either party honors the Nash equilibrium state and neither is tempted to
engage in the prisoner’s dilemma. In such an agreement, they work like
monopolies. The collusion is referred to as cartels.

4. Monopoly

In a monopoly market, a single company represents the whole industry. It has no

competitor, and it is the sole seller of products in the entire market. This type of
market is characterized by factors such as the sole claim to ownership of resources,
patent and copyright, licenses issued by the government, or high initial setup costs.

All the above characteristics associated with monopoly restrict other companies
from entering the market. The company, therefore, remains a single seller because
it has the power to control the market and set prices for its goods.

Perfect competition refers to a market situation where there are a large

number of buyers and sellers dealing in homogenous products.
Moreover, under perfect competition, there are no legal, social, or
technological barriers on the entry or exit of organizations.

In perfect competition, sellers and buyers are fully aware about the current
market price of a product. Therefore, none of them sell or buy at a higher
rate. As a result, the same price prevails in the market under perfect
competition.

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Under perfect competition, the buyers and sellers cannot influence the
market price by increasing or decreasing their purchases or output,
respectively. The market price of products in perfect competition is
determined by the industry. This implies that in perfect competition, the
market price of products is determined by taking into account two market
forces, namely market demand and market supply.

In the words of Marshall, “Both the elements of demand and supply are
required for the determination of price of a commodity in the same manner
as both the blades of scissors are required to cut a cloth.” As discussed in
the previous chapters, market demand is defined as a sum of the quantity
demanded by each individual organizations in the industry.

On the other hand, market supply refers to the sum of the quantity supplied
by individual organizations in the industry. In perfect competition, the
price of a product is determined at a point at which the demand and supply
curve intersect each other. This point is known as equilibrium point as well
as the price is known as equilibrium price. In addition, at this point, the
quantity demanded and supplied is called equilibrium quantity. Let us
discuss price determination under perfect competition in the next sections.

Demand under Perfect Competition:

Demand refers to the quantity of a product that consumers are willing to
purchase at a particular price, while other factors remain constant. A
consumer demands more quantity at lower price and less quantity at higher
price. Therefore, the demand varies at different prices.

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Figure-1 represents the demand curve under perfect competition:

As shown in Figure-1, when price is OP, the quantity demanded is OQ. On
the other hand, when price increases to OP1, the quantity demanded
reduces to OQ1. Therefore, under perfect competition, the demand curve
(DD’) slopes downward.

Supply under Perfect Competition:

Supply refers to quantity of a product that producers are willing to supply
at a particular price. Generally, the supply of a product increases at high
price and decreases at low price.

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Figure-2 shows the supply curve under perfect competition:

In Figure-2, the quantity supplied is OQ at price OP. When price increases

to OP1, the quantity supplied increases to OQ1. This is because the
producers are able to earn large profits by supplying products at higher
price. Therefore, under perfect competition, the supply curves (SS’) slopes
upward.
Equilibrium under Perfect Competition:
As discussed earlier, in perfect competition, the price of a product is
determined at a point at which the demand and supply curve intersect each
other. This point is known as equilibrium point. At this point, the quantity
demanded and supplied is called equilibrium quantity.

Figure-3 shows the equilibrium under perfect competition:

In Figure-3, it can be seen that at price OP1, supply is more than the
demand. Therefore, prices will fall down to OP. Similarly, at price OP2,
demand is more than the supply. Similarly, in such a case, the prices will
rise to OP. Thus, E is the equilibrium at which equilibrium price is OP and
equilibrium quantity is OQ.

Break-even analysis:-

Break-even analysis tells you how many units of a product must be sold to cover the
fixed and variable costs of production. The break-even point is considered a measure of the
margin of safety. Break-even analysis is used broadly, from stock and options trading to
corporate budgeting for various projects

What is a Break-Even Analysis

Break-even is a situation where an organisation is neither making money nor
losing money, but all the costs have been covered.
Break-even analysis is useful in studying the relation between the variable cost,
fixed cost and revenue. Generally, a company with low fixed costs will have a low
break-even point of sale. For example, say Happy Ltd has fixed costs of Rs. 10,000
vs Sad Ltd has fixed costs of Rs. 1,00,000 selling similar products, Happy Ltd will
be able to break-even with the sale of lesser products as compared to Sad Ltd.

Components of Break-Even Analysis

Fixed costs
Fixed costs are also called overhead costs. These overhead costs occur after the
decision to start an economic activity is taken and these costs are directly related to
the level of production, but not the quantity of production. Fixed costs include (but
are not limited to) interest, taxes, salaries, rent, depreciation costs, labour costs,
energy costs etc. These costs are fixed irrespective of the production. In case of no
production also the costs must be incurred.

Variable costs
Variable costs are costs that will increase or decrease in direct relation to the
production volume. These costs include cost of raw material, packaging cost, fuel
and other costs that are directly related to the production.

Calculation of Break-Even Analysis

The basic formula for break-even analysis is derived by dividing the total fixed
costs of production by the contribution per unit (price per unit less the variable
costs).
For an example:
Variable costs per unit: Rs. 400 Sale price per unit: Rs. 600 Desired profits: Rs.
4,00,000 Total fixed costs: Rs. 10,00,000 First we need to calculate the break-even
point per unit, so we will divide the Rs.10,00,000 of fixed costs by the Rs. 200
which is the contribution per unit (Rs. 600 – Rs. 200). Break-Even Point = Rs.
10,00,000/ Rs. 200 = 5000 units Next, this number of units can be shown in rupees
by multiplying the 5,000 units with the selling price of Rs. 600 per unit. We get
Break-Even Sales at 5000 units x Rs. 600 = Rs. 30,00,000. (Break-even point in
rupees)

Contribution Margin
Break-even analysis also deals with the contribution margin of a product. The
excess between the selling price and total variable costs is known as contribution
margin. For an example, if the price of a product is Rs.100, total variable costs are
Rs. 60 per product and fixed cost is Rs. 25 per product, the contribution margin of
the product is Rs. 40 (Rs. 100 – Rs. 60). This Rs. 40 represents the revenue
collected to cover the fixed costs. In the calculation of the contribution margin,
fixed costs are not considered.

When is Break-even analysis used

Starting a new business: To start a new business, a break-even analysis is a
must. Not only it helps in deciding whether the idea of starting a new
business is viable, but it will force the startup to be realistic about the costs,
as well as provide a basis for the pricing strategy.

Creating a new product: In the case of an existing business, the company

should still peform a break-even analysis before launching a new product—
particularly if such a product is going to add a significant expenditure.
 Changing the business model: If the company is about to the change the
business model, like, switching from wholesale business to retail business,
then a break-even analysis must be performed. The costs could change
considerably and breakeven analysis will help in setting the selling price.

Breakeven analysis is useful for the

following reasons:
 It helps to determine remaining/unused capacity of the company once the
breakeven is reached. This will help to show the maximum profit on a
particular product/service that can be generated.

 It helps to determine the impact on profit on changing to automation from

manual (a fixed cost replaces a variable cost).

 It helps to determine the change in profits if the price of a product is altered.

 It helps to determine the amount of losses that could be sustained if there is a

sales downturn.

Additionally, break-even analysis is very useful for knowing the overall ability of a
business to generate a profit. In the case of a company whose breakeven point is
near to the maximum sales level, this signifies that it is nearly impractical for the
business to earn a profit even under the best of circumstances.
Therefore, it’s the management responsibility to monitor the breakeven point
constantly. This monitoring certainly reduces the breakeven point whenever
possible.

Ways to monitor Break-even point

 Pricing analysis: Minimize or eliminate the use of coupons or other price
reductions offers, since such promotional strategies increase the breakeven
point.

 Technology analysis: Implementing any technology that can enhance the

business efficiency, thus increasing capacity with no extra cost.

 Cost analysis: Reviewing all fixed costs constantly to verify if any can be
eliminated can surely help. Also, review the total variable costs to see if they
can be eliminated. This analysis will increase the margin and reduce the
breakeven point.

 Margin analysis: Push sales of the highest-margin (high contribution

earning) items and pay close attention to product margins, thus reducing the
breakeven point.

 Outsourcing: If an activity consists of a fixed cost, try to outsource such

activity (whenever possible), which reduces the breakeven point.

Benefits of Break-even analysis

Catch missing expenses: When you’re thinking about a new business, it’s
very much possible that you may forget about a few expenses. Therefore, a
break-even analysis can help you to review all financial commitments to
figure out your break-even point. This analysis certainly restricts the number
of surprises down the road or atleast prepares a company for them.

Set revenue targets: Once the break-even analysis is complete, you will get
to know how much you need to sell to be profitable. This will help you and
your sales team to set more concrete sales goals.
 Make smarter decisions: Entrepreneurs often take decisions in relation to
their business based on emotion. Emotion is important i.e. how you feel,
though it’s not enough. In order to be a successful entrepreneur, decisions
should be based on facts.

 Fund your business: This analysis is a key component in any business plan.
It’s generally a requirement if you want outsiders to fund your business. In
order to fund your business, you have to prove that your plan is viable.
Furthermore, if the analysis looks good, you will be comfortable enough to
take the burden of various ways of financing.

 Better pricing: Finding the break-even point will help in pricing the
products better. This tool is highly used for providing the best price of a
product that can fetch maximum profit without increasing the existing price.

 Cover fixed costs: Doing a break-even analysis helps in covering all fixed
cost.

What Is the Time Value of Money (TVM)?

The time value of money (TVM) is the concept that a sum of money is worth more
now than the same sum will be at a future date due to its earning potetational in the
interim.

This is a core principle of finance. A sum of money in the hand has greater value than
the same sum to be paid in the future.

Time Value of Money Examples:-

If you invest $100 (the present value) for 1 year at a 5% interest rate (the discount rate), then
at the end of the year, you would have $105 (the future value). So, according to this example,
$100 today is worth $105 a year from today.

Interest:-

Interest is the monetary charge for the privilege of borrowing money, typically expressed as
an annual percentage rate (APR). Interest is the amount of money a lender or financial institution
receives for lending out money.
You can calculate Interest on your loans and investments by using the following formula
for calculating simple interest: Simple Interest= P x R x T ÷ 100, where P = Principal, R
= Rate of Interest and T = Time Period of the Loan/Deposit in years.
Formula: Simple Interest=P×r×t where: P=Principal
Principal Amount: Principal Amount remains cost
Meaning: Simple Interest is calculated on the...
Calculation: It is easy to calculate Simple Inter.
Simple interest:-

What is Simple Interest?

Simple interest is a quick and easy method to calculate interest on the money, in
the simple interest method interest always applies to the original principal amount,
with the same rate of interest for every time cycle.
Simple Interest Formula
Simple interest is calculated with the following formula: S.I. = P × R × T, where P = Principal, R =
Rate of Interest in % per annum, and T = Time, usually calculated as the number of years. The rate of
interest is in percentage r% and is to be written as r/100.

Principal: The principal is the amount that initially borrowed from the bank or invested. The principal
is denoted by P.
Rate: Rate is the rate of interest at which the principal amount is given to someone for a certain time,
the rate of interest can be 5%, 10%, or 13%, etc. The rate of interest is denoted by R.
Time: Time is the duration for which the principal amount is given to someone. Time is denoted by T.
Amount: When a person takes a loan from a bank, he/she has to return the principal borrowed plus the
interest amount, and this total returned is called Amount.
Amount = Principal + Simple Interest

A = P + S.I.

A = P + PRT

A = P (1 + RT)

Simple Interest Formula

Simple Interest Example:

Michael's father had borrowed $1,000 from the bank and the rate of interest was 5%. What would the
simple interest be if the amount is borrowed for 1 year? Similarly, calculate the simple interest if the
amount is borrowed for 2 years, 3 years, and 10 years?

Solution:

Principal Amount = $1,000, Rate of Interest = 5% = 5/100. (Add a sentence here describing the given
information in the question.)

Simple Interest

1 Year S.I = (1000 ×5 × 1)/100 = 50

2 Year S.I = (1000 × 5 × 2)/100 = 100
3 Year S.I = (1000 ×5 × 3)/100 = 150
10 YearS.I = (1000 × 5 × 10)/100 = 500
Now, we can also prepare a table for the above question adding the amount to be returned after the
given time period.

Simple Interest Amount

1 Year S.I = (1000 ×5 × 1)/100 = 50 A= 1000 + 50 = 1050
2 Year S.I = (1000 ×5 × 2)/100 = 100 A= 1000 + 100 = 1100
3 Year S.I = (1000 × 5 × 3)/100 = 150 A = 1000 + 150 = 1150
10 YearS.I = (1000 × 5 × 10)/100 = 500 A = 1000 + 500 = 1500

Simple Interest vs Compound Interest

Simple interest and compound interest are two ways to calculate interest on a loan
amount. It is believed that compound interest is more difficult to calculate than
simple interest because of some basic differences in both. Let's understand the
difference between simple interest and compound interest through the table given
below:

Simple Interest Compound Interest

 Simple interest is calculated on the
Compound interest is calculated on the
original principal amount every
accumulated sum of principal and interest.
time.

It is calculated using the following It is calculated using the following formula:

formula: S.I.= P × R × T C.I.= P × (1+r)t - P

It is different for every span of the time period

It is equal for every year on a certain
as it is calculated on the amount and not
principal.
principal.

Compound interest, or 'interest on interest', is calculated with the

compound interest formula.

The formula for compound interest is P (1 + r/n)^(nt), where P is the

initial principal balance, r is the interest rate, n is the number of times
interest is compounded per time period and t is the number of time
periods.

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The concept of compound interest is that interest is added back to the principal sum so
that interest is gained on that already-accumulated interest during the next
compounding period. How important is it? Just ask Warren Buffett, one of the world's
most successful investors:
"My wealth has come from a combination of living in
America, some lucky genes, and compound interest."
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In this article, we'll take a look at the compound interest formula in more depth. We'll
also go through an example and discuss other variations of the formula that can help
you to calculate the interest rate and time factor or to incorporate regular
contributions. Should you wish to try some calculations using your own figures, you
can use our popular compound interest calculator.

How to use the compound interest formula

To use the compound interest formula you will need figures for principal amount,
annual interest rate, time factor and the number of compound periods. Once you have
those, you can go through the process of calculating compound interest.

The formula for compound interest, including principal sum, is:

A = P (1 + r/n) (nt)

Where:

A = the future value of the investment/loan, including interest

P = the principal investment amount (the initial deposit or loan amount)
r = the annual interest rate (decimal)
n = the number of times that interest is compounded per unit t
t = the time the money is invested or borrowed for

It's worth noting that this formula gives you the future value of an investment or loan,
which is compound interest plus the principal. Should you wish to calculate the
compound interest only, you need to deduct the principal from the result. So, your
formula looks like this:

Compounded interest only (without principal): P (1 + r/n) (nt) - P

Let's look at an example

If an amount of $5,000 is deposited into a savings account at an annual interest rate of
5%, compounded monthly, the value of the investment after 10 years can be
calculated as follows...
P = 5000.
r = 5/100 = 0.05 (decimal).
n = 12.
t = 10.

If we plug those figures into the formula, we get the following:

(12 * 10)
A = 5000 (1 + 0.05 / 12) = 8235.05.

So, the investment balance after 10 years is $8,235.05.

Nominal Interest Rate:-

Nominal interest rate is also defined as a stated interest rate. This interest works according to
the simple interest and does not take into account the compounding periods. Effective interest
rate is the one which caters the compounding periods during a payment plan.

Example: A credit card company charges 21% interest per year, compounded monthly. What effective annual interest rate
does the company charge?

r = 0.21 per year

m = 12 months per year

ia = [ 1 + (.21 / 12) ] 12 - 1

= [1 + 0.0175 ] 12 - 1

= (1.0175)12 - 1 = 1.2314 - 1

= 0.2314 = 23.14%

It may be desired to find the effective interest rate for a period other than annual. In this case, adjust the period for "r" and
"m" as needed. For example, if the effective interest rate per semi annual period (every 6 months) is desired, then

r = nominal interest rate per 6 months

m = number of compounding periods per 6 months

and the effective interest rate, isa, per semi-annual period, is:

isa = [ 1 + (r / m) ] m - 1

Question 1.

If a lender charges 12% interest, compounded quarterly, what effective annual interest rate is the lender charging?

Choose an answer by clicking on one of the letters below, or click on "Review topic" if needed.

A ia = [ 1 + (0.12 / 12) ] 12 - 1 = (1.01)12 - 1 = 1.1268 - 1 = .1268 = 12.68%

B ia = [ 1 + 0.12 ] 12 - 1 = (1.12)12 - 1 = 3.8960 - 1 = 2.8960 = 289.6%

C ia = [ 1 + (0.12 / 12) ] 4 - 1 = (1.01)4 - 1 = 1.0406 - 1 = .0406 = 4.06%

D ia = [ 1 + (0.12 / 4) ] 4 - 1 = (1.03)4 - 1 = 1.1255 - 1 = .1255 = 12.55%

Cash Flow Diagrams

Engineering Costs and Cost Estimating
Cash Flow Diagrams

A cash-flow diagram is a financial tool used to represent the cashflows associated with a security,
"project", or business. As per the graphics, cash flow diagrams are widely used in structuring and
analyzing securities, particularly swaps.

Cash flow diagrams visually represent income and expenses over some time interval. The diagram consists of a horizontal
line with markers at a series of time intervals. At appropriate times, expenses and costs are shown.

Note that it is customary to take cash flows during a year at the end of the year, or EOY (end-of-year). There are certain cash
flows for which this is not appropriate and must be handled differently. The most common would be rent, which is normally
taken at the beginning of a cash period. There are other pre-paid flows which are handled similarly.

For example, consider a truck that is going to be purchased for $55,000. It will cost $9,500 each year to operate including
fuel and maintenance. It will need to have its engine rebuilt in 6 years for a cost of $22,000 and it will be sold at year 9 for
$6,000. Here is the cash flow diagram:

Note that the initial cost, the purchase price, is recorded at the beginning of Year 1, sometimes referred to as end-of-year 0,
or EOY 0. Also, operating and maintenance costs actually will occur during a year, but they are recorded at EOY, and so
forth.

Question 1.

Given the cash flow diagram below, answer the questions by clicking on the correct answer. Note that there are several
questions; as you correctly answer each, you go to the next question. (Note that these questions will take more time than
previous questions did.)
 Economic equvalance:-
Economic equivalence is a combination of interest rate and time value of money to determine
the different amounts of money at different points in time that are equal in economic value .

Economic equivalence is a fundamental concept upon which engineering economy

computations are based. Before we delve into the economic aspects, think of the many
types of equivalency we may utilize daily by transferring from one scale to another.
Some example transfers between scales are as follows:

Often equivalency involves two or more scales. Consider the equivalency of

a speed of 110 kilometers per hour (kph) into miles per minute using conversions
between distance and time scales with three-decimal accuracy.

Four scales—time in minutes, time in hours, length in miles, and length in

kilometers—are combined to develop these equivalent statements on speed. Note that
throughout these statements, the fundamental relations of 1 mile = 1.609 kilometres
and 1 hour = 60 minutes are applied. If a fundamental relation changes, the entire
equivalency is in error.

Now we consider economic equivalency.

Economic equivalence is a combination of interest rate and time value of

money to determine the different amounts of money at different points in time that are
equal in economic value.
As an illustration, if the interest rate is 6% per year, $100 today (present time) is
equivalent to $106 one year from today.

Amount accrued = 100 + 100(0.06) = 100(1 + 0.06) = $106

If someone offered you a gift of $100 today or $106 one year from today, it would
make no difference which offer you accepted from an economic perspective. In either
case you have $106 one year from today. However, the two sums of money are
equivalent to each other only when the interest rate is 6% per year. At a higher or
lower interest rate, $100 today is not equivalent to $106 one year from today.

In addition to future equivalence, we can apply the same logic to determine

equivalence for previous years. A total of $100 now is equivalent to $100 1.06 =
$94.34 one year ago at an interest rate of 6% per year. From these illustrations, we can
state the following: $94.34 last year, $100 now, and $106 one year from now are
equivalent at an interest rate of 6% per year. The fact that these sums are equivalent
can be verified by computing the two interest rates for 1-year interest periods.

The cash flow diagram in Figure 1–10 indicates the amount of interest needed each
year to make these three different amounts equivalent at 6% per year.
 Figure 1–10 Equivalence of money at 6% per year interest.

EXAMPLE 1.12
Manufacturers make backup batteries for computer systems available to Batteries +
dealers through privately owned distributorships. In general, batteries are stored
throughout the year, and a 5% cost increase is added each year to cover the inventory
carrying charge for the distributorship owner. Assume you own the City Centre
Batteries + outlet. Make the calculations necessary to show which of the following
statements are true and which are false about battery costs.

(a) The amount of $98 now is equivalent to a cost of $105.60 one year from now.
(b) A truck battery cost of $200 one year ago is equivalent to $205 now.
(c) A $38 cost now is equivalent to $39.90 one year from now.
(d) A $3000 cost now is equivalent to $2887.14 one year earlier.
(e) The carrying charge accumulated in 1 year on an investment of $20,000 worth
of batteries is $1000.

Comparison of alternative cash flow series requires the use of equivalence to

determine when the series are economically equal or if one is economically preferable
to another. The keys to the analysis are the interest rate and the timing of the cash
flows. Example 1.13 demonstrates how easy it is to be misled by the size and timing
of cash flows.

EXAMPLE 1.13
Howard owns a small electronics repair shop. He wants to borrow $10,000 now and
repay it over the next 1 or 2 years. He believes that new diagnostic test equipment will
allow him to work on a wider variety of electronic items and increase his annual
revenue. Howard received 2-year repayment options from banks A and B.

After reviewing these plans, Howard decided that he wants to repay the $10,000 after
only 1 year based on the expected increased revenue. During a family conversation,
Howard’s brother-in-law offered to lend him the $10,000 now and take $10,600 after
exactly 1 year. Now Howard has three options and wonders which one to take. Which
one is economically the best?

Solution

the repayment plans for both banks are economically equivalent at the interest rate of
5% per year. (This is determined by using computations that you will learn in Chapter
2.) Therefore, Howard can choose either plan even though the bank B plan requires a
slightly larger sum of money over the 2 years.

The brother-in-law repayment plan requires a total of $600 in interest 1 year later plus
the principal of $10,000, which makes the interest rate 6% per year. Given the two 5%
per year options from the banks, this 6% plan should not be chosen as it is not
economically better than the other two. Even though the sum of money repaid is
smaller, the timing of the cash flows and the interest rate make it less desirable. The
point here is that cash flows themselves, or their sums, cannot be relied upon as the
primary basis for an economic decision. The interest rate, timing, and economic
equivalence must be considered.
Engineering Evaluation project:-
Engineering project evaluation is to evaluate systematically the project about the process and
results based on specific criteria, in order to provide some suggestions for the policy-maker and
improvement to the project.

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

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.

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.

[Link]-Dominated Cash Flow Diagram

A generalized revenue-dominated cash flow diagram to demonstrate the present

worth method of comparison is presented in Fig.
 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]

[Link]-Dominated Cash Flow Diagram

A generalized cost-dominated cash flow diagram to demonstrate the

present worth method of comparison is presented in Fig.

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]

EXAMPLE

Alpha Industry is planning to expand its production operation. It has identified

three different technologies for meeting the goal. The initial outlay and annual
revenues with respect to each of the technologies are summarized in Table 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.

Fig. Cash flow diagram for technology 1.

The present worth expression for this technology is

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

Fig. Cash flow diagram for technology 2.

The present worth expression for this technology is

PW(20%)2 = – 20,00,000 + 6,00,000 (P/A, 20%, 10)

= – 20,00,000 + 6,00,000 (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.

 Fig. Cash flow diagram for technology 3.

The present worth expression for this technology is

PW(20%)3 = –18,00,000 + 5,00,000 (P/A, 20%, 10)

= –18,00,000 + 5,00,000 (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.
Cost benefits analysis for public project:-

The purpose of CBA is to ensure that the public sector allocates scarce re-sources efficiently to
competing public sector projects ...... CBA estimates and totals up the equivalent money value of the
benefits and costs to the community of projects to establish whether they are worth-while.

Depreciation:-

In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease of fair value
of an asset, such as the decrease in value of factory equipment each year as it is used ...

Capital depreciation refers to the decline in value of a capital asset. To give a simplified example,
if a machine is bought for $10,000 but only has a useful lifespan of five years, then every year, the value
of this machine will decline by $2,000. After three years, the machine is worth $4,000.
Causes of Depreciation:
 Wear and Tear: Some assets physically deteriorate due to wear and tear in use. ...
 Lapse of Time: There are certain assets like leasehold property, patents, copy-right etc. ...
 Obsolescence: ...
 Exhaustion: ...
 Non-Use: ...
 Maintenance: ...
 Market Trend:

methods of calculation of depreciation:-

Straight line basis is a method of calculating depreciation and amortization, the process of
expensing an asset over a longer period of time than when it was purchased. It is calculated by
dividing the difference between an asset's cost and its expected salvage value by the number of years
it is expected to be used.

What is Straight Line Depreciation?

With the straight line depreciation method, the value of an asset is reduced
uniformly over each period until it reaches its salvage value. Straight line
depreciation is the most commonly used and straightforward depreciation
method for allocating the cost of a capital asset. It is calculated by simply dividing
the cost of an asset, less its salvage value, by the useful life of the asset.
Image: CFI’s Free Accounting Course.

Straight Line Depreciation Formula

The straight line depreciation formula for an asset is as follows:

Where:

Cost of the asset is the purchase price of the asset

Salvage value is the value of the asset at the end of its useful life
Useful life of asset represents the number of periods/years in which the asset is
expected to be used by the company

Additionally, the straight line depreciation rate can be calculated as follows:

How to Calculate Straight Line Depreciation

The straight line calculation steps are:

1. Determine the cost of the asset.

2. Subtract the estimated salvage value of the asset from the cost of the asset to
get the total depreciable amount.
3. Determine the useful life of the asset.
4. Divide the sum of step (2) by the number arrived at in step (3) to get
the annual depreciation amount.

Straight Line Example

Company A purchases a machine for $100,000 with an estimated salvage value of

$20,000 and a useful life of 5 years.

The straight line depreciation for the machine would be calculated as follows:

1. Cost of the asset: $100,000

2. Cost of the asset – Estimated salvage value: $100,000 – $20,000 = $80,000
total depreciable cost
3. Useful life of the asset: 5 years
4. Divide step (2) by step (3): $80,000 / 5 years = $16,000 annual depreciation
amount

Therefore, Company A would depreciate the machine at the amount of $16,000

annually for 5 years.
The depreciation rate can also be calculated if the annual depreciation amount is
known. The depreciation rate is the annual depreciation amount / total depreciable
cost. In this case, the machine has a straight-line depreciation rate of $16,000 /
$80,000 = 20%.

Note how the book value of the machine at the end of year 5 is the same as the
salvage value. Over the useful life of an asset, the value of an asset should
depreciate to its salvage value.

Decline Balance Method:-

The declining balance method is an accelerated depreciation system of recording

larger depreciation expenses during the earlier years of an asset's useful life and
recording smaller depreciation expenses during the asset's later years.

Declining Balance Method Formula

Under the Declining Balance Method Formula, the depreciation is
computed as:

Declining Balance Method = (Net Book Value – Residual Value) *

Rate of Depreciation (in %)

Declining Balance Method Example

Let’s understand the same with the help of examples:
 Example #1
Ram purchased a Machinery costing $11000 with a useful life of 10 years
and a residual value of $[Link] rate of Depreciation is 20%.
Depreciation as per the DBM is computed as follows:

Year Depreciation Depreciation Value at the end of the year

1 20% ($11000-$1000) $2,000 $8,000

2 20% ($8000) $1,600 $6,400

3 20% ($6400) $1,280 $5,120

4 20% ($5120) $1,024 $4,096

Thus, the Machinery will depreciate over the useful life of 10 years at the
rate of depreciation (20% in this case). As we can observe, the DBM result
in higher depreciation during the initial years of an asset’s life and keeps
reducing as the asset gets older.

Among the most common DBM is Double Declining Balance (DDB).

Under the Double Declining Balance (DDB) method two times, the
straight-line rate is applied to the declining balance. It is an ideal
depreciation method for assets that quickly lose their value or are subject
to technological obsolescence. Under Double Declining Balance
Method the depreciation is computed by the formula:

It doesn’t always use assets salvage value (or residual value) while
computing the depreciation. However, depreciation ends once the
estimated salvage value of the asset is reached. However, in those cases
where the asset has no residual value, this method will never depreciate the
asset fully and is typically changed to the Straight Line Depreciation
Method at some stage during the asset’s life.
Let’s understand the same with the help of a declining balance method
example:
 Example #2
ABC Limited purchased a Machine costing $12500 with a useful life of 5
years. The Machine is expected to have a salvage value of $2500 at the
end of its useful life.
Let’s calculate the depreciation using the Double Declining Balance
method.

Year Depreciation Accumulated Depreciation

1 (2/5)*$12500=$5000 $5,000

2 (2/5)*($12500-$5000) = $3000 $8,000

3 (2/5)*($12500-$8000) = $1800 $9,800

4 (2/5)*($12500-$9800) = $1080 $10,880

From year 1 to 3, ABC Limited has recognized accumulated depreciation

of $[Link] the Machinery is having a residual value of $2500,
depreciation expense is limited to $10000 ($12500-$2500). As such, the
depreciation in year 4 will limit to $200 ($10000-$9800) rather than
$1080, as computed above. Also, for Year 5, depreciation expense will be
$0 as the assets are already fully depreciated.
Soyd method of Depreciation:-

Under the SYD method, the depreciation rate percentage for each year is calculated as the
number of years in remaining asset life for the same year divided by the sum of
remaining asset life every year through the asset's life. As the depreciation rate
decreases over time, so does the depreciation charge.

Sum of Years Digits Method Example

Let us understand the concept with an example below:

A Computer Company has purchased some computers worth $ 5,000,000.

It cost them $ 200,000 to transport the Computer to their location. The
 Company considers that the useful life of Computers is 5 years and they
can expire the computers at a value of 100,000.

Now, considering the above example, let us try to create a depreciation

schedule for the asset using the Sum of year depreciation method.

Step 1 – Calculate the Depreciable Amount

 Total Acquisition Cost = 5000000 + 200000 = 5200000
 Salvage Value = 100000
 Useful life of Computers = 5 years
 Depreciation Amount = Acquisition Cost – Salvage Value = 5200000 –
100000 = 5,100,000

Step 2 – Calculate the Sum of Useful Life

Sum of useful life = 5 + 4 + 3 + 2 + 1 = 15

Step 3 – Calculate Depreciation Factors

The depreciation factors are as follows

 Year 1 – 5/15
 Year 2 – 4/15
 Year 3 – 3/15
 Year 4 – 2/15
 Year 5 – 1/15

Step 4 – Calculate Depreciation for each year.

The depreciation expense of first year = $5,000,000 x 5/15 = $1,700,000

The amount left to be depreciated is calculated as $5,100,000 – $1,700,000

= $1,360,000

Likewise, we can calculate the depreciation expense for year 2, 3 and 4.

Year 5 depreciation is not calculated using the depreciation factor. As it is

the last useful year, we depreciate the full amount that is left for
depreciation. In this case, it is $340,000
 As can be seen from the above depreciation schedule of the sum of the
year depreciation method, the depreciation expense is highest in the early
years and keeps decreasing as the asset life increases, and it becomes
obsolete.

Advantages
1. The sum of years digits method is helpful in matching the cost of the asset
and benefit of the asset, which provides over the useful life of an asset.
The benefit of the asset declines as its useful life decreases, and the asset
grows older. Thus, charging the asset’s cost higher in the early years and
reducing the amount as years pass by reflects the economic condition and
benefits from the asset.
2. When the asset grows older and has been used for some good years, its
repair and maintenance costs rise. The rising repair and maintenance costs
can offset the low depreciation cost of the asset in the later period of its
useful life. The repair costs are lower in initial years, and the depreciation
amount is high and vice versa. If accelerated depreciation or sum of year
depreciation method is not used, the earnings might be distorted and vary
as they depreciation charge will be lower in the initial period and during
the end of the useful life of an asset, the charges will rise due to repair
costs thus decreasing the earnings.
3. The sum of year digits method provides a tax shield, especially during the
initial years. Since the depreciation expense is high, the Company can
report lower net income, thus decreasing the tax expense.
4. The sum of the year depreciation method is useful for depreciating an asset
that may become obsolete quickly. For e.g., Computers can become
obsolete very fast due to technological advancements; thus, it makes sense
to charge the expense in the early years of useful life.
Conclusion
The sum of years digits method is an accelerated depreciation method that
can be used to depreciate the value of the asset over the useful life of the
asset. The sum of the year depreciation method aims to depreciate the asset
at an accelerated rate, i.e., higher depreciation expense in the early years
and lower depreciation expense in later years. It is useful for deferring
tax payments and especially used for assets that have a lower useful life
and may become obsolete quickly.

Module :-
Controlling Inflation: 3 Important
Measures to Control Inflation

Some of the important measures to control inflation are as follows: 1.

Monetary Measures 2. Fiscal Measures 3. Other Measures.

Inflation is caused by the failure of aggregate supply to equal the increase

in aggregate demand. Inflation can, therefore, be controlled by increasing
the supplies of goods and services and reducing money incomes in order to
control aggregate demand.

ADVERTISEMENTS:

The various methods are usually grouped under three heads: monetary
measures, fiscal measures and other measures.

1. Monetary Measures:
Monetary measures aim at reducing money incomes.

(a) Credit Control:

One of the important monetary measures is monetary policy. The central
bank of the country adopts a number of methods to control the quantity
and quality of credit. For this purpose, it raises the bank rates, sells
securities in the open market, raises the reserve ratio, and adopts a number
of selective credit control measures, such as raising margin requirements
and regulating consumer credit. Monetary policy may not be effective in
controlling inflation, if inflation is due to cost-push factors. Monetary
policy can only be helpful in controlling inflation due to demand-pull
factors.

(b) Demonetisation of Currency:

However, one of the monetary measures is to demonetise currency of
higher denominations. Such a measures is usually adopted when there is
abundance of black money in the country.

(c) Issue of New Currency:

ADVERTISEMENTS:

The most extreme monetary measure is the issue of new currency in place
of the old currency. Under this system, one new note is exchanged for a
number of notes of the old currency. The value of bank deposits is also
fixed accordingly. Such a measure is adopted when there is an excessive
issue of notes and there is hyperinflation in the country. It is a very
effective measure. But is inequitable for its hurts the small depositors the
most.

2. Fiscal Measures:
Monetary policy alone is incapable of controlling inflation. It should,
therefore, be supplemented by fiscal measures. Fiscal measures are highly
effective for controlling government expenditure, personal consumption
expenditure, and private and public investment.

ADVERTISEMENTS:

The principal fiscal measures are the following:

(a) Reduction in Unnecessary Expenditure:
The government should reduce unnecessary expenditure on non-
development activities in order to curb inflation. This will also put a check
on private expenditure which is dependent upon government demand for
goods and services. But it is not easy to cut government expenditure.
Though this measure is always welcome but it becomes difficult to
distinguish between essential and non-essential expenditure. Therefore,
this measure should be supplemented by taxation.

(b) Increase in Taxes:

To cut personal consumption expenditure, the rates of personal, corporate
and commodity taxes should be raised and even new taxes should be
levied, but the rates of taxes should not be so high as to discourage saving,
investment and production. Rather, the tax system should provide larger
incentives to those who save, invest and produce more.
Further, to bring more revenue into the tax-net, the government should
penalise the tax evaders by imposing heavy fines. Such measures are
bound to be effective in controlling inflation. To increase the supply of
goods within the country, the government should reduce import duties and
increase export duties.

(c) Increase in Savings:

ADVERTISEMENTS:

Another measure is to increase savings on the part of the people. This will
tend to reduce disposable income with the people, and hence personal
consumption expenditure. But due to the rising cost of living, people are
not in a position to save much voluntarily.

Keynes, therefore, advocated compulsory savings or what he called

‘deferred payment’ where the saver gets his money back after some years.
For this purpose, the government should float public loans carrying high
rates of interest, start saving schemes with prize money, or lottery for long
periods, etc. It should also introduce compulsory provident fund, provident
fund-cum-pension schemes, etc. All such measures increase savings and
are likely to be effective in controlling inflation.

(d) Surplus Budgets:

An important measure is to adopt anti-inflationary budgetary policy. For
this purpose, the government should give up deficit financing and instead
have surplus budgets. It means collecting more in revenues and spending
less.

(e) Public Debt:

ADVERTISEMENTS:
At the same time, it should stop repayment of public debt and postpone it
to some future date till inflationary pressures are controlled within the
economy. Instead, the government should borrow more to reduce money
supply with the public.

Like monetary measures, fiscal measures alone cannot help in controlling

inflation. They should be supplemented by monetary, non-monetary and
non-fiscal measures.

3. Other Measures:
The other types of measures are those which aim at increasing aggregate
supply and reducing aggregate demand directly.

(a) To Increase Production:

The following measures should be adopted to increase production:
ADVERTISEMENTS:

(i) One of the foremost measures to control inflation is to increase the

production of essential consumer goods like food, clothing, kerosene oil,
sugar, vegetable oils, etc.

(ii) If there is need, raw materials for such products may be imported on
preferential basis to increase the production of essential commodities,

(iii) Efforts should also be made to increase productivity. For this purpose,
industrial peace should be maintained through agreements with trade
unions, binding them not to resort to strikes for some time,

(iv) The policy of rationalisation of industries should be adopted as a long-

term measure. Rationalisation increases productivity and production of
industries through the use of brain, brawn and bullion,
ADVERTISEMENTS:

(v) All possible help in the form of latest technology, raw materials,
financial help, subsidies, etc. should be provided to different consumer
goods sectors to increase production.

(b) Rational Wage Policy:

Another important measure is to adopt a rational wage and income policy.
Under hyperinflation, there is a wage-price spiral. To control this, the
government should freeze wages, incomes, profits, dividends, bonus, etc.

But such a drastic measure can only be adopted for a short period as it is
likely to antagonise both workers and industrialists. Therefore, the best
course is to link increase in wages to increase in productivity. This will
have a dual effect. It will control wages and at the same time increase
productivity, and hence raise production of goods in the economy.

(c) Price Control:

Price control and rationing is another measure of direct control to check
inflation. Price control means fixing an upper limit for the prices of
essential consumer goods. They are the maximum prices fixed by law and
anybody charging more than these prices is punished by law. But it is
difficult to administer price control.

(d) Rationing:
Rationing aims at distributing consumption of scarce goods so as to make
them available to a large number of consumers. It is applied to essential
consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to
stabilise the prices of necessaries and assure distributive justice. But it is
very inconvenient for consumers because it leads to queues, artificial
shortages, corruption and black marketing. Keynes did not favour
rationing for it “involves a great deal of waste, both of resources and of
employment.”

Conclusion:
ADVERTISEMENTS:

From the various monetary, fiscal and other measures discussed above, it
becomes clear that to control inflation, the government should adopt all
measures simultaneously. Inflation is like a hydra- headed monster which
should be fought by using all the weapons at the command of the
government.

NATIONAL Income:-Module:-V
What is National Income?
National Income of any country means the complete value of the goods and services
produced by any country during its financial year. It is thus the consequence of all economic
activities that are running in any country during the period of one year. It is valued in terms
of money. In short one can say that the national income of any country is the total amount of
income that is accrued by it through various economic activities in one year. It is also helpful
in determining the progress of the country.
National Income: Concept
There are various concepts of National Income including GDP, GNP, NNP, NI, PI, DI, and
PCI which explain the facts of economic activities.

a. GDP at market price: Is money value of all goods and services produced within the
domestic domain with the available resources during a year.

GDP = (P*Q)

Where,

GDP = gross domestic product

P = Price of goods and services

Q= Quantity of goods and services

GDP is made up of 4 Components

consumption
investment
government expenditure
net foreign exports of a country
GDP = C+I+G+(X-M)
Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import
b. Gross National Product (GNP): Is market value of final goods and services produced in a
year by the residents of the country within the domestic territory as well as abroad. GNP is
the value of goods and services that the country's citizens produce regardless of their location.

GNP=GDP+NFIA or,

GNP=C+I+G+(X-M) +NFIA

Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import

NFIA= Net factor income from abroad.

c. Net National Product (NNP) at MP: Is market value of net output of final goods and
services produced by an economy during a year and net factor income from abroad.
NNP=GNP-Depreciation
or, NNP=C+I+G+(X-M) +NFIA- IT-Depreciation

Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import

NFIA= Net factor income from abroad.

IT= Indirect Taxes

d. National Income (NI): Is also known as National Income at factor cost which means total
income earned by resources for their contribution of land, labour, capital and organisational
ability. Hence, the sum of the income received by factors of production in the form of rent,
wages, interest and profit is called National Income.

Symbolically or as per the formula

NI=NNP +Subsidies-Interest Taxes
or, GNP-Depreciation +Subsidies-Indirect Taxes
or, NI=C+G+I+(X-M) +NFIA-Depreciation-Indirect Taxes +Subsidies

e. Personal Income (PI): Is the total money income received by individuals and households of
a country from all possible sources before direct taxes. Therefore, personal income can be
expressed as follows:
PI=NI-Corporate Income Taxes-Undistributed Corporate Profits- Social Security
Contribution +Transfer Payments.

f. Disposable Income (DI) : It is the income left with the individuals after the payment of
direct taxes from personal income. It is the actual income left for disposal or that can be spent
for consumption by individuals.
Thus, it can be expressed as:

DI=PI-Direct Taxes

g. Per Capita Income (PCI): It is calculated by dividing the national income of the country by
the total population of a country.

Thus, PCI=Total National Income/Total National Population

Also Read| Why is stock market important for any country?

Measurement of National Income

There are three methods to calculate National Income:

Income Method
Product/ Value Added Method
Expenditure Method
Income Method
In this National Income is measured as flow of income.

We can calculate NI as:

Net National Income = Compensation of Employees+ Operating surplus mixed (w +R +P +I)

+ Net income + Net factor income from abroad.

Where,

W = Wages and salaries

R = Rental Income

P = Profit

I = Mixed Income
Product/ Value Added Method
In this National Income is measured as flow of goods and services.

We can calculate NI as:

NATIONAL INCOME = G.N.P – COST OF CAPITAL – DEPRECIATION – INDIRECT

TAXES

Expenditure Method
In this National Income is measured as flow of expenditure.

We can calculate NI through Expenditure method as:

National Income=National Product=National Expenditure.

So, above were the concepts of National Income explained in detail. The students of various
exams like UPSC, SSC and Bank PO must go through these concepts to excel in their exams.

Introduction
National income is the sum total of the value of all the goods and services
manufactured by the residents of the country, in a year., within its domestic
boundaries or outside. It is a net amount of income of the citizens by production in a
year.
Why is National Income Important?
1. Setting Economic Policy- National Income indicates the status of the
economy and can give a clear picture of the countries economic growth.
National Income statistics can help economist in formulating economic policies
for economic development.
 2. Inflation and Deflationary Gaps- For timely anti-inflationary and
deflationary policies, we need aggregate data of national income. If expenditure
increases from the total output, it shows inflammatory gaps and vice versa.
3. Budget Preparation- Budget of the country is highly dependent on the net
national income and its concepts. The Government formulates the yearly
budget with the help of national income statistics in order to avoid any cynical
policies.
4. Standard of Living- National income data assists the government in
comparing the standard of living amongst countries and people living in the
same country at different time.
5. Defence and Development: National income estimates help us to bifurcate the
national product between defence and development purposes of the country.
From such figures, we can easily know, how much can be set aside for the
defence budget.

National Income Definition-

The definition of National Income if of two types-

1. Traditional Definition of National Income-

According to Marshall: “The labour and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the true net annual income or
revenue of the country or national dividend.”

2. Modern Definition-
This definition has two sub-parts-
Gross Domestic Product-
Gross Domestic Product, abbreviated as GDP, is the aggregate value of goods and
services produced in a country. GDP is calculated over regular time intervals, such as
a quarter or a year. GDP as an economic indicator is used worldwide to measure the
growth of countries economy.
Goods are valued at their market prices, so:
 All goods measured in the same units (e.g., dollars in the U.S.) on
 Things without exact market value are excluded.
Constituents of GDP-
1. Wages and salaries
2. Rent
3. Interest
4. Undistributed profits
5. Mixed-income
6. Direct taxes
7. Dividend
8. Depreciation
The Formula for Calculation-
GDP = consumption + investment + government spending + exports - imports.

Gross National Product-

Gross National Product (GNP) is an estimated value of all goods and services
produced by a country’s residents and businesses. GNP does not include the services
used to produce manufactured goods because its value is included in the price of the
finished product. It also includes net income arising in a country from abroad.
Components of GNP-
1. Consumer goods and services
2. Gross private domestic income
3. Goods produced or services rendered
4. Income arising from abroad.
Formula to Calculate GNP-
GNP = GDP + NR( Net income from assets abroad or NetIncome Receipts) - NP (Net
payment outflow to foreign assets).

Methods of Measuring National Income-

There are four methods of measuring national income. Which method is to be used
depends on the availability of data in a country and the purpose in hand.

1. Income Method-
This method we add net income payments received by all citizens of a country in a
particular year. Net incomes that result to all the factor of production like net rents,
wages, interest, and profits are all added together, but income received in the form of
transfer payments are omitted.
2. Product Method-
According to this method, the aggregate value of final goods and services produced in
a country during a financial year is computed at market prices. To find out GNP, the
data of all the productive activities-agricultural products, Minerals, Industrial
products, the contributions to production made by transport, insurance,
communication, lawyers, doctors, teachers. Etc are accumulated and assessed.

3. Expenditure Method-
The total expenditure by the society in a financial year is summed up together and
includes personal consumption expenditure, net domestic investment, government
expenditure on goods and services, and net foreign investment. This concept is backed
by the assumption that national income is equal to national expenditure.

4. Value Added Method-

The distinction between the value of material outputs and material inputs at every
stage of production is Value added.

Banking :-
A bank is a financial institution that accepts deposits from the public and creates a demand deposit while
simultaneously making loans. Lending activities can be directly performed by the bank or indirectly
through capital markets.
A commercial bank is a financial institution which accepts deposits from the public and gives loans for the
purposes of consumption and investment to make profit.

Commercial Bank
What Is a Commercial Bank?
The term commercial bank refers to a financial institution that accepts deposits,
offers checking account services, makes various loans, and offers basic financial products
like certificates of deposit (CDs) and savings accounts to individuals and small businesses. A
commercial bank is where most people do their banking.

Commercial banks make money by providing and earning interest from loans such as
mortgages, auto loans, business loans, and personal loans. Customer deposits provide banks
with the capital to make these loans.
KEY TAKEAWAYS

 Commercial banks offer consumers and small to mid-sized businesses with basic
banking services including deposit accounts and loans.
 These banks make money from a variety of fees and by earning interest income from
loans.
 Banks have traditionally been located in physical locations, but a growing number
now operates exclusively online.
 Commercial banks are important to the economy because they create capital, credit,
and liquidity in the market.
Volume 75%
1. Accepting Deposits:
Banks attract the idle savings of people in the form of deposits.

These deposits may be of any of the following types:

ADVERTISEMENTS:

2. Demand deposits, also known as current accounts:

These are repayable on demand without any notice. Usually no interest is
paid on them, because the bank cannot utilize short-term deposits, and
must, therefore, keep almost cent per cent reserve against them. On the
other hand, a little commission is charged for the services rendered.
Occasionally, however, a small interest is paid to people who keep large
balances.

3. Fixed Deposits or Time Deposits:

These deposits can be withdrawn only after the expiry of the period for
which these deposits have been made. Higher interest is paid on them—the
rate rising with the length of the period and the amount of deposit. The
usual rate in India today varies between 6 per cent and 110 per cent,
depending upon the time-period for which deposits are made.

ADVERTISEMENTS:

4. Savings Bank Deposits:

These deposits stand midway between current and fixed accounts. These
deposits are not as freely withdraw-able as current accounts. One or two
withdrawals up to a limit of one-fourth of the deposit but not more than
Rs. 1,000 are generally allowed in a week. The rate of interest is less than
that on the Fixed Deposits.

5. Giving Loans:
But receiving of deposits is not the whole story about a bank’s functions.
If that were so, how could a bank pay interest? Hence, after collecting
money by way of deposits, a bank invests it or lends it out. Money is lent
to businessmen and traders usually for short periods only. This is so
because the bank must keep itself ready to meet the demands of the
depositors, who have deposited money for short periods.

Money is advanced by the banks in any one of the following ways:

6. By allowing an Overdraft:
Customers of standing are given the right to overdraw their accounts. In
other words, they can get more than they have deposited, but they have to
pay interest on the extra amount which has to repaid within a short period.
The amount of permissible over-draft varies with the financial position of
the borrower.

7. By Creating a Deposit:
Cash credit is another way of lending by the banks. When a person wants a
loan from a bank, he has to satisfy the .manager about his ability to repay,
the soundness of the venture and his honesty of purpose. In addition, the
bank may require a tangible security, or it may be satisfied with the
borrower’s personal security.

ADVERTISEMENTS:

Usually such security is accepted as can be easily disposed of in the

market, e.g., government securities or shares of approved concerns. Then
details about time and rate of interest are settled and the loan is advanced.
A borrower rarely wants to draw the whole amount of his loan in cash.
Usually he opens a current account with that amount the bank, if he
already has not got an account with this bank.

Now it is exactly as if that sum had been deposited by him. This is how a
deposit is ‘created’ by a bank. That is why it is said “every loans creates a
deposit.” A cheque book is given to the borrower with the right to draw
cheques up to the full amount of the loan, but interest is charged on the
whole sum even though only a part is withdrawn. After the period, for
which the money has been borrowed, is over, the borrower returns the
amount with interest to the bank. Banks make most of their profits thus by
giving loans.

8. Discounting Bills:
The discounting of bills by a bank is another way of lending money. The
banks purchase these bills through bill-brokers and discount; companies of
discount them directly for the merchants. These bills provide a very liquid
asset (i.e., an asset which can be easily turned into cash). The banks
immediately any cash for the bill after deducting the, discount (interest),
and wait for the bill to mature when they get back its full value.
ADVERTISEMENTS:

The investment in bills is considered quite safe, because a bill beats the
security of two businessmen, the drawer as well as the drawer, so that if
one proves dishonest or fails, the bank can claim the money from the
other. This is regarded as the best investment by the banks. It is liquid,
lucrative and safe. That is why it is said that a good bank manager knows
the difference between a bill and a mortgage.

9. Remitting Funds:
Banks remit funds-for their customers through bank draft to any place
where they have branches or agencies. This is the cheapest way of sending
money. It is also quite safe. Funds can also be remitted to foreign
countries.

10. Miscellaneous Functions:

ADVERTISEMENTS:

Besides these main functions, the banks perform several others as

given below:
11. Safe Custody:
Ornaments and valuable documents can be kept in safe deposit with a
bank, in its strong room fitted with lockers, on payment of a small sum per
year. Thus the risk of theft is avoided.

12. Agency Functions:

The bank works as an agent of their constituents. They receive payments
on their behalf. They collect rents, dividends on shares, etc. They pay
insurance premia and make other payments as instructed by their
depositors. They accept bills of exchange on behalf of their customers.
They pass bills of lading or railway receipts to the purchasers of goods
when they pay for them. This amount is passed on to the suppliers of
goods.

13. References:
ADVERTISEMENTS:

They provide references about the financial position of their customers

when required. They supply this information confidentially. This is done
when their customers want to establish business connections with some
new firms within or outside the country.

14. Letters of Credit:

In order to help the travelers, the banks issue letters of credit travelers’
cheques. A man going on a tour takes with him a letter of credit from his
bank. It is mentioned there that he can be paid sums up to a certain limit.
He shows this letter to banks in other places which make the payment to
him and debit the bank which has issued the letter of credit.

Central Bank:- A central bank, reserve bank, or monetary authority is an

institution that manages the currency and monetary policy of a state or formal monetary union, and
oversees their commercial banking system. In contrast to a commercial bank, a central bank possesses a
monopoly on increasing the monetary base.

Central Bank in India:-

Central Bank of India is an Indian nationalised bank. It is under the ownership of Ministry of Finance,
Government of India and is one of the oldest and largest nationalised commercial banks in India. It is
based in Mumbai, the financial capital of India and capital city of state of Maharashtra.

A central bank, reserve bank, or monetary authority is an institution that manages

the currency and monetary policy of a state or formal monetary union,[1] and oversees their commercial
banking system. In contrast to a commercial bank, a central bank possesses a monopoly on increasing
the monetary base. Most central banks also have supervisory and regulatory powers to ensure the stability
of member institutions, to prevent bank runs, and to discourage reckless or fraudulent behavior by member
banks.

Examples of Central Banks

Some of the well known central banks across the world are:
1. Federal Reserve (USA)
2. Reserve Bank of India (India)
3. People’s Bank of China (China)
4. Bank of England (UK)
5. European Central Bank (EU or European Union)
Goals of central banks:-
Functions of a central bank usually include:

 Monetary policy: by setting the official interest rate and controlling the money supply;
 Financial stability: acting as a government's banker and as the bankers' bank ("lender of last resort");
 Reserve management: managing a country's foreign-exchange and gold reserves and government
bonds;
 Banking supervision: regulating and supervising the banking industry;
 Payments system: managing or supervising means of payments and inter-banking clearing systems;
 Coins and notes issuance;
 Other functions of central banks may include economic research, statistical collection, supervision of
deposit guarantee schemes, advice to government in financial policy.

Top 5 Largest Central Bank by Total Assets:-

Rank Central Bank Profile Total Assets

1 People's Bank of China $5,196,560,000,000

2 Bank of Japan $4,945,440,000,000

3 Federal Reserve System $3,857,715,000,000

4 Bank of Spain $861,564,000,000

5 Central Bank of Brazil $856,248,000,000

entral bank is regarded as an apex financial institution in the banking system. It is considered as an integral
part of the economic and financial system of a nation. The central bank functions as an independent
authority and is responsible for controlling, regulating and stabilising the monetary and banking structure
of the country.
In India, the Reserve Bank of India is regarded as the central bank. It was set up in 1935. Central banks are
responsible for maintaining the financial stability and economic sovereignty of the country.
The functions of a central bank can be discussed as follows:
1. Currency regulator or bank of issue
2. Bank to the government
3. Custodian of Cash reserves
4. Custodian of International currency
5. Lender of last resort
6. Clearing house for transfer and settlement
7. Controller of credit
8. Protecting depositors interests
The above mentioned functions will be discussed in detail in the following lines.
Currency regulator or bank of issue: Central banks possess the exclusive right to manufacture notes in
an economy. All the central banks across the world are involved in issuing notes to the economy.
This is one of the most important functions of the central bank in an economy and due to this the central
bank is also known as the bank of issue.
Earlier all the banks were allowed to publish their own notes which resulted in a disorganised economy. To
avoid this situation the government around the world authorised the central banks to function as the issuer
of currency, which resulted in uniformity in circulation and balanced supply of money in the economy.
Bank to the government: One of the important functions of the central bank is to act as the bank to the
government. The central bank accepts deposits and issues funds to the government. It is also involved in
making and receiving payments for the government. Central banks also offer short term loans to the
government in order to recover from bad phases in the economy.
In addition to being the bank to the government, it acts as an advisor and agent of the government by
providing advice to the government in areas of economic policy, capital market, money market and loans
from the government.
In addition to that, the central bank is instrumental in formulation of monetary and fiscal policies that help
in regulation of money in the market and controlling inflation.
Custodian of Cash reserves: It is a practice of the commercial banks of a country to keep a part of their
cash balances in the form of deposits with the central bank. The commercial banks can draw that balance
when the requirement for cash is high and pay back the same when there is less requirement of cash.
It is for this reason that the central bank is regarded as the banker’s bank. Central bank also plays an
important role in the credit creation policy of commercial banks.
Custodian of International currency: An important function of the central bank is to maintain a
minimum balance of foreign currency. The purpose of maintaining such a balance is to manage sudden or
emergency requirements of foreign reserves and also to overcome any adverse deficits of balance of
payments.
Lender of last resort: The central bank acts as a lender of last resort by providing money to its member
banks in times of cash crunch. It performs this function by providing loans against securities, treasury bills
and also by rediscounting bills.
This is regarded as one of the most crucial functions of the central bank wherein it helps in protecting the
financial structure of the economy from collapsing.
Clearing house for transfer and settlement: Central bank acts as a clearing house of the commercial
banks and helps in settling of mutual indebtedness of the commercial banks. In a clearing house, the
representatives of different banks meet and settle the inter bank payments.
Controller of credit: Central banks also function as the controller of credit in the economy. It happens
that commercial banks create a lot of credit in the economy that increases the inflation.
The central bank controls the way credit creation by commercial banks is done by engaging in open market
operations or bringing about a change in the CRR to control the process of credit creation by commercial
banks.
Protecting depositors interests: Central bank also needs to keep an eye on the functioning of the
commercial banks in order to protect the interests of depositors.
Thank you so much.