Fundamental concepts used in

Business Decisions
 Opportunity Cost and decision making

• Related to alternative uses of scare resources

• Concepts of opportunity cost:
a) Scarce resources
b) Alternative resources
 Opportunity Cost and decision making

• Eg; Suppose a firm has Rs.100 million at its

disposal and three risk free alternative uses
like, and
• Alternative 1 expand the size of the firm earns Rs.20 mn
• Alternative 2 set up new production unit earns Rs.18 mn
• Alternative 3 buy shares in another firm earns Rs.16 mn
Alternative 2 is the second best alternative. Thus the opportunity
cost of availing an opportunity is the foregone income
expected from the second best opportunity cost of using the
resources.
 Opportunity Cost and decision making

• Opportunity cost assumes a great significance

where economic gain is neither insignificant
nor very large and requires a careful
evaluation of the two options.
• Economic Gain = Actual Earnings –
Opportunity cost
 Opportunity Cost and decision making
• Opportunity cost concept can be applied to all
resources in business decisions when at least two
alternatives are involved.
• If a firm decides to fire the labour officer, the loss of
an efficient labour officer is the opportunity cost of
buying peace with the labour union.
• Incase the firm decides to retain the labour officer,
cost of prolonged litigation, possible labour strike and
consequent reduction in output cost are the
opportunity costs of retaining the labour officer.
 Marginal Principle and Decision Rule

• The term ‘marginal’ refers to the change in

total quality or value due to a one-unit change
in its determinant.
• The marginal cost can be defined as the
change in total cost as a result of producing
one additional unit of a commodity.
• MC = TCn – TCn-1
• MR = TRn – TRn-1
 The Decision Rule
• Suppose a profit maximizing firm is faced with
a problem – how much to produce so that
profit is maximum.
• Basic principle is MR=MC
• Profit is maximized at a level of output where
cost of producing one additional unit equals
the revenue from the sale of that unit of
output.
 Limitations of Marginal principle
• Can be applied only when the management
has TC and TR data for each and every unit of
output.
• When MC is used in cost analysis, reduces the
value of MC to the change in variable cost
only. Therefore, the marginal analysis can be
applied to a situation in which only variable
cost changes.
 Incremental Principle and Decision Rule
• It is applied in business decisions which involve bulk
production and large increase in total cost and total
revenue.
• Such increase in TC and TR is called ‘incremental cost’ and
‘incremental revenue’ related to ‘incremental output’.
• Incremental costs include both FC and VC.
• Three major incremental costs are:
a) Present explicit cost
b) Opportunity cost
c) Future cost
 Three major incremental costs
• Present explicit cost : FC and VC
• Opportunity cost: expected income foregone
from the best use of the resources involved in
present decision
• Future cost : Depreciation and advertisement
costs if the product does not sell well as
expected.
 Incremental Reasoning in Business Decision
• It is used in business proposition in accepting or rejecting it.
• Suppose the incremental cost is Rs 15 mn and incremental
revenue is Rs.20 mn, the incremental return is 33.33%.
• Incremental concept is used more frequently than marginal
concept for two distinct reasons.
a) Marginal concept used in business analysis is associated
with one marginal unit of output produced or sold whereas
most of the business decisions involves large quantities
and value.
b) Marginal concept is of great significance in theoretical
analysis.
 Contribution Analysis
• Contribution = IR – IC
• It is applied to analyse the contribution made by the
business decision to overhead costs and revenue to work
out the net result of that business decision.
• It is used in whether or not to
a) Accept the project
b) Introduce a new product
c) Accept a fresh order
d) To add an additional plant
e) Make or buy decision
 Contribution Analysis and the relevant costs

• The relevant costs are

i) Present explicit costs:
a) Explicit variable costs – Direct labour, direct
material cost and direct variable overheads
b) Fixed costs – New additional equipment and
personnel.
ii) Opportunity Cost:
iii) Future Incremental Costs:
Contribution Analysis and the irrelevant costs

• Committed costs: payment of old debts,

interest, salaries and wages of mangers and
workers,
• Sunk Costs: Purchase of assets and non-
recoverable advance payments.
 Equi- Marginal Principle
• It is based on the law of Equi-marginal utility.
• This law states that a utility maximising consumer
distributes his consumption expenditure between
various goods and services he/she consumes in
such a way that the marginal utility derived from
each unit of expenditure on various goods and
services is the same. This pattern of consumption
expenditure maximises a consumer’s total utility.
 The Equi-marginal
principle
• This principle states that a a rational
decision maker would allocate the
resources in such a way that it provide
equal marginal benefit per unit of cost.
• MU1/MC1=MU2/MC2=MUn/MCn
 Law of Equi-marginal utility and Business Decision

• Business managers have over a period of time

applied this law to allocate resources between
alternative uses with a view to maximise profit in
case a firm carries out more than one business
activity.
• The principle suggests that available resources
(inputs) should be so allocated between the
alternate options that the marginal productivity
gains (MP) from various activities are equalised.
• MPA = MPB = MPC……………………MPN
 Equi - Marginal Principle

• Deals with allocation of resources among alternative

activities

• According to this principle an input should be employed in

different activities in such proportion that the value added
by last unit is the same in all activities or marginal products
from various activities are equalized.

• MPA=MPB=MPC=…MPN
Time Perspective in Business Decision
• Short term perspective – cracker industry
• Long term perspective – investment,
expansion, introduction of a new product,
advertisement etc.
• However the business decision of taking the
short term for the establishment of
Management Institute and long term
perspective of buying manufacturing
explosives is dangerous for cracker industry.
 The discounting
principle
• The time value of money refers to the
fact that a rupee received in the future is
not worth a rupee today.
• PV = A
(1+I)n
 Discounting Principle
• A rupee now is worth more than a rupee earned a year
after

• To take decision regarding investment which will yield

return over a period of time it is necessary to find its
present worth by using discounting principle

• This principle helps to bring value of future rupees to

present rupees
• PV=1/1+i i=8%
• PV=100/1.08=92.59