Cost Anaysis Akshita

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GROUP

AKSHITA JAIN

SHRUTI PATWA

SUMAN MAHAPATRO

ANUSHA REDDY

SANTOSH SINGH

DEEPAK K S

GANESH MAHARA

AZAM ZIA


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Managerial Economics

Module 4

Analysis of Costs


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CONTENT

Pricing of Factors of Production Factor Markets Land Pricing

Theory, Ricardian Theory of Rent, Opportunity Cost Theory of Rent

Market Demand and Supply of Labour Pricing of Labour Theory,

Marginal Productivity of Labour Theory, Wage bill Theory,

Subsistence Theory of Wage Differential Wages and skills.

Pricing of Capital

Demand and Supply of Loanable funds, Cost of

Capital, Opportunity Cost of Capital, Rewards of Capital, Theory of

Interest Rate and Liquidity preference.


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Factors of Production

Factors of production are the inputs to the

production process. Finished goods are

the output.

Eg. Land, labor, capital and technology are

required in combination at a time to produce

a commodity

Factors of production are any commodities or

services used to produce goods and services.


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Pricing of Factors of Production

When all factors are specific there is no principleof pricing that can be used.

It depends on the fixity or variability in theproportions of the combined factors used perunit of product.

If the factors can be combined only in certainfixed proportions to produce a given quantity ofproduct, then there can be no determinate price


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If the proportions of the factors can be varied

to produce a given result, then the pricing ofeach factor can be isolated and determined.

The prices are usually determined bybargaining, and it is obvious that the

variability in the proportions of the factors

does not aid in any determination of thespecific value or share of each particular

product.


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Example of rise in price

If the price of factor A increases compared to

B, the firm will use less of A and more of B in

producing its product. From this, demand

curves for each factor are deduced, and thepricing of each factor established.


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Factor Markets

'"Factor market'" refers to markets whereservices of the factors of production arebought and sold.

Eg. The market for construction workers bringstogether the buyers and sellers ofconstruction workers services.

The interaction between product and factormarkets involves the principle of deriveddemand.


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Derived demand

Derived demand refers to the demand for

productive resources, which is derived from

the demand for final goods and services or

output.

For example, if consumers demand for new

cars rose, producers will respond by increasing

their demand for the productive inputs orresources used to produce new cars.


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Ricardian Theory of rent

Proposed by - David Ricardo (1772-

1823)

Economic rent on land is the value ofthe difference in productivitybetween

a given piece of land and the poorest

[and/or most distant], most costly

piece of land producing the same

goods (e.g. bushels of wheat) underthe same conditions (of labour, capital,

technology, etc.).


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Opportunity Cost

The opportunity cost of doing A is the value of

any benefit foregone, or given up, by not

doing B; i.e., the value that would have beenproduced by using that factor of production in

the next best alternative opportunity.


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6 suppositions involved in the

concept of economic rent(1) In the initial stage of development, our starting point, with

a stable and low level of population, only the very bestlands are under cultivation: lands that are the most fertile,

the most easily worked, and the closest to the market --the lowest cost lands for producing grain.

(2) With population growth, the eventual diminishing returnson existing cultivated lands force into cultivation new, butinferior or marginal lands: lands that are less fertile,more difficult to work, and further from the market,involving higher production and transportation costs.


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(3) Thus the necessary consequence of addingon more and more inferior or marginal land isthe rising cost of producing those extra bushelsof grain to feed that growing population. We

assume that all people are fed.

(4) We must also assume that for any given

region, for any one given market zone, there isonly one price, the prevailing price that clearsthe market in that region.


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(5) The final or equilibrium market price for grain willthus equal the cost of producing that last bushel of grain

(under diminishing returns) on that last unit of landforced into production to feed that larger population.

Nobody is going to produce grain for very long at a costhigher than the market price;

Nobody will be foolish enough to sell grain at lowerprice than the prevailing market price.

In fact, as you can now deduce, the level of populationand of demand has really determined the market price ofgrain; for without that increased demand, that last unit ofland would not be producing grain for the market.


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(6) On that last piece of land put under cultivation, total sales

revenue equals total costs, with no surplus or profit. Thefarmer earns just enough to keep him in production, without

seeking alternative employment.

But conversely, on the other lands -- the more productive

and lower cost lands that were put into cultivation earlier --total sales revenues exceed total costs, because costs on

those better lands are lower -- very much lower on the best

lands.

That differential produces a surplus or a profit called

ECONOMIC RENT


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Opportunity cost & Economic Rent

Thus economic rent is the extra amount of earnings that afactor production earns over and above its transfer earnings:

For Ricardos agrarian model: that land had only one use ---

growing grains so: no transfer earnings were possible

Thus: all rent is surplus to what was necessary to keep thatland in its present use growing grain

The difference between the market price for grain and the

costs of producing it was therefore pure economic rent,

which was expropriated by the landlord The tenant would stay on the land so long as his own

transfer earnings were met: so long as he earned enough

not to seek alternative employment.


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Demand for the labour is thenumber of hours of hiringthat an employee is willing to

do based on the variousexternally determinedvariables it is faced with,such as the wage rate.

There is normally an inverserelationship betweendemand for labour and thewage rate.

Demand for labour


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SHIFTS IN THE LABOUR DEMAND

CURVE

MRP will increase when there is

1) an increase in labour productivity.

2) A higher demand for the product.

3) The price of a substitute input.


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The supply of labour

It refers to the number of hours that the

population desires to work in gainful activities.

Labour supply curve is always upward sloping.


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ELASTICITY OF LABOUR SUPPLY

The elasticity of labour supply measures theextent to which labour supply responds to a

change in the wage rate in a given time

period.


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MARGINAL PRODUCTIVITY OF

LABOUR THEORY

Also referred to as the marginal revenue product of labor and

the value of the marginal product .

Is the change in total revenue earned by a firm that results

from employing one more unit of labor.

The marginal revenue product (MRP) of a worker is equal to

the product of the marginal product of labor (MP) and

the marginal revenue (MR), given by MRMP = MRP.


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Mathematical relation MR = TR/Q

MPL= Q/L

MR x MPL= (TR/Q) x (Q/L) = TR/L

As above noted the firm will continue to add units of laboruntil the MRPL = w

Mathematically until :

MRPL = w MR(MPL) = w

MR = w/MPL

MR = MC which is the profit maximizing rule.


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Marginal Revenue Product in a

perfectly competitive market

Under perfect competition, marginal revenue product

is equal to marginal physical product (extra unitproduced as a result of a new employment) multiplied

by price.

MRP = MP * PRICE


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MRP in monopoly or

imperfect competition The MRP curve of a firm in monopoly or imperfect competition

will slope downwards at a faster rate than in perfect

competition. This can be explained as follows:

MPP slopes downwards because of the operation of the Law of

Diminishing Returns. MRP depends on MPP.

Because the firm faces a downward sloping demand curve for

its product, it must lower price to sell extra units of output.


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SUBSISTENCE THEORY OFWAGES

AND DIFFERENTIAL WAGES

AND SKILLS


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The subsistence theory of wages, advanced by David

Ricardo and other classical economists, was based on the

population theory of Thomas Malthus.

It held that the market price of labour would always tend

toward the minimum required for subsistence. If the supply

of labour increased, wages would fall, eventually causing a

decrease in the labour supply if the wage rose above the

subsistence.


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CRITICISM FOR THE THEORY

One-sided

Ambiguous

Unrealistic

Wages not uniform

Exploitation tendency


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WAGE

DIFFERENTIAL

Wage differential is an

element of location selection

that is a wage scalereflecting the average

schedule of workers' pay in

an area that takes into

account the performance of

related tasks or services.


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CLASSIFICATION OF WAGE DIFFERENTIALS

Occupational Differentials

Inter-occupational differentials

Inter-firm Differentials

Inter-area or Regional Differentials

Inter-industry Differentials

Personal Wage Differentials


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COMPENSATING

DIFFERENTIAL WAGES

A compensating differential, which is also called

a compensatingwage differential or

an equalizing difference, is defined as the

additional amount of income that a given worker

must be offered in order to motivate them toaccept a given undesirable job, relative to other

jobs that worker could perform.

The idea of compensating differentials has been

used to analyze issues such as the risk of futureunemployment,the risk of injury, the risk of

unsafe sex, the monetary value workers place

on their own lives.


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DEMAND AND SUPPLY OF LOANABLE

FUNDS

It brings SAVER and BORROWERS together

All HOUSE HOLD and BANKS to finance

Savers supply the loanable funds

Some times borrower use Bonds for loanablefunds


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INTEREST RATE

The interest rate is the cost of borrowing or

demanding loanable funds

It is measured in Annual Percentage Rate

If the firm borrows funds for more than twoyears compound interest is charged


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Compound interest is calculated on both

principal and accumulated unpaid interest

Formula to calculate

Amount repaid = X(1+r)2= time period


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Cost of capital

Cost of capital is a combined cost ofeach type of source by which a firm

raises funds.


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Importance of Cost of capital

Capital Budgeting Decisions

Designing the Corporate Financial Structure

Deciding about the method of financing in

lieu with capital market fluctuations Performance of top management

Other areas eg., dividend policy, working

capital


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Measuring cost of capital

Account for general uncertainty

Various degree of uncertainty

Effects of uncertainty

Differential effects of financing

It must reflect the changes in capital market


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Basic costs of capital

1. Cost of Equity Capital

2. Cost of Preference Shares

3. Cost of Debt

4. Cost of Retained Earnings


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Cost of equity capital

Cost of equity capital is acknowledged as the

rate of return that is necessary to satisfy

commitments made to the common

shareholders of the company.


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Cost of Preference Shares

The preference shareholders carry a prior right to receivedividends over the equity shareholders.

Moreover, preference shares are usually cumulative whichmeans that preference dividend will keep getting

accumulated unless it is paid.

Further, non-payment of preference dividend may entitletheir holders to participate in the management of the firmas voting rights are conferred on them in such cases.

Above all, the firm may encounter difficulty in raisingfurther equity capital mainly because the non-payment ofpreference dividend adversely affects the prospects ofordinary shareholders.


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Cost of debt

Cost of debt is the after-tax cost of long-term

funds through borrowing.

Net cash proceeds are the funds actually

received from the sale of security.

Flotation cost is the total cost of issuing and

selling securities.

Cost of perpetual/irredeemable debt

Cost of redeemable debt


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Cost of Retained Earnings

Retained earnings are dividends withheld,

that is, if they were in the hands of the

investors (shareholders) they could have

earned on these by investing somewhere else.


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Opportunity cost of capital

Opportunity cost of capital is rate of return on

our capital which we get on the investment in

one of best alternative.


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RETURN ON CAPITAL

&RETURN ON INVESTED CAPITAL

ROC = Net operating profit- Adjusted taxes

BV of Debt + BV of Equity- cash

ROIC = Net Operating Profit Adjusted taxes

Invested capital


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RETURN ON INVESTED CAPITAL

Return on invested capital (ROIC) is a financial

measure that quantifies how well a company

generates cash flow relative to the capital it

has invested in its business.

It is defined as net operating profit less

adjusted taxes divided by invested capital andis usually expressed as a percentage.


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LIQUIDITY PREFERENCE THEORY OF

INTEREST

Keynes defines the rate of interest as the reward for

parting with liquidity for a specified period of time.

According to him, the rate of interest is determined by

the demand for and supply of money.

Demand for money: Liquidity preference means the

desire of the public to hold cash. According to Keynes,

there are three motives behind the desire of the publicto hold liquid cash: (1) the transaction motive, (2) the

precautionary motive, and (3) the speculative motive.


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Transactions Motive: The transactions motive relates to

the demand for money or the need of cash for the

current transactions of individual and businessexchanges. Individuals hold cash in order to bridge the

gap between the receipt of income and its expenditure.

This is called the income motive.

Precautionary motive: Precautionary motive for holding

money refers to the desire to hold cash balances for

unforeseen contingencies. Individuals hold some cash to

provide for illness, accidents, unemployment and other

unforeseen contingencies. Similarly, businessmen keep

cash in reserve to tide over unfavourable conditions or

to gain from unexpected deals.


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Speculative Motive: The speculative motive

relates to the desire to hold ones resources inliquid form to take advantage of future changes

in the rate of interest or bond prices. Bond

prices and the rate of interest are inverselyrelated to each other. If bond prices are

expected to rise, i.e., the rate of interest is

expected to fall, people will buy bonds to sell

when the price later actually rises. If, however,

bond prices are expected to fall.


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Thankyou !!!

Cost Anaysis Akshita

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