Working capital

Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business,
organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment,
working capital is considered a part of operating capital. Gross working capital equals to current assets. Working
capital is calculated as current assets minus current liabilities.[1] If current assets are less than current liabilities, an
entity has a working capital deficiency, also called a working capital deficit.

A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be
converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and
that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing inventories, accounts receivable and payable, and cash.

Working capital is the difference between the current assets (except cash) and the current liabilities.

The basic calculation of the working capital is done on the basis of the gross current assets of the firm.

Inputs[edit]

Current assets and current liabilities include three accounts which are of special importance. These accounts
represent the areas of the business where managers have the most direct impact:

accounts receivable (current asset)

inventory (current assets), and

accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to
current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines
of credit.

An increase in net working capital indicates that the business has either increased current assets (that it has
increased its receivables, or other current assets) or has decreased current liabilities—for example has paid off
some short-term creditors, or a combination of both.

Working capital cycle[edit]

Definition[edit]

The working capital cycle (WCC) is the amount of time it takes to turn the net current assets and current liabilities
into cash. The longer the cycle is, the longer a business is tying up capital in its working capital without earning a
return on it. Therefore, companies strive to reduce their working capital cycle by collecting receivables quicker or
sometimes stretching accounts payable.

Meaning[edit]

A positive working capital cycle balances incoming and outgoing payments to minimize net working capital and
maximize free cash flow. For example, a company that pays its suppliers in 30 days but takes 60 days to collect its
receivables has a working capital cycle of 30 days. This 30 day cycle usually needs to be funded through a bank
operating line, and the interest on this financing is a carrying cost that reduces the company's profitability. Growing
businesses require cash, and being able to free up cash by shortening the working capital cycle is the most
inexpensive way to grow. Sophisticated buyers review closely a target's working capital cycle because it provides
them with an idea of the management's effectiveness at managing their balance sheet and generating free cash
flows.

As an absolute rule of funders, each of them wants to see a positive working capital. Such situation gives them the
possibility to think that your company has more than enough current assets to cover financial obligations. Though,
the same can’t be said about the negative working capital.[2] A large number of funders believe that businesses
can’t be sustainable with a negative working capital, which is a wrong way of thinking. In order to run a sustainable
business with a negative working capital it’s essential to understand some key components.

1. Approach your suppliers and persuade them to let you purchase the inventory on 1-2 month credit terms, but
keep in mind that you must sell the purchased goods, to consumers, for money. 2. Effectively monitor your
inventory management, make sure that it’s often refilled and with the help of your supplier, back up your
warehouse.

Plus, big companies like McDonald’s, Amazon, Dell, General Electric and Wal-Mart are using negative working
capital.

Working capital management[edit]

Decisions relating to working capital and short-term financing are referred to as working capital management.
These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal
of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient
cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital,
current assets and current liabilities, in respect to each other. Working capital management ensures a company has
sufficient cash flow in order to meet its short-term debt obligations and operating expenses.

Decision criteria[edit]

By definition, working capital management entails short-term decisions—generally, relating to the next one-year
period—which are "reversible". These decisions are therefore not taken on the same basis as capital-investment
decisions (NPV or related, as above); rather, they will be based on cash flows, or profitability, or both.

One measure of cash flow is provided by the cash conversion cycle—the net number of days from the outlay of
cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit
the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this
number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other
activities, management generally aims at a low net count.

In this context, the most useful measure of profitability is return on capital (ROC). The result is shown as a
percentage, determined by dividing relevant income for the 12 months by capital employed; return on equity (ROE)
shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which
results from working-capital management, exceeds the cost of capital, which results from capital investment
decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy
with long-term decision making. See economic value added (EVA).

Credit policy of the firm: Another factor affecting working capital management is credit policy of the firm. It
includes buying of raw material and selling of finished goods either in cash or on credit. This affects the cash
conversion cycle.

Management of working capital[edit]

Guided by the above criteria, management will use a combination of policies and techniques for the management
of working capital. The policies aim at managing the current assets (generally cash and cash equivalents,
inventories and debtors) and the short-term financing, such that cash flows and returns are acceptable.

Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but
reduces cash holding costs.

Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the
investment in raw materials—and minimizes reordering costs—and hence increases cash flow. Besides this, the
lead times in production should be lowered to reduce Work in Process (WIP) and similarly, the Finished Goods
should be kept on as low level as possible to avoid over production—see Supply chain management; Just In Time
(JIT); Economic order quantity (EOQ); Economic quantity

Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such
that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return
on Capital (or vice versa); see Discounts and allowances.

Short-term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is
ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or
overdraft), or to "convert debtors to cash" through "factoring".

What are Project Selection Methods?

Consider a scenario in which the organization you are working for has been handed a number of
project contracts. But due to resource constraints, the organization cannot take up all the projects
at once. Therefore, a decision has to be made as to which project needs to be taken up to
maximize profitability.

This is where Project Selection Methods come into play. There are various methods to help you
choose a project. These can be divided into two categories, namely:

Project Selection Methods Type I: Benefit Measurement Methods

Benefit Measurement is a project selection technique that is based on the present value of estimated cash
outflow and inflow. Cost benefits are calculated and then compared to other projects to make a decision.

The techniques that are used in Benefit Measurement are as follows:

Benefit/Cost Ratio

Cost/Benefit Ratio, as the name suggests, is the ratio between the Present Value of Inflow or the cost
invested in a project to the Present Value of Outflow which is the value of return from the project. Projects
that have a higher Benefit Cost Ratio or lower Cost Benefit Ratio are generally chosen over others.

Economic Model

The EVA or Economic Value Added is the performance metric that calculates the worth-creation of the
organization while defining the return on capital. It is also defined as the net profit after the deduction of
taxes and capital expenditure.
If there are several projects assigned to a project manager, the project that has the highest Economic
Value Added is picked. The EVA is always expressed in numerical terms and not as a percentage.

Scoring Model

The scoring model is an objective technique wherein the project selection committee lists relevant criteria,
weighs them according to their importance and their priorities and then adds the weighted values. Once
the scoring of these projects is completed, the project with the highest score is chosen.

Payback Period

The Payback Period is the ratio of the total cash to the average per period cash. In simpler terms, it is the
time necessary to recover the cost invested in the project.

The Payback Period is a basic project selection method. As the name suggests, the payback period takes
into consideration the payback period of an investment. It is the time frame that is required for the return
on an investment to repay the original cost that was invested. The calculation for payback is pretty simple.

When the Payback period is being used as the Project Selection Method, the project that has the
shortest Payback period is preferred since the organization can regain the original investment
faster.

There are, however, a few limitations to this method:

1. It does not consider the time value of money

2. The benefits that accrue after the payback period are not considered, meaning it focuses
more on the liquidity while profitability is neglected.
3. Risks involved in individual projects are neglected.

Net Present Value

The Net Present Value is the difference between the project’s current value of cash inflow and
the current value of cash outflow. The NPV must always be positive. When picking a project, one
with a higher NPV is preferred.

The advantage of considering the NPV over the Payback Period is that it takes into consideration
the future value of money.

However, there are limitations of the NPV, too:

1. There isn’t any generally accepted method of deriving the discount value used for the
present value calculation.
2. The NPV does not provide any picture of profit or loss that the organization can make by
embarking on a certain project.

For more details on the NPV and how to use the NPV as a tool to filter projects out, here's an
insightful article on calculating the opportunity costs for projects.
Discounted Cash Flow

It's well-known that the future value of money will not be the same as it is today. For example,
$20,000 will not carry the same worth 10 years down the line from today.

Thus, during calculations of cost investment and ROI, one must consider the concept
of discounted cash flow.

Internal Rate Of Return

The Internal Rate of Return is the interest rate at which the Net Present Value is zero. This state
is attained when the present value of outflow is equal to the present value of inflow.

It is defined as the “annualized effective compounded return rate” or the “discount rate that makes the net
present value of all cash flows (both positive and negative) from a particular investment equal to zero.”
The IRR is used to select the project with the best profitability.

When using the IRR as the project selection criteria, care should be taken to ensure this is not used
exclusively to judge the worth of a project. This is because a project with a lower IRR might have a higher
NPV and, assuming there is no capital constraint, the project with the higher NPV should be chosen as
this increases the shareholders' wealth.

When picking a project, the one with the higher IRR is chosen.

Opportunity Cost

The Opportunity Cost is cost that is being given up when picking another project. During project selection,
the project that has the lower opportunity cost is chosen.

Generally, most organizations use Benefits Measurement Methods to lead them into making a decision.

Constrained Optimization Methods

Constrained Optimization Methods, also known as the Mathematical Model of Project Selection, are used
for larger projects that require complex and comprehensive mathematical calculations.

The techniques that are used in Constrained Optimization Methods are as follow

Non-Financial Considerations
There are non-financial gains that an organization must consider and these factors are related to the overall
organization goals. The organizational strategy is a major factor in project selection methods that will affect the
organization’s choice in the choice of project.

Customer service relationship is chief among these organizational goals. An important necessity
in today’s business world is to build an effective and cordial relationship with the customers.

Other organizational factors may include: Political reasons, change of management, speculative
purposes, shareholders' requests, etc.
3 Techniques for Solving Time-
Value Problems in Finance
Knowing present, future, and recurring value methods can help you
evaluate streams of cash flow.
If you could choose between getting $500 now or getting $500 a year from now, most people
would take the money now. This fundamental axiom involves the time value of money, and
economists have sought ways to compare streams of money earned at different times in a way
that takes time value into account. Below, you'll learn about three techniques that you can use in
various situations to get the answers you're looking for.

Present value calculations

One common time-value problem deals with expecting a specified sum of money at a point in the
future. Because money earned in the future is worth less than money earned now, you have to
apply a discount to the future payment in order to get its equivalent present value. Often, the
discount rate used is equal to the prevailing risk-free rate for assets like Treasury securities
without default risk. The further into the future the payment is, the greater the discount.

The math behind a present value calculation is a bit complicated but can be done with a basic
calculator. To come up with present value, take 1 and add it to the discount rate used. Then raise
that number to the power of the number of years in the future that you'll receive the payment.
Save the resulting figure, and then divide the future payment amount by that figure. The final
result will be the present value.

For instance, say you know that you'll receive $110.25 in two years and decide that a discount
rate of 5% is appropriate. In that case, 1 plus 5% equals 1.05, and 1.05 raised to the second
power is 1.1025. Divide $110.25 by 1.1025, and you get $100, which is the present value.

Future value calculations

Future value calculations work in the opposite manner. You'll follow the same steps as you did for
present value, adding 1 to the discount rate and then raising that number to the power of the
number of years in the future that you're measuring the future value. But then, you'll need to
multiply the result by the value of the current payment. The final result is the future value.

For instance, if you want to know the future value of $100 in two years assuming a rate of 5%,
then 1 + 5% is 1.05, 1.05 raised to the second power is 1.1025, and $100 multiplied by 1.1025 is
$110.25. As you can see, this matches up with the present value calculation above.

Recurring value techniques

The two methods discussed above work well for one-time payments, but other methods are
better for recurring payments. You can always just calculate present or future value for each
payment separately, but there are sometimes shortcuts available for common situations.
For instance, say you have an asset that pays a perpetual stream of income. You can't calculate
each payment separately, but the equation for its present value turns out to be quite simple: take
the amount of each regular payment and divide it by the discount rate. So if you receive $100
each year and use a discount rate of 5%, then its present value is $100 / 5% = $2,000.

Knowing how to deal with time-value problems can save a lot of time and make it easier to
compare streams of future payments. That way, you can make smarter decisions about money.

A sinking fund is a fund established by an economic entity by setting aside revenue over a period of
time to fund a future capital expense, or repayment of a long-term debt.

In North America and elsewhere where it is common for public and private corporations to raise funds through
the issue of bonds, the term is normally used in this context. However, in the United Kingdom[1] and
elsewhere[2] where the issue of bonds (other than government bonds) is unusual, and where long-term
leasehold tenancies are common, the term is only normally used in the context of replacement or renewal of
capital assets, particularly the common parts of buildings.

Historical context[edit]
The sinking fund was first used in Great Britain in the 18th century to reduce national debt. While used
by Robert Walpole in 1716 and effectively in the 1720s and early 1730s, it originated in the commercial tax
syndicates of the Italian peninsula of the 14th century, where its function was to retire redeemable public debt
of those cities.

The fund received whatever surplus occurred in the national Budget each year. However, the problem was that
the fund was rarely given any priority in Government strategy. The result of this was that the funds were often
raided by the Treasury when they needed funds quickly.

In 1772, the nonconformist minister Richard Price published a pamphlet on methods of reducing the national
debt. The pamphlet caught the interest of William Pitt the Younger, who drafted a proposal to reform
the Sinking Fund in 1786. Lord North recommended "the Creation of a Fund, to be appropriated, and invariably
applied, under proper Direction, in the gradual Diminution of the Debt." Pitt's way of securing "proper Direction"
was to introduce legislation that prevented ministers from raiding the fund in crises. He also increased taxes to
ensure that a £1 million surplus could be used to reduce the national debt. The legislation also placed
administration of the fund in the hands of "Commissioners for Reducing the National Debt."

The scheme worked well between 1786 and 1793 with the Commissioners receiving £8 million and reinvesting
it to reduce the debt by more than £10 million. However, the event of war with France in 1793 "destroyed the
rationale of the Sinking Fund" (Eric Evans). The fund was abandoned by Lord Liverpool's government only in
the 1820s.

Sinking funds were also seen commonly in investment in the 1800s in the United States, especially with highly
invested markets like railroads. An example would be the Central Pacific Railroad Company, which challenged
the constitutionality of mandatory sinking funds for companies in the case In Re Sinking Funds Cases in 1878.[3]

Modern context – bond repayment[edit]

In modern finance, a sinking fund is a method by which an organization sets aside money over time to retire its
indebtedness. More specifically, it is a fund into which money can be deposited, so that over time preferred
stock, debentures or stocks can be retired.

In some US states, Michigan for example, school districts may ask the voters to approve a taxation for the
purpose of establishing a sinking fund. The State Treasury Department has strict guidelines for expenditure of
fund dollars with the penalty for misuse being an eternal ban on ever seeking the tax levy again. See
also sinking fund provision in bonds.

Types[edit]
A sinking fund may operate in one or more of the following ways:

1. The firm may repurchase a fraction of the outstanding bonds in the open market each year.
2. The firm may repurchase a fraction of outstanding bonds at a special call price associated with the
sinking fund provision (they are callable bonds).
3. The firm has the option to repurchase the bonds at either the market price or the sinking fund price,
whichever is lower. To allocate the burden of the sinking fund call fairly among bondholders, the bonds
chosen for the call are selected at random based on serial number. The firm can only repurchase a
limited fraction of the bond issue at the sinking fund price. At best some indentures allow firms to use
a doubling option, which allows repurchase of double the required number of bonds at the sinking fund
price.
4. A less common provision is to call for periodic payments to a trustee, with the payments invested so
that the accumulated sum can be used for retirement of the entire issue at maturity: instead of the
debt amortizing over the life, the debt remains outstanding and a matching asset accrues. Thus the
balance sheet consists of Asset = Sinking fund, Liability = Bonds..
Benefits and drawbacks[edit]
For the organization retiring debt, it has the benefit that the principal of the debt or at least part of it, will be
available when due. For the creditors, the fund reduces the risk the organization will default when the principal
is due: it reduces credit risk.

However, if the bonds are callable, this comes at a cost to creditors, because the organization has an option on
the bonds:

 The firm will choose to buy back discount bonds (selling below par) at their market price,
 while exercising its option to buy back premium bonds (selling above par) at par.

Therefore, if interest rates fall and bond prices rise, a firm will benefit from the sinking fund provision that
enables it to repurchase its bonds at below-market prices. In this case, the firm's gain is the bondholder's loss –
thus callable bonds will typically be issued at a higher coupon rate, reflecting the value of the option.

Modern context – capital expenditure[edit]

Sinking funds can also be used to set aside money for purposes of replacing capital equipment as it becomes
obsolete, or major maintenance or renewal of elements of a fixed asset, typically a building. Such a fund is also
commonly called a reserve fund, however the distinguishing feature of a sinking fund is that the payments into
it are calculated to amortize a forecast future expenditure whereas a reserve fund is intended to equalise
expenditure in respect of regularly recurring service items to avoid fluctuations in the amount of service charge
payable each year.[4]
Project appraisal
Project appraisal is the process of assessing, in a structured way, the case for proceeding with a project or
proposal, or the project's viability.[1] It often involves comparing various options, using economic appraisal or
some other decision analysis technique.[2][3]

Process[edit]
 Initial Assessment
 Define problem and long-list
 Consult and short-list
 Evaluate alternatives
 Compare and select Project appraisal

Types of appraisal[edit]
 Technical appraisal
 Project appraisal
 Commercial and marketing appraisal
 Financial/economic appraisal
 organisational or management appraisal
 Cost-benefit analysis[4][5][6]
 Economic appraisal[7]
 Cost-effectiveness analysis
 Scoring and weighting

Managerial Economics: 6 Basic

Principles of Managerial Economics
– Explained!
Introduction:
Managerial Economics is both conceptual and metrical. Before the substantive decision problems which
fall within the purview of managerial economics are discussed, it is useful to identify and understand some
of the basic concepts underlying the subject.

Economic theory provides a number of concepts and analytical tools which can be of considerable and
immense help to a manager in taking many decisions and business planning. This is not to say that
economics has all the solutions. In fact, actual problem solving in business has found that there exists a
wide disparity between economic theory of the firm and actual observed practice.

Therefore, it would be useful to examine the basic tools of managerial economics and the nature and
extent of gap between the economic theory of the firm and the managerial theory of the firm. The
contribution of economics to managerial economics lies in certain principles which are basic to managerial
economics. There are six basic principles of managerial economics. They are:

Content:
1. The Incremental Concept
2. The Concept of Time Perspective

3. The Opportunity Cost Concept

4. The Discounting Concept

5. The Equi-marginal Concept

6. Risk and Uncertainty

1. The Incremental Concept:

The incremental concept is probably the most important concept in economics and is certainly the most
frequently used in Managerial Economics. Incremental concept is closely related to the marginal cost and
marginal revenues of economic theory.

The two major concepts in this analysis are incremental cost and incremental revenue. Incremental cost
denotes change in total cost, whereas incremental revenue means change in total revenue resulting from
a decision of the firm.

The incremental principle may be stated as follows:

A decision is clearly a profitable one if

(i) It increases revenue more than costs.

(ii) It decreases some cost to a greater extent than it increases others.

(iii) It increases some revenues more than it decreases others.

(iv) It reduces costs more than revenues.

Illustration:
Some businessmen hold the view that to make an overall profit, they must make a profit on every job. The
result is that they refuse orders that do not cover full costs plus a provision of profit. This will lead to
rejection of an order which prevents short run profit. A simple problem will illustrate this point. Suppose a
new order is estimated to bring in an additional revenue of Rs. 10,000. The costs are estimated as under:

Labour Rs. 3,000

Materials Rs. 4,000

Overhead charges Rs. 3,600

Selling and administrative expenses Rs. 1,400

Full Cost Rs.12, 000
The order appears to be unprofitable. For it results in a loss of Rs. 2,000. However, suppose there is idle
capacity which can be utilised to execute this order. If order adds only Rs. 1,000 to overhead charges, and
Rs. 2000 by way of labour cost because some of the idle workers already on the pay roll will be deployed
without added pay and no extra selling and administrative costs, then the actual incremental cost is as
follows:

Labour Rs. 2,000

Materials’ Rs. 4,000

Overhead charges Rs. 1,000

Total Incremental Cost Rs. 7,000
Thus there is a profit of Rs. 3,000. The order can be accepted on the basis of incremental reasoning.
Incremental reasoning does not mean that the firm should accept all orders at prices which cover merely
their incremental costs.

The concept is mainly used by the progressive concerns. Even though it is a widely followed concept, it
has certain limitations:

(a) The concept cannot be generalised because observed behaviour of the firm is always variable.

(b) The concept can be applied only when there is excess capacity in the concern.

(c) The concept is applicable only during the short period.

2. Concept of Time Perspective:

The time perspective concept states that the decision maker must give due consideration both to the short
run and long run effects of his decisions. He must give due emphasis to the various time periods. It was
Marshall who introduced time element in economic theory.

The economic concepts of the long run and the short run have become part of everyday language.
Managerial economists are also concerned with the short run and long run effects of decisions on
revenues as well as costs. The main problem in decision making is to establish the right balance between
long run and short run.

In the short period, the firm can change its output without changing its size. In the long period, the firm can
change its output by changing its size. In the short period, the output of the industry is fixed because the
firms cannot change their size of operation and they can vary only variable factors. In the long period, the
output of the industry is likely to be more because the firms have enough time to increase their sizes and
also use both variable and fixed factors.

In the short period, the average cost of a firm may be either more or less than its average revenue. In the
long period, the average cost of the firm will be equal to its average revenue. A decision may be made on
the basis of short run considerations, but may as time elapses have long run repercussions which make it
more or less profitable than it at first appeared.

Illustration:
The firm which ignores the short run and long run considerations will meet with failure can be explained
with the help of the following illustration. Suppose, a firm having a temporary idle capacity, received an
order for 10,000 units of its product. The customer is willing to pay only Rs. 4.00 per unit or Rs. 40,000 for
the whole lot but no more.

The short run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to
overhead and profit is Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the firm executes this order, it will
have to face the following repercussion in the long run:

(a) It may not be able to take up business with higher contributions in the long run.

(b) The other customers may also demand a similar low price.

(c) The image of the firm may be spoilt in the business community.

(d) The long run effects of pricing below full cost may be more than offset any short run gain.

Haynes, Mote and Paul refer to the example of a printing company which never quotes prices below full
cost due to the following reasons:
(1) The management realized that the long run repercussions of pricing below full cost would more than
offset any short run gain.

(2) Reduction in rates for some customers will bring undesirable effect on customer goodwill. Therefore,
the managerial economist should take into account both the short run and long run effects as revenues
and costs, giving appropriate weight to most relevant time periods.

3. The Opportunity Cost Concept:

Both micro and macro economics make abundant use of the fundamental concept of opportunity cost. In
everyday life, we apply the notion of opportunity cost even if we are unable to articulate its significance. In
Managerial Economics, the opportunity cost concept is useful in decision involving a choice between
different alternative courses of action.

Resources are scarce, we cannot produce all the commodities. For the production of one commodity, we
have to forego the production of another commodity. We cannot have everything we want. We are,
therefore, forced to make a choice.

Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of
alternatives is involved when carrying out a decision requires using a resource that is limited in supply with
the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by pursuing one course of
action rather than another.

The concept of opportunity cost implies three things:

1. The calculation of opportunity cost involves the measurement of sacrifices.

2. Sacrifices may be monetary or real.

3. The opportunity cost is termed as the cost of sacrificed alternatives.

Opportunity cost is just a notional idea which does not appear in the books of account of the company. If
resource has no alternative use, then its opportunity cost is nil.

In managerial decision making, the concept of opportunity cost occupies an important place. The
economic significance of opportunity cost is as follows:

1. It helps in determining relative prices of different goods.

2. It helps in determining normal remuneration to a factor of production.

3. It helps in proper allocation of factor resources.

4. Equi-Marginal Concept:

One of the widest known principles of economics is the equi-marginal principle. The principle states that
an input should be allocated so that value added by the last unit is the same in all cases. This
generalisation is popularly called the equi-marginal.

Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is involved in
five activities viz., А, В, C, D and E. The firm can increase any one of these activities by employing more
labour but only at the cost i.e., sacrifice of other activities.
An optimum allocation cannot be achieved if the value of the marginal product is greater in one activity
than in another. It would be, therefore, profitable to shift labour from low marginal value activity to high
marginal value activity, thus increasing the total value of all products taken together.

If, for example, the value of the marginal product of labour in activity A is Rs. 50 while that in activity В is
Rs. 70 then it is possible and profitable to shift labour from activity A to activity B. The optimum is reached
when the values of the marginal product is equal to all activities. This can be expressed symbolically as
follows:

VMPLA = VMPLB = VMPLC = VMPLD = VMPLE

Where VMP = Value of Marginal Product.

L = Labour

ABCDE = Activities i.e., the value of the marginal product of labour employed in A is equal to the value of
the marginal product of the labour employed in В and so on. The equimarginal principle is an extremely
practical notion.

It is behind any rational budgetary procedure. The principle is also applied in investment decisions and
allocation of research expenditures. For a consumer, this concept implies that money may be allocated
over various commodities such that marginal utility derived from the use of each commodity is the same.
Similarly, for a producer this concept implies that resources be allocated in such a manner that the
marginal product of the inputs is the same in all uses.

5. Discounting Concept:

This concept is an extension of the concept of time perspective. Since future is unknown and incalculable,
there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth more than a rupee
will be two years from now. This appears similar to the saying that “a bird in hand is more worth than two
in the bush.” This judgment is made not on account of the uncertainty surrounding the future or the risk of
inflation.

It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same
sum is available only at the end of the period. In technical parlance, it is said that the present value of one
rupee available at the end of two years is the present value of one rupee available today. The
mathematical technique for adjusting for the time value of money and computing present value is called
‘discounting’.

The following example would make this point clear. Suppose, you are offered a choice of Rs. 1,000 today
or Rs. 1,000 next year. Naturally, you will select Rs. 1,000 today. That is true because future is uncertain.
Let us assume you can earn 10 per cent interest during a year.

You may say that I would be indifferent between Rs. 1,000 today and Rs. 1,100 next year i.e., Rs. 1,100
has the present worth of Rs. 1,000. Therefore, for making a decision in regard to any investment which will
yield a return over a period of time, it is advisable to find out its ‘net present worth’. Unless these returns
are discounted and the present value of returns calculated, it is not possible to judge whether or not the
cost of undertaking the investment today is worth.

The concept of discounting is found most useful in managerial economics in decision problems pertaining
to investment planning or capital budgeting.

The formula of computing the present value is given below:

V = A/1+i

where:
V = Present value

A = Amount invested Rs. 100

i = Rate of interest 5 per cent

V = 100/1+.05 = 100/1.05 =Rs. 95.24

Similarly, the present value of Rs. 100 which will be discounted at the end of 2 years: A 2 years V = A/
(1+i) 2
For n years V = A/ (1+i) n
6. Risk and Uncertainty:

Managerial decisions are actions of today which bear fruits in future which is unforeseen. Future is
uncertain and involves risk. The uncertainty is due to unpredictable changes in the business cycle,
structure of the economy and government policies.

This means that the management must assume the risk of making decisions for their institution in
uncertain and unknown economic conditions in the future. Firms may be uncertain about production,
market prices, strategies of rivals, etc. Under uncertainty, the consequences of an action are not known
immediately for certain.

Economic theory generally assumes that the firm has perfect knowledge of its costs and demand
relationships and of its environment. Uncertainty is not allowed to affect the decisions. Uncertainty arises
because producers simply cannot foresee the dynamic changes in the economy and hence, cost and
revenue data of their firms with reasonable accuracy.

Also dynamic changes are external to the firm, they are beyond the control of the firm. The result is that
the risks from unexpected changes in a firm’s cost and revenue data cannot be estimated and therefore
the risks from such changes cannot be insured. But products must attempt to predict the future cost and
revenue data of their firms and determine the output and price policies.

The managerial economists have tried to take account of uncertainty with the help of subjective
probability. The probabilistic treatment of uncertainty requires formulation of definite subjective expec-
tations about cost, revenue and the environment. The probabilities of future events are influenced by the
time horizon, the risk attitude and the rate of change of the environment.

5 Nobel Prize-Winning Economic

Theories You Should Know
About
1. Management of Common Pool Resources
In 2009, Indiana University political science professor Elinor Ostrom became the first
woman to win the prize. She received it "for her analysis of economic governance,
especially the commons." Ostrom's research showed how groups work together to
manage common resources such as water supplies, fish and lobster stocks, and pastures
through collective property rights. She showed that ecologist Garrett Hardin's prevailing
theory of the "tragedy of the commons" is not the only possible outcome, or even the most
likely outcome, when people share a common resource.

Hardin's theory says that common resources should be owned by the government or
divided into privately owned lots to prevent the resources from becoming depleted
through overuse. He said that each individual user will try to obtain maximum personal
benefit from the resource to the detriment of later users. Ostrom showed that common
pool resources can be effectively managed collectively, without government or private
control, as long as those using the resource are physically close to it and have a
relationship with each other. Because outsiders and government agencies don't
understand local conditions or norms, and lack relationships with the community, they
may manage common resources poorly. By contrast, insiders who are given a say in
resource management will self-police to ensure that all participants follow the
community's rules.

Learn more about Ostom's prize-winning research in her 1990 book, "Governing the
Commons: The Evolution of Institutions for Collective Action," and in her
1999 Science journal article, "Revisiting the Commons: Local Lessons, Global
Challenges."

2. Behavioral Economics
The 2002 prize went to psychologist Daniel Kahneman, "for having integrated insights
from psychological research into economic science, especially concerning human
judgment and decision-making under uncertainty." Kahneman showed that people do not
always act out of rational self-interest, as the economic theory of expected utility
maximization would predict. This concept is crucial to the field of study known as
behavioral finance. Kahneman conducted his research with Amos Tversky, but Tversky
was not eligible to receive the prize because he died in 1996 and the prize is not awarded
posthumously.

Kahneman and Tversky identified common cognitive biases that cause people to use
faulty reasoning to make irrational decisions. These biases include the anchoring effect,
the planning fallacy and the illusion of control. Their article, "Prospect Theory: An Analysis
of Decision Under Risk," is one of the most frequently cited in economics journals. Their
award-winning prospect theory shows how people really make decisions in uncertain
situations. We tend to use irrational guidelines such as perceived fairness and loss
aversion, which are based on emotions, attitudes and memories, not logic. For example,
Kahneman and Tversky observed that we will expend more effort to save a few dollars on
a small purchase than to save the same amount on a large purchase.

Kahneman and Tversky also showed that people tend to use general rules, such as
representativeness, to make judgments that contradict the laws of probability. For
example, when given a description of a woman who is concerned about discrimination
and asked if she is more likely to be a bank teller or a bank teller who is a feminist activist,
people tend to assume she is the latter even though probability laws tell us she is much
more likely to be the former.

3. Asymmetric Information
In 2001, George A. Akerlof, A. Michael Spence and Joseph E. Stiglitz won the prize "for
their analyses of markets with asymmetric information." The trio showed that economic
models predicated on perfect information are often misguided because, in reality, one
party to a transaction often has superior information, a phenomenon known as
"information asymmetry."

An understanding of information asymmetry has improved our understanding of how

various types of markets really work and the importance of corporate transparency.
Akerlof showed how information asymmetries in the used car market, where sellers know
more than buyers about the quality of their vehicles, can create a market with numerous
lemons (a concept known as "adverse selection"). A key publication related to this prize is
Akerlof's 1970 journal article, "The Market for 'Lemons': Quality Uncertainty and the
Market Mechanism."

Spence's research focused on signaling, or how better-informed market participants can

transmit information to lesser-informed participants. For example, he showed how job
applicants can use educational attainment as a signal to prospective employers about
their likely productivity and how corporations can signal their profitability to investors by
issuing dividends.

Stiglitz showed how insurance companies can learn which customers present a greater
risk of incurring high expenses (a process he called "screening") by offering different
combinations of deductibles and premiums.

Today, these concepts are so widespread that we take them for granted, but when they
were first developed, they were groundbreaking.

4. Game Theory
The academy awarded the 1994 prize to John C. Harsanyi, John F. Nash Jr. and
Reinhard Selten "for their pioneering analysis of equilibria in the theory of non-cooperative
games." The theory of non-cooperative games is a branch of the analysis of strategic
interaction commonly known as "game theory." Non-cooperative games are those in
which participants make non-binding agreements. Each participant bases his or her
decisions on how he or she expects other participants to behave, without knowing how
they will actually behave.

One of Nash's major contributions was the Nash Equilibrium, a method for predicting the
outcome of non-cooperative games based on equilibrium. Nash's 1950 doctoral
dissertation, "Non-Cooperative Games," details his theory. The Nash Equilibrium
expanded upon earlier research on two-player, zero-sum games. Selten applied Nash's
findings to dynamic strategic interactions, and Harsanyi applied them to scenarios with
incomplete information to help develop the field of information economics. Their
contributions are widely used in economics, such as in the analysis of oligopoly and the
theory of industrial organization, and have inspired new fields of research.

5. Public Choice Theory

James M. Buchanan Jr. received the prize in 1986 "for his development of the contractual
and constitutional bases for the theory of economic and political decision-making."
Buchanan's major contributions to public choice theory bring together insights from
political science and economics to explain how public-sector actors (e.g., politicians and
bureaucrats) make decisions. He showed that, contrary to the conventional wisdom that
public-sector actors act in the public's best interest (as "public servants"), politicians and
bureaucrats tend to act in their own self-interest, just like private-sector actors (e.g.,
consumers and entrepreneurs). He described his theory as "politics without romance."

Using Buchanan's insights regarding the political process, human nature and free
markets, we can better understand the incentives that motivate political actors and better
predict the results of political decision-making. We can then design fixed rules that are
more likely to lead to desirable outcomes. For example, instead of allowing deficit
spending, which political leaders are motivated to engage in because each program the
government funds earns politicians support from a group of voters, we can impose a
constitutional restraint on government spending, which benefits the general public by
limiting the tax burden.

Buchanan lays out his award-winning theory in a book he coauthored with Gordon Tullock
in 1962, "The Calculus of Consent: Logical Foundations of Constitutional Democracy."

Honorable Mention: Black-Scholes Theorem

Robert Merton and Myron Scholes won the 1997 Nobel Prize in economics for the Black-
Scholes theorem, a key concept in modern financial theory that is commonly used for
valuing European options and employee stock options. Though the formula is
complicated, investors can use an online options calculator to get its results by inputting
an option's strike price, the underlying stock's price, the option's time to expiration,
its volatility and the market's risk-free interest rate. Fisher Black also contributed to the
theorem, but could not receive the prize because he passed away in 1995.

The Bottom Line

Each of the dozens of winners of the Nobel memorial prize in economics has made
outstanding contributions to the field, and the other award-winning theories are worth
getting to know, too. A working knowledge of the theories described here, however, will
help you to establish yourself as someone who is in touch with the economic concepts
that are essential to our lives today.
Demand forecasting
Demand forecasting is the art and science of forecasting customer demand to drive holistic execution of such
demand by corporate supply chain and business management. Demand forecasting involves techniques
including both informal methods, such as educated guesses, and quantitative methods, such as the use of
historical sales data and statistical techniques or current data from test markets. Demand forecasting may be
used in production planning, inventory management, and at times in assessing future capacity requirements, or
in making decisions on whether to enter a new market
Demand forecasting is predicting future demand for the product. In other words, it refers to the prediction of
probable demand for a product or a service on the basis of the past events and prevailing trends in the present.

Methods that rely on qualitative assessment[edit]

Forecasting demand based on expert opinion. Some of the types in this method are,

 Unaided judgment
 Prediction market
 Delphi technique
 Game theory
 Judgmental bootstrapping
 Simulated interaction
 Intentions and expectations surveys
 jury of executive method

Methods that rely on quantitative data[edit]

 Discrete Event Simulation
 Extrapolation
 Group method of data handling (GMDH)
 Reference class forecasting
 Quantitative analogies
 Rule-based forecasting
 Neural networks
 Data mining
 Conjoint analysis
 Causal models
 Segmentation
 Exponential Smoothing Models
 Box-Jenkins Models
 Hybrid Models

Some of the other methods[edit]

a) time series projection methods this includes:

 moving average method

 exponential smoothing method
 trend projection methods
b) causal methods this includes:

 chain-ratio method
 consumption level method
 end use method
Definition: Demand Analysis
Demand analysis is to find out the customer demand for a product or service in a particular market.
Demand analysis is one of the important consideration for a variety of business decisions like determining sales
forecasting, pricing products/services, marketing and advertisement spending, manufacturing decisions, expansion
planning etc.
For a new company, the demand analysis can tell whether a substantial demand exists for the product/service and
given the other information like number of competitors, size of competitors, industry growth etc it helps to decide if
the company could enter the market and generate enough returns to sustain and advance its business.

Demand analysis helps in identifying key business areas where demand is highest and areas which needs attention as
very low demand indicates different problems like either the customers are not aware of the product/service and
more focus must be in advertisement and promotion or the customer needs are not met by current product/service
and improvements are needed or competitors have sprung up with better offerings etc.

Production and Cost Analysis

BIBLIOGRAPHY

Production processes can be studied empirically in terms of either production functions or cost functions.
Estimates of the parameters of these functions provide valuable insights into the technology of firms and
industries. The central questions relating to technology are (1) whether production processes display
decreasing, constant, or increasing returns to scale; (2) how technological progress affects the parameters
of production processes; and (3) at what rate technological progress has occurred. Estimation and
interpretation of the estimates is complicated by the fact that observations on inputs, outputs, and costs
reflect not only the state of technology but also the economic decisions made by producers and factor
suppliers. Assumptions regarding economic behavior and competition in input and output markets often
play a crucial role in the statistical analyses, and it is not always easy to determine whether the results
reveal the nature of technology or serve instead to test the validity of the economic assumptions.

Production functions. The fundamental productive organization is the firm, which enters into contractual
arrangements in buying, transforming, and selling goods and services. The production set of a firm
describes at a given time the possible relationships between inputs and outputs. For the single-product firm,
the production function describes the maximum output that can be produced from given quantities of
inputs. Let X denote output in physical homogeneous units, and let L and K denote two inputs—labor and
capital—in homogeneous units; then the production function is Xmax = f(K,L), or simply X = f(K,L). The
numbers X, K, andL can take on positive or zero values only, and for a given technology the function is
normally specified as univalued.

An important practical distinction in statistical studies is between the ex ante (or planning) production or
cost function and the ex post (or realized) function. Decisions about the type and scale of plant are made
years before the plant is completed. Expectations, formed in previous years, about prices and output levels
determine the quantity and character of new capital employed in the current period. The ex post function is
the realized relationship and is the one that is normally measured in practice. If all plans and expectations
are perfectly realized, the ex ante and ex post functions are equivalent.

Functional forms. The most popular form of the production function for statistical testing is the Cobb–
Douglas function (Cobb & Douglas 1928), i.e.,

X = AKαLβ, A, α, β ≥ 0,

where α and β are elasticities of output with respect to capital and labor. Assuming perfect competition in
the markets for output and for factors of production, with prices P for output, Wfor labor, and R for capital,
we obtain the marginal productivity conditions β = WL/PX and α =RK/PX. In equilibrium the elasticities
are equal to the ratios of factor rewards to total revenue. The Cobb–Douglas function is a homogeneous
function of degree α + β If α + β = 1, then increasing both K and L by the same proportion will increase
output by that proportion, i.e., constant returns to scale prevails. Decreasing and increasing returns to scale
correspond to the cases α + β < 1 and α + β > 1. The Cobb–Douglas function can easily be extended to
cover the case of many inputs and many outputs.

Another form of the production function often used for statistical testing is the general constantelasticity-
of-substitution (CES) form, i.e.,

X = γ[δK–ρ + (1 – δ) L–ρ]–v/ρ,

where γ is a positive constant reflecting the scale in which X is measured, δ is a “distribution” parameter (0
< ≤ δ ≤ 1), and v is a nonnegative scale parameter which increases with economies of scale and takes a
value of unity when there are constant returns (Arrow et al. 1961). The parameter ρ is closely related to the
elasticity of substitution (α) between capital and labor:

When the elasticity of substitution approaches unity (i.e., when ρ approaches zero), the Ces function
simplifies to the Cobb–Douglas form. When the elasticity approaches zero (i.e., when papproaches
infinity), the Ces function becomes a Leontief-type input–output function. The marginal productivity
conditions with v = 1 give

The CES function can be extended to incorporate many inputs, but it is not so simple an extension as in the
case of the Cobb–Douglas function.

Specification and estimation In estimating the parameters, one may fit either the production function itself
or the marginal productivity equations. Most Cobb–Douglas function studies have estimated parameters
directly from the logarithmically linear production function, thus leaving open an apparent test of the
marginal productivity law. Most CES studies have avoided fitting the nonlinear production relation and
have instead concentrated on fitting the logarithmically linear marginal productivity equations.

Simultaneous estimation of both production and marginal productivity relations is beset with difficulties of
statistical and economic specification, identification, and interpretation (Marschak & Andrews 1944).
Thus, for the Cobb–Douglas form (and denoting logarithms by lower-case letters) we have for the
production function

x – αk – βl = a + u0

and for the marginal productivity relations

x – k = – α + γ – p + u1,

x – l = – β + ω – p u0.

The variables u0 , u1 and u2 may be interpreted as random variables, u0 affecting “productive efficiency”
and u1 and u2 affecting “economic efficiency” in choosing the correct factor inputs. Different interpretations
are, however, required for crosssection and time series studies. To estimate the parameters, restrictions
must be imposed on the joint distribution function of u0 ,u1, and u2. If there is no correlation
between u0 and u1 and between u0 and u2 then a simple extension of the usual method of least squares will
provide suitable estimates, but the empirical evidence suggests that there are in fact significant correlations
between technical and economic efficiency (Walters 1963).

Cost functions. An alternative way of analyzing the production process is to estimate the cost function,
which describes cost as determined by the level of output and the prices of inputs when the firm uses the
most efficient technique. If the perfectly competitive marginal productivity conditions are substituted into
the Cobb–Douglas production function, we obtain the cost function (C = cost),

which is linear in the logarithms of factor prices and output. Most empirical studies of cost have been
concerned with measuring the variation of C and X, and not with estimating the effect of factor prices on C.
It is clear, however, that if factor prices do change, there is an opportunity to measure the coefficients of
the production function by regressing cost on factor prices and output (Nerlove 1963).

Cost functions, although apparently more useful than production functions because of the availability of
accounting data, are often more intractable, owing to the difficulties of defining and measuring cost. The
cost function reflects not only the technological conditions of production but also competitive conditions in
factor markets. If, for example, the business is faced with a rising supply curve of labor, the parameters of
that supply curve will enter as determinants of the cost function. In addition, one does not escape the
simultaneous equations difficulty referred to above.

Time series estimates. The production function or cost function of the firm can be measured by observing
the firm as it reacts to different stimuli— such as changes in relative factor and output prices. A time series
of observations will produce variations in output, inputs, and cost from which production and cost
functions can be traced. These observations will usually generate the short-run production and cost
relationships—very short-run for monthly observations—and what may be called an intermediate-run
production function for annual observations. The main difficulty with this type of study is that it samples a
dynamic adjustment process—a mixture of factor price movements, technological change, and exogenous
shocks. One cannot be sure that one has identified the static production function or cost function.

Most time series studies of firms have been cast in the form of cost functions. Accounting data are adjusted
for changes in factor prices. Usually the cost is measured as “direct” or “production” cost, but sometimes
total cost has been used. The difficulties with accounting data are that (a) the unit period (the financial
year) is longer than the short period of economic theory, and (b) the valuation of stocks, capital, and
depreciation is usually conventional and based on the requirements of tax law. Studies vary according to
their success in dealing with these problems. The general result is, however, reasonably clear: marginal
cost is constant or even declining over the range of outputs recorded in the statistical studies. There is no
striking evidence of sharply rising marginal cost. Close scrutiny of these results reveals that some can be
explained by the fact that output levels were cyclically low relative to the size of the plant. There does
remain, however, evidence of excess capacity in certain industries.

Cross-section estimates. To avoid the problems of technological and other changes over time, researchers
frequently use observations on a number of firms for a particular year—a cross-section sample. Variations
in inputs and outputs from one firm to another provide the raw material for crosssection estimates.
Differences in the sizes of firms are so large and have normally persisted for so long that the cross-section
results are usually interpreted as long-run relationships.

The main difficulty with cross-section analysis, however, is that in a competitive market there is no
separate and quantitatively different stimulus for each firm. The success of cross-section studies of
households in measuring Engel curves is due to the fact that each household has a different income, which
generates different expenditure patterns. But this is not the case with businesses in a competitive industry.
For firms in a competitive market, prices are the same throughout, so that recorded variations in inputs and
outputs must be due to influences other than price—perhaps due to accidental influences or to special
nonexchangeable inputs, such as “entrepreneurship” There is no variation in factor price ratios to generate
variations in relative factor inputs. Any observed differences in factor inputs are caused by differences in
production functions (or accidents), and the observations do not identify a particular production function.
Similarly, the cost function in a perfectly competitive cross section shows that average costs, as measured
by price, are constant over the sample. If one measured costs by deducting entrepreneurial rewards, one
would find only how these rewards per unit of output varied over the population of firms; nothing can be
deduced about the variation in cost as a representative firm expands its output. Constant cost curves in
cross sections may be evidence of competition rather than of constant returns to scale.

This criticism does not apply to studies of firms in isolated factor or goods markets or to instances where
there are imperfections in factor markets and output markets or where the level (or price) of output is
controlled exogenously by a government agency. In these cases, there is some opportunity for measuring
the production and cost functions (Nerlove 1963). When the production relationship is measured directly,
i.e., when quantities of inputs and outputs are used, the results should approximate the underlying
production function. But in measuring marginal productivity conditions and cost functions, the parameters
of the supply curve of factors must be known before one can calculate the production function or cost
function parameters. With international or, in some cases, interregional cross sections it is sometimes
reasonable to specify both separate factor or goods markets and competitive conditions in each; in these
circumstances a cross section may give observations which are suitable for estimating production
functions.

Production function
From Wikipedia, the free encyclopedia

Graph of total, average, and marginal product

In economics, a production function relates physical output of a production process to physical inputs
or factors of production. The production function is one of the key concepts
of mainstream neoclassical theories, used to define marginal product and to distinguish allocative efficiency,
the defining focus of economics.The primary purpose of the production function is to address allocative
efficiency in the use of factor inputs in production and the resulting distribution of income to those factors, while
abstracting away from the technological problems of achieving technical efficiency, as an engineer or
professional manager might understand it.
In macroeconomics, aggregate production functions are estimated to create a framework in which to distinguish
how much of economic growth to attribute to changes in factor allocation (e.g. the accumulation of capital) and
how much to attribute to advancing technology. Some non-mainstream economists, however, reject the very
concept of an aggregate production function.[1][2]
The theory of production functions[edit]
In general, economic output is not a (mathematical) function of input, because any given set of inputs can be
used to produce a range of outputs. To satisfy the mathematical definition of a function, a production function is
customarily assumed to specify the maximum output obtainable from a given set of inputs. The production
function, therefore, describes a boundary or frontier representing the limit of output obtainable from each
feasible combination of input. (Alternatively, a production function can be defined as the specification of the
minimum input requirements needed to produce designated quantities of output.) Assuming that maximum
output is obtained from given inputs allows economists to abstract away from technological and managerial
problems associated with realizing such a technical maximum, and to focus exclusively on the problem
ofallocative efficiency, associated with the economic choice of how much of a factor input to use, or the degree
to which one factor may be substituted for another. In the production function itself, the relationship of output to
inputs is non-monetary; that is, a production function relates physical inputs to physical outputs, and prices and
costs are not reflected in the function.

In the decision frame of a firm making economic choices regarding production—how much of each factor input
to use to produce how much output—and facing market prices for output and inputs, the production function
represents the possibilities afforded by an exogenous technology. Under certain assumptions, the production
function can be used to derive a marginal product for each factor. The profit-maximizing firm in perfect
competition (taking output and input prices as given) will choose to add input right up to the point where the
marginal cost of additional input matches the marginal product in additional output. This implies an ideal
division of the income generated from output into an income due to each input factor of production, equal to the
marginal product of each input.

The inputs to the production function are commonly termed factors of production and may represent primary
factors, which are stocks. Classically, the primary factors of production were Land, Labor and Capital. Primary
factors do not become part of the output product, nor are the primary factors, themselves, transformed in the
production process. The production function, as a theoretical construct, may be abstracting away from the
secondary factors and intermediate products consumed in a production process. The production function is not
a full model of the production process: it deliberately abstracts from inherent aspects of physical production
processes that some would argue are essential, including error, entropy or waste, and the consumption of
energy or the co-production of pollution. Moreover, production functions do not ordinarily model the business
processes, either, ignoring the role of strategic and operational business management. (For a primer on the
fundamental elements of microeconomic production theory, seeproduction theory basics).

The production function is central to the marginalist focus of neoclassical economics, its definition of efficiency
as allocative efficiency, its analysis of how market prices can govern the achievement of allocative efficiency in
a decentralized economy, and an analysis of the distribution of income, which attributes factor income to the
marginal product of factor input.

Pricing Decisions Definition

To provide a satisfying marketing-mix, companies must set a price that is acceptable to target market members
(Pride and Ferrell, 2011). Price is the value paid for a product or service in the market, it is a key element in the
marketing-mix and one that generally is the only variable that can be quickly changed to react to market
changes such as competitor actions or demand variations.
Pricing is the process whereby a business sets the price at which it will sell its products and services, and may
be part of the business'smarketing plan. Lemuel In setting prices, the business will take into account the price
at which it could acquire the goods, themanufacturing cost, the market place, competition, market
condition, brand, and quality of product.

Pricing is also a key variable in microeconomic price allocation theory. Pricing is a fundamental aspect
of financial modeling and is one of the four Ps of the marketing mix. (The other three aspects are product,
promotion, and place.) Price is the only revenue generating element amongst the four Ps, the rest being cost
centers. However, the other Ps of marketing will contribute to decreasing price elasticityand so enable price
increases to drive greater revenue and profits.

Pricing can be a manual or automatic process of applying prices to purchase and sales orders, based on
factors such as: a fixed amount, quantity break, promotion or sales campaign, specific vendor quote, price
prevailing on entry, shipment or invoice date, combination of multiple orders or lines, and many others.
Automated systems require more setup and maintenance but may prevent pricing errors. The needs of the
consumer can be converted into demand only if the consumer has the willingness and capacity to buy the
product. Thus, pricing is the most important concept in the field of marketing, it is used as a tactical decision in
response to comparing market situation.

Objectives of pricing[edit]
The objectives of pricing should include:

 to achieve the financial goals of the company (i.e. profitability)

 to fit the realities of the marketplace (will customers buy at that price?)
 to support a product's market positioning and be consistent with the other variables in the marketing mix

 price is influenced by the type of distribution channel used, the type of promotions used, and the
quality of the product

 price will usually need to be relatively high if manufacturing is expensive, distribution is exclusive,
and the product is supported by extensive advertising andpromotional campaigns
 a low cost price can be a viable substitute for product quality, effective promotions, or an energetic
selling effort by distributors

Pricing Practicies
Micromarketing is the practice of tailoring products, brands (microbrands), and promotions to meet the needs
and wants of microsegments within a market. It is a type of market customization that deals with pricing of
customer/product combinations at the store or individual level.

Dynamic pricing is a pricing strategy in which businesses set highly flexible prices for products or services
based on changes in the level of market demand.

There is a need to follow certain guidelines in pricing of the new product. Following
are the common pricing strategies −

Pricing policies and practice of pricing a new product

Most companies do not consider pricing strategies in a major way, on a day-today basis. The marketing of a

new product poses a problem because new products have no past information.

Fixing the first price of the product is a major decision. The future of the company depends on the soundness of

the initial pricing decision of the product. In large multidivisional companies, top management needs to

establish specific criteria for acceptance of new product ideas.

The price fixed for the new product must have completed the advanced research and development, satisfy

public criteria such as consumer safety and earn good profits. In pricing a new product, below mentioned two

types of pricing can be selected −

Skimming Price
Skimming price is known as short period device for pricing. Here, companies tend to charge higher price in

initial stages. Initial high helps to “Skim the Cream” of the market as the demand for new product is likely to be

less price elastic in the early stages.

Penetration Price
Penetration price is also referred as stay out price policy since it prevents competition to a great extent. In

penetration pricing lowest price for the new product is charged. This helps in prompt sales and keeping the

competitors away from the market. It is a long term pricing strategy and should be adopted with great caution.

Multiple Products
As the name indicates multiple products signifies production of more than one product. The traditional theory of

price determination assumes that a firm produces a single homogenous product. But firms in reality usually

produce more than one product and then there exists interrelationships between those products. Such products

are joint products or multi–products. In joint products the inputs are common in the production process and in

multi-products the inputs are independent but have common overhead expenses. Following are the pricing

methods followed −

Full Cost Pricing Method

Full cost plus pricing is a price-setting method under which you add together the direct material cost, direct

labor cost, selling and administrative cost, and overhead costs for a product and add to it a markup percentage

in order to derive the price of the product. The pricing formula is −

Pricing formula =

Total production costs − Selling and administration costs − Markup Number of units expected to sell

This method is most commonly used in situations where products and services are provided based on the

specific requirements of the customer. Thus, there is reduced competitive pressure and no standardized product

being provided. The method may also be used to set long-term prices that are sufficiently high to ensure a profit

after all costs have been incurred.

Marginal Cost Pricing Method

The practice of setting the price of a product to equal the extra cost of producing an extra unit of output is

called marginal pricing in economics. By this policy, a producer charges for each product unit sold, only the
addition to total cost resulting from materials and direct labor. Businesses often set prices close to marginal cost

during periods of poor sales.

For example, an item has a marginal cost of $2.00 and a normal selling price is $3.00, the firm selling the item

might wish to lower the price to $2.10 if demand has waned. The business would choose this approach because

the incremental profit of 10 cents from the transaction is better than no sale at all.

Transfer Pricing
Transfer Pricing relates to international transactions performed between related parties and covers all sorts of

transactions.

The most common being distributorship, R&D, marketing, manufacturing, loans, management fees, and IP

licensing.

All intercompany transactions must be regulated in accordance with applicable law and comply with the "arm's

length" principle which requires holding an updated transfer pricing study and an intercompany agreement

based upon the study.

Some corporations perform their intercompany transactions based upon previously issued studies or an ill

advice they have received, to work at a “cost plus X%”. This is not sufficient, such a decision has to be

supported in terms of methodology and the amount of overhead by a proper transfer pricing study and it has to

be updated each financial year.

Dual Pricing
In simple words, different prices offered for the same product in different markets is dual pricing. Different

prices for same product are basically known as dual pricing. The objective of dual pricing is to enter different

markets or a new market with one product offering lower prices in foreign county.

There are industry specific laws or norms which are needed to be followed for dual pricing. Dual pricing strategy

does not involve arbitrage. It is quite commonly followed in developing countries where local citizens are offered

the same products at a lower price for which foreigners are paid more.

Airline Industry could be considered as a prime example of Dual Pricing. Companies offer lower prices if tickets

are booked well in advance. The demand of this category of customers is elastic and varies inversely with price.

As the time passes the flight fares start increasing to get high prices from the customers whose demands are

inelastic. This is how companies charge different fare for the same flight tickets. The differentiating factor here

is the time of booking and not nationality.

Price Effect
Price effect is the change in demand in accordance to the change in price, other things remaining constant.

Other things include − Taste and preference of the consumer, income of the consumer, price of other goods
which are assumed to be constant. Following is the formula for price effect −

Price Effect =
 Proportionate change in quantity demanded of X Proportionate change in price of X

Price effect is the summation of two effects, substitution effect and income effect

Price effect = Substitution effect − Income effect

Substitution Effect
In this effect the consumer is compelled to choose a product that is less expensive so that his satisfaction is

maximized, as the normal income of the consumer is fixed. It can be explained with the below examples −

 Consumers will buy less expensive foods such as vegetables over meat.

 Consumers could buy less amount of meat to keep expenses in control.

Income Effect
Change in demand of goods based on the change in consumer’s discretionary income. Income effect comprises

of two types of commodities or products −

Normal goods − If there is a price fall, demand increases as real income increases and vice versa.

Inferior goods − In case of inferior goods, demand increases due to an increase in the real income.

Financial accounting
Financial accounting (or financial accountancy) is the field of accounting concerned with the summary,
analysis and reporting of financial transactions pertaining to a business.[1] This involves the preparation
of financial statements available for public consumption. Stockholders, suppliers, banks,
employees, government agencies, business owners, and other stakeholders are examples of people interested
in receiving such information for decision making purposes.
Financial accountancy is governed by both local and international accounting standards. Generally Accepted
Accounting Principles(GAAP) is the standard framework of guidelines for financial accounting used in any given
jurisdiction. It includes the standards, conventions and rules that accountants follow in recording and
summarising and in the preparation of financial statements. On the other hand, International Financial
Reporting Standards (IFRS) is a set of international accounting standards stating how particular types of
transactions and other events should be reported in financial statements. IFRS are issued by the International
Accounting Standards Board (IASB).[2][3] With IFRS becoming more widespread on the international
scene, consistency in financial reporting has become more prevalent between global organisations.
While financial accounting is used to prepare accounting information for people outside the organisation or not
involved in the day-to-day running of the company, management accounting provides accounting information to
help managers make decisions to manage the business.

Objectives of financial accounting[edit]

Financial accounting and financial reporting are often used as synonyms.
1. According to International Financial Reporting Standards, the objective of financial reporting is:
To provide financial information about the reporting entity that is useful to existing and potential investors,
lenders and other creditors in making decisions about providing resources to the entity.[4]
2. According to the European Accounting Association:
Capital maintenance is a competing objective of financial reporting.[5]

Qualities of financial accounting[edit]

Financial accounting is the preparation of financial statements that can be consumed by the public and the
relevant stakeholders using either Historical Cost Accounting (HCA) orConstant Purchasing Power
Accounting (CPPA). When producing financial statements, they must comply to the following:[6]

 Relevance: Financial accounting which is decision-specific. It must be possible for accounting information
to influence decisions. Unless this characteristic is present, there is no point in cluttering statements.
 Materiality: information is material if its omission or misstatement could influence the economic decisions
of users taken on the basis of the financial statements.
 Reliability: accounting must be free from significant error or bias. It should be easily relied upon by
managers. Often information that is highly relevant isn’t very reliable, and vice versa.
 Understandability: accounting reports should be expressed as clearly as possible and should be
understood by those to whom the information is relevant.
 Comparability: financial reports from different periods should be comparable with one another in order to
derive meaningful conclusions about the trends in an entity’s financial performance and position over time.
Comparability can be ensured by applying the same accounting policies over time.

Three components of financial statements[edit]

Statement of Cash Flows[edit]
The Statement of Cash Flows considers the inputs and outputs in concrete cash within a stated period. The
general template of a cash flow statement is as follows: Cash Inflow - Cash Outflow + Opening Balance =
Closing Balance
Example 1: in the beginning of September, Ellen started out with $5 in her bank account. During that same
month, Ellen borrowed $20 from Tom. At the end of the month, Ellen bought a pair of shoes for $7. Ellen's cash
flow statement for the month of September looks like this:

 Cash inflow: $20

 Cash outflow: $7
 Opening balance: $5
 Closing balance: $20 – $7 + $5 = $18
Example 2: in the beginning of June, WikiTables, a company that buys and resells tables, sold 2 tables. They'd
originally bought the tables for $25 each, and sold them at a price of $50 per table. The first table was paid out
in cash however the second one was bought in credit terms. WikiTables' cash flow statement for the month of
June looks like this:

 Cash inflow: $50 - How much WikiTables received in cash for the first table. They didn't receive cash for
the second table (sold in credit terms).
 Cash outflow: $50 - How much they'd originally bought the 2 tables for.
 Opening balance: $0
 Closing balance: $50 – $50 + $0 = $0 - Indeed, the cash flow for the month of June for WikiTables
amounts to $0 and not $50.
Important: the cash flow statement only considers the exchange of actual cash, and ignores what the person in
question owes or is owed.
Profit and Loss Statement (also called Statement of Comprehensive Income)[edit]
In case of service organisations they are called as profit & loss a/c as income statement.
the profit or loss is determined by:
Sales (revenue) – Cost of Sales – total expenses + total income – tax paid = profit/loss

 If there's a negative balance, it's a loss

 if there's a positive balance, it's a profit
Statement of Financial Position (also called Balance Sheet)[edit]
The balance sheet is the statement showing assets & liabilities. As per the proforma, on its right it shows
assets and on its left side it shows liabilities. It helps know the status of a company. The difference between
current assets and current liabilities is called working capital. The assets are mainly divided into 2 types:

1. fixed assets and

2. current assets
The liabilities are

1. long term liabilities and

2. short term liabilities or current liabilities.
The statements assist detailed study and analysis in each segment. For suppose in case of if you analyse the
income or profit and loss statement that means you analyse the real meaning to how much earned or sustained
loss when compare to last financial year to this year.

Basic accounting concepts[edit]

THE STABLE MEASURING UNIT ASSUMPTION One of the basic principles in accounting is “The Measuring
Unit principle:
The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle
also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered
sufficiently important to require adjustments to the basic financial statements.”[7]
Historical Cost Accounting, i.e., financial capital maintenance in nominal monetary units, is based on the stable
measuring unit assumption under which accountants simply assume that money, the monetary unit of measure,
is perfectly stable in real value for the purpose of measuring (1) monetary items not inflation-indexed daily in
terms of the Daily CPI and (2) constant real value non-monetary items not updated daily in terms of the Daily
CPI during low and high inflation and deflation.
UNITS OF CONSTANT PURCHASING POWER The stable measuring unit assumption is not applied during
hyperinflation. IFRS requires entities to implement capital maintenance in units of constant purchasing power in
terms of IAS 29 Financial Reporting in Hyperinflationary Economies.
Financial accountants produce financial statements based on the accounting standards in a given jurisdiction.
These standards may be the Generally Accepted Accounting Principles of a respective country, which are
typically issued by a national standard setter, or International Financial Reporting Standards (IFRS), which are
issued by theInternational Accounting Standards Board (IASB).
Financial accounting serves the following purposes:

 producing general purpose financial statements

 producing information used by the management of a business entity for decision making, planning and
performance evaluation
 producing financial statements for meeting regulatory requirements.
Objectives of Financial Accounting

 Systematic recording of transactions: basic objective of accounting is to systematically record the

financial aspects of business transactions (i.e. book-keeping). These recorded transactions are later on
classified and summarized logically for the preparation of financial statements and for their analysis and
interpretation.[8]
 Ascertainment of result of above recorded transactions: accountant prepares profit and loss account
to know the result of business operations for a particular period of time. If expenses exceed revenue then it
is said that business running under loss. The profit and loss account helps the management and different
stakeholders in taking rational decisions. For example, if business is not proved to be remunerative or
profitable, the cause of such a state of affair can be investigated by the management for taking remedial
steps.
 Ascertainment of the financial position of business: businessman is not only interested in knowing the
result of the business in terms of profits or loss for a particular period but is also anxious to know that what
he owes (liability) to the outsiders and what he owns (assets) on a certain date. To know this, accountant
prepares a financial position statement of assets and liabilities of the business at a particular point of time
and helps in ascertaining the financial health of the business.
 Providing information to the users for rational decision-making: accounting as a ‘language of
business’ communicates the financial result of an enterprise to various stakeholders by means of financial
statements. Accounting aims to meet the financial information needs of the decision-makers and helps
them in rational decision-making.
 To know the solvency position: by preparing the balance sheet, management not only reveals what is
owned and owed by the enterprise, but also it gives the information regarding concern’s ability to meet its
liabilities in the short run (liquidity position) and also in the long-run (solvency position) as and when they
fall due.

Bookkeeping is the recording of financial transactions, and is part of the process

of accounting in business.[1] Transactions include purchases, sales, receipts, and payments by an individual
person or an organization/corporation. There are several standard methods of bookkeeping, such as the single-
entry bookkeeping system and the double-entry bookkeeping system, but, while they may be thought of as
"real" bookkeeping, any process that involves the recording of financial transactions is a bookkeeping process.

Bookkeeping is usually performed by a bookkeeper. A bookkeeper (or book-keeper) is a person who records
the day-to-day financial transactions of a business. He or she is usually responsible for writing the daybooks,
which contain records of purchases, sales, receipts, and payments. The bookkeeper is responsible for ensuring
that all transactions whether it is cash transaction or credit transaction are recorded in the correct daybook,
supplier's ledger, customer ledger, and general ledger; an accountant can then create reports from the
information concerning the financial transactions recorded by the bookkeeper.

The bookkeeper brings the books to the trial balance stage: an accountant may prepare the income
statement and balance sheetusing the trial balance and ledgers prepared by the bookkeeper.

Process[edit]
The bookkeeping process primarily records the financial effects of transactions. The difference between a
manual and any electronic accounting system results from the former'slatency between the recording of a
financial transaction and its posting in the relevant account. This delay—absent in electronic accounting
systems due to nearly instantaneous posting into relevant accounts—is a basic characteristic of manual
systems, thus giving rise to primary books of accounts such as Cash Book, Bank Book, Purchase Book, and
Sales Book for recording the immediate effect of a financial transaction.

In the normal course of business, a document is produced each time a transaction occurs. Sales and
purchases usually have invoices or receipts. Deposit slips are produced when lodgements (deposits) are made
to a bank account. Checks (spelled "cheques" in the UK and several other countries) are written to pay money
out of the account. Bookkeeping first involves recording the details of all of these source documents into multi-
column journals (also known as books of first entry or daybooks). For example, all credit sales are recorded in
the sales journal; all cash payments are recorded in the cash payments journal. Each column in a journal
normally corresponds to an account. In thesingle entry system, each transaction is recorded only once. Most
individuals who balance their check-book each month are using such a system, and most personal-finance
software follows this approach.

After a certain period, typically a month, each column in each journal is totalled to give a summary for that
period. Using the rules of double-entry, these journal summaries are then transferred to their respective
accounts in the ledger, or account book. For example, the entries in the Sales Journal are taken and a debit
entry is made in each customer's account (showing that the customer now owes us money), and a credit entry
might be made in the account for "Sale of class 2 widgets" (showing that this activity has generated revenue for
us). This process of transferring summaries or individual transactions to the ledger is called posting. Once the
posting process is complete, accounts kept using the "T" format undergo balancing, which is simply a process
to arrive at the balance of the account.

Daybooks[edit]
A daybook is a descriptive and chronological (diary-like) record of day-to-day financial transactions also called
a book of original entry. The daybook's details must be entered formally into journals to enable posting to ledgers.
Daybooks include:

 Sales daybook, for recording all the sales invoices.

 Sales credits daybook, for recording all the sales credit notes.
 Purchases daybook, for recording all the purchase invoices.
 Purchases Debits daybook, for recording all the purchase Debit notes.
 Cash daybook, usually known as the cash book, for recording all money received as well as money paid out. It
may be split into two daybooks: receipts daybook for money received in, and payments daybook for money paid
out.
 General Journal daybook, for recording journals.

Petty cash book[edit]

A petty cash book is a record of small-value purchases before they are later transferred to the ledger and final
accounts; it is maintained by a petty or junior cashier. This type of cash book usually uses the imprest system: a
certain amount of money is provided to the petty cashier by the senior cashier. This money is to cater for minor
expenditures (hospitality, minor stationery, casual postage, and so on) and is reimbursed periodically on satisfactory
explanation of how it was spent.

Journals[edit]
Journals are recorded in the general journal daybook. A journal is a formal and chronological record of financial
transactions before their values are accounted for in the general ledger as debits and credits. A company can
maintain one journal for all transactions, or keep several journals based on similar activity (e.g., sales, cash receipts,
revenue, etc.), making transactions easier to summarize and reference later. For every debit journal entry recorded,
there must be an equivalent credit journal entry to maintain a balanced accounting equation.[3]

Ledgers[edit]
A ledger is a record of accounts.The ledger is a permanent summary of all amounts entered in supporting Journals
which list individual transactions by date. These accounts are recorded separately, showing their
beginning/ending balance. A journal lists financial transactions in chronological order, without showing their balance
but showing how much is going to be charged in each account. A ledger takes each financial transaction from the
journal and records it into the corresponding account for every transaction listed. The ledger also sums up the total of
every account, which is transferred into the balance sheet and the income statement. There are three different kinds
of ledgers that deal with book-keeping:

 Sales ledger, which deals mostly with the accounts receivable account. This ledger consists of the records of the
financial transactions made by customers to the business.
 Purchase ledger is the record of the purchasing transactions a company does; it goes hand in hand with the
Accounts Payable account.

What is the 'Accounting Cycle'

The accounting cycle is the name given to the collective process of recording and processing
the accounting events of a company. The series of steps begin when a transaction occurs and
end with its inclusion in the financial statements. The nine steps of the accounting cycle are:

1. Collecting and analyzing data from transactions and events.

2. Putting transactions into the general journal.
3. Posting entries to the general ledger.
4. Preparing an unadjusted trial balance.
5. Adjusting entries appropriately.
6. Preparing an adjusted trial balance.
7. Organizing the accounts into the financial statements.
8. Closing the books.
9. Preparing a post-closing trial balance to check the accounts.

Journal (through French from Latin diurnalis, daily) has several related meanings:

 a daily record of events or business; a private journal is usually referred to as a diary

 a newspaper or other periodical, in the literal sense of one published each day
 many publications issued at stated intervals, such as academic journals (including scientific journals), or
the record of the transactions of a society, are often called journals.[1]In academic use, a journal refers to a
serious, scholarly publication that is peer-reviewed. A non-scholarly magazine written for an educated
audience about an industry or an area of professional activity is usually called a trade magazine.[2]

Ledger
A ledger[1] is the principal book or computer file for recording and totaling economic transactions measured in
terms of a monetaryunit of account by account type, with debits and credits in separate columns and a
beginning monetary balance and ending monetary balance for each account.

Government financial statements

From Wikipedia, the free encyclopedia
Government financial statements are annual financial statements or reports for the year. The financial
statements, in contrast to budget, present the revenue collected and amounts spent. The government financial
statements usually include a statement of activities (similar to an income statement in the private sector), a
balance sheet and often some type of reconciliation. Cash flow statements are often included to show the
sources of the revenue and the destination of the expenses.

In India[edit]
The Annual Financial Statement of India is tabled in the Indian Parliament by the Finance Minister on the
Budget Day. 13-15 other documents are also released in the Parliament along with the actual Statement.
Briefly divided into three parts, namely- Consolidated Fund, Contingency Fund and Public Account, the
Statement comprises the receipts and expenditure incurred by the Government on each part.

Definition - What are Financial Statements?

Financial Statements represent a formal record of the financial activities of an entity. These are written reports that
quantify the financial strength, performance and liquidity of a company. Financial Statements reflect the financial
effects of business transactions and events on the entity.

Four Types of Financial Statements

The four main types of financial statements are:
1. Statement of Financial Position

Statement of Financial Position, also known as the Balance Sheet, presents the financial position of an entity
at a given date. It is comprised of the following three elements:
 Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc)
 Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)
 Equity: What the business owes to its owners. This represents the amount of capital that remains in the
business after its assets are used to pay off its outstanding liabilities. Equity therefore represents the
difference between the assets and liabilities.
View detailed explanation and Example of Statement of Financial Position

2. Income Statement

Income Statement, also known as the Profit and Loss Statement, reports the company's financial
performance in terms of net profit or loss over a specified period. Income Statement is composed of the
following two elements:
 Income: What the business has earned over a period (e.g. sales revenue, dividend income, etc)
 Expense: The cost incurred by the business over a period (e.g. salaries and wages, depreciation, rental
charges, etc)
Net profit or loss is arrived by deducting expenses from income.

View detailed explanation and Example of Income Statement

3. Cash Flow Statement

Cash Flow Statement, presents the movement in cash and bank balances over a period. The movement in
cash flows is classified into the following segments:
 Operating Activities: Represents the cash flow from primary activities of a business.
 Investing Activities: Represents cash flow from the purchase and sale of assets other than inventories (e.g.
purchase of a factory plant)
 Financing Activities: Represents cash flow generated or spent on raising and repaying share capital and debt
together with the payments of interest and dividends.
View detailed explanation and Example of Cash Flow Statement

4. Statement of Changes in Equity

Statement of Changes in Equity, also known as the Statement of Retained Earnings, details the movement
in owners' equity over a period. The movement in owners' equity is derived from the following components:
 Net Profit or loss during the period as reported in the income statement
 Share capital issued or repaid during the period
 Dividend payments
 Gains or losses recognized directly in equity (e.g. revaluation surpluses)
 Effects of a change in accounting policy or correction of accounting error
IFCI, previously Industrial Finance Corporation of India, is an Indian government owned development
bank to cater to the long-term finance needs of the industrial sector. It was the first Development Financial
Institution established by the Indian government after independence.

Until the establishment of ICICI in 1956 , IFCI remained solely responsible for implementation of the
government's industrial policy initiatives. Its contribution to the modernization of Indian Industry, export
promotion, import substitution, entrepreneurship development, pollution control, energy conservation and
generation of both direct and indirect employment is noteworthy.

In 1993 it was reconstituted as a company to impart higher degree of operational flexibility. IFCI was allowed to
access the capital markets directly.

Objectives[edit]
The main objective of IFCI is to provide medium and long term financial assistance to large scale industrial
undertakings, particularly when ordinary bank accommodation does not suit the undertaking or finance cannot
be profitably raised by the concerned by the issue of shares.

Functions[edit]
The functions of the IFCI base as follows:

(i) The corporation grants loans and advances to industrial concerns.

(ii) Granting of loans both in rupees and foreign currencies.

(iii) The corporation underwrites the issue of stocks, bonds, shares etc.

(iv) The corporation can grant loans only to public limited companies and co-operatives but not to private
limited companies or partnership firms.

IDBI Bank (Hindi:आआ.आआ.आआ.आआ आआआआ) is an Indian government-owned financial service company,

formerly known as Industrial Development Bank of India, headquartered in Mumbai, India. It was established
in 1964 by an Act of Parliament to provide credit and other financial facilities for the development of the
fledgling Indian industry.

It is currently 10th largest development bank in the world in terms of reach, with 3340 ATMs, 1848 branches,
including one overseas branch at Dubai, and 1378 centers.[3] It is one of 27 commercial banks owned by the
Government of India.

The Bank has an aggregate balance sheet size of INR 3.74 trillion as on 31 March 2016.

Formation of Industrial Development Bank of India (IDBI)[edit]

The Industrial Development Bank of India (IDBI) was established in 1964 under an Act of Parliament as a
wholly owned subsidiary of the Reserve Bank of India. In 1976, the ownership of IDBI was transferred to the
Government of India and it was made the principal financial institution for coordinating the activities of
institutions engaged in financing, promoting and developing industry in India. IDBI provided financial
assistance, both in rupee and foreign currencies, for green-field projects as also for expansion, modernisation
and diversification purposes. In the wake of financial sector reforms unveiled by the government since 1992,
IDBI also provided indirect financial assistance by way of refinancing of loans extended by State-level financial
institutions and banks and by way of rediscounting of bills of exchange arising out of sale of indigenous
machinery on deferred payment terms.[citation needed]
After the public issue of IDBI in July 1995, the Government shareholding in the Bank came down from 100% to
75%.

IDBI played a pioneering role, particularly in the pre-reform era (1964–91), in catalyzing broad based industrial
development in India in keeping with its Government-ordained ‘development banking’ charter.[citation needed]
Some of the institutions built with the support of IDBI are the Securities and Exchange Board of
India (SEBI), National Stock Exchange of India (NSE), the National Securities Depository Limited (NSDL),
the Stock Holding Corporation of India Limited (SHCIL), the Credit Analysis & Research Ltd, the Exim Bank
(India), the Small Industries Development Bank of India (SIDBI) and the Entrepreneurship Development
Institute of India.

Conversion of IDBI into a commercial bank[edit]

A committee formed by RBI under chairmanship of S.H.Khan recommended the development financial
institution (IDBI) to diversify its activity and harmonise the role of development financing and banking activities
by getting away from the conventional distinction between commercial banking and developmental banking. To
keep up with reforms in financial sector, IDBI reshaped its role from a development finance institution to a
commercial institution. With the Industrial Development Bank (Transfer of Undertaking and Repeal) Act, 2003,
IDBI attained the status of a limited company viz., IDBI Ltd.

Subsequently, in September 2004, the Reserve Bank of India incorporated IDBI as a 'scheduled bank' under
the RBI Act, 1934. Consequently, IDBI, formally entered the portals of banking business as IDBI Ltd. from 1
October 2004. The commercial banking arm, IDBI BANK, was merged into IDBI in 2005.

STOCKS & SHARES

In today's financial markets, the distinction between stocks and shares has been somewhat blurred.
Generally, these words are used interchangeably to refer to the pieces of paper that denote
ownership in a particular company, called stock certificates. However, the difference between the two
words comes from the context in which they are used.

For example, "stock" is a general term used to describe the ownership certificates of any company, in
general, and "shares" refers to a the ownership certificates of a particular company. So, if investors
say they own stocks, they are generally referring to their overall ownership in one or more companies.
Technically, if someone says that they own shares - the question then becomes - shares in what
company?

Bottom line, stocks and shares are the same thing. The minor distinction between stocks and shares
is usually overlooked, and it has more to do with syntax than financial or legal accuracy.

The stock (also capital stock) of a corporation constitutes the equity stake of its owners. It represents the
residual assets of the company that would be due to stockholders after discharge of all senior claims such as
secured and unsecured debt. Stockholders' equity cannot be withdrawn from the company in a way that is
intended to be detrimental to the company's creditors.[

Shares[edit]
The stock of a corporation is partitioned into shares, the total of which are stated at the time of business
formation. Additional shares may subsequently be authorized by the existing shareholders and issued by the
company. In some jurisdictions, each share of stock has a certain declared par value, which is a nominal
accounting value used to represent the equity on the balance sheet of the corporation. In other jurisdictions,
however, shares of stock may be issued without associated par value.

Shares represent a fraction of ownership in a business. A business may declare different types (or classes) of
shares, each having distinctive ownership rules, privileges, or share values. Ownership of shares may be
documented by issuance of a stock certificate. A stock certificate is a legal document that specifies the amount
of shares owned by the shareholder, and other specifics of the shares, such as the par value, if any, or the
class of the shares.

EQUITY CAPITAL
In accounting and finance, equity is the difference between the value of the assets and the cost of
the liabilities of something owned. For example, if someone owns a car worth $15,000 but owes $5,000 on a
loan against that car, the car represents $10,000 equity. Equity can be negative if liability exceeds assets.

In an accounting context, shareholders' equity (or stockholders' equity, shareholders' funds, shareholders'
capital or similar terms) represents the equity of a company as divided
among shareholders of common or preferred stock. Accounting shareholders are the cheapest risk bearers as
they deal with the public.[1] Negative shareholders' equity is often referred to as a shareholders' deficit.

For purposes of liquidation during bankruptcy, ownership equity is the equity which remains after all liabilities
have been paid.

Equity in real estate[edit]

The notion of equity with respect to real estate comes the equity of redemption. This equity is a property right
valued at the difference between the market value of the property and the amount of any mortgage or other
encumbrance.

Equity investments[edit]
Main article: Stock trader

An equity investment generally refers to the buying and holding of shares of stock on a stock market by
individuals and firms in anticipation of income from dividends and capital gains. Typically, equity holders
receive voting rights, meaning that they can vote on candidates for the board of directors (shown on
a diversification of the fund(s) and to obtain the skill of the professional fund managers in charge of the fund(s).
An alternative, which is usually employed by large private investors and pension funds, is to hold shares
directly; in the institutional environment many clients who own portfolios have what are called segregated
funds, as opposed to or in addition to the pooled mutual fund alternatives.
Basic Economic and Financial Principles of
Construction Project Investments
This first chapter in the second half of this book commences with a look at investment
in construction projects. In this case the term ‘investment’ should be regarded as a
financial involvement in a project undertaking, aimed at gaining a benefit in the future;
usually profit, but not necessarily so. This said, it is significant that the value of such
investment expenditure or financial involvement which takes place is a known entity
while the future potential benefits, that is, the profit from the investment, is only a
possibility and not therefore secure.

By definition ‘to invest’ means to designate financial means not for consumption, but
for specific profits to be earned in the future. On this basis, investment per se may
occur in a number of ways; for instance through depositing money in a bank, buying
bonds, stocks, machines or real estate property. As mentioned above the future
benefits are not secured; therefore, every financial investment must be associated with
an element of risk which must be analyzed as thoroughly as possible in order to
eliminate its negative consequences. In order to plan the future investment or project
undertaking effectively, it is often necessary to consider many various aspects of the
investment activity. Such analysis is aimed not just at finding the current and future
possibilities of the investment’s performance, but also the threats to those projects.

Understanding and using the tools of financial assessment of investment undertakings

is a natural element of the economic education of every investor regardless of where
the funds may be invested. The investment process itself can encompass the entire
project development activity and usually consists of the three phases:

 Phase 1 is the Pre-Investment or Pre-Decision Phase before the award of a

contract, constituting the necessary tests, studies and expert’s opinions aimed at
selecting the best version of the project and making a decision on an investment
opportunity.

 Phase 2 is the Investment Phase which consists of planning and contracting for
the material deliveries, services, plant, equipment and furnishing. For
construction projects this also includes the traditional activities of hiring the
contractors and their supply chain for design, construction, installation and
commissioning works.
  Phase 3 is the Operations Phase which covers the normal use of the facility as a
result of its need for management resources, maintenance and repair
requirements. This phase is of most benefit to projects where the investor has a
long-term commitment other than just the delivery of the project, for example: in
undertaking contracts such as PPP projects as described later in Chapter 8.

Incidentally these three phases were also mentioned in Chapter 5 with a particular
focus on the project risk considerations at the pre-investment phase for international
projects. The development of an investment project using the three phases is shown
in Figures 6.1,6.2 and 6.3 with a discussion on each. It is important to note that the
investment decisions of the three phases are considered and used to secure the
project’s investment at the outset; whilst in the three phases described below, the
funding obligation will need to be allocated in toto at the outset.

Figure 6.1 Phase 1 process for project investment

The four stages of the pre-investment phase provide:

1. A study and analysis of the project concept together with initial advice on the
investment and the preliminary economic assessment of the project (opportunity
study).

2. A preliminary study covering the project selection and specification of the

method of construction and project implementation (pre-feasibility study).
 3. Formulating of the final version of the project (feasibility study), including a
complete set of technical, economic, trade and financial aspects of the
investment.

4. Final assessment of the project (assessment report) as a basis for the

implementation decision.

As the pre-investment phase is divided into the above four stages this avoids, or at
least reduces, direct transition from the concept to a final project study without
examination and presentation of any alternative solutions. The first stage of an
opportunity study prompts the potential investor to consider various investment options
and proposals for projects that are to be subject to analysis during the further stages.
The aim of analysis in the first place, is a quick and inexpensive general presentation
of the most important aspects of the investment, particularly the project viability and
the potential profitability of the investment made. This leads to the next step of
considering a more detailed analysis. The pre-feasibility study of the investment
project is aimed at analyzing further the project viability and its profitability, this stage
is often not overly costly or time-consuming as it builds on previous work. It should
however allow the selection of a concept and suggest a final version of the project.
Therefore, for maximum benefits, the structure of the pre-feasibility study must be
consistent with the final objectives of the project.

In some situations, additional comparative analyses may be conducted, pertaining, for

instance, to the selected aspects of an investment project with this likely to cover a
market analysis, aimed at specifying the demand for the product to be manufactured,
material resources needed, the quality and quantity of production, plant location,
selection of equipment and tools and so on. These are usually only prepared in the
case of large projects especially if the investor is required to have an operational role
or receive financial return on the investment from the performance of the constructed
facility such as with transport, healthcare and education facility projects undertaken on
a long-term contractual PPP arrangement.

The project feasibility study, or any other form of analysis such as a project business
plan, should serve as a basis for the implementation decision with regard to the
technical and technological issues, as well as economic, organizational, practical
construction and financial considerations. After completion of the feasibility study, the
parties interested in the project conduct an assessment according to their own
objectives, early risk assessments and, cost and benefit criteria which is then
documented in a final assessment report. Naturally the more thorough the pre-
investment study, the easier it is to assess the project and to make the final
investment decision on launching a realistic and achievable project.

Moving to the investment phase shown in Figure 6.2, which consists of a wide range
of consulting, construction, commercial and technical management activities, the first
stage would reveal any problems that need to be encountered for the purchase of
land, through to the outline and then the detailed technical design and contracting
strategy. This first stage will also include involvement in production of tender
documents, assessment of offers, contractor negotiations prior to contract award for
technical design, construction, installation of equipment and commissioning activities
up to recruitment and training of operational staff. This phase is expected to be of a
significant duration necessary to cover the detailed technical design, preparatory
works on site and preparation of schedules of construction works and plans. The
phase commences with signing of contracts between the investor and the financial
institutions, consultants, architects, contractors, various suppliers of materials and so
on.

Figure 6.2 Phase 2 process for project investment

The five stages in the investment phase provide:

1. Preparation of the technical report and the implementation plan.

 2. Negotiating and concluding contractual agreements for suppliers, works and
services, construction or modernization of the facility (design, construction,
installation, commissioning of plant and process equipment).

3. Obtaining of permission for spatial development and performance and operation

of facility.

4. Delivery of facility (in whole or in part) for operation.

5. Management of the performance of the project, including the supervision, control

and coordination of performance of the facility during this stage.

Public–private partnership
From Wikipedia, the free encyclopedia

A public–private partnership (PPP, 3P or P3) is a government service or private business

venture that is funded and operated through a partnership of government and one or
more private sector companies.
PPP involves a contract between a public sector authority and a private party, in which the
private party provides a public service or project and assumes substantial financial, technical and
operational risk in the project. In some types of PPP, the cost of using the service is borne
exclusively by the users of the service and not by the taxpayer.[1] In other types (notably
the private finance initiative), capital investment is made by the private sector on the basis of a
contract with government to provide agreed services and the cost of providing the service is
borne wholly or in part by the government. Government contributions to a PPP may also be in
kind (notably the transfer of existing assets). In projects that are aimed at creating public
goods like in the infrastructure sector, the government may provide a capital subsidy in the form
of a one-time grant, so as to make the project economically viable. In some other cases, the
government may support the project by providing revenue subsidies, including tax breaks or
by guaranteed annual revenues for a fixed time period. In all cases, the partnerships include a
transfer of significant risks to the private sector, generally in an integrated and holistic way,
minimizing interfaces for the public entity. An optimal risk allocation is the main value generator
for this model of delivering public service.
There are usually two fundamental drivers for PPPs. First, PPPs are claimed to enable the public
sector to harness the expertise and efficiencies that the private sector can bring to the delivery of
certain facilities and services traditionally procured and delivered by the public sector. Second, a
PPP is structured so that the public sector body seeking to make a capital investment does not
incur any borrowing. Rather, the PPP borrowing is incurred by the private sector vehicle
implementing the project. On PPP projects where the cost of using the service is intended to be
borne exclusively by the end user, the PPP is, from the public sector's perspective, an "off-
balance sheet" method of financing the delivery of new or refurbished public sector assets. On
PPP projects where the public sector intends to compensate the private sector through
availability payments once the facility is established or renewed, the financing is, from the public
sector's perspective, "on-balance sheet"; however, the public sector will regularly benefit from
significantly deferred cash flows. Generally, financing costs will be higher for a PPP than for a
traditional public financing, because of the private sector higher cost of capital. However, extra
financing costs can be offset by private sector efficiency, savings resulting from a holistic
approach to delivering the project or service, and from the better risk allocation in the long run.
Typically, a private sector consortium forms a special company called a "special purpose vehicle"
(SPV) to develop, build, maintain and operate the asset for the contracted period. [1][2] In cases
where the government has invested in the project, it is typically (but not always) allotted
an equity share in the SPV.[3] The consortium is usually made up of a building contractor, a
maintenance company and equity investor(s). It is the SPV that signs the contract with the
government and with subcontractors to build the facility and then maintain it. In
the infrastructure sector, complex arrangements and contracts that guarantee and secure
the cash flows make PPP projects prime candidates for project financing. A typical PPP example
would be a hospital building financed and constructed by a private developer and then leased to
the hospital authority. The private developer then acts as landlord, providing housekeeping and
other non-medical services while the hospital itself provides medical services. [1]

Financing of PPP
A key motivation for governments considering public-private partnerships is the possibility of
bringing in new sources of financing for funding public infrastructure and service needs. [21] It is
important to understand the main mechanisms for infrastructure projects, the principal investors
in developing countries, sources of finance (limited recourse, debt, equity, etc.), the typical
project finance structure, and key issues arising from developing project financed
transactions.[36] An interesting aspect, quite ubiquitous in project finance, is the dual nature of the
parties involved, being both service providers to and contracted with the newly created entity
(Special purpose entity), and shareholders of that entity. For example, it is quite common for the
construction contractor or operations and maintenance service provider to hold an equity stake in
a project finance's capital structure.[37] Some governments utilize a public sector comparator for
assessing the financial benefit of a public-private partnership and the optimal level of private
sector involvement.
A number of key risks need to be taken into consideration as well. These risks will need to be
allocated and managed to ensure the successful financing of the project. The party that is best
placed to manage these risks in a cost-effective way may not necessarily always be the private
sector. However, there are a number of mechanisms products available in the market for project
sponsors, lenders and governments to mitigate some of the project risks, such as: Hedging and
futures contracts; insurance; and risk mitigation products provided by international finance
institutions.[

Project risk management is an important aspect of project management. According to

the Project Management Institute's PMBOK, Risk management is one of the ten knowledge areas in which a
project manager must be competent. Project risk is defined by PMI as 'an uncertain event or condition that, if it
occurs, has a positive or negative effect on a project’s objectives'.

Good Project Risk Management depends on supporting organisational factors, clear roles and responsibilities,
and technical analysis skills.

Project risk management in its entirety, includes the following six process groups:[1]

 Planning risk management

 Risk identification
 Performing qualitative risk analysis
 Performing quantitative risk analysis
 Planning risk responses
 Monitoring and controlling risks

Project Risk management is the identification, assessment, and prioritization of risks followed by coordinated
and economical application of resources to minimize, monitor, and control the probability and/or impact of
unfortunate events or to maximize the realization of opportunities.

Risk management is the identification, assessment, and prioritization of risks (defined

in ISO 31000 as the effect of uncertainty on objectives) followed by coordinated and economical
application of resources to minimize, monitor, and control the probability and/or impact of unfortunate
events[1] or to maximize the realization of opportunities. Risk management’s objective is to
assure uncertaintydoes not deflect the endeavor from the business goals.[2]

Risks can come from various sources including uncertainty in financial markets, threats from project
failures (at any phase in design, development, production, or sustainment life-cycles), legal liabilities,
credit risk, accidents, natural causes and disasters, deliberate attack from an adversary, or events of
uncertain or unpredictable root-cause. There are two types of events i.e. negative events can be classified
as risks while positive events are classified as opportunities. Several risk management standards have
been developed including the Project Management Institute, the National Institute of Standards and
Technology, actuarial societies, and ISO standards.[3][4] Methods, definitions and goals vary widely
according to whether the risk management method is in the context of project management,
security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health and
safety.

Risk sources are identified and located in human factor variables, mental states and decision making as
well as infrastructural or technological assets and tangible variables. The interaction between human
factors and tangible aspects of risk highlights the need to focus closely on human factors as one of the
main drivers for risk management, a "change driver" that comes first of all from the need to know how
humans perform in challenging environments and in face of risks (Daniele Trevisani, 2007). As the author
describes, «it is an extremely hard task to be able to apply an objective and systematic self-observation,
and to make a clear and decisive step from the level of the mere "sensation" that something is going
wrong, to the clear understanding of how, when and where to act. The truth of a problem or risk is often
obfuscated by wrong or incomplete analyses, fake targets, perceptual illusions, unclear focusing, altered
mental states, and lack of good communication and confrontation of risk management solutions with
reliable partners. This makes the Human Factor aspect of Risk Management sometimes heavier than its
tangible and technological counterpart»[5]
Method[edit]
For the most part, these methods consist of the following elements, performed, more or less, in the following
order.

1. identify, characterize threats

2. assess the vulnerability of critical assets to specific threats
 3. determine the risk (i.e. the expected likelihood and consequences of specific types of attacks on
specific assets)
4. identify ways to reduce those risks
5. prioritize risk reduction measures based on a strategy
Principles of risk management[edit]
The International Organization for Standardization (ISO) identifies the following principles of risk
management:[7]

Risk management should:

 create value – resources expended to mitigate risk should be less than the consequence of inaction
 be an integral part of organizational processes
 be part of decision making process
 explicitly address uncertainty and assumptions
 be a systematic and structured process
 be based on the best available information
 be tailorable
 take human factors into account
 be transparent and inclusive
 be dynamic, iterative and responsive to change
 be capable of continual improvement and enhancement
 be continually or periodically re-assessed

Potential risk treatments[edit]

Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of
these four major categories:[11]

 Avoidance (eliminate, withdraw from or not become involved)

 Reduction (optimize – mitigate)
 Sharing (transfer – outsource or insure)
 Retention (accept and budget)

Ideal use of these strategies may not be possible. Some of them may involve trade-offs that are not
acceptable to the organization or person making the risk management decisions. Another source, from the
US Department of Defense (see link), Defense Acquisition University, calls these categories ACAT, for
Avoid, Control, Accept, or Transfer. This use of the ACAT acronym is reminiscent of another ACAT (for
Acquisition Category) used in US Defense industry procurements, in which Risk Management figures
prominently in decision making and planning.

Risk avoidance[edit]

This includes not performing an activity that could carry risk. An example would be not buying
a property or business in order to not take on the legal liability that comes with it. Another would be not
flying in order not to take the risk that the airplane were to be hijacked. Avoidance may seem the answer
to all risks, but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk
may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning
profits. Increasing risk regulation in hospitals has led to avoidance of treating higher risk conditions, in
favor of patients presenting with lower risk.[12]

Hazard prevention[edit]
Main article: Hazard prevention

Hazard prevention refers to the prevention of risks in an emergency. The first and most effective stage of
hazard prevention is the elimination of hazards. If this takes too long, is too costly, or is otherwise
impractical, the second stage is mitigation.

Risk reduction[edit]

Risk reduction or "optimization" involves reducing the severity of the loss or the likelihood of the loss from
occurring. For example, sprinklers are designed to put out a fire to reduce the risk of loss by fire. This
method may cause a greater loss by water damage and therefore may not be suitable. Halon fire
suppression systems may mitigate that risk, but the cost may be prohibitive as a strategy.

Acknowledging that risks can be positive or negative, optimizing risks means finding a balance between
negative risk and the benefit of the operation or activity; and between risk reduction and effort applied. By
an offshore drilling contractor effectively applying HSE Management in its organization, it can optimize risk
to achieve levels of residual risk that are tolerable.[13]

Modern software development methodologies reduce risk by developing and delivering software
incrementally. Early methodologies suffered from the fact that they only delivered software in the final
phase of development; any problems encountered in earlier phases meant costly rework and often
jeopardized the whole project. By developing in iterations, software projects can limit effort wasted to a
single iteration.

Outsourcing could be an example of risk reduction if the outsourcer can demonstrate higher capability at
managing or reducing risks.[14] For example, a company may outsource only its software development, the
manufacturing of hard goods, or customer support needs to another company, while handling the
business management itself. This way, the company can concentrate more on business development
without having to worry as much about the manufacturing process, managing the development team, or
finding a physical location for a call center.

Risk sharing[edit]

Briefly defined as "sharing with another party the burden of loss or the benefit of gain, from a risk, and the
measures to reduce a risk."

The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that you can transfer
a risk to a third party through insurance or outsourcing. In practice if the insurance company or contractor
go bankrupt or end up in court, the original risk is likely to still revert to the first party. As such in the
terminology of practitioners and scholars alike, the purchase of an insurance contract is often described as
a "transfer of risk." However, technically speaking, the buyer of the contract generally retains legal
responsibility for the losses "transferred", meaning that insurance may be described more accurately as a
post-event compensatory mechanism. For example, a personal injuries insurance policy does not transfer
the risk of a car accident to the insurance company. The risk still lies with the policy holder namely the
person who has been in the accident. The insurance policy simply provides that if an accident (the event)
occurs involving the policy holder then some compensation may be payable to the policy holder that is
commensurate with the suffering/damage.
Some ways of managing risk fall into multiple categories. Risk retention pools are technically retaining the
risk for the group, but spreading it over the whole group involves transfer among individual members of
the group. This is different from traditional insurance, in that no premium is exchanged between members
of the group up front, but instead losses are assessed to all members of the group.

Risk retention[edit]

Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self insurance falls in this
category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would
be greater over time than the total losses sustained. All risks that are not avoided or transferred are
retained by default. This includes risks that are so large or catastrophic that they either cannot be insured
against or the premiums would be infeasible. War is an example since most property and risks are not
insured against war, so the loss attributed by war is retained by the insured. Also any amounts of potential
loss (risk) over the amount insured is retained risk. This may also be acceptable if the chance of a very
large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the
goals of the organization too much.

Risk Management plan

Select appropriate controls or countermeasures to measure each risk. Risk mitigation needs to be
approved by the appropriate level of management. For instance, a risk concerning the image of the
organization should have top management decision behind it whereas IT management would have the
authority to decide on computer virus risks.

The risk management plan should propose applicable and effective security controls for managing the
risks. For example, an observed high risk of computer viruses could be mitigated by acquiring and
implementing antivirus software. A good risk management plan should contain a schedule for control
implementation and responsible persons for those actions.

According to ISO/IEC 27001, the stage immediately after completion of the risk assessment phase
consists of preparing a Risk Treatment Plan, which should document the decisions about how each of the
identified risks should be handled. Mitigation of risks often means selection of security controls, which
should be documented in a Statement of Applicability, which identifies which particular control objectives
and controls from the standard have been selected, and why.

Decisions Under Risk and Uncertainty

When managers make choices or decisions under risk or uncertainty, they must somehow
incorporate this risk into their decision-making process. This chapter presented some basic
rules for managers to help them make decisions under conditions of risk and uncertainty.
Conditions of risk occur when a manager must make a decision for which the outcome is not
known with certainty. Under conditions of risk, the manager can make a list of all possible
outcomes and assign probabilities to the various outcomes. Uncertainty exists when a
decision maker cannot list all possible outcomes and/or cannot assign probabilities to the
various outcomes. To measure the risk associated with a decision, the manager can examine
several characteristics of the probability distribution of outcomes for the decision. The
various rules for making decisions under risk require information about several different
characteristics of the probability distribution of outcomes: (1) the expected value (or mean)
of the distribution, (2) the variance and standard deviation, and (3) the coefficient of
variation.

While there is no single decision rule that managers can follow to guarantee that profits are
actually maximized, we discussed a number of decision rules that managers can use to help
them make decisions under risk: (1) the expected value rule, (2) the mean–variance rules,
and (3) the coefficient of variation rule. These rules can only guide managers in their
analysis of risky decision making. The actual decisions made by a manager will depend in
large measure on the manager's willingness to take on risk. Managers' propensity to take on
risk can be classified in one of three categories: risk averse, risk loving, or risk neutral.

Expected utility theory explains how managers can make decisions in risky situations. The
theory postulates that managers make risky decisions with the objective of maximizing the
expected utility of profit. The manager's attitude for risk is captured by the shape of the
utility function for profit. If a manager experiences diminishing (increasing) marginal utility
for profit, the manager is risk averse (risk loving). If marginal utility for profit is constant,
the manager is risk neutral.

If a manager maximizes expected utility for profit, the decisions can differ from decisions
reached using the three decision rules discussed for making risky decisions. However, in the
case of a risk-neutral manager, the decisions are the same under maximization of expected
profit and maximization of expected utility of profit. Consequently, a risk-neutral decision
maker can follow the simple rule of maximizing the expected value of profit and
simultaneously also be maximizing utility of profit.

In the case of uncertainty, decision science can provide very little guidance to managers
beyond offering them some simple decision rules to aid them in their analysis of uncertain
situations. We discussed four basic rules for decision making under uncertainty in this
chapter: (1) the maximax rule, (2) the maximin rule, (3) the minimax regret rule, and (4)
the equal probability

Financial Risk
Inflation
Prices in the marketplace tend to increase, or inflate, over time. Inflation causes the value of money
to fall. If the average cost of goods goes up 5 percent, each dollar you have buys 5 percent less. As
a result, inflation reduces the effective returns you get from saving and investing. For instance, if a
savings account pays 3 percent interest, but the inflation rate is 2 percent, your effective return is
only 1 percent. Conservative investments with low returns run the risk of failing to beat inflation,
which can cause the value of your savings to fall over time.
Market Risk
The value of property can change over time based on consumer demand. For example, if you buy a
home, its value could go up if many people want to move to your neighborhood. On the other
hand, the value of a home can go down if few people are interested in buying. Many economic
factors can influence consumer demand, such as changes in interest rates, unemployment, lending
practices and the growth rate of the economy. The possibility of property losing value due to
changes in market demand is known as market risk and is a major concern when investing in things
such as stocks and real estate.
Taxation
The Internal Revenue Service makes you pay taxes on a wide range of income sources, including
cash you make from savings and investments. Taxes on investment profits are higher if you sell an
investment within a year after buying it, so trading investments frequently can increase your taxes.
Putting cash in tax-advantaged retirement plans such as a 401(k) or individual retirement account
can help cut your taxes and increase the chances of making money.
Fees and Expenses
Some investments come with expenses and fees that serve to reduce your total return. For instance,
you typically have to pay a transaction fee each time you buy or sell a stock, and financial
companies may charge a fee for keeping an account open. Fees and expenses eat into investment
returns over time and increase the risk of losing money. For example, if you invest in a mutual
fund that generates a 4 percent annual return, but the inflation rate is 3 percent and the fund
charges a 2 percent annual fee, the real value of your investment would actually fall by 1 percent
due to the combined effects of inflation and fees.

A benefit-cost ratio (BCR) is an indicator, used in the formal discipline

of cost-benefit analysis, that attempts to summarize the overall value for money of
a project or proposal. A BCR is the ratio of the benefits of a project or proposal,
expressed in monetary terms, relative to its costs, also expressed in monetary
terms. All benefits and costs should be expressed in discounted present values.
Benefit cost ratio (BCR) takes into account the amount of monetary gain realized
by performing a project versus the amount it costs to execute the project. The
higher the BCR the better the investment. General rule of thumb is that if the
benefit is higher than the cost the project is a good investment.