2 Fundamental Concepts

Fundamental Concepts
• Incremental Reasoning
• Opportunity Cost
• Contribution
• Time Perspective
• Time value of money
• Risk & Uncertainty
Incremental Reasoning
• It involves estimating the impact of decision
alternatives
• It has got 2 sub-concepts. Viz.
– Incremental Cost
– Incremental Revenue
• Incremental cost (IC) is defined as the change
in total cost as a result of change in the level
of output, investment etc..
• Incremental Revenue (IR) is defined as the
change in total revenue as a result of change
in the level of output, price etc..
• While taking a decision, a manager should
always determine the worthwhileness of a
decision on the basis that the incremental
revenue exceeds incremental cost
• Eg. A firm gets an order which can get it an
additional revenue of Rs.2,000. The normal
cost of production is :
– Labor : Rs.600
– Materials : Rs.800
– Overheads : Rs.720
– Selling & Admin exp. : Rs.280
– Total Cost : Rs.2,400
• Should the firm accept the order or not?
?
• If this order is acceptable, it would need the use
of some of the existing facilities & under utilised
capacity of the firm.
• Therefore it would cost much less than Rs. 2,400.
• The additional cost due to this new order may be:
– Labor : Rs.400
– Materials : Rs.800
– Overheads : Rs.200
– Total Incremental Cost : Rs.1,400
Eg.II
Units of O/P Total Total Cost
Revenue
Units of O/P Total Total Cost
Revenue
1 20 15
2 40 29
3 60 42
4 80 52
5 100 65
6 120 81
7 140 101
8 160 125
Units of O/P Total Total Cost Total Profit
Revenue
1 20 15 5
2 40 29 11
3 60 42 18
4 80 52 28
5 100 65 35
6 120 81 39
7 140 101 39
8 160 125 35
Units of O/P Total Total Cost Total Profit Average
Revenue Profit
1 20 15 5
2 40 29 11
3 60 42 18
4 80 52 28
5 100 65 35
6 120 81 39
7 140 101 39
8 160 125 35
Units of O/P Total Total Cost Total Profit Average
Revenue Profit
1 20 15 5 5.0
2 40 29 11 5.5
3 60 42 18 6.0
4 80 52 28 7.0
5 100 65 35 7.0
6 120 81 39 6.5
7 140 101 39 5.6
8 160 125 35 4.4

Units of O/P Total Total Cost Total Profit Average Marginal
Revenue Profit Profits
1 20 15 5 5.0
2 40 29 11 5.5
3 60 42 18 6.0
4 80 52 28 7.0
5 100 65 35 7.0
6 120 81 39 6.5
7 140 101 39 5.6
8 160 125 35 4.4

Units of O/P Total Total Cost Total Profit Average Marginal
Revenue Profit Profits
1 20 15 5 5.0 --
2 40 29 11 5.5 6
3 60 42 18 6.0 7
4 80 52 28 7.0 10
5 100 65 35 7.0 7
6 120 81 39 6.5 4
7 140 101 39 5.6 Zero
8 160 125 35 4.4 (-)4

• Theory I:
A course of action should be pursued up to
the point where its incremental benefits equal
its incremental costs.
Opportunity Cost
• Opportunity cost of a decision is the sacrifice
of alternatives required by that decision.
• It represents the benefit or revenue forgone
by pursuing one course of action rather than
another.
Contribution
• The concept of contribution tells us about the
contribution of a unit of output to overheads and
profits.
– It helps in determining the best product mix when
allocating the scarce resource is involved.
– It also indicates whether or not it is advantageous to
accept a fresh order, to introduce a new product, to
shut down, to continue with the existing plant, etc…
• Unit contribution is the per unit difference of
incremental revenue from incremental cost.
• Eg. A firm has to make a choice between 4
products, all needing to use the same scarce
resource (M/c – time), which product should the
firm manufacture?
Product No. Price (Rs.) Inc. Cost per Contribution M/c time
unit (Rs.) (Rs.) required per
unit (Minutes)
1 44 26 18 180
2 40 24 16 120
3 37 22 15 90
4 20 08 12 60
Product Contribution per unit
(Rs.)
1 6 per M/c hour
2 8 per M/c hour
3 10 per M/c hour
4 12 per M/c hour

Time Perspective
• There are two types

– Short term
– Long term
• Short term is a period within which some of
the inputs (called fixed inputs) cannot be
altered or changed.
• Long term is a period where all the inputs can
be changed. (i.e there are no fixed inputs)
Time value of Money
• Also referred as Discounting principle.

Risk and Uncertainty
• Economic logic assumes that the firm has
perfect knowledge of its costs and demand
relationships and of its environment.
• Uncertainty is not allowed to influence the
decision of the firm.
• However in real world, uncertainty influences
the estimation of costs and revenues and
hence the decisions of the firm
• Management deals with decisions which have
long term bearing.
• Since future conditions are not perfectly
predictable, there is always an element of
RISK and UNCERTAINTY about the outcome of
such decisions.
• A decision maker deals with it using
probability.
• Risk is the chance of loss because all possible
outcomes and their probability of happening
are unknown.
• Uncertainty exists when the outcomes of
managerial decisions cannot be predicted
with absolute accuracy but all possibilities and
their associated probabilities are known.

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Fundamental Concepts

7 140 101 39 5.6

8 160 125 35 4.4

7 140 101 39 5.6

8 160 125 35 4.4

7 140 101 39 5.6 Zero

8 160 125 35 4.4 (-)4

1 6 per M/c hour

2 8 per M/c hour

3 10 per M/c hour

4 12 per M/c hour

• There are two types

• Also referred as Discounting principle.

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