Theory of Production (Part - 2) CA Foundation Notes | EduRev

Business Economics for CA Foundation

CA Foundation : Theory of Production (Part - 2) CA Foundation Notes | EduRev

The document Theory of Production (Part - 2) CA Foundation Notes | EduRev is a part of the CA Foundation Course Business Economics for CA Foundation.
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Entrepreneur:
Having explained the three factors namely land, labour and capital, we now turn to the description of the fourth factor of production, namely, the entrepreneur. It is not enough to say that production is a function of land, capital and labour. There must be some factor which mobilises these factors, combines them in the right proportion, initiates the process of production and bears the risks involved in it. This factor is known as the entrepreneur. He has also been called the organiser, the manager or the risk taker. But, in these days of specialisation and separation of ownership and management, the tasks performed by a manager or organiser have become different from that of the entrepreneur. While organisation and management involve decision-making of routine and non-routine types, the task of the entrepreneur is to initiate production work and to bear the risks involved in it.
Functions of an entrepreneur: In general, an entrepreneur performs the following functions:
(i) Initiating business enterprise and resource co-ordination: An entrepreneur senses business opportunities, conceives project ideas, decides on scale of operation, products and processes and builds up, owns and manages his own enterprise. The first and the foremost function of an entrepreneur is to initiate a business enterprise. An entrepreneur perceives opportunity, organizes resources needed for exploiting that opportunity and exploits it. He undertakes the dynamic process of obtaining different factors of production such as land, labour and capital, bringing about co-ordination among them and using these economic resources to secure higher productivity and greater yield. An entrepreneur hires the services of various other factors of production and pays them fixed contractual rewards: labour is hired at predetermined rate of wages, land or factory building at a fixed rent for its use and capital at a fixed rate of interest. The surplus, if any, after paying for all factors of production hired by him, accrues to the entrepreneur as his reward for his efforts and risk-taking. Thus, the reward for an entrepreneur, that is a profit, is not certain or fixed. He may earn profits, or incur losses. Other factors get the payments agreed upon, irrespective of whether the entrepreneur makes profits or losses. (ii) Risk bearing or uncertainty bearing: The ultimate responsibility for the success and survival of business lies with the entrepreneur. What is planned and anticipated by the entrepreneur may not come true and the actual course of events may differ from what was anticipated and planned. The economy is dynamic and changes occur every day. The demand for a commodity, the cost structure, fashions and tastes of the people and government’s policy regarding taxation, credit, interest rate etc. may change. All these changes bring about changes in the cost and/or demand conditions of a business firm. It may happen that as a result of certain broad changes which were not anticipated by the entrepreneur, the firm has to incur losses. Thus, the entrepreneur has to bear these financial risks. Apart from financial risks, the entrepreneur also faces technological risks which arise due to the inventions and improvement in techniques of production, making the existing techniques and machines obsolete. The entrepreneur has to assess and bear the risks. However, Frank Knight is of the opinion that profit is the reward for bearing uncertainties. An entrepreneur need not bear the foreseeable risks such as of fire, theft, burglary etc. as these can be insured against. Uncertainties are different from risks in the sense that these cannot be insured against and therefore, the entrepreneur has to bear them. For example genuine business uncertainties such as change in tastes, emergence of competition etc. cannot be foreseen or insured against. Thus, an entrepreneur earns profits because he bears uncertainty in a dynamic economy where changes occur every day. While nearly all functions of an entrepreneur can be delegated or entrusted with paid managers, risk bearing cannot be delegated to anyone. Therefore, risk bearing is the most important function of an entrepreneur
(iii) Innovations: According to Schumpeter, the true function of an entrepreneur is to introduce innovations. Innovation refers to commercial application of a new idea or invention to better fulfilment of business requirements. Innovations, in a very broad sense, include the introduction of new or improved products, devices and production processes, utilisation of new or improved source of raw-materials, adoption of new or improved technology, novel business models, extending sales to unexplored markets etc. According to Schumpeter, the task of the entrepreneur is to continuously introduce new innovations. These innovations may bring in greater efficiency and competitiveness in business and bring in profits to the innovator. A successful innovation will be imitated by others in due course of time. Therefore, an innovation may yield profits for the entrepreneur for a short time but when it is widely adopted by others, the profits tend to disappear. The entrepreneurs promote economic growth of the country by introducing new innovations from time to time and contributing to technological progress. But innovations involve risks and only a few individuals in the society are capable of introducing new innovations. The greater the innovating ability, the greater the supply of entrepreneurs in the economy, and greater will be the rate of technological progress.
Enterprise’s objectives and constraints: The standard assumption about an enterprise is that its business activity is carried out with the sole objective of earning profits. However, in the real world, enterprises do not make decisions based exclusively on profit maximisation objective alone. Since an enterprise functions in the economic, social, political and cultural environment, its objectives will have to be set up in relation to its survival and growth in such environments.
Thus, the objectives of an enterprise may be broadly categorised under the following heads:
1) Organic objectives
2) Economic objectives
3) Social objectives
4) Human objectives
5) National objectives
1. Organic objectives: The basic minimum objective of all kinds of enterprises is to survive or to stay alive. An enterprise can survive only if it is able to produce and distribute products or services at a price which enables it to recover its costs. If an enterprise does not recover its costs of staying in business, it will not be in a position to meet its obligations to its creditors, suppliers and employees with the result that it will be forced into bankruptcy. Therefore, survival of an enterprise is essential for the continuance of its business activity. Once the enterprise is assured of its survival, it will aim at growth and expansion.
Growth as an objective has assumed importance with the rise of professional managers. R.L. Marris’s theory of firm assumes that the goal that managers of a corporate firm set for themselves is to maximise the firm’s balanced growth rate subject to managerial and financial constraints. In corporate firms, the structural division of ownership and management, yields opportunity for mangers to set goals which may not conform to the utility function of owner shareholders. It is pointed out that ability or success of the managers is judged by their performance in promoting the growth or expansion of the firm and rewards obtained by them are reflection of their success is achieving growth of the firms managed by them. While owners want to maximise their utility function which relate to profit, capital, market share and public reputation, the managers want to maximise their utility function which includes variables such as salary, power, and status and job security. Although there is divergence and some degree of conflict between these utility functions, Marris argues that most of the variables incorporated in both of them are positively related to size of the firm and therefore, the two utility functions converge into a single variable, namely, a steady growth in the size of the firm. The managers do not aim at optimising profits; rather they aim at optimisation of the balanced rate of growth of the firm which involves optimisation of the rate of increase of demand for the commodities of the firm and the rate of increase of capital supply.
2. Economic Objectives: The profit maximising behaviour of the firm has been the most basic assumption made by economists over the last more than two hundred years and is still at the heart of neo classical micro economic theory. This assumption is simple, rational and quantitative and is amenable to equilibrium analysis. Under this assumption, the firm determines the price and output policy in such a way as to maximize profits within the constraints imposed upon it such as technology, finance etc. The investors expect that their company will earn sufficient profits in order to ensure fair dividends to them and to improve the prices of their stocks. Not only investors but creditors and employees are also interested in a profitable enterprise. Creditors will be reluctant to lend money to an enterprise which is not making profits. Similarly, any increase in salaries, wages and perquisite of employees can come only out of profits.
The definition of profits in Economics is different from the accountants’ denition of profits. Profit, in the accounting sense, is the difference between total revenue and total costs of the firm. Economic profit is the difference between total revenue and total costs, but total costs here costs include both explicit and implicit costs. Accounting profit considers only explicit costs while economic profit reflects explicit and implicit costs i.e. the cost of self owned factors used by the entrepreneur in his own business. Since economic profit includes these opportunity costs associated with self owned factors, it is generally lower than the accounting profit. When the economist speaks of profits, he means profits after taking into account the capital and labour provided by the owners i.e. he differentiates between normal profits and super normal profits. Normal profits include normal rate of return on capital invested by the entrepreneur, remuneration for the labour and the reward for risk bearing function of the entrepreneur. Normal  profit (zero economic profit) is a component of costs and therefore what a business owner considers as the minimum necessary to continue in the business. Supernormal profit,  also called economic profit or abnormal profit is over and above normal profits. It is earned when total revenue is greater than the total costs. Total costs in this case include a reward to all the factors, including normal profit.
The profit maximisation objective has been subject to severe criticism in recent years. Many economists have pointed out that all firms do not aim to maximise profits. Some firms try to achieve security, subject to reasonable level of profits. H A Simon argues that firms have ‘satisficing’ behaviour and strive for profits that are satisfactory. Baumol’s theory of sales maximisation holds that sales revenue maximisation rather than profit maximisation is the ultimate goal of the business firms. He cites empirical evidence for his hypothesis that sales rank ahead of profits as the main objective of the enterprise. He asserts that it is quite a common experience that when an executive is asked about his business, he will answer that his sales have been increasing (or decreasing) and talks about profits only as an afterthought. He, however, points out that in their attempt to maximise sales, businessmen do not completely ignore costs incurred on output and profits to be made.
In 1932, A. A. Berle and G.C. Means pointed out that in large business corporations, management is separated from ownership and therefore the managers enjoy discretionary powers to set goals of the firm they manage. Williamson’s model of maximisation of managerial utility function is an important contribution to managerial theory of firms’ behaviour. The owners (shareholders) of joint stock companies prefer profit maximisation; but managers maximise their own utility function subject to a minimum profit, rather than maximising profit.
The objective of utility maximization has been discussed in the context of two types of firms: First in case of firms owned and managed by the entrepreneur himself, utility maximisation implies that in choosing an output level, the entrepreneur owner considers not only the money profits which he will make, but also the sacrifice of leisure which he would have to make in doing the necessary activity for producing that level of output. Second, in case of large joint stock companies, the utility function of managers or executives of these companies includes not only the profits which they earn for the shareholders but also the promotion of sales, maintaining lavish offices, seeking to have a larger member of staff under their supervision etc. In this case, the manager will maximise his utility by attaining a best combination of profits and the above mentioned other objectives. Cyert and March suggests four possible functional goals in addition to profit goal namely, production goal, inventory goal, sales goal and market share goal.
3. Social Objectives: Since an enterprise lives in a society, it cannot grow unless it meets the needs of the society. Some of the important social objectives of business are:

  • To maintain a continuous and sufficient supply of unadulterated goods and articles of standard quality
  • To avoid profiteering and anti-social practices.
  • To create opportunities for gainful employment for the people in the society.
  • To ensure that the enterprise’s output does not cause any type of pollution - air, water or noise

An enterprise should consistently endeavour to contribute to the quality of life of its community in particular and the society in general. If it fails to do so, it may not survive for long.
4. Human Objectives: Human beings are the most precious resources of an organisation. If they are ignored, it will be difficult for an enterprise to achieve any of its other objectives. Therefore, the comprehensive development of its human resource or employees’ should be one of the major objectives of an organisation. Some of the important human objectives are:

  • To provide fair deal to the employees at different levels
  • To develop new skills and abilities and provide a work climate in which they will grow as mature and productive individuals.
  • To provide the employees an opportunity to participate in decision-making in matters affecting them.
  • To make the job contents interesting and challenging.

If the enterprise is conscious of its duties towards its employees, it will be able to secure their loyalty and support.
5. National objectives: An enterprise should endeavour for fulfilment of national needs and aspirations and work towards implementation of national plans and policies. Some of the national objectives are:

  • To remove inequality of opportunities and provide fair opportunity to all to work and to progress.
  • To produce according to national priorities.
  • To help the country become self-reliant and avoid dependence on other nations.
  • To train young men as apprentices and thus contribute in skill formation for economic growth and development.

Since all the enterprises have multiple goals, they need to set priorities. This requires appropriate balancing of the objectives in order to determine the relative importance of each.
Various objectives of an enterprise may conflict with one another. For example, the profit maximisation objective may not be wholly consistent with the marketing objective of increasing its market share which may involve improvement in quality, slashing down of product prices, improved customer service, etc. Similarly, its social responsibility objective may run into conflict with the introduction of technological changes which may cause environmental pollution. In such situations, the manager has to strike a balance between the two so that both can be achieved with reasonable success.
In the above paragraphs, we have discussed the different objectives of an enterprise. However, no comprehensive economic theory explaining the multitudes of behaviour of firms under various market conditions (perfect competition, monopoly, etc.) has been developed so far. Therefore, in rest of this book, we shall continue to assume that firms aim at maximising profits until and unless otherwise mentioned.
In the pursuit of this objective, an enterprise’s actions may get constrained by many factors. Important among them are:
1. Lack of knowledge and information: The enterprise functions in an uncertain world where due to lack of accurate information, many variables that affect the performance of the firm cannot be correctly predicted for the current month or the current year, let alone for the future years. Similarly, the firms may not know about the prices of all inputs and the characteristics of all relevant technologies. Under such circumstances, it is very difficult to determine what the profit maximising price is.
2. There may be other constraints such as restrictions imposed in the public interest by the state on the production, price and movement of factors. In practice, there are several hindrances for free mobility of labour and capital. For example, trade unions may place several restrictions on the mobility of labour or specialised training may be required to enable workers to change occupation. These contingencies may make attainment of maximum profits a difficult task.
3. There may be infrastructural inadequacies and consequent supply chain bottlenecks resulting in shortages and unanticipated emergencies. For example, there could be frequent power cuts, irregular supply of raw-materials or non-availability of proper transport. This could put limitations on the power of enterprises to maximise profits.
4. Changes in business and economic conditions which become contagious due to the highly connected nature of economies, place constraints by causing demand fluctuations and instability in firms’ sales and revenues. Besides, external factors such as sudden change in government policies with regard to location, prices, taxes, production, etc. or natural calamities like fire, flood etc. may place additional burdens on the business firms and defeat their plans. When firms are forced to implement policies in response to fiscal limitations, legal, regulatory, or contractual requirements, these have adverse consequences on the firms’ profitability and growth plans.
5. Events such as inflation, rising interest rates, unfavourable exchange rate fluctuations cause increased raw material, capital and labour costs and affect the budgets and financial plans of firms. Significant constraints are also imposed by the inability of firms to find skilled workforce at competitive wages as well as due to the recurring need for personnel training.

Enterprise’s Problems
An enterprise faces a number of problems from its inception, through its life time and till its closure. We shall try to get a few insights about them from the following discussion. Problems relating to objectives: As mentioned earlier, an enterprise functions in the economic, social, political and cultural environment. Therefore, it has to set its objectives in relation to its environment. The problem is that these objectives are multifarious and very often conflict with one another. For example, the objective of maximising profits is in conflict with the objective of increasing the market share which generally involves improving the quality, slashing the prices etc. Thus the enterprise faces the problem of not only choosing its objectives but also striking a balance among them.
Problems relating to location and size of the plant: An enterprise has to decide about the location of its plant. It has to decide whether the plant should be located near the source of raw material or near the market. It has to consider costs such as cost of labour, facilities and cost of transportation. Of course, the entrepreneur will have to weigh the relevant factors against one another in order to choose the right location which is most economical.
Another problem relates to the size of the firm. It has to decide whether it is to be a small scale unit or large scale unit. Due consideration will have to be given to technical, managerial, marketing and financial aspects of the proposed business before deciding on the scale of operations. It goes without saying that the management must make a realistic evaluation of its strengths and limitations while choosing a particular size for a new unit.
Problems relating to selecting and organising physical facilities: A firm has to make decision on the nature of production process to be employed and the type of equipments to be installed. The choice of the process and equipments will depend upon the design chosen and the required volume of production. As a rule, production on a large scale involves the use of elaborate, specialized and complicated machinery and processes. Quite often, the entrepreneur has to choose from among different types of equipments and processes of production. Such a choice will be based on the evaluation of their relative cost and efficiency. Having determined the equipment to be used and the processes to be employed, the entrepreneur will prepare a layout illustrating the arrangement of equipments and buildings and the allocation for each activity.
Problems relating to Finance: An enterprise has to undertake not only physical planning but also expert financial planning. Financial planning involves
(i) determination of the amount of funds required for the enterprise with reference to the physical plans already prepared
(ii) assessment of demand and cost of its products
(iii) estimation of profits on investment and comparison with the profits of comparable existing concerns to find out whether the proposed investment will be profitable enough and
(iv) determining capital structure and the appropriate time for financing the enterprise etc.
Problems relating to organisation structure: An enterprise also faces problems relating to the organisational structure. It has to divide the total work of the enterprise into major specialised functions and then constitute proper departments for each of its specialized functions. Not only this, the functions of all the positions and levels would have to be clearly laid down and their inter-relationship (in terms of span of control, authority, responsibility, etc) should be properly defined. In the absence of clearly defined roles and relationships, the enterprise may not be able to function efficiently.
Problems relating to marketing: Proper marketing of its products and services is essential for the survival and growth of an enterprise. For this, the enterprise has to discover its target market by identifying its actual and potential customers, and determine tactical marketing tools it can use to produce desired responses from its target market. After identifying the market, the enterprise has to make decision regarding 4 P’s namely,

  • Product: variety, quality, design, features, brand name, packaging, associated services, utility etc.
  • Promotion: Methods of communicating with consumers through personal selling, social contacts, advertising, publicity etc.
  • Price: Policies regarding pricing, discounts, allowance, credit terms, concessions, etc.
  • Place: Policy regarding coverage, outlets for sales, channels of distribution, location and layout of stores, inventory, logistics etc.

Problems relating to legal formalities: A number of legal formalities have to be carried out during the time of launching of the enterprise as well as during its life time and its closure. These formalities relate to assessing and paying different types of taxes (corporate tax, excise duty, sales tax, custom duty, etc.), maintenance of records, submission of various types of information to the relevant authorities from to time, adhering to various rules and laws formulated by government (for example, laws relating to location, environmental protection and control of pollution, size, wages and bonus, corporate management licensing, prices) etc.
Problems relating to industrial relations: With the emergence of the present day factory system of production, the management has to devise special measures to win the co-operation of a large number of workers employed in industry. Misunderstanding and conflict of interests have assumed enormous dimensions that these cannot be easily and promptly dealt with. Industrial relations at present are much more involved and complicated. Various problems which an enterprise faces with regard to industrial relations are - the problem of winning workers’ cooperation, the problem of enforcing proper discipline among workers, the problem of dealing with organised labour and the problem of establishing a state of democracy in the industry by associating workers with the management of industry

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