UNIT- I

DEMAND FORECASTING
AND
ELEMENTS OF COST
What you will know?
Macro and Micro economics
Demand and supply
Factors influencing demand
Elasticity of demand
Demand forecasting time series, exponential
smoothing, casual, Delphi method,
correlation and regression, Barometric
method, long and short run forecast
Elements of cost Material cost, labour cost
Expenses- types of cost, cost of production,
overhead expenses, problems

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 Macro and Micro Economics
The study of economics is divided into two parts.
- Micro Economics and Macro Economics
Micro economics: Microeconomics is the study of
the small part or component of the whole economy
that we are analyzing. For example we may be
studying an individual firm or in any particular
industry. In Microeconomics we study the price of a
particular product or particular factor of the
production.

The Micro Economics theory studies the behavior

of individual decision-making units such as
consumers, business owners and business firms.
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Macro Economics
Macro economics is the study of behavior of the
economy as a whole. It examines the overall
level of nations out put, employment, price and
foreign trade.
Macroeconomics is concerned with aggregate
and average of entire economy.
e.g. In Macro economics we study about forest
not about tree.
In other words in macro economics study how
these aggregates and averages of economy as
whole are determined and what causes
fluctuation in them. For making of useful
economic policies for the nation
macroeconomics is necessary.

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We can summarize the objects of macroeconomics as :

1. A high and rising level of real output.

2. High employment and low unemployment,
providing good jobs with high salary to those who
want to work.
3. A stable or gently rising price level, with process
and wages determined by free markets.
4. Foreign economic relations marked by stable
foreign exchange rate and exports more or less
balancing imports.

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 Macro economics involves choice among
alternative central objectives.
A nation cant always have high
consumption and rapid growth.
High inflation rate has either a period of high
unemployment and low output, or
interference with free markets through
wage-price policies. These difficult choices
are among those that must be faced by
macroeconomic policy makers in any nation.

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 Demand and Supply
What is the salary of a school teacher?
How much does a management guru like
Arindham Chaudhry charges per hour?

What salary does a bus driver get?

How much does a pilot flying an aircraft get?

How much do sportsmen like Sachin or Dhoni

make?
How much do actors and actresses make?

Why this difference in earnings?

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 Have you ever awakened at 3 AM with a bad
headache and had to rush to the pharmacy to
buy some aspirin?
How did the store know to have aspirin in
stock?
Who coordinates this production to make sure
there is enough? What price should be charged
for aspirin?
Government officials don't tell businesses how
much aspirin to produce nor the price to charge.
Private producers figure out production levels
and prices on their own.
The producer supplies the product if she can
make a profit by doing so.

The forces of supply and demand coordinate all

this activity.
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 The Market System
Market consists of:
Consumers - create a demand for a product

Demand
the amount consumers desire to purchase at various
prices
Not what they will buy, but what they would like to buy!

Effective demand must be willing AND able to pay

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Individual and Market Demand

Market demand consists of the sum of

all individual demand schedules
in the market
Represented by a demand curve
At higher prices, consumers generally
willing to purchase less than at lower
prices
Demand curve negative slope,
downward sloping from left to right

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 Demand Curve
The demand curve
slopes downwards from
left to right (a negative
slope) indicating an
Price

inverse relationship
between price and the
quantity demanded.
Rs.100
Demand will be higher
at lower prices than at
Demand higher prices. As price
falls, demand rises. As
price rises, demand
Rs.50
falls.

100 150
Quantity
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Factors influencing demand
D = f (Pn,PnPn-1, Y, T, P, A, E)
Where:
Pn = Price
PnPn-1 = Prices of other goods substitutes
and complements
Y = Incomes the level and distribution
of income
T = Tastes, Trends and fashions
P = The level and structure of the population,
Popularity
A = Advertising, Attitude
E = Expectations of consumers
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Elasticity of demand (EOD)

The law of demand tells us that as the price of

a commodity falls, the quantity demanded
increases, and vice versa.
But it does not state by how much the quantity
demanded increases as a result of a certain fall
in the price or by how much the quantity
demanded decreases as a result of the rise in
the price.
In other words it only tells us only direction of
change but not the rate of change.

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 Definition and formula of EOD
The degree of responsiveness of the quantity demanded to a change
in price

Change in quantity demanded

ep=
Change in price

Change in quantity demanded / Quantity demanded

Or ep =
Change in price / price

ep = (Q2-Q1) / Q1 ( where ,ep= price elasticity of demand)

(P2-P1) / P1
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Contd..
Where
Q1 = Quantity demanded before price change
Q2 = Quantity demanded after price change
P1 = Price charged before price change
P2 = Price charged after price change

If Q1= 2000, Q2 = 2500, P1 = 10 and P2 = 9, then

(2500 2000) / 2000

(9-10) / 10
= - 2.5

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 Types of elasticity of demand
Perfectly elastic demand
Perfectly inelastic demand
Demand with unity elasticity
Relatively elastic demand
Relatively inelastic demand

Type Description Curve shape

Perfectly elastic Infinite Horizontal
Perfectly inelastic Zero Vertical
unity elasticity One Rectangular hyperbola
Relatively elastic More than one Flat
Relatively inelastic Less than one steep

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 Perfectly elastic demand Perfectly inelastic demand

Price
Price

Quantity demanded Quantity demanded

Relatively elastic demand Relatively inelastic demand

Price

Price

Quantity demanded Quantity demanded 17

Factors affecting Elasticity of Demand
Type of goods- elastic for luxury items and inelastic/less
elastic for necessities

Existence of substitutes: Elastic if substitutes exist. (Tea

and coffee)

No. of uses of goods: Elastic if commodity has variety of

uses. (Demand for coal)

Time element: Elastic if use can be postponed

Price of the good (demand for high priced products and

very low priced products is less elastic;

Taste and tradition

Customers income: Inelastic if expenditure is only a small

part of income 18
Demand Forecasting

Time series,
Exponential smoothing,
Casual,
Delphi method,
Correlation and regression,
Barometric method,
Long and short run forecast

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Delphi Method
The most primitive method of forecasting is
guessing.
Delphi is used for long-range forecast.

It is generally used for

new product demand,
technological forecast for new technology,
effect of scientific advances,
changes in society,
changes in competitive environment, etc.

For example, the effect of internet/intranet or

information-highway in the educational system
of India in next 25 years may be forecasted
through this approach.
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 The result may be rated acceptable if the
person making the guess is an expert in the
matter.
In this method, a panel of outside experts is
identified.
They are given a series of structured
questionnaires.
The answers of each questionnaire are used as
input for the design of the next questionnaire.
The identity of experts is not disclosed. This is
for the purpose that nobody should influence
the opinion of others.

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 In the next step, the researcher coordinator
makes a summary of all the replies he has
received.
He then sends the summary to the respondents
and asks if any of them wants to revise his
original response.
The Delphi procedure is normally repeated until
the respondents are no longer willing to adjust
their responses.
The opinions are compared for similarity or
variation
If the variation is too much, the expert is asked
to justify for the opinion
Based on the replies a final consensus will be
arrived about the product demand
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Disadvantages of Delphi technique
The process is time consuming to coordinate and
manage.

It can be difficult to maintain active participation by

participants the whole way through, and so drop
outs are more likely than at one off meetings.

The decision-making process is less transparent

than face to face meetings, and can be more easily
influenced by the coordinator. This can lead to less
trust in the process and outcome/s by participants.

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Exponential smoothing.

A firm uses simple exponential

smoothing with = 0.3 to forecast
demand. The forecast for the first week
of January was 500 units, whereas the
actual demand turned out to be 450
units.
A) Forecast the demand for the second
week of January.

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Elements of cost

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Classification of costs

According to
Nature
Function
Behaviour
Identifiably
Association with products
Controllability
Normality
Time
Relevance and
Other costs

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According to nature or elements

The three main elements of costs are

Material
Labour
Expense

Material cost Direct Materials

Indirect Materials

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Direct materials
Also known as Productive materials,
it is the cost of the material that enter into and forms a
part of the product
it is essential for the completion of the product

Examples:
Timber in furniture making and clay in brick making,
HSS bit for making turning tool
Ni, Fe, Cr etc for making alloy steels

Indirect materials
Essentially needed to convert the raw materials into final
products but not used directly in the product itself.
Eg. coolants, grease, cotton waste , thread, nail, gum,
fuel, etc
The cost associated with indirect material is called
indirect cost

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Labour cost
Cost of remuneration of the employees
of an organization. Such as wages,
salaries, bonus, commissions etc.

Types:
Direct labour cost
Indirect labour cost

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Direct labour cost
The cost of labour that can be directly
associated with the manufacture of the product
and can be allocated to cost centers and cost
units.
A direct labour is one who converts the direct
material into a saleable product and the
expenses incurred on such labour is called
direct labour cost
The direct labour cost may be apportioned to
the unit of the cost or on the basis of the time
spent by the worker or as the price for some
physical measurement of the product

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Indirect labour cost

The cost of the labour that does not alter

the construction, composition,
conformation, or the condition of the
direct material but is necessary for the
progressive movement and handling of
the product to the point of dispatch.
This cost is absorbed by the cost
centers and cost units.
Eg. Maintenance men, helpers, machine
setters, supervisors, foremen etc.
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Expenses
Its a collective title which refers to all
charges other than those incurred as a
direct result of employing workers or
obtaining material.
Types:
Direct expenses
Indirect expenses

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Direct expense
Expenses that can be identified with and
allocated to cost centers /cost units
Eg: Costs of special layouts, designs, drawings,
for a special job
Hiring special purpose machines or equipments
for a particular production order

Indirect Expense:
Expenses absorbed by cost centers or cost
units
Eg: building rent, Insurance, phone bills etc.

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Fixed expense
Costs that remain fixed independent of
the volume of production
Eg: land tax, water tax, building tax,
depreciation, rent , insurance, salary etc.

Variable expense:
Costs that vary directly with volume of
production.
Eg: electricity, wages for contract labour,
consumables, raw material cost etc..

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Prime cost
Direct labour cost + Direct expenses

Note: Prime cost is limited in its use to

manufacturing division of a business
concern

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Overheads
All expenses other than direct expenses
Defn.: cost of indirect material, indirect labour
and other indirect expenses including services.

Overheads are subdivided into

Manufacturing overheads,
Administrative overheads
Selling overhead
Distribution overhead
R & D overhead

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i) Manufacturing overhead

All direct expenses incurred by the company from

the receipt of production order to its completion
for dispatch to the customer

Typical manufacturing overheads are

1. Building expenses rent, insurance, repairs,
heating and lighting, depreciation etc.
2. Indirect labour supervisors, foremen, machine
setters, general workers, maintenance men, shop
clerks, shop inspectors etc.

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 3. Water, fuel, power
4. Consumables like cotton waste, grease
etc.
5. Plant maintenance and depreciation
6. Sundry expenses such as security,
employment office, welfare measures,
recreation facilities, restrooms etc.

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ii) Administrative overhead

Expenses incurred in direction, control,

administration of an enterprise
It is the expense of providing a general
management and clerical service
Eg: rent, salaries of clerks, salaries of
directors, GM etc, insurance, legal costs,
taxes, postage, telephone, audit fees, bank
charges, etc.

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iii) Selling overhead

Expenses required to maintain and

increase volume of sales
All expenses direct or indirect necessary
to persuade consumers to buy
Advertising
Salaries and commissions for sales people
Showroom rent
After sales service cost etc.

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iv) Distribution overhead

Expenses connected with storing and

transportation to customers
Warehouse charges
Transportation of goods
Loading and unloading charges
Maintenance of delivery vehicles
Depreciation of vehicles etc

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R & D overhead

Expenses on research
Expenses on product development

Factory Cost:
= Prime cost + factory overhead
= direct material cost + direct labour cost +
direct expenses + factory overhead

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Total cost = Factory cost
+ selling overhead
+ distribution overhead
+ administrative overhead

Selling Price = total cost + profit or loss

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Problem
From the data below find the following
Material cost
Prime cost
Direct cost
Factory cost
Admin overheads
Cost of production
Selling and distribution overheads
Total cost or cost of sales
Selling price
Assume a net profit of Rs. 10,000/=

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 Material in hand: 60,000 As on 01 April 2009
New material purchased: 2,50,000
Directors fee: 3,500
Advertising: 12,000
Depreciation on car: 1,200
Printing and stationery: 300
Plant depreciation: 5,000
Wages of direct workers:70,000
Wages of indirect workers: 10,000
Factory building rent: 5,000
Postage: 200
Electricity: 1000
Office salaries; 2,000

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 Office rent: 500
Showroom rent: 1,500
Salesmen commission: 2,500
Expenses on sales dept car:1,500
Material in hand as on 31 March 2010: 50,000
Variable direct expenses: 750
Plant repair and maintenance: 3,000
Heating and lighting for office; 2,500
Distribution cost: 2,000

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Solution

Material cost: = cost of material as on

01 April 2009 cost of material as on 31
March 2010 + cost of new material
purchased = 60,000 - 50,000 + 2,50,000
= 2,60,000
Prime cost: Direct material cost + direct
labour cost + Variable direct expenses
= 2,60,000 + 70,000 + 750 = 3,30,750

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 Direct cost = same as prime cost = 3,30,750
Factory cost: Prime cost + production
overhead where production overhead=Plant
depreciation: 5,000 + Wages of indirect
workers:10,000+ Factory building rent: 5,000+
Electricity: 1000 + Plant repair and maintenance:
3,000
= 3,30,750 + [5,000 +10,000 + 5000 +1000
+3000 ] = 3,54,750

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 Administrative overheads:= director fee;3,500
+Printing charges:300+ postage:200+ office
salaries:2000+office rent: 500 + distribution
cost:2000 = 3500 + 300 + 200 + 2,000 + 500 +
2,500
= 9,000
Cost of production: = Factory cost + Admin
overheads= 3,54,750 + 9,000
= 3,63,750
Selling and Distribution overheads: =
advertising: 12,000+ Depreciation on car:
1,200+showroom rent:1,500+ salesmen
commission: 2,500 +Expenses on sales dept
car:1,500+Distribution cost: 2,000
= 20,700
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 Total cost or cost of sales:= cost of
production + sales and distribution
overheads = 3,63,750 + 20,700
= 3,84,450
Selling price = Cost of sales + profit
= 3,84,450 + 10,000
= 3,94,450

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