DEMAND FORECASTING

DEMAND FORECASTING

Introduction:

One of the crucial aspects in which managerial economics differs from pure economic theory lies
in the treatment of risk and uncertainty. Traditional economic theory assumes a risk-free world of
certainty; but the real world business is full of all sorts of risk and uncertainty. A manager cannot,
therefore, afford to ignore risk and uncertainty. The element of risk is associated with future
which is indefinite and uncertain. To cope with future risk and uncertainty, the manager needs to
predict the future event. The likely future event has to be given form and content in terms of
projected course of variables, i.e. forecasting. Thus, business forecasting is an essential
ingredient of corporate planning. Such forecasting enables the manager to minimize the element
of risk and uncertainty. Demand forecasting is a specific type of business forecasting.

Steps in Demand Forecasting:

Demand or sales forecasting is a scientific exercise. It has to go through a number of steps. At

each step, you have to make critical considerations. Such considerations are categorically listed
below:

1) Nature of forecast: To begin with, you should be clear about the uses of forecast data- how it
is related to forward planning and corporate planning by the firm. Depending upon its use, you
have to choose the type of forecasts: short-run or long-run, active or passive, conditional or non-
conditional etc.

2) Nature of product: The next important consideration is the nature of product for which you
are attempting a demand forecast. You have to examine carefully whether the product is
consumer goods or producer goods, perishable or durable, final or intermediate demand, new
demand or replacement demand type etc. A couple of examples may illustrate the importance of
this factor. The demand for intermediate goods like basic chemicals is derived from the final
demand for finished goods like detergents. While forecasting the demand for basic chemicals, it
becomes essential to analyze the nature of demand for detergents. Promoting sales through
advertising or price competition is much less important in the case of intermediate goods
compared to final goods. The elasticity of demand for intermediate goods depends on their
relative importance in the price of the final product.

Time factor is a crucial determinant in demand forecasting. Perishable commodities such as fresh
vegetables and fruits can be sold over a limited period of time. Here skilful demand forecasting
is needed to avoid waste. If there are storage facilities, then buyers can adjust their demand
according to availability, price and income. The time taken for such adjustment varies from
product to product. Goods of daily necessities that are bought more frequently will lead to
quicker adjustments. Whereas in case of expensive equipment which is worn out and replaced
after a long period of time, adaptation of demand will be spread over a longer duration of time.

3) Determinants of demand: Once you have identified the nature of product for which you are
to build a forecast, your next task is to locate clearly the determinants of demand for the product.
Depending on the nature of product and nature of forecasts, different determinants will assume
different degree of importance in different demand functions.
 In the preceding unit, you have been exposed to a number of price-income factors or
determinants-own price, related price, own income-disposable and discretionary, related income,
advertisement, price expectation etc. In addition, it is important to consider socio-psychological
determinants, specially demographic, sociological and psychological factors affecting demand.
Without considering these factors, long-run demand forecasting is not possible.

Such factors are particularly important for long-run active forecasts. The size of population, the
age-composition, the location of household unit, the sex-composition-all these exercise influence
on demand in. varying degrees. If more babies are born, more will be the demand for toys; if
more youngsters marry, more will be the demand for furniture; if more old people survive, more
will be the demand for sticks. In the same way buyers psychology-his need, social status, ego,
demonstration effect etc. also effect demand. While forecasting you cannot neglect these
factors.

4) Analysis of factors &determinants: Identifying the determinants alone would not do, their
analysis is also important for demand forecasting. In an analysis of statistical demand function, it
is customary to classify the explanatory factors into (a) trend factors, which affect demand over
long-run, (b) cyclical factors whose effects on demand are periodic in nature, (c) seasonal
factors, which are a little more certain compared to cyclical factors, because there is some
regularly with regard to their occurrence, and (d) random factors which create disturbance
because they are erratic in nature; their operation and effects are not very orderly.

An analysis of factors is specially important depending upon whether it is the aggregate demand
in the economy or the industrys demand or the companys demand or the consumers; demand
which is being predicted. Also, for a long-run demand forecast, trend factors are important; but
for a short-run demand forecast, cyclical and seasonal factors are important.

5) Choice of techniques: This is a very important step. You have to choose a particular
technique from among various techniques of demand forecasting. Subsequently, you will be
exposed to all such techniques, statistical or otherwise. You will find that different techniques
may be appropriate for forecasting demand for different products depending upon their nature. In
some cases, it may be possible to use more than one technique. However, the choice of technique
has to be logical and appropriate; for it is a very critical choice. Much of the accuracy and
relevance of the forecast data depends accuracy required, reference period of the forecast,
complexity of the relationship postulated in the demand function, available time for forecasting
exercise, size of cost budget for the forecast etc.

6) Testing accuracy: This is the final step in demand forecasting. There are various methods for
testing statistical accuracy in a given forecast. Some of them are simple and inexpensive, others
quite complex and difficult. This stating is needed to avoid/reduce the margin of error and
thereby improve its validity for practical decision-making purpose. Subsequently you will be
exposed briefly to some of these methods and their uses.

Techniques of Demand Forecasting:

There are two approaches to demand forecasting- one is to obtain information about the likely
purchase behavior of the buyer through collecting experts opinion or by conducting interviews
with consumers, the other is to use past experience as a guide through a set of statistical
techniques. Both these methods rely on varying degrees of judgment. The first method is usually
found suitable for short-term forecasting, the latter for long-term forecasting. There are specific
techniques which fall under each of these broad methods.

We shall now taker up each one of these techniques under broad category of methods suggested
above.

Qualitative Methods:

For forecasting the demand for existing product, such survey methods are often employed. In this
set of methods, we may undertake the following exercise.

1) Experts Opinion Poll/ Delphi Technique:: In this method, the experts on the particular
product whose demand is under study are requested to give their opinion or feel about the
product. These experts, dealing in the same or similar product, are able to predict the likely sales
of a given product in future periods under different conditions based on their experience. If the
number of such experts is large and their experience-based reactions are different, then an
average-simple or weighted is found to lead to unique forecasts. Sometimes this method is also
called the hunch method but it replaces analysis by opinions and it can thus turn out to be
highly subjective in nature.

2) Consumers Survey-

(a) Complete Enumeration Method: Under this, the forecaster undertakes a complete survey of
all consumers whose demand he intends to forecast, Once this information is collected, the sales
forecasts are obtained by simply adding the probable demands of all consumers.

The principle merit of this method is that the forecaster does not introduce any bias or value
judgment of his own. He simply records the data and aggregates. But it is a very tedious and
cumbersome process; it is not feasible where a large number of consumers are involved.
Moreover if the data are wrongly recorded, this method will be totally useless.

(b) Sample Survey Method: Under this method, the forecaster selects a few consuming units
out of the relevant population and then collects data on their probable demands for the product
during the forecast period. The total demand of sample units is finally blown up to generate the
total demand forecast.

Compared to the former survey, this method is less tedious and less costly, and subject to less
data error; but the choice of sample is very critical. If the sample is properly chosen, then it will
yield dependable results; otherwise there may be sampling error. The sampling error can
decrease with every increase in sample size

3) Sales Force opinion method: A method commonly used by companies for short-term
forecasts is to take advantage of their field staff's intimate knowledge of customers' needs and
market conditions by asking them to forecast the company's sales for their respective areas for
the coming season or year. The field estimates can be adjusted by routing them through the Area
Manager who applies his judgment and knowledge of the market.

Complex Statistical Methods:

We shall now move from simple to complex set of methods of demand forecasting. Such
methods are taken usually from statistics. As such, you may be quite familiar with some the
statistical tools and techniques, as a part of quantitative methods for business decisions.
(1) Time series analysis or trend method: Under this method, the time series data on the under
forecast are used to fit a trend line or curve either graphically or through statistical method of
Least Squares.

The trend line is worked out by fitting a trend equation to time series data with the aid of an
estimation method. The trend equation could take either a linear or any kind of non-linear form.
The trend method outlined above often yields a dependable forecast. The advantage in this
method is that it does not require the formal knowledge of economic theory and the market, it
only needs the time series data. The only limitation in this method is that it assumes that the past
is repeated in future. Also, it is an appropriate method for long-run forecasts, but inappropriate
for short-run forecasts. Sometimes the time series analysis may not reveal a significant trend of
any kind. In that case, the moving average method or exponentially weighted moving average
method is used to smoothen the series.

(2) Barometric Techniques or Lead-Lag indicators method: This consists in discovering a set
of series of some variables which exhibit a close association in their movement over a period or
time.

It shows the movement of agricultural income (AY series) and the sale of tractors (ST series).
The movement of AY is similar to that of ST, but the movement in ST takes place after a years
time lag compared to the movement in AY. Thus if one knows the direction of the movement in
agriculture income (AY), one can predict the direction of movement of tractors sale (ST) for the
next year. Thus agricultural income (AY) may be used as a barometer (a leading indicator) to
help the short-term forecast for the sale of tractors.

Generally, this barometric method has been used in some of the developed countries for
predicting business cycles situation. For this purpose, some countries construct what are known
as diffusion indices by combining the movement of a number of leading series in the economy
so that turning points in business activity could be discovered well in advance. Some of the
limitations of this method may be noted however. The leading indicator method does not tell you
anything about the magnitude of the change that can be expected in the lagging series, but only
the direction of change. Also, the lead period itself may change overtime. Through our estimation
we may find out the best-fitted lag period on the past data, but the same may not be true for the
future. Finally, it may not be always possible to find out the leading, lagging or coincident
indicators of the variable for which a demand forecast is being attempted.

3) Correlation and Regression: These involve the use of econometric methods to determine the
nature and degree of association between/among a set of variables. Econometrics, you may
recall, is the use of economic theory, statistical analysis and mathematical functions to determine
the relationship between a dependent variable (say, sales) and one or more independent variables
(like price, income, advertisement etc.). The relationship may be expressed in the form of a
demand function, as we have seen earlier.

Such relationships, based on past data can be used for forecasting. The analysis can be carried
with varying degrees of complexity. Here we shall not get into the methods of finding out
correlation coefficient or regression equation; you must have covered those statistical
techniques as a part of quantitative methods. Similarly, we shall not go into the question of
economic theory. We shall concentrate simply on the use of these econometric techniques in
forecasting.
we are on the realm of multiple regression and multiple correlation. The form of the equation
may be:

DX = a + b1 A + b2PX + b3Py

You know that the regression coefficients b1, b2, b3 and b4 are the components of relevant
elasticity of demand. For example, b1 is a component of price elasticity of demand. The reflect
the direction as well as proportion of change in demand for x as a result of a change in any of its
explanatory variables. For example, b2< 0 suggest that DX and PX are inversely related; b4 > 0
suggest that x and y are substitutes; b 3 > 0 suggest that x is a normal commodity with commodity
with positive income-effect.

Given the estimated value of and b i, you may forecast the expected sales (D X), if you know the
future values of explanatory variables like own price (P X), related price (Py), income (B) and
advertisement (A). Lastly, you may also recall that the statistics R2 (Co-efficient of
determination) gives the measure of goodness of fit. The closer it is to unity, the better is the fit,
and that way you get a more reliable forecast.

The principle advantage of this method is that it is prescriptive as well descriptive. That is,
besides generating demand forecast, it explains why the demand is what it is. In other words, this
technique has got both explanatory and predictive value. The regression method is neither
mechanistic like the trend method nor subjective like the opinion poll method. In this method of
forecasting, you may use not only time-series data but also cross section data. The only
precaution you need to take is that data analysis should be based on the logic of economic theory.

COST AND OUTPUT RELATIONSHIP

Introduction:

Cost and revenue are the two major factors that a profit maximizing firm needs to monitor
continuously. It is the level of cost relative to revenue that determines the firms overall
profitability. In order to maximize profits, a firm tries to increase its revenue and lower its cost.
While the market factors determine the level of revenue to a great extent, the cost can be brought
down either by producing the optimum level of output using the least cost combination of inputs,
or increasing factor productivities, or by improving the organizational efficiency. The firms
output level is determined by its cost.
Various Types of Costs:

There are different types of costs that a firm may consider relevant for decision-making under
varying situations.

Direct and Indirect Costs

There are some costs which can be directly attributed to production of a given product.

The use of raw material, labour input, and machine time involved in the production of each unit
can usually be determined. On the other hand, there are certain costs like stationery and other
office and administrative expenses, electricity charges, depreciation of plant and buildings, and
other such expenses that cannot easily and accurately be separated and attributed to individual
units of production, except on arbitrary basis. When referring to the separable costs of first
category accountants call them the direct, or prime costs per unit. The joint costs of the second
category are referred to as indirect or overhead costs by the accountants. Direct and indirect costs
are not exactly synonymous to what economists refer to as variable costs and fixed costs.

Relevant Costs and Irrelevant Costs

The relevant costs for decision-making purposes are those costs which are incurred as a result of
the decision under consideration and which are relevant for the business purpose. The relevant
costs are also referred to as the incremental costs.

There are three main categories of relevant or incremental costs. These are the present-period
explicit costs, the opportunity costs implicitly involved in the decision, and the future cost
implications that flow from the decision. For example, direct labour and material costs, and
changes in the variable overhead costs are the natural consequences of a decision to increase the
output level.

Out Of Pocket Costs

Out of pocket costs are those costs are expenses which are current payments to the outsiders of
the firm. All the explicit costs fall into the category of out of pocket costs.
Examples: Rent Payed, wages, salaries, interest etc

Accounting Costs
Accounting costs are the actual or outlay costs that point out the amount of expenditure that has
already been incurred on a particular process or on production as such accounting costs facilitate
for managing the taxation need and profitability of the firm.
Examples: All Sunk costs are accounting costs

Economic Costs
Economic costs are related to future. They play a vital role in business decisions as the costs
considered in decision - making are usually future costs. They have the nature similar to that of
incremental, imputed explicit and opportunity costs.

Opportunity Cost
Opportunity cost is concerned with the cost of forgone opportunities/alternatives. In other
words, it is the return from the second best use of the firms resources which the firms forgoes in
order to avail of the return from the best use of the resources. It can also be said as the
comparison between the policy that was chosen and the policy that was rejected. The concept of
opportunity cost focuses on the net revenue that could be generated in the next best use of a scare
input. Opportunity cost is also called as "Alternative Cost".

If a firm owns a land, there is no cost of using the land (ie., the rent) in the firms account. But
the firm has an opportunity cost of using the land, which is equal to the rent forgone by not
letting the land out on rent.

Separable and Common Costs

Costs can also be classified on the basis of their tractability. The costs that can be easily
attributed to a product, a division, or a process are called separable costs, and the rest are called
non-separable or common costs. The separable and common costs are also referred to as direct
and indirect costs. The distinction between direct and indirect costs is of particular significance
in a multi-product firm for setting up economic prices for different products.

Sunk Cost
Sunk costs are those do not alter by varying the nature or level of business activity. Sunk costs
are generally not taken into consideration in decision - making as they do not vary with the
changes in the future. Sunk costs are a part of the outlay/actual costs. Sunk costs are also called
as "Non-Avoidable costs" or "Inescapable costs".
Examples: All the past costs are considered as sunk costs. The best example is amortization of
past expenses, like depreciation.

Following are the cost concepts that are taken into consideration in the short run:
i. Total Fixed Costs (TFC):
Refer to the costs that remain fixed in the short period. These costs do not change with the
change in the level of output. For example, rents, interest, and salaries. In the words of Ferguson,
Total fixed cost is the sum of the short run explicit fixed costs and implicit costs incurred by
the entrepreneur. Fixed costs have implication even when the production of an organization is
zero. These costs are also called supplementary costs, indirect costs, overhead costs, historical
costs, and unavoidable costs.

TFC remains constant with respect to change in the level of output. Therefore, the slope of TFC
curve is a horizontal straight line.

Figure-3 depicts the TFC curve:

As shown in Figure-3, TFC curve is horizontal to x- axis. From Figure-3, it can be seen that TFC
remains the same at all the levels with respect to change in the level of output.

ii. Total Variable Costs (TVC):

Refer to costs that change with the change in the level of production. For example, costs incurred
on purchasing raw material, hiring labor, and using electricity. According to Ferguson, total
variable cost is the sum of amounts spent for each of the variable inputs used If the output is
zero, then the variable cost is also zero. These costs are also called prime costs, direct costs, and
avoidable costs.

Figure-4 shows the TVC curve:

In Figure-4, it can be seen that TVC curve changes with the change in the level of output.

iii. Total Cost (TC):

Involves the sum of TFC and TVC.

It can be calculated as follows:

Total Cost = TFC + TVC

TC also changes with the changes in the level of output as there is a change in TVC.

Figure-5 shows the total cost curve derived from sum of TVC and TFC:

It should be noted that both TVC and TC increase initially at decreasing rate and then they
increase at increasing rate Here, decreasing rate implies that the rate at which cost increases with
respect to output is less, whereas increasing rate implies the rate at which cost increases with
respect to output is more.

iv. Average Fixed Costs (AFC):

Refers to the per unit fixed costs of production. In other words, AFC implies fixed cost of
production divided by the quantity of output produced.
It is calculated as:
AFC = TFC/Output

TFC is constant as production increases, thus AFC falls.

Figure-6 shows the AFC curve:

In Figure-6 AFC curve is shown as a declining curve, which never touches the horizontal axis.
This is because fixed cost can never be zero. The curve is also called rectangular hyperbola,
which represents that total fixed costs remain same at all the levels.

v. Average Variable Costs (AVC):

Refer to the per unit variable cost of production. It implies organizations variable costs divided
by the quantity of output produced.

It is calculated as:
AVC = TVC/ Output

Initially, AVC decreases as output increases. After a certain point of time, AVC increases with
respect to increase in output.

Thus, it is a U- shaped curve, as shown in Figure-7:

vi. Average Cost (AC):

Refer to the total costs of production per unit of output.

AC is calculated as:
AC = TC/ Output

AC is also equal to the sum total of AFC and AVC. AC curve is also U-shaped curve as average
cost initially decreases when output increases and then increases when output increases.

Figure-8 shows the AC curve:

vii. Marginal Cost:

Refer to the addition to the total cost for producing an additional unit of the product.

Marginal cost is calculated as:

MC = TCn = TCn-1
n= Number of units produced

It is also calculated as:

MC = TC/Output

MC curve is also a U-shaped curve as marginal cost initially decreases as output increases and
afterwards, rises as output increases. This is because TC increases at decreasing rate and then
increases at increasing rate.

Figure- 9 shows the MC curve:

Short Run Cost-curve

Marginal cost is the change in total cost that arises when the quantity produced changes by one
unit. In general terms, marginal cost at each level of production includes any additional costs
required to produce the next unit. So, the marginal costs involved in making one more wooden
table are the additional materials and labour cost incurred.

average cost

The average cost is the total cost divided by the number of goods produced. It is also
equal to the sum of average variable costs and average fixed costs. Average cost can be
influenced by the time period for production (increasing production may be expensive or
impossible in the short run).
Long-Run Cost Functions

Long-run total cost curves are derived from the long-run production functions in which all inputs
are variable. In the long run none of the factors are variable and all can be varied to increase the
level of output.

The long run average cost of production is the least possible average cost of production of
producing any given level of output when all inputs are variable, including of course the size of
the plant. In the long run there is only the variable cost as total cost. Thus we study the shape and
relationship of long run average cost curve and long run marginal cost curve.

Long run is a planning horizon. Its only a perspective view for the future course of action. Long
run comprises all possible short run situations from which a choice is made for the actual course
of operation.
Diseconomies:

1.Internal Economies: It is a condition which brings about a decrease in LRAC of the firm
because of changes happening within the firm.

e.g.As a company's scope increases, it may have to distribute its goods and services in
progressively more dispersed areas. This can actually increase average costs resulting in
diseconomies of scale.

2.External Economies:

It is a condition which brings about a decrease in LRAC of the firm because of changes
happening outside the firm.

E.g. Taxation policies of Gov

Features of Long Run Average Cost (LAC) Curve:

Tangent curve: By joining the loci of various plant curves relating to different operational
short run phases, the LAC curve is drawn as a tangent curve.
 Envelope curve: It is also referred to as the envelope curve because it is the envelope of a
group of short run curves.

Planning curve: It denotes the least unit cost of producing each possible level of output
and the size of the plant in relation to LAC curve.

Minimum cost combination: It is derived as a tangent to various SACs curve under

consideration, so the cost level presented by LAC curve for different level of output reflect
minimum cost combination at each long run level of output.

Flatter U-shaped: It is less shaped or rather dish shaped. It gradually slopes downward
and then after reaching a certain level, gradually begins to slope upwards.

Standard Costs and Variance Analysis

STANDARD COSTS

A standard cost is a carefully predetermined cost. Narrowly defined, it is the estimated cost to
manufacture a single unit of a product or to perform a single service. More broadly defined, it is
the estimated cost of a product, job, project, or operation, including manufacturing, selling, and
administrative costs.

A budgeted cost is a standard cost multiplied by a volume figure. In other words, a standard cost
is a unit cost while a budgeted cost is a total amount, although the terms are often used
interchangeably.

VARIANCE ANALYSIS

Variance analysis is the process of measuring and evaluating actual performance against
standards or budgeted performance targets. Static-budget variances, or master-
budget variances, are the differences between actual amounts and static- budget
amounts. Static-budget variances are of limited use since they compare a cost or revenue result
against a budget that typically reflects a budgeted volume level that usually differs from actual.

Difference between Estimated Costs and Standard Costs

Although, Pre-determination is the essence of both Standard Costing and Estimated Costing, the two
differ from each other in the following respects:
Standard Costing Estimated Costing
 (1) It is used on the basis of (1) It is used on the basis of statistical
scientific. facts and figures.
(2) It emphasises "what the cost (2) It emphasises "what the cost will
should be." be."
(3) It is used to evaluate actual (3) It is used to cost ascertainment for
performance and it fixing sales price.
serves as an effective tool of cost. (4) It is applicable to concern engaged
(4) It is applied to any industry in construction
engaged in mass work.
production. (5) It is not a part of accounting system
(5) It is a part of accounting system because it is
and standard based on statistical facts and figures.
costing variances are recorded in the
books of
accounts.

Direct Material Variances

Direct Material Variances are also termed as Material Cost Variances. The Material Cost
Variance is the difference between the Standard cost of materials for the Actual Output and the
Actual Cost of materials used for producing actual output. The Material Cost Variance is
calculated as:
Material Cost Variance = Standard Cost - Actual Cost
MCV = SC-AC
(or)
MCV = { Standard x Standard} { Actual x Actual }
Quantity Price Quantity Price
= (SQ x SP) - (AQ x AP)
Note: If the actual costs is more than standard cost the variance will be unfavourable or adverse
variance and. on the other hand. if the actual cost is less than standard cost the variance will be
favourabie variance. The material
cost variance is further classified into:
(I) Material Price Variance
(2) Material Usage Variance
(3) Material Mix Variance
(4) Material Yield Variance

(1) Material Price Variance (MPV) : Material Price Variance is that portion of the Material
Cost Variance which is due to the difference between the Standard Price specified and the Actual
Price paid for purchase of materials. Material Price Variance may be calculated by
Material Price Variance = Actual x { Standard Actual}
Quantity Price Price

MPV = AQ (SP - AP)

Note : If actual cost of materials used is more than the standard cost the variance is adverse. it
represents
negative (-) symbol. And on the other hand. if the variance is favourable it is to be represented by
positive (+) symbol.

(2) Material Usage Variance (MUV): Material Usage Variance is that part of Material Cost
Variance which refers to the difference between the standard cost of standard quantity of material
for actual output and the Standard cost of the actual material used. Material Usage Variance is
calculated as follows:
 Material Usage Variance = Standard x { Standard Actual}
Price Quantity Quantity

MUV = SP (SQ - AQ)

Note: This Variance will be favourable when standard cost of actual material is more than the
Standard material cost for actual output, and Vice Versa.

(3) Material Mix Variance (MMV) : It is the portion of the material usage variance which is
due to the difference between the Standard and the actual composition of mix. Material Mix
Variance is calculated under two situations as follows :
(a) When actual weight of mix is equal to standard weight to mix
(b) When actual weight of mix is different from the standard mix .
(a) When Actual Weight and Standard Weight of Mix are equa

(i) The formula is used to calculate the Variance:

Material Mix Variance = Standard Price (Revised Standard Quantity - Actual Quantity)

RSQ= (AM/SM) * SQ

*NOTE:

Material Yield Variance = (Std Input Qty - Actual Input Qty) * Std Price of Std Input

Reasons of Material Variance

Change in Basic price.
Fail to purchase anticipated standard quantities at appropriate price.
Use of sub-standard material.
Ineffective use of materials.
Pilferage.

LABOUR VARIANCES

A labor variance arises when the actual expense associated with a labor activity varies (either
better or worse) from the expected amount. The expected amount is typically a budgeted or
standard amount. The labor variance concept is most commonly used in the production area,
where it is called a direct labor variance.

This variance can be subdivided into two additional variances, which are:

Labor efficiency variance. Measures the difference between actual and expected hours
worked, multiplied by the standard hourly rate.
Labor rate variance. Measures the difference between the actual and expected cost per
hour, multiplied by the actual hours incurred.
Labour Variance

Labour Cost Variance = (Standard Hrs X Standard Rate Per Hour)

(Actual Hrs X Actual Rate
Per Hour)
Labour Rate Variance = Actual Hrs (Standard Rate - Actual Rate)
Labour efficiency Variance = Standard Rate (Std Hrs - Actual Hrs worked)
Idle Time Variance = Idle Hours X Std Rate

Reasons of Labour Variance

Time Related Issues.
Change in design and quality standard.
Low Motivation.
Poor working conditions.
Improper scheduling/placement of labour.
Inadequate Training.

Rate Related Issues.

Increments / high labour wages.
Overtime.
Labour shortage leading to higher rates.
Union agreement.

OVERHEAD VARIANCE

The variable overhead efficiency variance is the difference between the actual and budgeted
hours worked, which are then applied to the standard variable overhead rate per hour.
The formula is: Standard overhead rate x (Actual hours - standard hours)

Variable Overheads (OH) Variance

Variable OH Cost Variance = (Standard Hrs X Standard Variable OH Rate) Actual OH Cost

Variable OH Efficiency Variance = (Standard Hrs - Actual Hrs) X Standard Variable OH Rate
Fixed Overheads (OH) Variance
Fixed OH Cost Variance = Absorbed OH Actual OH
Absorbed OH = Actual Units * Standard OH Rate per unit
Fixed OH Variance
Fixed OH Expenditure Variance = Budgeted OH Actual OH
Fixed OH Volume Variance = Absorbed OH Budgeted OH

Reasons of Overheads Variance

Under or over absorption of fixed overheads.

Fall in demand/ Improper planning.
Breakdowns /Power Failure.
Labour issues.
Inflation.
Lack of planning.
Lack of cost control.
 CVP ANALYSIS

Cost-volume-profit (CVP) analysis looks at how profit changes when there are changes in
variable costs, sales price, fixed costs and quantity.

It is a good example of what if ? Analysis and it in particular looks at sales minus variable costs
which is known as contribution. It allows management to understand the level of sales needed to
cover all costs of a project and what level of sales is needed start making profits.

To break even would mean an organization would be earning no profit and no loss.

Sales revenue = All variable and fixed cost

Main assumptions in this model are that selling price, fixed costs and variable costs are constant.

5.2 Formulae to learn

Contribution per unit = sales price per unit less variable cost per unit
Break-even volume = Fixed overhead
Contribution per unit
The number of units you would need to sell in order to earn enough contribution to cover
the fixed overhead e.g. the number of units sold where the contribution would equal the
fixed overhead.

The contribution to sales ratio (C/S ratio)

The contribution to sales (or C/S) ratio (also called the profit-volume or P/V ratio) would
calculate how much contribution a product would earn for every 1 of sales generated,
expressed as a decimal or percentage. For example a 0.4 or 40% C/S ratio, would mean 40
pence of contribution is earned for every 1 of sales generated.
C/S ratio = Contribution per unit
Sales price per unit
C/S ratio = Total contribution
Total sales revenue
Break Even Analysis

Break even analysis helps to identify the level of output and sales volume at which the firm
breaks even. It means the revenues are sufficient to cover all costs of production. Various
managerial decisions of firms are taken by the managers based on the break- even point.
It is a study of cost, revenues and sales of a firm and finding out the volume of sales where the
firms costs and revenues will be equal. There is no profit and no loss. The total revenue is equal
to the total cost of production. The amount of money which the firm receives by the sale of its
output in the market is known as revenue.
Graph Break Even Point
The above graph shows the break- even point of an organization. The total revenue curve (TR)
and total cost curve (TC) is given. When they produce 50 units the total cost and total revenue
are equal that is $ 150000 which is at the intersecting point of the curves. Breakeven point
always denotes the quantity produced or sold to equalize the revenue and cost.
When the firm produces less than 50 units the revenue earned is less than the cost of production
(TR<TC) therefore in the initial period the firm incurs loss which is shown in the graph. Through
selling more than 50 units the revenue increases more than the cost of production therefore the
difference increases and provides profit to the organization (TR>TC).
It can be calculated with the help of the following formula

TFC
Break even quantity = ------------------------
Selling Price - AVC
TFC + targeted profit
To decide a quantity to achieve a targeted profit = -------------------------
Selling price AVC
Sales - BEP
Safety margin = ---------------------- X 100
Sales

Managerial Uses Of Break-Even Analysis:

1. Product planning: it helps the firm in planning its new product development. Decisions
regarding removal or addition of new products in their product line.

2. Activity planning: the firm decides the expansion of production capacity.

3. Profit planning: this helps the firm to plan about their profit well in advance and at the same
time it helps to identify the quantity to be sold to achieve the targeted profit.

4. Target capacity: the targeted sales quantity helps to decide the purchase, inventory and
management.

5. Price and cost decision: Decision regarding how much the price of the commodity should be
reduced or increased to cover their cost of production.

6. Safety margin: it helps to understand the extent to which the firm can withstand their fall in
sales.

7. Price decision: the selling price can be fixed based on its expected revenue or profit.

8. Promotional decision: the firm can decide the kind of promotion required and how much
amount could be spent

9. Distribution decision: Break even analysis helps to improve the distribution system and for
business expansion.

10. Dividend decision: firm can decide the dividend to be fixed for their shareholders.

11. Make or buy decision: break even analysis helps to decide on whether to make or buy the
product. It means outsourcing or in house production.