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ENGINEERING ECONOMICS AND FINANCIAL ACCOUNTING

SUBMITTED BY S.PRIYADARSHINI IV YEAR CSE-A

UNIT II 1. EXPLAIN DEMAND FORECASTING AND ITS TYPES INTRODUCTION: Demand for a particular product varies from time to time. Demand forecasting also forms the basis or lays the foundation in the entire planning activities. Demand forecasting for products and the service determines what products are needed where, when and in what quantities. DEMAND: Demand in economics means effective demand, which is one which meets with all its three characteristics; desire to have a good, willingness to pay for that good & ability to pay for that good. DETERMINANTS OF DEMAND 1. Non-durable consumer goods: a. Purchasing power disposable personal income b. Price. c. Demography 2. Durable consumer goods: a. Choice between using the goods longer by repairing it, b. Disposing it off and replacing it with a new one. c. Require special facilities for their use, example: roads for automobiles. d. Household demand vis--vis individual demand. e. Family characteristics. f. Total demand consists of a. New-owner demand and, b. Replacement demand g. Price and credit conditions. 3. Capital goods: It is used for further production. Demand will depend upon the specific markets they serve and the end uses for which they are bought. Data required for estimating the demand for capital goods: a. The growth prospects of the user industries. b. The norm of consumption of capital goods per unit of installed capacity. c. The velocity of their use. DEMAND FORECASTING: An activity of determining quantity of goods to be purchased in future Demand forecasting means estimation of the demand for the good in the forecast period. It is a process of estimating a future event by casting forward past data. The past data are systematically combined in a predetermined way to obtain the estimate of future demand. IMPORTANCE OF DEMAND FORECASTING Demand forecasts are necessary since the basic operations process, moving from the suppliers' raw materials to finished goods in the customers' hands, takes time. Most firms cannot simply wait for demand to emerge and then react to it. Instead, they must anticipate and plan for future demand so that they can react immediately to customer orders as they occur.

FACTOR INVOLVED IN DEMAND FORECASTING: How far ahead the long-term forecast goes. Should the forecast be general or specific? Problems & methods of forecasting are usually different for new products from those for products already well established in the market. It is important to classify the products as producer goods, consumer durable, or consumer goods & services. Finally, in every forecast, special factors peculiar to the product & the market must be taken into account. Undertaken at three levels: Macro-level Industry level Firm level PURPOSES OF FORECASTING Purposes of short-term forecasting a. Appropriate production scheduling. b. Reducing costs of purchasing raw materials. c. Determining appropriate price policy d. Setting sales targets and establishing controls and incentives. e. Evolving a suitable advertising and promotional campaign. f. Forecasting short term financial requirements. Purposes of long-term forecasting a. Planning of a new unit or expansion of an existing unit. b. Planning long term financial requirements. c. Planning man-power requirements.

APPROACH TO FORECASTING 1. Identify and clearly state the objectives of forecasting.

2. Select appropriate method of forecasting. 3. Identify the variables. 4. Gather relevant data. 5. Determine the most probable relationship. 6. For forecasting the companys share in the demand, two different assumptions may be made: (a) Ratio of company sales to the total industry sales will continue as in the past. (b) On the basis of an analysis of likely competition and industry trends, the company may assume a market share different from that of the past. (alternative / rolling forecasts) 7. Forecasts may be made either in terms of units or sales in rupees. 8. May be made in terms of product groups and then broken for individual products. 9. May be made on annual basis and then divided month-wise, etc. LENGTH OF FORECASTS Short-term forecasts; short-term forecasts, involving a period up to twelve months. Medium-term forecasts; medium-term forecasts, involving a period from one to two years. Long-term forecasts; long-term forecasts, involving a period of three to ten years. METHODS OF DEMAND FORECASTING Forecast methods are classified as follows: a. Qualitative Forecasting Methods: Delphi Approach: The Delphi method employs a panel of experts in arriving at the forecast & proceeds through a series of rounds. It is iterative method wherein each expert is asked to make individual predictions based on available data. Market Research: Market research involves estimation of the market size based on testing new products or ideas with few selected potential customers. Life Cycle Analogy: Products go through a life cycle of introduction, growth, maturity & decline. Based on the experiences of similar products in the past , one can make decision. Informed Judgment: This forecast is made by an individual or a group based on experience & understanding of the situation. b. Quantitative Forecasting Methods: Within quantitative models two types are commonly used in forecasting applications: Time series method of forecasting uses historical data to make forecasts. It is assumed that the future is going to be very similar to the past. Causal forecasting model shows the cause for demand and its relation to other variables. Usually regression is used for modeling the cause-and-effect behavior. CONCLUSION: Future demand has a component that is systematic in nature, which forecasting attempts to predict. Even with the best forecasting methodology, one will still not be able to predict some part of demand, which is known as random demand since it is unpredictable in nature.

2. EXPLAIN IN DETAIL ABOUT SUPPLY INTRODUCTION: Supply and demand trends form the basis of the modern economy. Each specific good or service will have its own supply and demand patterns based on price, utility and personal preference. If people demand a good and are willing to pay more for it, producers will add to the supply. As the supply increases, the price will fall given the same level of demand. Ideally, markets will reach a point of equilibrium where the supply equals the demand (no excess supply and no shortages) for a given price point; at this point, consumer utility and producer profits are maximized. SUPPLY: A fundamental economic concept that describes the total amount of a specific good or service that is available to consumers. Supply can relate to the amount available at a specific price or the amount available across a range of prices if displayed on a graph. This relates closely to the demand for a good or service at a specific price; all else being equal, the supply provided by producers will rise if the price rises because all firms look to maximize profits. Individuals control the factors of production inputs, or resources, necessary to produce goods. Individuals supply factors of production to intermediaries or firms. FACTORS AFFECTING SUPPLY Innumerable factors and circumstances could affect a seller's willingness or ability to produce and sell a good. Some of the more common factors are: Goods own price: The basic supply relationship is between the price of a good and the quantity supplied. Price of related goods: For purposes of supply analysis related goods refer to goods from which inputs are derived to be used in the production of the primary good. Conditions of Production. The most significant factor here is the state of technology. If there is a technological advancement in one's good's production, the supply increases. Other variables may also affect production conditions. For instance, for agricultural goods, weather is crucial for it may affect the production outputs. Expectations: Sellers expectations concerning future market condition can directly affect supply. If the seller believes that the demand for his product will sharply increase in the foreseeable future the firm owner may immediately increase production in anticipation of future price increases. The supply curve would shift out. Price of inputs: Inputs include land, labor, energy and raw materials. If the price of inputs increases the supply curve will shift in as sellers are less willing or able to sell goods at existing prices.

Number of suppliers - the market supply curve is the horizontal summation of the individual supply curves. As more firms enter the industry the market supply curve will shift out driving down prices. Government policies and regulations: Government intervention can have a significant effect on supply. Government intervention can take many forms including environmental and health regulations, hour and wage laws, taxes, electrical and natural gas rates and zoning and land use regulations. THE LAW OF SUPPLY There is direct relationship between the price of a commodity and its quantity offered fore sale over a specified period of time. This relationship between price and the quantities which suppliers are prepared to offer for sale is called the law of supply. ASSUMPTIONS OF LAW OF SUPPLY: (i) Nature of Goods. If the goods are perishable in nature and the seller cannot wait for the rise in price. Seller may have to offer all of his goods at current market price because he may not take risk of getting his commodity perished. (ii) Government Policies. Government may enforce the firms and producers to offer production at prevailing market price. In such a situation producer may not be able to wait for the rise in price. (iii) Alternative Products. If a number of alternative products are available in the market and customers tend to buy those products to fulfill their needs, the producer will have to shift to transform his resources to the production of those products. (iv) Squeeze in Profit. Production costs like raw materials, labor costs, overhead costs and selling and administration may increase along with the increase in price. Such situations may not allow producer to offer his products at a particular increased price. IMPORTANCE OF LAW OF SUPPLY: (i) Supply responds to changes in prices differently for different goods, depending on their elasticity or inelasticity. Goods are elastic when a modest change in price leads to a large change in the quantity supplied. In contrast, goods are inelastic when a change in price leads to relatively no response to the quantity supplied. An example of an elastic good would be soft drinks, whereas an example of an inelastic service would be physicians' services. Producers will be more likely to want to supply more inelastic goods such as gas because they will most likely profit more off of them. (ii) Law of supply is an economic principle that states that there is a direct relationship between the price of a good and how much producers are willing to supply. (iii) As the price of a good increase, suppliers will want to supply more of it. However, as the price of good decreases, suppliers will not want to supply as much of it. For producers to want to produce a good, the incentive of profit must be greater than the opportunity cost of production, the total cost of producing the good, which includes the resources and value of the other goods that could have been produced instead. (iv) Entrepreneurs enter business ventures with the intention of making a profit. A profit occurs when the revenues from the goods a producer

supplies exceeds the opportunity cost of their production. However, consumers must value the goods at the price offered in order for them to buy them. Therefore, in order for a consumer to be willing to pay a price for a good higher than its cost of production, he or she must value that good more than the other goods that could have been produced instead. So supplier's profits are dependent on consumer demands and values DETERMINANTS OF SUPPLY: (v) Technology changes. Technology helps a producer to minimize his cost of production (vi) Resource supplies. The producer also has to pay for other resources such as raw materials and labor. if his money is short on supplying a certain number of products because of an increase in resource supplies, then he has to reduce his supply. (vii) Tax/ Subsidy. A producer aims to maximize his profit, but an increase in tax will only increase his expenses, decreasing his capacity to buy resource supplies and forcing him to reduce his supply. (viii) Price of other goods produced. A producer may not only produce on product but other products as well. A producer's money is limited and if he increases his supply in one product, he would have to decrease his supply in the other product, no unless his sales increase. LIMITATIONS/EXCEPTIONS OF LAW OF SUPPLY: Exceptions that affect law of supply may include: (i) Ability to move stock. (ii) Legislation restricting quantity. (iii) External factors that influence your industry. THE SUPPLY CURVE A supply graph shows the hypothetical supply of a product or service that would be available at different price points. The supply curve usually slopes upward, since higher prices give producers an incentive to supply more in the hope of making greater revenue. In the short run the price-supply tradeoff is greater than in the long run. In the short run, an increase in price will usually cause an increase in supply, but the leading producers can only manage a limited increase. However, in the longer term, new producers enter the market attracted by higher prices, and the supply at each price increases more significantly.

UNIT-II 1. EXPLAIN THE PRODUCTION FUNCTION AND ITS MANAGERIAL USES INTRODUCTION A business firm is an economic unit. It is also called as a production unit. Production is one of the most important activities of a firm in the circle of economic activity. The main objective of production is to satisfy the demand for different kinds of goods and services of the community. MEANING OF PRODUCTION AND PRODUCTION FUNCTION The concept of production can be represented in the following manner.

The term Production means transformation of physical Inputs into physical Outputs. The term Inputs refers to all those things or items which are required by the firm to produce a particular product. Four factors of production are land, labor, capital and organization. In addition to four factors of production, inputs also include other items like raw materials of all kinds, power, fuel, water, technology, time and services like transport and communications, warehousing, marketing, banking, shipping and Insurance etc. It also includes the ability, talents, capacities, knowledge, experience, wisdom of human beings. Thus, the term inputs have a wider meaning in economics. FACTOR INPUTS ARE OF TWO TYPES.

1. Fixed Inputs. Fixed inputs are those factors the quantity of which remains constant irrespective of the level of output produced by a firm. For example, land, buildings, machines, tools, equipments, superior types of labor, top management etc. 2. Variable inputs. Variable inputs are those factors the quantity of which varies with variations in the levels of output produced by a firm For example, raw materials, power, fuel, water, transport and communication etc. TYPES OF PRODUCTION FUNCTION: 1. Short Run Production Function In this case, the producer will keep all fixed factors as constant and change only a few variable factor inputs. In the short run, we come across two kinds of production functions. a. Quantities of all inputs both fixed and variable will be kept constant and only one variable input will be varied. For example, Law of Variable Proportions. b. Quantities of all factor inputs are kept constant and only two variable factor inputs are varied. For example, IsoQuants and IsoCost curves. 2. Long Run Production Function In this case, the producer will vary the quantities of all factor inputs, both fixed as well as variable in the same proportion. For Example, The laws of returns to scale. Each firm has its own production function which is determined by the state of technology, managerial ability, organizational skills etc of a firm. If there are any improvements in them, the old production function is disturbed and a new one takes its place. It may be in the following manner: 2. The quantity of inputs may be reduced while the quantity of output may remain same. 3. The quantity of output may increase while the quantity of inputs may remain same. 4. The quantity of output may increase and quantity of inputs may decrease. USES OF PRODUCTION FUNCTION Though production function may appear as highly abstract and unrealistic, in reality, it is both logical and useful. It is of immense utility to the managers and executives in the decision making process at the firm level. There are several possible combinations of inputs and decision makers have to choose the most appropriate among them. The following are some of the important uses of production function. 1. It can be used to calculate or work out the least cost input combination for a given output or the maximum output input combination for a given cost. 2. It is useful in working out an optimum, and economic combination of inputs for getting a certain level of output. The utility of employing a unit of variable factor input in the production process can be better judged with the help of production function. Additional employment of a variable factor input is desirable only when the marginal revenue productivity of

that variable factor input is greater than or equal to cost of employing it in an organization. 3. Production function also helps in making long run decisions. If returns to scale are increasing, it is wise to employ more factor units and increase production. If returns to scale are diminishing, it is unwise to employ more factor inputs & increase production. Managers will be indifferent whether to increase or decrease production, if production is subject to constant returns to scale. Thus, production function helps both in the short run and long run decision making process. ASSUMPTIONS OF THE LAW Only one variable factor unit is to be varied while all other factors should be kept constant. Different units of a variable factor are homogeneous. Techniques of production remain constant. The law will hold good only for a short and a given period. There are possibilities for varying the proportion of factor inputs. MANAGERIAL USES OF PRODUCTION FUNCTION: (i) There are several managerial uses of the production function. It can be used to compute the least-cost combination of inputs for a given output or to choose the input combination that yields the maximum level of output with a given level of cost. (ii) There are several feasible combinations of input factors and it is highly useful for decision-makers to find out the most appropriate among them. (iii) The production function is useful in deciding on the additional value of employing a variable input in the production process. So long as the marginal revenue productivity of a variable factor exceeds it price, it may be worthwhile to increase its use. (iv) The additional use of an input factor should be stopped when its marginal revenue productivity just equals its price. (v) Production functions also aid long-run decision-making. If returns to scale are increasing, it will be worthwhile to increase production through a proportionate increase in all factors of production, provided, there is enough demand for the product. On the other hand, if returns to scale are decreasing, it may not be worthwhile to increase the production through a proportionate increase in all factors of production, even if there is enough demand for the product. (vi) However, it may in the discretion of the producer to increase or decrease production in the presence of constant returns to scale, if there is enough demand for the product. 2. EXPLAIN COST FUNCTION, ITS TYPES AND ESTIMATION OF COST COST FUNCTION: Cost function expresses the relationship between cost and its determinants such as the size of plant, level of output, input prices, technology, managerial efficiency, etc. In a mathematical form, it can be expressed as, C = f (S, O, P, T, E..)

Where, C = cost (it can be unit cost or total cost) S = plant size O = output level P = prices of inputs used in production T = nature of technology E = managerial efficiency DETERMINANTS OF COST FUNCTION The cost of production depends on many factors and these factors vary from one firm to another firm in the same industry or from one industry to another industry. The main determinants of a cost function are: a) Plant size: Plant size is an important variable in determining cost. The scale of operations or plant size and the unit cost are inversely related in the sense that as the former increases, unit cost decreases, and vice versa. Such a relationship gives downward slope of cost function depending upon the different sizes of plants taken into account. Such a cost function gives primarily engineering estimates of cost. b) Output level: Output level and total cost are positively related, as the total cost increases with increase in output and total cost decreases with decrease in output. This is because increased production requires increased use of raw materials, labor, etc., and if the increase is substantial, even fixed inputs like plant and equipment, and managerial staff may have to be increased. c) Price of inputs: Changes in input prices also influence cost, depending on the relative usage of the inputs and relative changes in their prices. This is because more money will have to be paid to those inputs whose prices have increased and there will be no simultaneous reduction in the costs from any other source. Therefore, the cost of production varies directly with the prices of production. d) Technology: Technology is a significant factor in determining cost. By definition, improvement in technology increases production leading to increase in productivity and decrease in production cost. Therefore, cost varies inversely with technological progress. Technology is often quantified as capital-output ratio. Improved technology is generally found to have higher capital-output ratio. e) Managerial efficiency: This is another factor influencing the cost of production. More the managerial efficiency less the cost of production. It is difficult to measure managerial efficiency quantitatively. However, a change in cost at two points of time may explain how organizational or managerial changes within the firm have brought about cost efficiency, provided it is possible to exclude the effect of other factors. TYPES OF COST: 1. Actual (or, Acquisition or, Outlay) Costs and Opportunity (or, Alternative) Costs. Actual costs are the costs which the firm incurs while producing or acquiring a good or a service like the cost on raw material, labor, rent, interest, etc. 2. Sunk Costs and Outlay Costs. As discussed above, outlay costs mean the actual expenditure incurred for producing or acquiring a good or service. These actual expenditures are recorded in the books of account of the business unit, e.g., wage bill. These costs are also known as actual costs or absolute costs. Sunk costs are the costs that are not altered by a change in quantity and cannot be recovered; e.g., depreciation. Sunk costs are a part of the outlay costs. However, most

business decisions require cost estimates that are essentially incremental and not sunk in nature. 3. Explicit (or, Paid-out) Costs and Implicit (or, Imputed) Costs: Explicit costs are those expenses which are actually paid by the firm (paid-out costs). These costs appear in the accounting records of the firm. On the other hand, implicit or imputed costs are theoretical costs in the sense that they go unrecognized by the accounting system. 4. Opportunity Costs and Imputed Costs: Opportunity cost is concerned with the cost of forgone opportunities. In other words, it is the comparison between the policy that was chosen and the policy that was rejected. The concept of opportunity cost focuses attention on the net revenue that could be generated in the next best use of a scarce input. Imputed costs, on the other, are a sub-division of opportunity costs. These never show up in the accounting records but are definitely important for certain types of decisions. 5. Incremental (or, Avoidable or, Escapable or, Differential) Costs and Sunk (or, Non-avoidable or, Non-escapable) Costs: The incremental costs are the additions to costs resulting from a change in the nature and level of business activity, e.g., change in product line or output level, adding or replacing a machine, changing distribution channels, etc. Since these costs can be avoided by not bringing about any change in the activity, the incremental costs are also called avoidable costs or escapable costs. Moreover, since incremental costs may also be regarded as the difference in total costs resulting from a contemplated change, they are also called differential costs. 6. Book Costs and Out-of-pocket Costs. Out-of-pocket costs are those expenses which are current cash payments to outsiders. All the explicit costs like payment of rent, wages, salaries, interest, transport charges, etc., fall in the category of out-of-pocket costs. 7. Accounting Costs and Economic Costs: Accounting costs are the actual or outlay costs. These costs point out how much expenditure has already been incurred on a particular process or on production as such 8. Private Costs and Social Costs: Economic costs can be calculated at two levels: micro-level and macro-level. The micro-level economic costs relate to functioning of a firm' as a production unit, while the macro-level economic costs are the ones that are generated by the decisions of the firm but are paid by the society and not the firm. Far example, if the decision of a firm to expand its output leads to increase in its costs, this cost will be of the former type, known as private costs. . Social costs, on the other hand, are the total costs to the society or account of production of a good. Thus, the economic costs include both the private and social costs. However, the net social cost is the total social cost minus the private cost. 9. Direct (or, Traceable or, Assignable) Costs and Indirect (or Non-traceable or, Non-assignable or, Common) Costs. The direct or traceable or assignable costs are the ones that have direct relationship with a unit of operation like a product, a process or a department of the firm. In other words, the costs which are directly and definitely identifiable are the direct costs. On the other hand, the indirect or no traceable or common or non-assignable costs are those whose

course cannot be easily and definitely traced to a plant, a product, a process or a department 10. Controllable Costs vs. Non-controllable Costs: Controllable costs are those which are capable of being controlled or regulated by executive vigilance and, therefore, can be used for assessing executive efficiency. Noncontrollable costs are those which cannot be subjected to administrative control and supervision. Most of the costs are controllable, except, of course, those due to obsolescence and depreciation. 11. Replacement Costs and Original (or, Historical) Costs: The basis of distinction between historical and replacement costs is the way in which the assets are carried on in the balance sheet and the manner in which the amount of cost is determined. Historical cost of an asset states the cost of plant, equipment and materials at the price paid originally for them, while the replacement cost states the cost that the from would have to incur if it wants to replace or acquire the same assets now. 12. Shutdown Costs and Abandonment Costs. Shutdown costs are those which the firm incurs if it temporary stops it operations. These costs could be saved if the operations are allowed to continue. Shutdown costs include, besides the fixed costs, the cost of sheltering plant and equipment, lay-off expenses, employment and training of workers when the plant is restarted, and above all loss of the market. Abandonment costs are the costs of retiring altogether a fixed asset from use. For example, the plant installed during war time may be so improvised that it may not be required during peace time. Abandonment costs; thus, involve the problem of the disposal of assets. 13. Urgent Costs and Postponable Costs: Urgent costs are those that must be incurred so that the operations of the firm continue, like the costs on material, labour, fuel, etc. Those costs whose postponement does not affect (at least for some time) the operational efficiency of the firm, are: known as postponable costs, e.g., the maintenance of building, machinery, etc. This distinction of cost becomes quite obvious during the period of war or inflation when firms want to produce the maximum and postpone the maintenance of their plants, buildings, etc. 14. Business Costs and Full Costs: Business costs are relevant for the firm's profit and loss accounts and for legal and tax purposes. These costs include all the payments and contractual obligations made by the firm together with the boak.cost of depreciation an plant and equipment: On the other hand, the full costs a~e the sum of opportunity cost and normal profit. Opportunity cost is the expected earnings from the next best use of the firm's resources like capital, land, buildings and entrepreneur's effort and time. In order that the firm continues to produce, it must earn a necessary minimum return, called the normal profit. 15.Total cost, Average cost and Marginal cost: Total cost represents the money value of the total resources for production of goods and services by the firm. Average cost is the cost per unit of output, assuming that production of each unit of output incurs the same cost.That is, Average cost = Total cost Number of units

Marginal costs are the increnental or additional costs incurred when there is additional to the existing out puts of goods and services. 16. Fixed Costs and Variable Costs: Economists often divide costs into the two main groups: fixed cost and variable costs. Fixed (or, constant) costs are that part of the total cost of the firm which does not vary with output, e.g. expenditures on depreciation, rent of land and buildings, property taxes, etc. Variable costs, on the other-hand, are directly dependent on the volume of output or service. Variable costs (for example, expenditure on labour, raw material, etc.) increase but not necessarily in the same proportion as the increase in output. 17. Short-run Costs and Long-run Costs: The short-run is defined as a period in which the supply of at least one of the inputs cannot be changed by the firm. To illustrate, certain inputs like machinery, buildings, etc., cannot be changed by the firm whenever it so desires. It takes time to replace, add or dismantle them. Long-run, on the other hand, is defined as a period in which all inputs can be varied as desired: In other words, it is that time-span in which all adjustments and changes are possible to realise. 18. Incremental Cost and Marginal Cost: Marginal cost deals with unit-by-unit changes in output, whereas incremental cost is not restricted to a unit change. Marginal cost is the amount added to total cost by a unit increase in output. Incremental cost is ,related to change in any number of units of output or even change in its quality. ESTIMATION OF COST: Decision making requires forward planning. Thus, a firm, be it a new one or an existing one, would like to know the cost function facing it. Of course, the exact function may not be available until the firm really goes for expansion of its output there are methods through which the firm could get approximate information of its future cost output relationship. As is usual with regard to methods, there are alternative methods available for this purpose. The three well-known are the following: 1. Engineering method 2. Survivorship method 3. Statistical method