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 can’t 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 charge 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, Pn…Pn-1 , Y, T, P, A, E)
Where:
 Pn = Price
 Pn…Pn-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.( Eg. Gold)
 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

= (Q2-Q1) / Q1
(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
= - 0. 25

This implies that a 1% reduction in price will increase

demand by 2.5%

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 Types of elasticity of demand
 Perfectly elastic demand (At a given price or less than the given price, infinite qty will
be bought)
 Perfectly inelastic demand ( Same qty will be bought at any price)
 Demand with unity elasticity (Equally proportionate demand for proportionate change)
 Relatively elastic demand ( More than proportionate demand due to price change)
 Relatively inelastic demand (less than proportionate demand due to price change)

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 EOD
 Type of goods- elastic for luxuries and inelastic
for necessities
 Existence of substitutes: Inelastic if substitutes
exist
 No. of uses of goods: Elastic if commodity has
variety of uses
 Time element: Elastic if use can be postponed
 Price of the good:
 Taste and tradition
 Customer’s income: Inelastic if expenditure is
only a small part of income

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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
 The Delphi method is not very reliable.
 Results of Delphi questionnaires are often later
found to have predicted the real course of
events remarkably badly.
 Wrong guesses are often made by renowned
specialists and sometimes even by a majority of
them, and the odd person who is later found to
have predicted right would perhaps never have
been elected to the Delphi group of experts

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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
 It’s 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 despatch to the customer

 Typical mfg 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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