UNIT_III

DEMAND ANALYSIS AND FORECASTING

Demand is crucial for the survival of any business enterprise. A firms own profit and/or sales, depend mainly
upon the demand for its product. A managements decisions on production, advertising, cost allocation, pricing,
inventory holdings, etc. all requires an analysis of demand. Demand analysis attempts to identify and measure
the factors that determine sales, on the basis of which alternative methods of manipulating or managing demand
can be worked out. Demand forecasting attempts to estimate the expected future demand for a product, which
helps to plan production better. In this context, it is important to understand the types and determinants of
demand and their relative importance.
Demand is broadly classified as: (a) Demand for consumers goods and producers goods,
(b) Demand for perishable and durable goods,
(c) Derived and autonomous demands,
(d) Firm and industry demands, and
(e) Demand by total market and by market segments.
a) Consumers goods and producers goods - Consumers goods are directly used for final consumption.
Meanwhile, producers goods are used for further production of other goods, which may either be in the form of
consumers or producers goods. The former includes clothes, houses, food, etc., while the latter includes
machines, tools, raw materials, etc. Consumers goods are also known as direct demand. Whereas producers
goods is known as derived demand.
b) Perishable and durable goods demand - Consumers and producers goods are further classified as
perishable and non-durable goods. Those goods which can be consumed only once are known as perishable
goods, whereas the durable goods can be used more than once during a period of time. For example, vegetables,
fruits and milk are perishable consumer goods, while oil, raw materials and coal are non-durable producer
goods. On the other hand, car, refrigerator and furniture are durable consumers goods, while industrial
buildings, machine and tools are durable producers goods.
c) Derived and autonomous demand When the demand for a good is associated with another parent good, it
is called derived demand. For example, the demand for steel is not for its own sake, but for satisfying the
demand for construction. In this sense, the demand for all producers goods is derived. On the other hand,
autonomous demand is wholly independent of all other demands. It is difficult to name a product which is fully
autonomous
d) Firm and industry demands Firm demand represents the demand for products of a single company, while
industry demand refers to the demand of an industry.
e) Demands by total market and by market segments The total market demand for a product refers to the
total demand, while the demand arising from different segments of the market is market segment demand.
Segments include different regions, product use, distribution channels, customer sizes, and sub-products. Each
of them differ significantly with respect to delivered prices, net profit margins, competition, seasonal patterns
and cyclical sensitivity. Wide differences in them call for a demand analysis restricted to an individual market
segment, which in turn would help a firm to manipulate the total demand. Hence, a A company/ industry would
be interested in the both these demands. Risk and uncertainty are involved in every decision-making process.
The producer, manager or any decision-making authority should be aware of the existing level of demand for
the products being produced, and estimate the gap between demand and supply. In a growth-oriented decisionmaking process, the manager decision-maker is expected to know the changes that are expected to take place in
the future demand. Such knowledge would help to determine the targets to be achieved to match the future
demand with the available supply. Thus, the manager decision-maker, whether a firm or a state planning

agency, must not only estimate the present level of demand, but should also forecast the future demand (Barla
2000).
The extent of objectivity and precision with which demand for a product is estimated and projected for the
future would determine the ability of a decision-making agent in dealing with further uncertainties. For
example, if there is a possibility of rise in the prices of petroleum products, the automobile producers may plan
to switch over to the production of smaller cars. Such switch-over decisions need to be made on the basis of
accuracy of demand forecasts. Thus, major decisions in business enterprises depend upon forecasts of one kind
or the other.
Stages in forecasting demand
Based on the scope of demand forecasting for a commodity, the following sequence is generally adopted in
projecting demand: (1) Specification of objective(s): Specification of the purpose of demand forecasts is the foremost task in
forecasting demand.
(2) Selection of appropriate technique: Next, selection of appropriate technique for the purpose is important.
If it is proposed to use regression method, the model has to be specified properly by identifying the necessary
variables and the nature of relationship between X and Yj.
(3) Collection of appropriate data: Collection of quality and adequate data for the demand forecasting would
determine the quality and reliability of results. Hence, the data collected should also be representative.
(4) Estimation and interpretation of results: The results obtained through the analysis of collected data, either
manually or with the help of computers, should be interpreted carefully in correspondence with the objectives
examined.
(5) Evaluation of the forecasts: A model used for demand forecasting with objectivity, would yield good
results. The results, however, need to be verified by persons possessing professional acumen and expertise.
Data and techniques of demand forecasting
A good set of data is required for the estimation of present level of demand and forecasting the future demand.
A private sector forecasts demand on the basis of past experience and the data collected from various sources.
Similarly, a public sector uses data collected by different government and research agencies for the purpose.
The following are some of the techniques adopted for estimating the existing and future demands.
Demand Forecasting is the method of predicting the future demand for the firms product. It is guess or anticipation or
prediction of what is likely to happen in the future. Forecast can be done for several things. It is based on the
experience.

Techniques or methods of Demand Forecasting: Method of Demand Forecasting is based on whether the good is
Established Good or new good.

Methods of Demand Forecasting for established goods:

Information of the established good is available so the forecast can be based on this information. Two basic methods
of demand forecasting for the established goods are:

Interview and Survey Approach (for short period forecast): Interview and Survey Approach collects
information in the different way. Depending upon how the information is collected, we have different sub
methods as follows:

Opinion-Polling Method: This method tries to collect information from the customer directly or
indirectly through market research department of the firm or through the whole sellers or the
retailers. Consumers are contacted through mails or phones or Internet and information regarding
their expected expenditure is collected. This method is useful when consumers are small in number.

Limitations:

It is difficult and costly to contact all the customers

It is suitable only for short period
Consumers are not sure of their purchase plans

Collective Opinion Method: Large firms have organized sales department. The salesman has the
technical training as how to collect the information from the buyers. This information is further used
for forecasting the demand.

Limitations:

It is difficult and costly to contact all the customers

It is suitable only for short period
This is based on judgment & has no scientific basis.

Sample Survey Method: The total number of consumers for the firms product is very large called as
population. It is practically not possible to contact all the consumers. Only few of them are contacted
and this forms the sample. The sample forecasts are then generalized for the whole population
through advanced statistical methods available.

Limitations:

Information collected may not be accurate.

Sample is not a random sample.
Consumers do not have the correct idea of their purchases in future.

Panel of experts: Panel of experts consists of persons either from within the firm or from outside the
firm. These experts come together and forecast the demand for their product that is purely based on
the judgment of these experts so they are less accurate. But if based on the scientific method the
forecast would be accurate.

Composite management opinion: The opinions of the experienced person within the firm are collected
and manger analyses this information. This method is quick, easy and saves time, but is not based on
the scientific analysis and thus may not give very accurate results.

Projection Approach(for long period forecast): In this method past experience is projected into the future.
This can be done with the help of statistical methods.

Correlation and Regression Analysis: Past data regarding the factors affecting the demand can be
collected. It is possible to express this on the graph. This is a scatter diagram.

Example: If we collect the past data about the sales and advertising expenditure of the firm,
it is possible to express in the form of scatter diagram as shown below:

A
* *
** * *
*
*
* *
* **
A
Sales

X
O

Advertisement Expenditure

In the above diagram we get the functional relationship as line AA. Here Advertisement Expenditure is
the independent variable and Sales is the dependent variable. The relationship between these
variables is correlation and the technique of establishing this relationship is regression. In simple
correlation we establish relationship between 2 variables and more than 2 variables in multiple
correlation.

Limitations:

Assumption made is that correlation between two variables will continue in

also, this might not happen.

future

Time Series Analysis: Demand forecasts for a period of 2-3 years are based on time series analysis. It
is similar to the correlation analysis. It is based on the assumption that the relationship between the
dependent and the independent variable continues to hold in the future.

Methods of Demand Forecasting for new products:

Indirect methods of forecasting are used to estimate demand for new products. Following are the methods suggested:

Evolutionary Method: Some new goods evolve from already established goods. Demand forecast for such new
good is based on already established good from which they are evolved. For example Demand for the color TV
can be calculated from Demand for the black and white TV, from which it is actually evolved.

Limitations:

The product should have been evolved from the existing product.
It ignores the problem of how the new product differs from the old product.

Substitution Method: Some new goods are substituted of already established goods. For example VCR
substituted with VCD player.

Limitations:

New product may have many uses and each use has different substitutability
When the substitute is added is added into market existing firm may react by changing the
prices.

Opinion Polling Method: Expected buyers and the consumers are directly contacted and opinion about the
product is directly taken from them. If the population is large then sample is selected and results are
generalized for the population.

Limitations:

It is difficult and costly to contact all the customers

It is suitable only for short period
Consumers are not sure of their purchase plans

Sample Survey Method: New product are first introduced in the sample market and the results seen in the
sample market are generalized for the total market.

Limitations:

Information collected may not be accurate

Tastes and the preferences may differ from market to market

Indirect Opinion Polling Method: Opinion of the consumers is indirectly collected through the dealers who are
aware of the needs of the customers.

Limitations:

It is based on the judgment

Limited Scope

How is demand forecast determined?

There are two approaches to determine demand forecast (1) the qualitative approach, (2) the quantitative
approach. The comparison of these two approaches is shown below:
Quantitative Approach

Description

Qualitative Approach

Applicability

Used when situation is vague & little Used when situation is stable &
data exist (e.g., new products and historical data exist
technologies)
(e.g. existing products, current
technology)

Considerations

Involves intuition and experience

Involves mathematical techniques

Techniques

Jury of executive opinion

Time series models

Sales force composite

Causal models

Delphi method
Consumer market survey
Qualitative Forecasting Methods
Your company may wish to try any of the qualitative forecasting methods below if you do not have historical
data on your products' sales.
Qualitative Method
Jury
of
opinion

Description

executive The opinions of a small group of high-level managers are

pooled and together they estimate demand. The group uses
their managerial experience, and in some cases, combines
the results of statistical models.

Sales force composite

Each salesperson (for example for a territorial coverage) is

asked to project their sales. Since the salesperson is the one
closest to the marketplace, he has the capacity to know what
the customer wants. These projections are then combined at
the municipal, provincial and regional levels.

A panel of experts is identified where an expert could be a

decision maker, an ordinary employee, or an industry expert.
Each of them will be asked individually for their estimate of
the demand. An iterative process is conducted until the
experts have reached a consensus.

Delphi method

Consumer
survey

market The customers are asked about their purchasing plans and
their projected buying behavior. A large number of
respondents is needed here to be able to generalize certain
results.

QUANTITATIVE FORECASTING METHODS

There are two forecasting models here (1) the time series model and (2) the causal model. A time series is a s
et of evenly spaced numerical data and is o btained by observing responses at regular time periods. In the time
series model , the forecast is based only on past values and assumes that factors that influence the past, the
present and the future sales of your products will continue.
On the other hand, t he causal model uses a mathematical technique known as the regression analysis that
relates a dependent variable (for example, demand) to an independent variable (for example, price,
advertisement, etc.) in the form of a linear equation. The time series forecasting methods are described below:

Description

Time
Series
Forecasting
Method
Nave Approach Assumes that demand in the next period is the same as demand in most
recent period; demand pattern may not always be that stable
For example:
If July sales were 50, then Augusts sales will also be 50

Description

Time
Series
Forecasting
Method
Moving
(MA)

Averages MA is a series of arithmetic means and is used if little or no trend is

present in the data; provides an overall impression of data over time
A simple moving average uses average demand for a fixed sequence of
periods and is good for stable demand with no pronounced behavioral

patterns.
Equation:
F 4 = [D 1 + D2 + D3] / 4

F forecast, D Demand, No. Period

(see illustrative example simple moving average)
A weighted moving average adjusts the moving average method to reflect
fluctuations more closely by assigning weights to the most recent data,
meaning, that the older data is usually less important. The weights are
based on intuition and lie between 0 and 1 for a total of 1.0
Equation:
WMA 4 = (W) (D3) + (W) (D2) + (W) (D1)
WMA Weighted moving average, W Weight, D Demand, No.
Period
(see illustrative example weighted moving average)
Exponential
Smoothing

The exponential smoothing is an averaging method that reacts more

strongly to recent changes in demand by assigning a smoothing constant to
the most recent data more strongly; useful if recent changes in data are the
results of actual change (e.g., seasonal pattern) instead of just random
fluctuations
F t + 1 = a D t + (1 - a ) F t

Where
F t + 1 = the forecast for the next period
D t = actual demand in the present period
F t = the previously determined forecast for the present period
= a weighting factor referred to as the smoothing constant
(see illustrative example exponential smoothing)
Time
Series The time series decomposition adjusts the seasonality by multiplying the
normal forecast by a seasonal factor
Decomposition
(see illustrative example time series decomposition)
SIGNIFICANCE OF DEMAND FORECASTING

Estimating and forecasting demand are crucial to the following types of decision-makers for knowing the
present level of demand and the expected increase in demand over time.
(i) Producers: A producer allocates various factors of production for maximization of profit, for which
knowledge of both the present and future demand are important. Future demand estimates helps the producer to
plan the extent of expansion in scale of operations, so as to deal with the increased demand and earn higher
profits.
(ii) Policy makers and planners: It helps government to formulate economic policies through the planning
boards or planning commissions to allocate resources for economic development through production in the
public, private and export sectors to achieve the targets set for a given time period. It also ensures adequate
supply of inputs for achieving the objectives of industrial policy, import-export policies, credit policy, public
distribution system, and other related policies, which involves forecasting of future demand.
(iii) Other groups of the society: Demand forecasts are also useful to researchers, social workers and others
with futuristic approach, to understand the levels of future demand or supply, the gaps, and their expected
impact on prices or the economy.
PRODUCTION FUNCTION
A production function expresses the technological or engineering relationship between the output of a
commodity and its factor inputs. Traditionally, economic theory considers four factors of production, namely,
land, labour, capital and organisation or management. Now, technology is also considered as an important
determinant, as it contributes to output growth.
Therefore, output is a positive function of the quantities of land, labour, capital, the quality of management, and
the level of technology employed in its production (Mote, et. al, 1997). This relationship may be expressed as
follows:X = f (A, L , K, M, T)
Where, f1,f2, f3, f4, f5 > 0
X = output of commodity X,
A = land employed in the production of X,
L = labour employed,
K = capital employed,
M = management employed,
T = technology used,
f = unspecified function, and
f1 = partial derivative of f with respect to the ith independent variable.
This function describes a general production function. For the production of different commodities, one or all
the factor inputs may not be equally important for all commodities. The importance of a factor of production
varies from product to product. For instance, while land is the most important factor in the case of an
agricultural product, its importance is relatively lower in the case of a manufacturing product. Meanwhile, the
significance of management and technology may be greater in the case of an industrial product, rather than for
an agricultural product. Therefore, researchers modify the production function according to the product and the
specific objectives analysed.
Generally for the analysis of production decision problems, labour and capital are the only two factor inputs
considered for convenience. Then, the production function reduces to:X = f (L.K)
For a given level of output of commodity X, various combinations of L and K may be used, which is known as
production process or technology. Further, these combinations would also vary with variations in the level of X.

Usually for production, both labour and capital are necessary and they substitute each other. When an
entrepreneur employs more of labour than capital, then the production process is known as labour intensive
production technique. Whereas, if more of capital is used in relation to labour, the production technique
becomes capital intensive.
LAW OF VARIABLE PROPORTIONS

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.
The producer has to pay for factors of production for their services. The expenses incurred on these factors of production
are known as the cost of production, or in short cost.
Product prices are determined by the interaction of the forces of demand and supply. The basic factor underlying the
ability and willingness of firms to supply a product in the market is the cost of production. Thus, cost of production
provides the floor to pricing. It is the cost that forms the basis for many managerial decisions like which price to quote,
whether to accept a particular order or not, whether to abandon or add a product to the existing product line, whether or
not to increase the volume of output, whether to use idle capacity or rent out the facilities, whether to make or buy a
product, etc. However, it is essential to underline here that all costs are not relevant for every decision under
consideration.
The purpose of this unit is to explore cost and its relevance to decision-making. We begin by developing the important
cost concepts, an understanding of which can aid managers in making correct decisions.

COST CONCEPTS
Classification of Cost
Cost may be classified into different categories depending upon the purpose of classification. Some of the
important categories in which the costs are classified are as follows:
1. Fixed, Variable and Semi-Variable Costs
The cost which varies directly in proportion with every increase or decrease in the volume of output or
production is known as variable cost. Some of its examples are as follows:

Wages of laborers
Cost of direct material
Power

The cost which does not vary but remains constant within a given period of time and a range of activity inspite
of the fluctuations in production is known as fixed cost. Some of its examples are as follows:

Rent or rates
Insurance charges
Management salary

The cost which does not vary proportionately but simultaneously does not remain stationary at all times is
known as semi-variable cost. It can also be named as semi-fixed cost. Some of its examples are as follows:

Depreciation
Repairs

Fixed costs are sometimes referred to as period costs and variable costs as direct costs in system of direct
costing. Fixed costs can be further classified into:

Committed fixed costs

Discretionary fixed costs

Committed fixed costs consist largely of those fixed costs that arise from the possession of plant, equipment and
a basic organization structure. For example, once a building is erected and a plant is installed, nothing much can
be done to reduce the costs such as depreciation, property taxes, insurance and salaries of the key personnel etc.
without impairing an organizations competence to meet the long-term goals.
Discretionary fixed costs are those which are set at fixed amount for specific time periods by the management in
budgeting process. These costs directly reflect the top management policies and have no particular relationship
with volume of output. These costs can, therefore, be reduced or entirely eliminated as demanded by the
circumstances. Examples of such costs are research and development costs, advertising and sales promotion
costs, donations, management consulting fees etc. These costs are also termed as managed or programmed
costs.
In some circumstances, variable costs are classified into the following:

Discretionary cost
Engineered cost

The term discretionary cost is generally linked with the class of fixed cost. However, in the circumstances
where management has predetermined that the organization would spend a certain percentage of its sales for the
items like research, donations, sales promotion etc., discretionary costs will be of a variable character.
Engineered variable costs are those variable costs which are directly related to the production or sales level.
These costs exist in those circumstances where specific relationship exists between input and output. For
example, in an automobile industry there may be exact specifications as one radiator, two fan belts, one battery
etc. would be required for one car. In a case where more than one car is to be produced, various inputs will have
to be increased in the direct proportion of the output.
Thus, an increase in discretionary variable costs is due to the authorization of management whereas an increase
in engineered variable costs is due to the volume of output or sales.
2. Product Costs and Period Costs

The costs which are a part of the cost of a product rather than an expense of the period in which they are
incurred are called as product costs. They are included in inventory values. In financial statements, such costs
are treated as assets until the goods they are assigned to are sold. They become an expense at that time. These
costs may be fixed as well as variable, e.g., cost of raw materials and direct wages, depreciation on plant and
equipment etc.
The costs which are not associated with production are called period costs. They are treated as an expense of the
period in which they are incurred. They may also be fixed as well as variable. Such costs include general
administration costs, salaries salesmen and commission, depreciation on office facilities etc. They are charged
against the revenue of the relevant period. Differences between opinions exist regarding whether certain costs
should be considered as product or period costs. Some accountants feel that fixed manufacturing costs are more
closely related to the passage of time than to the manufacturing of a product. Thus, according to them variable
manufacturing costs are product costs whereas fixed manufacturing and other costs are period costs. However,
their view does not seem to have been yet widely accepted.
3. Direct and Indirect Costs
The expenses incurred on material and labor which are economically and easily traceable for a product, service
or job are considered as direct costs. In the process of manufacturing of production of articles, materials are
purchased, laborers are employed and the wages are paid to them. Certain other expenses are also incurred
directly. All of these take an active and direct part in the manufacture of a particular commodity and hence are
called direct costs.
The expenses incurred on those items which are not directly chargeable to production are known as indirect
costs. For example, salaries of timekeepers, storekeepers and foremen. Also certain expenses incurred for
running the administration are the indirect costs. All of these cannot be conveniently allocated to production and
hence are called indirect costs.
4. Decision-Making Costs and Accounting Costs
Decision-making costs are special purpose costs that are applicable only in the situation in which they are
compiled. They have no universal application. They need not tie into routine-financial accounts. They do not
and should not conform the accounting rules. Accounting costs are compiled primarily from financial
statements. They have to be altered before they can be used for decision-making. Moreover, they are historical
costs
and show what has happened under an existing set of circumstances. Decision-making costs are future costs.
They represent what is expected to happen under an assumed set of conditions. For example, accounting costs
may show the cost of a product when the operations are manual whereas decision-making cost might be
calculated to show the costs when the operations are mechanized.
5. Relevant and Irrelevant Costs
Relevant costs are those which change by managerial decision. Irrelevant costs are those which do not get
affected by the decision. For example, if a manufacturer is planning to close down an unprofitable retail sales
shop, this will affect the wages payable to the workers of a shop. This is relevant in this connection since they
will disappear on closing down of a shop. But prepaid rent of a shop or unrecovered costs of any equipment
which will have to be scrapped are irrelevant costs which should be ignored.
6. Shutdown and Sunk Costs

A manufacturer or an organization may have to suspend its operations for a period on account of some
temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc. During this period,
though no work is done yet certain fixed costs, such as rent and insurance of buildings, depreciation,
maintenance etc., for the entire plant will have to be incurred. Such costs of the idle plant are known as
shutdown costs.
Sunk costs are historical or past costs. These are the costs which have been created by a decision that was made
in the past and cannot be changed by any decision that will be made in the future. Investments in plant and
machinery, buildings etc. are prime examples of such costs. Since sunk costs cannot be altered by decisions
made at the later stage, they are irrelevant for decision-making.
An individual may regret for purchasing or constructing an asset but this action could not be avoided by taking
any subsequent action. Of course, an asset can be sold and the cost of the asset will be matched against the
proceeds from sale of the asset for the purpose of determining gain or loss. The person may decide to continue
to own the asset. In this case, the cost of asset will be matched against the revenue realized over its effective
life. However, he/she cannot avoid the cost which has already been incurred by him/her for the acquisition of
the asset. It is, as a matter of fact, sunk cost for all present and future decisions.
Example
Jolly Ltd. purchased a machine for $. 30,000. The machine has an operating life of five yea$ without any scrap
value. Soon after making the purchase, management feels that the machine should not have been purchased
since it is not yielding the operating advantage originally contemplated. It is expected to result in savings in
operating costs of $. 18,000 over a period of five years. The machine can be sold immediately for $. 22,000.
To take the decision whether the machine should be sold or be used, the relevant amounts to be compared are $.
18,000 in cost savings over five yea$ and $. 22,000 that can be realized in case it is immediately disposed. $.
30,000 invested in the asset is not relevant since it is same in both the cases. The amount is the sunk cost. Jolly
Ltd., therefore, sold
the machinery for $. 22,000 since it would result in an extra profit of $. 4,000 as compared to keeping and using
it.
7. Controllable and Uncontrollable Costs
Controllable costs are those costs which can be influenced by the ratio or a specified member of the
undertaking. The costs that cannot be influenced like this are termed as uncontrollable costs.
A factory is usually divided into a number of responsibility centers, each of which is in charge of a specific
level of management. The officer incharge of a particular department can control costs only of those matte$
which come directly under his control, not of other matte$. For example, the expenditure incurred by tool room
is controlled by the foreman incharge of that section but the share of the tool room expenditure which is
apportioned to a machine shop cannot be controlled by the foreman of that shop. Thus, the difference between
controllable and uncontrollable costs is only in relation to a particular individual or level of management. The
expenditure which is controllable by an individual may be uncontrollable by another individual.
8. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs
Avoidable costs are those which will be eliminated if a segment of a business (e.g., a product or department)
with which they are directly related is discontinued. Unavoidable costs are those which will not be eliminated
with the segment. Such costs are merely reallocated if the segment is discontinued. For example, in case a
product is discontinued, the salary of a factory manager or factory rent cannot be eliminated. It will simply

mean that certain other products will have to absorb a large amount of such overheads. However, the salary of
people attached to a product or the bad debts traceable to a product would be eliminated. Certain costs are partly
avoidable and partly unavoidable. For example, closing of one department of a store might result in decrease in
delivery expenses but not in their altogether elimination.
It is to be noted that only avoidable costs are relevant for deciding whether to continue or eliminate a segment
of a business.
9. Imputed or Hypothetical Costs
These are the costs which do not involve cash outlay. They are not included in cost accounts but are important
for taking into consideration while making management decisions. For example, interest on capital is ignored in
cost accounts though it is considered in financial accounts. In case two projects require unequal outlays of cash,
the management should take into consideration the capital to judge the relative profitability of the projects.
10. Differentials, Incremental or Decrement Cost
The difference in total cost between two alternatives is termed as differential cost. In case the choice of an
alternative results in an increase in total cost, such increased costs are known as incremental costs. While
assessing the profitability of a proposed change, the
incremental costs are matched with incremental revenue. This is explained with the following example:
Example
A company is manufacturing 1,000 units of a product. The present costs and sales data are as follows:
Selling price per unit
Variable cost per unit
Fixed costs

$. 10
$. 5
$. 4,000

The management is considering the following two alternatives:

i.
ii.

To accept an export order for another 200 units at $. 8 per unit. The expenditure of
the export order will increase the fixed costs by $. 500.
To reduce the production from present 1,000 units to 600 units and buy another 400
units from the market at $. 6 per unit. This will result in reducing the present fixed
costs from $. 4,000 to $. 3,000.

Which alternative the management should accept?

Solution
Statement showing profitability under different alternatives is as follows:
Particulars

Present situation
$.
$.

Sales.
Less:

5,000
4,000

10,000
9,000

Proposed situations
6,000 11,600 5,400 10,000
4,500 10,500 3,000 8,400

Variable purchase costs

Fixed costs Profit

1,000

1,100

1,600

Observations
i.
ii.

iii.

In the present situation, the company is making a profit of $. 1,000.

In the proposed situation (i), the company will make a profit of $. 1,100. The
incremental costs will be $. 1,500 (i.e. $. 10,500 - $. 9,000) and the incremental
revenue (sales) will be $. 1,600. Hence, there is a net gain of $. 100 under the
proposed situation as compared to the existing situation.
In the proposed situation (ii), the detrimental costs are $. 600 (i.e. $. 9,000 to $.
8,400) as there is no decrease in sales revenue as compared to the present situation.
Hence, there is a net gain of $. 600 as compared to the present situation.

Thus, under proposal (ii), the company makes the maximum profit and therefore it should adopt alternative (ii).
The technique of differential costing which is based on differential cost is useful in planning and decisionmaking and helps in selecting the best alternative.
In case the choice results in decrease in total costs, this decreased costs will be known as detrimental costs.
11. Out-of-Pocket Costs
Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that will vary
depending upon the nature of the decision made. For example, a company has its own trucks for transporting
raw materials and finished products from one place to another. It seeks to replace these trucks by keeping public
carriers. In making this decision, of course, the depreciation of the trucks is not to be considered but the
management should take into account the present expenditure on fuel, salary to drive$ and maintenance. Such
costs are termed as out-of-pocket costs.
12. Opportunity Cost
Opportunity cost refers to an advantage in measurable terms that have foregone on account of not using the
facilities in the manner originally planned. For example, if a building is proposed to be utilized for housing a
new project plant, the likely revenue which the building could fetch, if rented out, is the opportunity cost which
should be taken into account while evaluating the profitability of the project. Suppose, a manufacturer is
confronted with the problem of selecting anyone of the following alternatives:
a. Selling a semi-finished product at $. 2 per unit
b. Introducing it into a further process to make it more refined and valuable
Alternative (b) will prove to be remunerative only when after paying the cost of further processing, the amount
realized by the sale of the product is more than $. 2 per unit. Also, the revenue of $. 2 per unit is foregone in
case alternative (b) is adopted. The term opportunity cost refers to this alternative revenue foregone.
13. Traceable, Untraceable or Common Costs
The costs that can be easily identified with a department, process or product are termed as traceable costs. For
example, the cost of direct material, direct labor etc. The costs that cannot be identified so are termed as
untraceable or common costs. In other words, common costs are the costs incurred collectively for a number of
cost centers and are to be suitably apportioned for determining the cost of individual cost centers. For example,

overheads incurred for a factory as a whole, combined purchase cost for purchasing several materials in one
consignment etc.
Joint cost is a kind of common cost. When two or more products are produced out of one material or process,
the cost of such material or process is called joint cost. For example, when cottonseeds and cotton fibers are
produced from the same material, the cost incurred till the split-off or separation point will be joint costs.
14. Production, Administration and Selling and Distribution Costs
A business organization performs a number of functions, e.g., production, illustration, selling and distribution,
research and development. Costs are to be curtained for each of these functions. The Chartered Institute of
Management accountants, London, has defined each of the above costs as follows:
i.

Production Cost

The cost of sequence of operations which begins with supplying materials, labor and services and ends with the
primary packing of the product. Thus, it includes the cost of direct material, direct labor, direct expenses and
factory overheads.
ii. Administration Cost
The cost of formulating the policy, directing the organization and controlling the operations of an undertaking
which is not related directly to a production, selling, distribution, research or development activity or function.
iii.

Selling Cost

It is the cost of selling to create and stimulate demand (sometimes termed as marketing) and of securing orders.
iv.

Distribution Cost
It is the cost of sequence of operations beginning with making the packed product available for dispatch and
ending with making the reconditioned returned empty package, if any, available for reuse.

v.

Research Cost
It is the cost of searching for new or improved products, new application of materials, or new or improved
methods.

vi.

Development Cost
The cost of process which begins with the implementation of the decision to produce a new or improved
product or employ a new or improved method and ends with the commencement of formal production of that
product or by the method.

vii.

Pre-Production Cost
The part of development cost incurred in making a trial production as preliminary to formal production is called
pre-production cost.
15. Conversion Cost

The cost of transforming direct materials into finished products excluding direct material cost is known as
conversion cost. It is usually taken as an aggregate of total cost of direct labor, direct expenses and factory
overheads.
Total Cost

Total cost is the sum of fixed and variable cost at each level of output. It is shown in column 4 of Table-1. At zero unit of
output, total cost is equal to the firms fixed cost. Then for each unit of production (through 1 to 10), total cost varies at
the same rate as does variable cost.

Per Unit, or Average Costs

Besides their total costs, producers are equally concerned with their per unit, or average costs. In particular, average cost
data is more relevant for making comparisons with product price,
AVERAGE COST:
AC =TC/Q
Where TC =total cost ;
AC = average cost
Q = quantity
Average Fixed Costs
Average fixed cost (AFC) is derived by dividing total fixed cost (TFC) by the corresponding output (Q). That is
TFC
AFC =
-----Q
While total fixed cost is, by definition, independent of output, AFC will decline so long as output increases. As output
increases, a given total fixed cost of Rs. 100 is obviously being spread over a larger and larger output. This is what
business executives commonly refer to as spreading the overhead. We find in Figure-III that the AFC curve is
continuously declining as the output is increasing. The shape of this curve is of an asymptotic hyperbola.
Average Variable Costs

Average variable cost (AVC) is found by dividing total variable cost (TVC) by the corresponding output (Q):
AVC = TVC
-----Q
AVC declines initially, reaches a minimum, and then increases again,
AFC + AVC = ATC
ATC
--------- = MC
Q

Average Total Costs

Average total cost (ATC) can be found by dividing total cost (TC) by total output (Q) or, by adding AFC and AVC for
each level of output. That is:
TC
ATC = ----- = AFC + AVC
Q

These data are shown in column 7 of the above Table.

Marginal Cost
Marginal cost (MC) is defined as the extra, or additional, cost of producing one more unit of output. MC can be
determined for each additional unit of output simply by noting the change in total cost which that units production
entails:
Change in TC
TC
MC = ------------------ = --------Change in Q
Q
The marginal cost concept is very crucial from the managers point of view. Marginal cost is a strategic concept because it
designates those costs over which the firm has the most direct control. More specifically, MC indicates those costs which
are incurred in the production of the last unit of output and therefore, also the cost which can be saved by reducing total
output by the last unit. Average cost figures do not provide this information. A firms decisions as to what output level to
produce is largely influenced by its marginal cost. When coupled with marginal revenue, which indicates the change in
revenue from one more or one less unit of output, marginal cost allows a firm to determine whether it is profitable to
expand or contract its level of production.

Relationship of MC to AVC and ATC

It is also notable that marginal cost cuts both AVC and ATC at their minimum (Figure III). When both the marginal and
average variable costs are falling, average will fall at a slower rate. And when MC and AVC are both rising, MC will rise
at a faster rate. As a result, MC will attain its minimum before the AVC. In other words, when MC is less than AVC, the
AVC will fall, and when MC exceeds AVC, AVC will rise. This means (Figure III) that so long as MC lies below AVC,
the latter will fall and where MC is above AVC,AVC will rise. Therefore, at the point of intersection where
MC=AVC,AVC has just ceased to fall and attained its minimum, but has not yet begun to rise. Similarly, the marginal
cost curve cuts the average total cost curve at the latters minimum point. This is because MC can be defined as the
addition either to total cost or to total cost or to total variable cost resulting from one more unit of output. However, no
such relationship exists between MC and the average fixed cost, because the two are not related; marginal cost by
definition includes only those costs which change with output and fixed costs by definition are independent of output.
Managerial Uses of the Short-Run Cost Concepts
As already emphasized the relevant costs to be considered for decision-making will differ from one situation to the other
depending on the problem faced by the manager. In general, the total cost concept is quite useful in finding out the breakeven quantity of output. The total cost concept is also used to find out whether firm is making profits or not. The average
cost concept is important for calculating the per unit profit of a business firm. The marginal and incremental cost concepts
are essential to decide whether a firm should expand its production or not.
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. There is no dichotomy of total cost into fixed and variable costs. 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.
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.

THE LAW OF VARIABLE PROPORTIONS:

The law examines the relationship between one variable factor and output, keeping the quantities of other
factors fixed.
Definition
As the proportion of one factor in a combination of factors is increased, after a point, first the marginal and then
the average product of that factor will diminish.
Assumptions of the law
The law is based on the following assumptions
(i) Only one factor is made variable and other factors are kept constant.
(ii) This law does not apply in case all factors are proportionately varied. i.e. where the factors must be used in
rigidly fixed proportions to yield a product.
(iii) The variable factor units are homogenous i.e. all the units of variable factors are of equal efficiency.
(iv) Input prices remain unchanged
(v) The state of technology does not change or remains the same at a given point of time.
(vi) The entire operation is only for short-run, as in the long-run all inputs are variable.
PRODUCTION FUNCTION
The transformation of inputs into output is called production function. In economic theory we are commonly
interested in two types of production functions.
First: when the quantities of some inputs are kept constant and quantity of one input is varied. This kind of
production function is called law of variable proportions or return to a factor.
Secondly: We study input-output relation by varying all inputs in the same proportion. This forms the subject
matter of the law of returns to scale.
Total, Average and Marginal physical Products.
Regarding physical production of factors there are three concepts:
Total Physical Products (TPP):-TPP of a factor is the amount of total output produced by a given amount of
variable factor, keeping the quantity of other factors such as capital, land etc fixed.
Marginal physical product (MPP):- MPP of a variable factor is the addition to the total production by the
employment of an extra unit of a factor.
MPL = Q X L
Or
MPL = TP n TP n-1
Average physical product (ap):-

ap of a variable factor is the total product divided by the amount of labour employed with a given quantity of
capital ( faxed factor )
apl = q l
Law of variable proportion (returns to an input)
it refers to the input-output relation when the output is increased by varying the quantity of one input, keeping
the quantity of other factors constant. the proportion between the factors is altered. Therefore, this law is known
as law of variable proportion.
This law has been stated by the economists in the following manner Prof K.E.Boulding is of the view:- that if
we increase the quantity of any one input which is combined with a fixed quantity of other inputs, the MPP of
the variable input must eventually decline.
Assumption of the law: The law of variable proportion holds good under the following conditions:
1. First, the state of technology is assumed to be given and unchanged.
2. Second, there must be some inputs whose quantity is kept constant.
3. Third, the law is based upon the possibility of varying the proportions in which the various factors can be
combined.
Three phases of the law of variable proportions.
The behaviour of output can be divided into three phases as explained .

Phase 1: Phase of increasing returns: Phase one ends where the AP reaches its highest point. Thus during
stage 1, whereas MP curve rises in a part and then falls and the AP curve reaches its highest.
Phase 1 is known as the state of increasing returns because AP of the variable factor increases throughout
during this stage.
Phase 2 : Phase of diminishing returns:
In Phase 2, the total product continues to increase at a diminishing rate until it reaches to its maximum point H
where the second stage ends. At the end of the second stage, that is, at point M marginal product of variable

factor is zero. This phase is known as the stage of diminishing returns as both the average and marginal
products of the variable factor continuously fall during this stage
Phase 3 : Phase of negative returns :
In this stage TP declines and therefore the TP curve steps downward. As a result, MP is negative and MP curve
goes beyond the X-axis.

Tabular presentation of the three stages of the law

Units
Of Total
Labour
Product
( Quintals )
1
8
2
17
3
29
4
39
5
45
6
45
7
43
8
38

Marginal Product
( Quintals )

Average Product
(Quintals )

8
9
12
10
6
0
-2
-5

8
8.50
9.67
9.75
9.00
7.50
6.14
4.75

PHASE 1

PHASE 2
PHASE 3

Causes of increasing return to a factor:

1. Indivisibility of the factors: Generally those factors are taken as fixed which are indivisible. Therefore, when
more and more units of the variable factor are added to the constant amount of fixed factor, then fixed factor is
more intensively and effectively utilized. This causes the production to increase at a rapid rate.
2. Division of labour:
The second reason is that as more units of the variable factor are employed the efficiency of the variable factor
itself increases.
Causes of diminishing returns:
1.
2.
3.
4.
5.

Scarcity of fixed factor

Indivisibility of the fixed factor:
3. Imperfect substitutability of the factor:
Causes of negative returns:
As the amount of the variable factor continues to be increased to the constant quantity of the fixed factor
the variable factor becomes too excessive relative to the fixed factor, so that they get in each others way
with the result that the TP falls instead of rising.

COST CURVE
In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a
free market economy, productively efficient firms use these curves to find the optimal point of production,
where they make the most profits. There are a few different types of cost curves, each relevant to a different
area of economics.

The Short Run average total cost curve (SATC or SAC)

The average total cost curve is constructed to capture the relation between cost per unit and the level of output,
ceteris paribus. A productively efficient firm organizes its factors of production in such a way that the average
cost of production is at lowest point and intersects Marginal Cost.
In the short run, when at least one factor of production is fixed, this occurs at the optimum capacity where it has
enjoyed all the possible benefits of specialisation and no further opportunities for decreasing costs exist. This is
usually not U shaped, it is a checkmark shaped curve. This is at the minimum point in the diagram on the
right.Example: Q=2K.5L.5 STC=Pk(K)+Pw(Q2/4K) SATC or SAC= (Pk(K)/Q)+Pw(Q/4K)

The long-run average cost curve (LRAC)

The long-run average cost curve depicts the per unit cost of producing a good or service in the long run when
all inputs are variable. The curve is created as an envelope of an infinite number of short-run average total cost
curves. The LRAC curve is U-shaped, reflecting economies of scale when negatively-sloped and diseconomies
of scale when positively sloped. Contrary to Viner, the envelope is not created by the minimum point of each
short-run average cost curve. This mistake is recognized as Viner's Error.
In the long run, when all factors of production can be changed, the scale of the enterprise can be increased. In
this case productive efficiency occurs at the optimum scale of output where all the possible economies of scale
have been enjoyed and the firm is not large enough to experience diseconomies of scale. This at output level Q2
in the diagram.
In perfect competition, the LRAC curve is flat, at the point of equilibrium- there are constant returns to scale.
Typical LRACs are U-shaped, which means that up to a certain optimum point, there are economies of scale,
and as production increases beyond this, there are diseconomies of scale. LRAC are generally flatter than short
run average cost curve.
In some industries, the LRAC is L-shaped, and economies of scale increase indefinitely. This means that the
largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is
called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to
variable costs, such as water supply and electricity supply.
The marginal cost curve (MC)
A marginal cost that graphically represents the relation between marginal cost incurred by a firm in the shortrun product of a good or service and the quantity of output produced. This curve is constructed to capture the
relation between marginal cost and the level of output, holding other variables, like technology and resource
prices, constant. The marginal cost curve is U-shaped. Marginal cost is relatively high at small quantities of
output, then as production increases, declines, reaches a minimum value, then rises. The marginal cost is shown
in relation to marginal revenue, the incremental amount of sales that an additional product or service will bring
to the firm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal
returns (and the law of diminishing marginal returns - Diminishing returns).
Combining cost curves
Cost curves can be combined to provide information about firms. In this diagram for example, firms are
assumed to be in a perfectly competitive market. The marginal cost curve will cut the average cost curve at its
lowest point. In a perfectly competitive market a firm's profit maximising price would be at or above the price at
which the average cost curve cuts the marginal cost curve. If the marginal revenue is above the average total
cost price the firm is deriving an economic profit.

The short run is a time period where at least one factor of production is in fixed supply. We normally assume that the quantity of
plant and machinery is fixed and that production can be altered through changing variable inputs such as labour, raw materials and
energy.
In the short run, the law of diminishing returns states that as we add more units of a variable input to fixed amounts of land and
capital, the change in total output will at first rise and then fall. Diminishing returns to labour occurs when marginal product of labour
starts to fall. This means that total output will be increasing at a decreasing rate.
The marginal cost of supplying an extra unit of output is linked with the marginal productivity of labour. The law of diminishing
returns implies that marginal cost will rise as output increases. Eventually, rising marginal cost will lead to a rise in average total
cost.
When diminishing returns set in the marginal cost curve starts to rise. Average total cost continues to fall until the point where the
rise in average variable cost equates with the fall in average fixed cost. This is known as the output of productive efficiency.
Short run cost curves

Returns to scale
In the long run, all factors of production are variable. How the output of a business responds to a change in factor inputs is
called returns to scale.
Increasing returns to scale occur when the % change in output > % change in inputs
Decreasing returns to scale occur when the % change in output < % change in inputs
Constant returns to scale occur when the % change in output = % change in inputs
The nature of the returns to scale affects the shape of a businesss long run average cost curve.
The long run average cost curve (LRAC) is also known as the envelope curve and is usually drawn on the assumption of their being
an infinite number of plant sizes hence its smooth appearance in the next diagram below. The points of tangency between LRAC
and SRAC curves do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale
(MES) is achieved.
If LRAC is falling when output is increasing then the firm is experiencing economies of scale. For example a doubling of factor inputs
might lead to a more than doubling of output.
Conversely, When LRAC eventually starts to rise, the firm experiences diseconomies of scale, and, If LRAC is constant, then the firm
is experiencing constant returns to scale

Returns to scale

Returns to scale and cost per unit