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BUSINESS MATHEMATICS and LOGICAL REASONING & STATISTICS

CA FOUNDATION - PAPER 3 - BUSINESS MATHEMATICS and
LOGICAL REASONING & STATISTICS
Often, we encounter news of price rise, GDP growth, production growth, etc. It is important for students of
Chartered Accountancy to learn techniques of measuring growth/rise or decline of various economic and business
data and how to report them objectively. After reading this capsule, students will be able to understand Purpose of
constructing index number and its important applications in understanding rise or decline of production, prices,
etc. different methods of computing index number.

CHAPTER 18: Index Numbers

Methods of Index numbers:
INTRODUCTION
Index numbers are convenient devices for measuring relative changes Methods
of differences from time to time or from place to place. Just as the
arithmetic mean is used to represent a set of values, an index number
is used to represent a set of values over two or more different periods Simple Weighted
or localities.
The basic device used in all methods of index number construction
is to average the relative change in either quantities or prices since
Aggregative Relative Aggregative Relative
relatives are comparable and can be added even though the data from
which they were derived cannot themselves be added. For example,
if wheat production has gone up to 110% of the previous year’s
production and cotton production has gone up to 105%, it is possible
Price Index numbers
to average the two percentages as they have gone up by 107.5%. This
assumes that both have equal weight; but if wheat production is twice
as important as cotton, percentage should be weighted 2 and 1. The (a) Simple aggregative price index =
average relatives obtained through this process are called the index (b) Laspeyres’ Index: In this Index base year quantities are used as
numbers. weights:
• Relatives: One of the simplest examples of an index number is a Laspeyres Index =
price relative, which is the ratio of the price of single commodity in
a given period to its price in another period called the base period
(c) Paasche’s Index: In this Index current year quantities are used as
or the reference period. It can be indicated as follows:
weights:
Price relative = Passche’s Index =

There can be other relatives such as of quantities, volume of (d) The Marshall-Edgeworth index uses this method by taking the
consumption, exports, etc. The relatives in that case will be: average of the base year and the current year

Quantity relative = Marshall-Edgeworth Index =

Similarly, there are value relatives: (e) Fisher’s ideal Price Index: This index is the geometric mean of
Laspeyres’ and Paasche’s.
Value relative =
Fisher’s Index = x 100

(g) Weighted Average of Relative Method:

Index number Overview
Link relative of current year x Chain Index of the previous year
(h) Chain Index =
100
Issues Involved Index Numbers Price Index Numbers
Quantity Index Numbers
Types of Inex Numbers Quantity Index • Simple aggregate of quantities: x 100

Construction of Index numbers Value Index Numbers • The simple average of quantity relatives:
x 100
Index Numbers

• Weighted aggregate quantity indices:

Chain Index Numbers
(i) With base year price as weight : x 100 (Laspeyre’s index)

Deflating Index Numbers (ii) With current year price as weight : x 100 (Paasche’s index)
Usefulness of Index Number
Splicing of Index Numbers (iii) Geometric mean of (i) and (ii) : x 100 (Fisher’s Ideal)

Unit Test •B
 ase-year weighted average of prices as relatives in Marshall-
Edgeworth quantity index number.
Tests of Adequacy Times Reversal Text
Weighted Relative method formula x 100
Factor Reversal Text
Circular Test • Value Indices
x 100

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THE CHAIN INDEX NUMBERS changes over a period of time gets reflected in the data collected.
Thereafter, to determine how much the physical goods and services
So far we concentrated on a fixed base but it does not suit when
have grown over time, the effect of changes in price over different
conditions change quite fast. In such a case the changing base for
values of GNP is excluded. The real economic growth in terms of
example, 2018 for 2019, and 2019 for 2020, and so on, may be more
constant prices of the base year therefore is determined by deflating
suitable. If, however, it is desired to associate these relatives to a
GNP values using price index.
common base the results may be chained. Thus, under this method
the relatives of each year are first related to the preceding year called GNP
the link relatives and then they are chained together by successive Wholesale Real
Year at Current
multiplication to form a chain index. Price Index GNP
Prices
The formula is:
2019 113.1 7499 6630
Chain Index = Link relative of current year x Chain Index of the previous year 2020 116.3 7935 6823
100
2021 121.2 8657 7143
Illustrations 2022 127.7 9323 7301
The formula for conversion can be stated as
Commodities 2018 2019 2020
x 100
Cheese (per 100 gms)
Egg (per piece) 120 150 160
30 36 40
Potato (per kg)
50 60 60
Aggregrate 200 246 260 Shifting and Splicing of Index Numbers
Index 100 123 130 These refer to two technical points: (i) how the base period of the
index may be shifted, (ii) how two index covering different bases may
Simple Aggregative Index for 2019 over 2018 = be combined into single series by splicing.
Shifted Price Index
and for 2020 over 2018 =
Year Original Price Index Shifted Price Index to base 2021
The above method is easy to understand but it has a serious defect.
2011 100 71.4
It shows that the first commodity exerts greater influence than the
other two because the price of the first commodity is higher than that 2012 104 74.3
of the other two. Further, if units are changed then the Index numbers 2013 106 75.7
will also change. Students should independently calculate the Index 2014 107 76.4
number taking the price of eggs per dozen i.e., ` 36, ` 43.20, ` 39.60 for
the three years respectively. This is the major flaw in using absolute 2015 110 78.6
quantities and not the relatives. Such price quotations become the 2016 112 80.0
concealed weights which have no logical significance. 2017 115 82.1
2018 117 83.6
Limitations of Index Numbers
So far we have studied various types of index numbers. However, 2019 125 89.3
they have certain limitations. They are: 2020 131 93.6
1. As the indices are constructed mostly from deliberate samples, 2021 140 100.0
chances of errors creeping in cannot be always avoided.
2022 147 105.0
2. Since index numbers are based on some selected items, they
simply depict the broad trend and not the real picture. The formula used is, Shifted Price Index =
3. Since many methods are employed for constructing index numbers,
the result gives different values and this at times create confusion. Splicing two sets of price index numbers covering different periods
of time is usually required when there is a major change in quantity
weights. It may also be necessary on account of a new method of
Usefulness of Index Numbers calculation or the inclusion of new commodity in the index.
In spite of its limitations, index numbers are useful in the following areas:
1. Framing suitable policies in economics and business. They provide Splicing Two Index Number Series
guidelines to make decisions in measuring intelligence quotients, Year Old Price Index Revised Price Spliced Price
research etc. [2010 = 100] Index [2015=100] Index [2015 = 100]
2.  They reveal trends and tendencies in making important
conclusions in cyclical forces, irregular forces, etc. 2010 100.0 87.6
3. They are important in forecasting future economic activity. They 2011 102.3 89.6
are used in time series analysis to study long-term trend, seasonal 2012 105.3 92.2
variations and cyclical developments.
2013 107.6 94.2
4. Index numbers are very useful in deflating, i.e., they are used
to adjust the original data for price changes and thus transform 2014 111.9 98.0
nominal wages into real wages. 2015 114.2 100.0 100.0
5. Cost of living index numbers measure changes in the cost of living 2016 102.5 102.5
over a given period.
2017 106.4 106.4
DEFLATING TIME SERIES USING INDEX NUMBERS 2018 108.3 108.3
Sometimes a price index is used to measure the real values in 2019 111.7 111.7
economic time series data expressed in monetary units. For example,
2020 117.8 117.8
GNP initially is calculated in current price so that the effect of price
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You will notice that the old series 2010 has to be converted shifting
to the base. 2015 i.e, 114.2 to have a continuous series, even when the (iv) Circular Test: It
two parts have different weights is concerned with the
measurement of price changes
over a period of years, when
TEST OF ADEQUACY it is desirable to shift the base.
l  is test is not met by
Th
There are four tests: Laspeyres, or Paasche’s
For example, if the 1970 index or the Fisher’s ideal
1. Unit Test: This test requires that the formula should be with base 1965 is 200 and index. The simple
independent of the unit in which or for which prices and 1965 index with base 1960 is geometric mean of
quantities are quoted. Except for the simple (unweighted) 150, the index 1970 on base price relatives and the
aggregative index all other formulae satisfy this test. 1960 will be 300. This property weighted aggregative
therefore enables us to adjust with fixed weights
(ii) Time Reversal Test: It is a test to determine whether a given the index values from period meet this test.
method will work both ways in time, forward and backward. to period without referring
The test provides that the formula for calculating the index each time to the original base.
number should be such that two ratios, the current on the base The test of this shiftability of
and the base on the current should multiply into unity. In other base is called the circular test.
words, the two indices should be reciprocals of each other.
Symbolically,
Example 1: Compute Fisher’s Ideal Index from the following data:
P01 x P10 = 1
where P01 is the index for time 1 on 0 and P10 is the index for time 0 on 1. Base Year Current Year
Commodities
You will notice that Laspeyres’ method and Paasche’s method do Price Quantity Price Quantity
not satisfy this test, but Fisher’s Ideal Formula does.
A 4 3 6 2
While selecting an appropriate index formula, the Time Reversal Test B 5 4 6 4
and the Factor Reversal test are considered necessary in testing the C 7 2 9 2
consistency. D 2 3 1 5
Show how it satisfies the time and factor reversal tests.
Laspeyres:
Solution:
Commodities P0 Q 0 P1 Q1 P0Q0 P1Q0 P0Q1 P1Q1
A 4 3 6 2 12 18 8 12
B 5 4 6 4 20 24 20 24
Paasche’s: C 7 2 9 2 14 18 14 18
D 2 3 1 5 6 3 10 5

52 63 52 59

Fisher’s Ideal Index: P01 =

=
Fisher’s:
Time Reversal Test:

∴ Time Reversal Test is satisfied.

Factor Reversal Test:
(iii) Factor Reversal Test: This holds when the product of
P01 x Q01 =
price index and the quantity index should be equal to the
corresponding value index, i.e.,
Since, is also equal to , the Factor Reversal Test is satisfied.
Symbolically: P01 x Q01 = V01
Example 2: If the ratio between Laspeyre’s index number and Paasche’s
Fishers’ Index number is 28 : 27. Then the missing figure in the following table P is :

P01 × Q01 = = V01 Base Year Current Year

= Commodity
Price Quantity Price Quantity
Thus Fisher’s Index satisfies Factor Reversal test. Because
Fisher’s Index number satisfies both the tests in (ii) and (iii), it X L 10 2 5
is called an Ideal Index Number. Y L 5 P 2

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Solution: So Laspeyre’s index number = ∑ PxQo / ∑ PoQo
= 2 x 10 + P x 5 / L x 10 + L x 5
= 20 + 5P / 15 L
= 5 (4 + P) / 15 L
= 4 + P / 3L
Now for the Paasche’s index number we have, ∑ Px Qx / ∑ Po Qx
=2x5+Px2/Lx5+Lx2
= 2P + 10 / 7L
= 2 (P + 5) / 7L =
Given Ratio = L : P = 28:27
So 4 + p / 3L / 2 (P + 5) / 7L = 28/27
or 7 (4 + P) / 6(P + 5) = 28/27 Thus, we can say that even though money wage of the worker had
or 9(4 + P) = 8(P + 5) increased from R330 to R500, his real wage has fallen from R300 to
36 + 9P = 8P + 40 R250. This implies a loss of R50 in real terms.
or P = 40 – 36
or P = 4 Example 6: If the price of a commodity in a place have decreased by
30% over the base period prices, then the index number of that place is:
Example 3: The consumer price index for 2006 on the basis for 2006
on the basis of 2005 from the following data is: Solution: Base price of any commodity = 10 decreased price = 30%
of 100 = 30
Commodities Quantities Prices in Prices in Index number of that place now = 100-30 =70
in 2005 consumed in 2005 2005 2006
Example 7: If with an increase of 10% in prices, the rise in wages is
A 6 5.75 6.00 20% then the real wages has increased by
B 6 5.00 8.00
C 1 6.00 9.00
D 6 8.00 10.00
E 4 2.00 1.50
F 1 20.00 15.00
Example 8: In the year 2010, the monthly salary of clerk was
Solution: R24,000. The consumer price index was 140 in the year 2010, which
rises to 224 in 2016. If he has to be rightly compensated, what
Commodities Quantities Price Prices p1q0 P0q0
additional monthly salary to be paid to him?
in 2005 consumed in 2005 in 2006
in 2005(q0) (P0) (P1) Solution
A 6 5.75 6.00 36 34.50
Year CPI Salary
B 6 5.00 8.00 48 30.00
2010 140 24000
C 1 6.00 9.00 9 6.00
D 6 8.00 10.00 60 48.00 2016 224 X
E 4 2.00 1.50 6 8.00 = 140/224 = 24000/x
F 1 20.00 15.00 15 20.00
∑ P1q0=174 ∑P0q0=146.5

Consumer Price Index =

Example 4: Net monthly salary of an employee was R30,000 in 2000.

The consumer price index 2015 is 250 with 2000 as base year, if he Important Points:
has to rightly compensated, then dearness allowance to be paid to
1. Circular Test is an extension of time reversal test.
the employee is:
2. Time Reversal Test and Factor Reversal Test is satisfied by:
Solution: The consumer price index number in 2015 is 250 with 2000
Fisher’s Ideal Index.
as base year.
3. The ratio of price of single commodity in a given period to its
if in 2000 = 100 then in 2015 = 250
price in the preceding year price is called the relative price.
if in 2000 = 1 then in 2015 = 250/100 = 2.5
4. Fisher’s Ideal Formula does not satisfy Circular test.
if in 2000 = 30000 then 250/100* 30000 = 75,000
5. The best average for constructing an index number is: Geometric Mean.
additional dearness allowance to be paid to the employee is = 75000
6. The time reversal test is satisfied by Fisher’s index number.
– 30000 = R45000
7. The factor reversal test is satisfied by : Fisher’s index.
additional dearness allowance to be paid to the employee = R45,000
6. The circular test is satisfied by Simple GM price relative.
Example 5: Consumer price index number goes up from 110 to
200 and the Salary of a worker is also raised from R330 to R500. 7. Fisher’s index number is based on Geometric mean of Laspeyre’s
Therefore, in real terms, to maintain his previous standard of living, and Paasche’s index numbers.
he should get an additional amount of: 8. Paasche index is based on: Current year quantities.
Solution: Cost of Living Index in base year = 110, 9. Fisher’s Ideal Formula does not satisfy Circular test.
Cost of Index in current year = 200 10. Purchasing Power of Money is the Reciprocal of price index
Salary of worker in base year = 330 number and inverse relationship between Purchasing power of
money and price index number.
Salary of worker in current year = 500

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