UNIT NO 3

COST ANALYSIS AND DEMAND

FORECASTING
 Cost elements
The total production costs in short-run production can
be divided into two groups as: fixed cost (FC) and
variable cost (VC). FC does not vary with production
quantity, whereas VC varies with production quantity. In
addition to these costs, some other terminologies like
average variable cost (AVC), ATC and marginal cost (MC)
1. Fixed cost (FC): It refers to the costs of all fixed
inputs in a production process that does not
change with the quantity of the output produced.
2. Variable cost (VC): It refers to the cost of all variable
inputs in a production process that changes with
the quantity of the output produced.
3. Total cost (TC): It is the sum of FC and VC, TC = + FC
VC.
4. Average cost or average total cost (AC or ATC):
Average cost (AC), also known as ATC, is the
average cost per unit of output. It is the ratio of TC
and the quantity (Q) the firm is producing. The ATC
and AVC curves are shown in Figure
Mathematically, ATC and AVC are expressed as
where AFC is average fixed cost, AVC is average
variable cost, FC is fixed cost, VC is variable cost
and Q is volume of output.
5. Marginal cost (MC): It is the additional cost
that results from increasing the output by one
unit. Mathematically, it is represented as: MC =
ΔTC / ΔQ
Broadly, three elements of cost are considered in the
production process; these are material cost, labour cost
and expenses.
 Material cost can be divided into two classes: direct
material cost and indirect material cost. Direct
material cost is the cost incurred on the material which
is processed through various production stages, e.g.,
raw material.
The cost of direct material includes the purchase price
as well as expenses such as freight, insurance, loading
and unloading charges, etc.
Indirect material cost is the cost incurred on the
material which is not an integral part of the product but
used to process the direct material, e.g., lubricating oil
or the coolant
Labour cost can be divided into two classes: direct and
indirect labour costs.
Direct labour cost consists of wages of the workers
directly involved in the manufacturing of the product,
e.g. labourers working on the machine.
Indirect labour cost consists of the wages of the
workers engaged indirectly to help the production of
the product. But, they are not directly engaged of
responsible for the production, e.g. administrative
staff.
Apart from the material and labour costs, there are
several other expenditures such as cost of
advertisement, depreciation charges of plant and
machinery, the cost of transportation and packages, etc.
 These expenditures are known as OVERHEAD
expenses. Expenses can be divided into two classes:
direct expenses and indirect expenses.
Direct expenses are those which can be directly charged
for a particular product, e.g. cost of jigs and fixture for a
special job, experimental set for a special job, are the
direct expenses.
Indirect expenses include factory expenses,
administrative expenses, selling expenses and
distribution expenses.
Prime cost: It is also called as a direct cost and consists
of direct labour, direct material and direct expenses; i.e.
Prime cost = Direct material cost + Direct labour cost +
Direct expenses.
Factory cost: It consists of prime cost and factory
expenses; i.e. Factory cost = Prime cost + Factory
expenses.
Production cost: It consists of factory cost and
administrative expenses; i.e. Production cost = Factory
cost + Administrative expenses.
Total cost: It includes production cost and selling and
distribution charges; i.e. Total cost = Production cost +
Selling expenses + Distribution charges.
Question(a) Two mechanics are employed in a casting process
for 20 jobs, each weighing 5 kg in a shift of 8 hours. They are
paid at the rate of Rs 120 and Rs 100 per day. The forged
material costs Rs 4.50 per kg. If the factory and administrative
on costs put together are thrice the labour cost, find the cost of
production per unit. (b) A product is manufactured in batches of
500. The direct material cost is Rs 15,000, direct labour cost is Rs
20,000, and factory overheads are 40 per cent of the prime cost.
If the selling expenses are 30 per cent of the factory cost, what
would be the selling price of each product so that profit is 20
per cent of the total cost?
 Break-Even Analysis
Break-even analysis (BEA) is a graphical representation of the
cost–volume relationship. Breakeven point (BEP) represents the
level of output at which there is no profit and no loss.
Profit is the difference between total revenue and total
production cost:
Total revenue = No. of units produced × Price per unit
Total cost = No. of units produced × Cost per unit .
Total cost consists of VC and FC. VC varies with the volume of
production but, FC remains fixed. By definition, VCs change (in
total) in response to changes in volume of production.
It is also assumed that the relationship between VCs and volume
of production is proportional.
Examples include the costs of direct labour, raw materials and
sales commissions. By definition, FCs do not change (in total) in
response to changes in volume or activity. Examples include the
costs of depreciation, supervisory salaries and maintenance
expenses
Assumptions: BEA or cost–volume–profit (CVP) analysis
has the following assumptions:
1. The changes in the level of revenues and costs arise
due to the changes in the number of products/or services
units produced and sold. A cost driver is any factor that
affects costs, a revenue driver is any factor that affects
revenue.
2. Total costs can be divided into a fixed component and a
component that is variable with respect to the level of
output. VCs include the following: (a) Direct materials. (b)
Direct labour. (c) Direct chargeable expenses. Variable
overheads include the following: (a) Variable part of
factory overheads. (b) Administration overheads. (c)
Selling and distribution overheads
3. There is a linear relationship between revenue and
cost. When put in a graph, the behaviour of total revenue
and total cost is linear (straight line), that is, y m= +x c
holds good, which is the equation of a straight line, where
y is revenue and x is the cost, m is the coefficient of cost
representing profit, c is a constant.
4. The unit SP (Selling Price), unit VCs and FCs are
constant.
5. The theory of CVP is based upon the production of a
single product. However, of late, management
accountants are functioning to give a theoretical and a
practical approach to multi-product CVP analysis.
6. The CVP analysis either covers a single product or
assumes that the sales mix of multiple products will
remain constant as the level of total units sold changes.
7. All revenues and costs can be added and compared
without taking into account the time value of money.
8. The theory of CVP is based on the technology that
remains constant.
9. The theory of price elasticity is not taken into
consideration.
Margin of safety, contribution margin (CM) and profit
volume ratio are the important terms and help in the
decision-making process. These terms are discussed as
follows:
Margin of safety: The margin of safety is the difference
between the expected level of sales and a break-even
sales. It may be expressed in units or rupees of sales.
Contribution margin: It is the difference between the SP
and the VC per unit. It measures the amount each unit sold
contributes to cover FCs (first) and increase profit (once
FCs are covered). The relationship is as SP – VC.
Contribution margin ratio: This ratio expresses the
contribution of every sales rupee in covering FCs (first) and
operating profit (second).
Angle of incidence, φ: It is the angle at which the total
revenue line intersects the total cost line (see in
Figure ).
Profit–volume ratio: It is the ratio of contribution and
sales

Break-even analysis
 FORECASTING
Forecasting is the first major activity in the planning. It
involves careful study of past data and present scenario.
The main purpose of forecasting is to estimate the
occurrence, timing, or magnitude of future events.
For example, the trend of past ten years in the demand of
cars and corresponding purchasing power of the
consumers may form a basis of forecasting the demand of
cars during next year.
Once, the reliable forecast for the demand is available, a
good planning of activities is needed to meet the future
demand. Forecasting, thus, provides the input to the
planning and scheduling process.
Precise forecasting of economic activities, such as product
demand, is almost impossible because of many interactive
factors, which are difficult to model.
Despite the fact that highly reliable forecast is unrealistic,
the approximate estimate forms the basis of planning
process.
 BENEFITS OF FORECASTING
1. Effective handling of uncertainty
2. Better labour relations
3. Balanced work-load
4. Minimisation in the fluctuations of production
5. Better use of production facilities
6. Better material management
7. Better customer service
8. Better utilisation of capital and resources
9. Better design of facilities and production system.
Efforts in forecasting activity involve two types of costs.
While more effort in forecasting causes increased cost
due to data collection and analysis, lesser forecasting
activity involves lost revenue, which may be due to
unplanned labour, unplanned material or unplanned
capital cost (see Figure 1). Therefore, each firm should
maintain a balance in its forecasting effort and stick to a
zone near to accuracy cost trade off (see Figure 2).
Difference between Forecasting and Prediction
 TYPES OF FORECASTING
Long-Range Forecasting
Medium-Range Forecasting
 Short-Range Forecasting

Long-Range Forecasting Long-range forecasting consists of

time period of more than 5 years.
Characteristics: Normally, it is difficult to model and foresee
events for more than five years.
It is mainly due to economic uncertainty and variation in
the behaviour of the interrelated processes.
For example, state of economy and technology may
completely change in next five years and, therefore, the
trend of data during past few years may not be sufficient.
Applications: Long-range forecasting is useful in the
following areas: • Capital planning • Plant location • Plant
layout or expansion • New product planning • Research
and development planning • Technology management,
etc.
Method of Forecasting: Long-range planning is a difficult
task. Generally, these forecasts are broad in nature and
general type in characteristic.
Mostly, qualitative techniques are used. Studies, related
to technological break-through, economic studies,
marketing survey, demographic projections, etc., are used
to make judgemental estimate of the future event.
Medium-Range Forecasting :The range for medium-
range forecasting is generally 1 to 5 years.
 Characteristics: As the range of forecast shortens
from .5 to 1 year, the accuracy of forecast increases. This
is due to better understanding of future and relatively
lesser uncertainty. For these forecasts, more numerical
estimates are needed. Estimate of reliability of forecast
may be useful in medium-range forecast.
Applications: Medium range forecast is vary useful in
following areas: • Sales planning and sales force
decisions • Productions planning • Capital and cash
planning • Inventory planning • Enrollment of students in
a college, etc.
Method of frecasting: Medium-range forecasting needs
judgement as well as time series analysis. Combination of
collective opinion, regression analysis, correlation of
different index and inflation, etc., may be useful in
forecasting.
Short-Range Forecasting: The range for short-range
forecasting is typically less—from one hour to one year. In
most cases, it is for one season, a few months or a few
weeks.
Characteristics: The short-range forecasting is needed at
detailed level, such as demand of specific items. This
forecast may affect the purchasing activity. Specific value
of forecast is needed. There is very less sLope of
judgement in short-range forecast and, therefore, past
data are mainly projected into future.
Applications: Short-range forecasting is commonly used in
immediate control of activities. Some related applications
are: • Purchasing • Overtime decisions • Scheduling of job
• Machine maintenance, etc.
Methods of Forecasting: Short-range forecasting is based
on past data. The trend of data is projected or
extrapolated into future. For this exponential smoothing,
graphical projections, part explosion into product family,
etc., are used. For example, monthly forecast of sales may
form the basis of production planning activities.
COMMONLY OBSERVED DEMAND PATTERN
 QUALITATIVE METHODS OF FORECASTING
Qualitative methods are needed in forecasting when
data, necessary to use time series or causal model, are
not available.
For example, when a new product is to be launched in
the market, its past demand data are not available.
Therefore, time series trend analysis is impractical.
Qualitative techniques, which incorporate human
judgement, expert opinion, management intuition,
market research, historical analogy or grass root
forecasting are useful in such cases.
Delphi Method:
 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.
The coordinator of the project prepares the statistical
summary of responses. This, along with the support for
the responses, is provided to the experts in the next
round.
The participants are asked if they want to modify their
previous response. In this way, after few rounds of
questionnaires, the final forecast is derived. 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 intemet/intranet or
information-highway in the educational system of India in
next 25 years may be forecasted through this approach
Advantages of Delphi Method:
The advantages of Delphi methd are:
• It is effective, when past data is absent.
• It does not require experts to meet in person.
• It is extremely useful for the forecast of new technology
or new product.
Limitations of Delphi Method: The limitations of Delphi
method are as follows:
• It is a time consuming process, which may be around one
year. During this period, the experts may change their
perception. Sometimes, the very need of forecasting loses
its significance due to the delay.
• As experts are not accountable, their response may be
less meaningful.
• If the questionnaires are poorly designed, Delphi would
be ineffective.
• Accuracy or reliability of forecast is relatively poor in
Delphi method. Therefore, it should only be used when
past trend is absent and quantitative models are difficult to
use.
 Market Research It is used to determine consumer liking
in a product or service. A set of hypothesis is tested
through the data, which is generated in the survey.
 Salesforce Forecast Salesforce is a team that is closest to
the customer. Their estimates are compiled to assess the
future demand. 1, pharmaceutical market, the estimates
given by medical representatives of all territories are
oftenly us to determine the sales forecast of a particular
medicine.
Historical Analogy It is used when the new product or
new technology is strongly similar to an established
product whose demand dat-1 is known. This. approach is
effective for medium to long-range forecast and it is quite
cost effective.
 QUANTITATIVE METHODS OF FORECASTING
Extrapolation
Extrapolation is one of the easiest ways to forecast. For
example, based on the past few values of a production
capacity, next value may be extrapolated on a graph paper.
 This may be done by extending the curve (or line) joining
the already known values.
For example, if the production capacity of a firm has been
445, 545 and 645, then in the next year one may expect a
production capacity requirement of 745 units The
 limitation with the extrapolation method is its inability to
deal with non-linear trend and swing in the pattern of past
data.
Forecasting of Production Capacity by Extrapolation
Time Series Analysis: There are some models in forecasting
which involve analysis of past data or happenings. These
models are as follows.
1. Simple moving average
2. Weighted moving average
3. Exponential smoothing
4. Double exponential smoothing.

Simple Moving Average (SMA) Following approach is

followed in simple moving average method: Compute the
mean of only a specified number of .consecutive data
which are most recent values in series. Call this Ft. This Ft
would be the forecast for next period.
It may be observed in SMA approach:
1. The longer the moving-average period, the greater the
random elements smoothening.
2. In case of trend (increasing/decreasing), the SMA has
adverse trend. This is due to lagging trend.
3. The longer is the time span, the smoother is the
forecast but with lagging trend.
4. Simple moving average method involves quite large
data handling as we go fol. large period average
Effect of period in simple moving average method of forecasting