Managerial Economics Book.pdf 5a1s1z

10/15/2015

VISION INTERNATIONAL

MANAGERIAL ECONOMICS

COLLEGE

Course outline | Hassan Abdulkadir Mohamed

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CHAPTER I: MANAGERIAL DECISION MAKING ................................................................................. 3 INTRODUCTION ................................................................................................................................................... 3 DECISION MAKING PROCESS............................................................................................................................... 3 DECISION MAKING STEPS .................................................................................................................................... 3 MANAGEMENT DECISION PROBLEMS .................................................................................................................. 4 TYPES OF DECISIONS........................................................................................................................................... 4 ORGANIZATIONAL AND PERSONAL DECISIONS .................................................................................................... 4 BASIC AND ROUTINE DECISIONS .......................................................................................................................... 5 PROGRAMMED AND NON-PROGRAMMED DECISIONS............................................................................................ 5 CONDITIONS AFFECTING DECISION MAKING ...................................................................................................... 5 Certainty ........................................................................................................................................................ 5 Risk ................................................................................................................................................................ 6 Uncertainty .................................................................................................................................................... 6 DECISION MAKING MODELS ............................................................................................................................... 6 The Classical Model ...................................................................................................................................... 6 The istrative Model .............................................................................................................................. 7 DECISION MAKING TECHNIQUES ........................................................................................................................ 8 Marginal Analysis .......................................................................................................................................... 8 Financial Analysis ......................................................................................................................................... 8 GROUP DECISION TECHNIQUES ........................................................................................................................... 8 Brainstorming ................................................................................................................................................ 9 Nominal Group Technique ............................................................................................................................. 9 Delphi Group Technique................................................................................................................................ 9 DECISION MAKING TOOLS .................................................................................................................................. 9 Linear Programming ..................................................................................................................................... 9 Inventory Control ........................................................................................................................................... 9 CHAPTER II: DEMAND ANALYSIS ........................................................................................................ 10 MEANING OF DEMAND ...................................................................................................................................... 10 TYPES OF DEMAND ........................................................................................................................................... 10 Individual and Market Demand ................................................................................................................... 10 Autonomous and derived demand ................................................................................................................ 11 Demand for durable and nondurable goods ................................................................................................ 11 Demand for firm’s product and industry product ........................................................................................ 11 Demand for consumers and producers goods .............................................................................................. 11 DETERMINANTS OF DEMAND ............................................................................................................................ 12 DEMAND FUNCTION .......................................................................................................................................... 12 LAW OF DEMAND .............................................................................................................................................. 13 DEMAND SCHEDULE ......................................................................................................................................... 13

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DEMAND CURVE ............................................................................................................................................... 13 SHIFT OF DEMAND CURVE V/S MOVEMENT ALONG THE DEMAND CURVE ......................................................... 14 ELASTICITIES OF DEMAND ................................................................................................................................ 14 The Price Elasticity of Demand ................................................................................................................... 15 The income elasticity of demand .................................................................................................................. 16 The cross elasticity of demand ..................................................................................................................... 16 CLASSIFICATION OF GOODS .............................................................................................................................. 16 EXCEPTIONS TO THE LAW OF DEMAND – UPWARD SLOPING DEMAND CURVE ................................................. 16 The Cardinal Utility Theory ......................................................................................................................... 17 The Ordinal Utility Theory .......................................................................................................................... 17 THE CONSUMER SURPLUS .................................................................................................................................. 19 CHAPTER III: COST ANALYSIS .............................................................................................................. 20 INTRODUCTION ................................................................................................................................................. 20 ING COST CONCEPTS ......................................................................................................................... 20 Opportunity vs. Actual Cost ......................................................................................................................... 20 Explicit cost vs. Implicit cost........................................................................................................................ 20 ANALYTICAL C OST C ONCEPTS ..................................................................................................................... 20 Sunk vs. Incremental cost ............................................................................................................................. 20 Fixed and Variable Costs............................................................................................................................. 21 Total, Average and Marginal Costs ....................................................................................................... 21 Chapter-IV: Business Forecasting ......................................................................................................... 23 INTRODUCTION ..................................................................................................................................................... 23 PURPOSE AND NEED OF FORECASTING ............................................................................................................... 23 Short term: ................................................................................................................................................... 23 Long term: .................................................................................................................................................... 23 SPECIFIC PURPOSES OF DEMAND FORECASTING ................................................................................................. 23 STEPS INVOLVED IN FORECASTING ................................................................................................................... 24 PERIOD OF FORECASTING .................................................................................................................................. 24 LEVELS OF FORECASTING ................................................................................................................................. 24 METHODS OF FORECASTING.............................................................................................................................. 25 Qualitative Forecast .................................................................................................................................... 25 Statistical Forecast ...................................................................................................................................... 27 FLUCTUATIONS IN TIME SERIES DATA ............................................................................................................... 29 Cyclical fluctuations .................................................................................................................................... 29 Seasonal variation ....................................................................................................................................... 29 Irregular and random variation ................................................................................................................... 29 RISKS IN DEMAND FORECASTING...................................................................................................................... 29

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MANAGERIAL ECONOMICS

CHAPTER I: MANAGERIAL DECISION MAKING

INTRODUCTION Managerial Economics is the integration of economic theory with business practices for the purpose of facilitating Decision Making and Forward Planning by the management. Economic Theory helps managers to collect the relevant information and process it in order to arrive at the optimal decision given the goals of a firm A decision is optimal if it brings the firm closest to its goals. As decision making is a basic function of manager, economics is a valuable guide to the manager. In the following we shall be discussing the decision making process of the management and how managerial economics and its various tools and techniques help a manager in this process.

DECISION MAKING PROCESS Decision making is commonly defined a choosing from among alternatives. Decision is a choice made from alternative courses of action in order to deal with a problem. A problem is the difference between a desired situation and the actual situation. Therefore, decision making is the process of choosing among alternative courses of action to solve a problem.

DECISION MAKING STEPS 1. Identify the problem. 2. Diagnose the situation. 3. Collect and analyze data relevant to the issue. 4. Ascertain alternative solutions that may be used in solving the problem 5. Analyze these alternative solutions. 3

6. Select the approach that appears most likely to solve the problem 7. Implement it.

MANAGEMENT DECISION PROBLEMS 1. Product Price and Output 2. Production Technique 3. Stock Levels 4. Advertising Media and intensity 5. Labor hiring and firing 6. Investment and Financing

TYPES OF DECISIONS Managers make different sorts of decisions, and in order to obtain a clear understanding of the decision making process, a classification system is useful. Decisions are classified based on three systems; each based on different types of decisions. 

Organizational and personal decisions,



Basic and routine decisions



Programmed and non-programmed decisions. Organizational and personal decisions Organizational decisions are those executives make in their official role as managers. The adoption of strategies, the setting of objectives and the approval of plans constitute only a few of these. Such decisions are often delegated to others, requiring the of many people throughout the organization if they are to be properly implemented.

ORGANIZATIONAL AND PERSONAL DECISIONS Personal decisions are related to the managers as an individual, not as a member of the organizations. Such decisions are not delegated to others because their implementation does not require the of organizational personnel. Deciding to retire, taking a job offer from a competitive firm, or slipping out and spending the afternoon on the golf course are all personal decisions. 4

BASIC AND ROUTINE DECISIONS Basic decisions can be viewed a much more important than routine ones. They involve long-range commitments, large expenditures of funds, and such a degree of importance that a serious mistake might well jeopardize the well being of the company. Selection of a product line, the choice of a new plant site, or a decision to integrate vertically by purchasing sources of raw materials to complement the current production facilities are all basic decisions. Routine decisions are often repetitive in nature, having only a minor impact on the firm. For this reason, most organizations have formulated a host of procedures to guide the manager in handing these matters. Since some individuals in the organization spend most of their time making routine decisions, these guidelines are very useful to them.

PROGRAMMED AND NON-PROGRAMMED DECISIONS Taking a cue from computer technology, decision could be classified as computer technology programmed and non-programmed. Programmed decisions correspond roughly to the routine decisions, with procedures playing a key role. Non programmed decisions are similar to the category of basic decisions, being highly novel, important, and unstructured in nature. The value of viewing decision making in this manner is that it permits a clearer understanding of the methods that accompany each type.

CONDITIONS AFFECTING DECISION MAKING In an ideal business situation, managers would have all the information they need to make decisions with certainty. Most business situations however are characterized by incomplete or ambiguous information, which affects the level of certainty with which a manager makes a decision. There are three conditions that affect decision making:  Certainty  Risk  Uncertainty

CERTAINTY

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Certainty is the condition that exists when decision makers are fully informed about a problem its alternative solutions, and their respective outcomes. Under this condition, individuals can anticipate, and even exercise some control over events and their outcomes.

RISK In the context of decision making, risk is the condition that exists when decisionmakers must rely on incomplete, yet reliable information. Under a state of risk, the decision-maker does not know with certainty the future outcomes associated with alternative courses of action; the results are subjects to chance. However, the manager has enough information to determine the probabilities associated with each alternative. He or she can then choose. The alternative that has the highest probability of success.

UNCERTAINTY Uncertainty is the condition that exists when little or no factual information is available about a problem, its alternative solution, and their respective outcomes. In a state of uncertainty, the decision-maker does not have enough information to determine the probabilities associated with each alternative. Actually, the decisionmaker may have so little information that he or she may be unable even to define the problem, let alone identify alternative solutions and possible outcomes.

DECISION MAKING MODELS There are basically two major models of decision-making – •

The classical model and

•

The istrative model.

THE CLASSICAL MODEL The classical model of decision making is a prescriptive approach that outlines how managers should make decisions. Also called the rational model, the classical model is based on economic assumptions and asserts that managers are logical, rational individuals who make decision that are in the best interest of the organization. The classical model is characterized by the following assumptions:

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•

The manager has complete information about the decision situation and operations under a condition of certainty.

•

The problem is clearly defined, and the decision-maker has knowledge of all possible alternatives and their outcomes.

•

Through the use of quantitative techniques, rationality, and logic, the decisionmaker evaluates the alternatives and selects the optimum alternative -the one that will maximize the decision situation by offering the best solution to the problem.

THE ISTRATIVE MODEL The istrative model of decision making is a descriptive approach that outlines how managers actually do make decisions. Also called the organizational, neoclassical, or behavioral model, the istrative model is based on the work of economist Herbert A. Simon who recognized that people do not always make decisions with logic and rationality, and he introduced two concepts that have become hallmarks of the istrative model•

Bounded rationality and

•

Satisficing. The istrative Model Bounded rationality means that people have limits, or boundaries, to their rationality. These limits exist because people are bound by their own values and skills, incomplete information, and their own inability-due to time, resource, and rational decisions. Because managers often lack the time of ability to process complete information about complex decisions, they usually wind up having to make decisions with only partial knowledge about alternative solutions and their outcomes. this leads managers often forgo the six steps of decision making in favor of a quicker, yet satisfying, process- satisficing. Assumptions in istrative model The istrative model of decision making also have some basic assumptions:

•

The manager has incomplete information about the decision situation and operates under a condition of risk or uncertainty.

•

The problem is not clearly defined, and the decision-maker has limited knowledge of possible alternatives and their outcomes.

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•

The decision-maker satisfies by choosing the first satisfactory alternative- one that will resolve the problem situation by offering a good solution to the problem.

DECISION MAKING TECHNIQUES It is useful to examine some of the specific technique that has proved valuable in the decision making process, two of which are •

Marginal analysis and

•

Financial analysis.

MARGINAL ANALYSIS The "marginal product" of a productive factor is the extra product or output added by one extra unit of that factor, while other factors are being held constant. Labor’s marginal product is the extra output you get when you add one unit of Labor holding all other inputs constant. Similarly, land's marginal product is the change in total product resulting from one additional unit of land with all other inputs held constant. The manager can use the concept to answer questions such as how much more output will result if one more worker is hired? The answer often called marginal physical product, provides a basis for determining whether or not one new man will bring about profitable additional output.

FINANCIAL ANALYSIS The firms are supposed to safeguard their interest and avert the possibilities of risk or try to minimize it. For this a firm needs to analyze the assets as well as liabilities, efficiency of capital investment, choice of project and various vital ratios. The cost benefit/financial analysis ensures the firms to take prudent financial decision.

GROUP DECISION TECHNIQUES There are several group decision techniques: •

Brainstorming

•

Nominal Group Technique

•

Delphi Group Technique

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BRAINSTORMING Brainstorming is a technique in which group spontaneously suggest keys to solve a problem. Its primary purpose is to generate a multitude of creative alternatives, regardless of the likelihood of their being implemented.

NOMINAL GROUP TECHNIQUE The Nominal Group Technique involves, the use of highly structured meeting agenda and restricts discussion or interpersonal communication during the decision making process. While the group are all physically present, they are required to operate independently.

DELPHI GROUP TECHNIQUE The Delphi group Technique employs a written survey to gather expert opinions from a number of people without holding a group meeting. Unlike in brainstorming and nominal groups, Delphi group participants never meet face to face; in fact, they may be located in different cities and never see each other.

DECISION MAKING TOOLS LINEAR PROGRAMMING One of the most widely used techniques is that of linear programming. It has been described as a technique for specifying how to use limited resources or capacities of a business to obtain a particular objective, such as least cost, highest margin, or least time, when those resources have alternative uses. It is a technique that systematizes for certain conditions the process of selecting the most desirable course of action from a number of available courses of action, thereby giving management information for making a more effective decision about the resources under its control.

INVENTORY CONTROL A problem faced by managers is that of maintaining adequate inventories. On the one hand, no one wants to have too many units available because there are costs associated with carrying these customer future businesses. There are two types of costs that merit the manager's consideration: The Ordering cost and Carrying costs. 9

CHAPTER II: DEMAND ANALYSIS

MEANING OF DEMAND Conceptually, demand can be defined as the desire for a good backed by the ability and willingness to pay for it. The desire without adequate purchasing power and willingness to pay do not become effective demand and only an effective demand matters in economic analysis and business decisions.

TYPES OF DEMAND The demand for various commodities is generally classified on the basis of the consumers of the product, suppliers of the product, nature of goods, duration of the consumption of the commodity, interdependence of demand, period of demand and nature of use of the commodity(intermediate or final). 

Individual and Market Demand



Autonomous and derived demand



Demand for durable and nondurable goods



Demand for firm’s product and industry product



Demand for consumers and producers goods

INDIVIDUAL AND MARKET DEMAND The quantity of a commodity which an individual is willing to buy at a particular price during a specific time period given his money income, his taste and prices of other commodities is called individual’s demand for a commodity. On the other hand market demand of a commodity is the summation of individual demand by all the consumers. Market demand is a multivariate relationship and determined by many factors simultaneously. Some of the most important determinants of the market demand for a particular commodity are its own price, consumer’s income, prices of other commodities, consumer’s taste, income distribution, total population, consumer’s wealth, credit availability, Government policy, past level of income and past level of demand.

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AUTONOMOUS AND DERIVED DEMAND The demand for a commodity that arises on its own out of a natural desire to consume or possesses a commodity independent of the demand of other commodities, which may be substitute or complementary or on the raw material side or on the product side, the demand for the product is termed as independent. Commodities like tea and vegetables do come on absolute . On the other hand if the demand for a product is tied to the demand for some parent product, the demand is termed as derived demand.

DEMAND FOR DURABLE AND NONDURABLE GOODS Durable goods are those whose total utility is not exhausted in a single or short run use. Such goods can be used repeatedly over a period of time. Durable goods may be consumer goods as well as producer goods. The demand for durable goods changes over a relatively longer period. Perishable (non-durable) goods are defined as those which can be used only once. Their demand is of two types. Replacement of old products and expansion of existing stock. The demand for nondurable goods depends largely on their prices, consumer income and is subject to frequent change.

DEMAND FOR FIRM’S PRODUCT AND INDUSTRY PRODUCT Firm’s demand denotes the demand for the products by a particular company or firm whereas industry demand is the aggregation of demand for the product of all the firms of an industry as a whole. A Clear understanding of the relation between company and industry demand necessitates the understanding of different market structures. These structures can be differentiated the basis of product differentiation and number of sellers.

DEMAND FOR CONSUMERS AND PRODUCERS GOODS

Consumer goods are those, which are, meant for the final consumption by the consumers or the end s. Producer's goods on the other hand are used for the production of consumer goods or they are intermediate goods, which are further processed upon to convert them into a form to be used by the end . Another distinction is that the demand for producer’s goods is derived demand and it indirectly depends on the demand for the consumer goods which the producer goods is used to produce. It may also be possible that this demand may be accelerated or accentuated in the same proportion as the change in the demand for the final consumer goods. A small change in the demand for consumer goods

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may either completely wipes out the demand for the producer goods or may accelerate it.

DETERMINANTS OF DEMAND



Commodity’s Own Price



Prices of related goods → Substitutes and Complements



Income level of consumer



Tastes & Preferences



Expectations



Population



Other exogenous factors

DEMAND FUNCTION 

The determinants of quantity demanded when summarized in the form of functional notations are called a demand function. A typical demand function can be specified as follows: = f( pn, p1, p2,…….pn-1, Y,T, Ep, Ey, Ad. Exp., N, D, u)



Dn



Where



P1………Pn-1 = Prices of other products



Y

= income level of consumers



T

= Taste and preferences of consumers



Ep

= expected prices



Ey

= expected income



Ad. Exp.

= advertising expenditure



N

= number of consumers



D

= distribution of consumers

 u

pn = price of n product

= other factors

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LAW OF DEMAND There is negative relationship between price of a product and quantity demanded of that product, ceteris paribus i.e., other factors remaining constant.

DEMAND SCHEDULE A demand schedule is one way of showing the relationship between quantity demanded and price, all other things being held constant. Price($

per

Quantity

demanded

dozen)

(dozen per month)

0.50

7.0

1.00

5.0

1.50

3.5

2.00

2.5

2.50

1.5

3.00

1.0

DEMAND CURVE Demand curve is the graphical representation of the relationship between price and quantity demanded of a good, all other things being held constant. A demand curve is said to be linear when its slope is constant all along the curve, whereas for a nonlinear or curvilinear curve the slope never remains constant. The linear demand curve may be written in the form of;

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P

P

Linear Demand

Q

Curve

Non – Linear Demand

Q

Curve

SHIFT OF DEMAND CURVE V/S MOVEMENT ALONG THE DEMAND CURVE A movement along the demand curve is in response to a change in price and leads to expansion or Contraction of Demand. This is called Change in Quantity Demanded. On the other hand Shift in the demand curve either upward or downward is in response to a change in one of the other determinants of demand.

ELASTICITIES OF DEMAND There are as many types elasticity of demand as its determinants. The most important types of elasticity are: 

Price elasticity of demand



Income elasticity of demand



Cross elasticity of demand

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THE PRICE ELASTICITY OF DEMAND The price elasticity is a measure of the responsiveness of demand to changes in the commodity’s own price. For very small changes in price point elasticity of demand is used as a measure of responsiveness of demand and arc elasticity of demand is the suitable measure for comparatively large changes in price. The point elasticity of demand is defined as the proportionate change in the quantity demanded resulting from a very small proportionate change in price.

We may summarize 

this relationship as follows:

If the demand is inelastic (e < 1) an increase in price leads to an increase in total revenue and vice versa.



If the demand is elastic (e>1) an increase in price will lead to a decrease in total revenue and vice versa.



If the demand has unitary elasticity (e =1), total revenue is not affected by changes in price.

Determinants of Price Elasticity of Demand 

Number and availability of Substitutes



The proportion of income spent on the particular commodity



Nature of the need that the product satisfies



Length of time period under consideration



The number of uses to which a commodity can be put

Price elasticity and Decision Making 

Information about price elasticity can be extremely useful to managers as they contemplate pricing decisions.



If demand is inelastic at the current price, a price decrease will result in a decrease in total revenue.



Alternatively, reducing the price of a product with elastic demand would cause revenue to increase.

TR = P*Q

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THE INCOME ELASTICITY OF DEMAND The income elasticity of demand is defined as the proportionate change in the quantity demanded resulting from a proportionate change in income. The income elasticity is positive for normal goods.

THE CROSS ELASTICITY OF DEMAND The cross elasticity of demand is defined as the proportionate change in the quantity demanded of x commodity resulting from a proportionate change in the price of y commodity. The sign of cross elasticity is negative if x and y are complementary goods and positive if x and y are substitutes. The higher the value of the cross elasticity the stronger will be the degree of substitutability or complementarity of x and y.

CLASSIFICATION OF GOODS 

Normal Goods – Demand Increases as Income increases



Inferior Goods – Demand decreases as consumer Income increases

Basic Necessities – Commodities like a salt, food grain etc. for which demand is relatively inelastic and does not vary with income after a point EXCEPTIONS TO THE LA W OF DEMAND – UPWARD SLOPING DEMAND CURVE



Giffen Goods – a subclass of Inferior goods for which the income effect outweighs the substitution effect



Veblen Products / Snob effect – Goods that have a snob value attached to them for which demand actually increases as price goes up



Speculative Effect – In periods of rising prices, anticipation of future increases may cause consumers to demand more



Bandwagon Effect – Occurs when people demand a commodity only because others are demanding it and in order to be fashionable



Emergencies like war, famine etc.

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THEORY OF CONSUMER BEHAVIOR The consumer is assumed to be rational. Given his income and the market prices of the various commodities, he plans the spending of his income so as to attain the highest possible satisfaction or utility. This is the axiom of utility maximization. In order to attain this objective the consumer must be able to compare the utility of the various ‘baskets of goods’ which he can buy with his income. There are two basic approaches to compare the utilities, the cardinalist approach and the ordinalist approach.

THE CARDINAL UTILITY THEORY The cardinal school stated that utility can be measured. Under certainty i.e., complete knowledge of market conditions and income levels over the planning period utility can be measured in monetary units, called utils. There are certain assumptions of cardinal utility theory. 

Rationality of consumer



Constant marginal utility of money



Diminishing marginal utility



Total utility is additive

Equilibrium of Consumer Assuming the simple model of a single commodity x, the consumer can either buy x or retain his money income y. Under these conditions the consumer is in equilibrium when the marginal utility of x is equated to its market price.

MU x  Px If there are more commodities, the condition for the equilibrium is the equality of the ratios of the marginal utilities of the individual commodities to their prices.

THE ORDINAL UTILITY THEORY The ordinalist school postulated the utility is not measurable, but is an ordinal magnitude. It suffices for the consumer to be able to rank the various baskets of goods according to the satisfaction derived. The main ordinal theory is known as the indifference-curve theory is based on certain assumptions. 

Rationality of consumer



Utility is ordinal 17



Diminishing Marginal rate of substitution



Consistency and transitivity of choice



Total utility depends on the quantities of the commodities consumed

Equilibrium of Consumer 

The consumer is in equilibrium when he maximizes his utility, given his income and the market prices. Two conditions must be fulfilled for the consumer to be in equilibrium.



The first condition is that the marginal rate of substitution be equal to the ratio of commodity prices.



The second condition is that the indifference curve be convex to the origin. This condition is fulfilled by the axiom of diminishing marginal rate of substitution of x for y and vice versa.



At the point of tangency (point e) the slopes of the budget line ( P x / P y ) and of the indifference curve ( MRS x ,y  MU x / MU y ) are equal:

Properties of Indifference Curve 

An indifference curve has a negative slope



The further away from the origin an indifference curve lies, the higher the utility it denotes



Indifference curve do not intersect



The indifference curves are convex to the origin

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THE CONSUMER SURPLUS Consumer surplus is equal to the difference between the amount of money that a consumer actually pays to buy a certain quantity of a commodity and the amount that he would be willing to pay for this quantity rather than do without it. Graphically the consumers’ surplus may be found by his demand curve for commodity and the current market price, which he cannot affect by his purchase of that commodity.

Consumer surplus = PCA

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CHAPTER III: COST ANALYSIS

INTRODUCTION Cost functions are derived functions from the production function which describes the available efficient methods of production at any one time. The cost of production is an important factor in almost all the business analysis and decisions, especially those related to locating the weak points in production management, minimizing the cost, finding the optimum level of output, determination of price and dealers margin, estimation of the cost of business operation. The cost concepts can be grouped under two categories on the basis of their nature and purpose.

ING COST CONCEPTS OPPORTUNITY VS ACTUAL COST The opportunity cost may be defined as the expected returns from the second best use of the resources which are foregone due to the scarcity of resources. It is also called alternative cost. The concept of economic rent or economic profit is associated with it. On the other hand actual Cost considers only explicit cost, the out of pocket cost for items such as wages, salaries, materials, and property rentals.

EXPLICIT COST VS IMPLICIT COST Explicit costs are cash expenses for the payment of wages, salaries, material, license fee, insurance , depreciation charges and are recorded in normal ing practices. In contrast implicit costs are non-cash expenses. Opportunity cost is an important example of implicit cost. The explicit and implicit costs together make the economic cost.

AN alytical Cost Concepts SUNK VS INCREMENTAL COST The sunk costs are those which cannot be altered, increased or decreased, by varying the rate of output. A sunk cost is an expenditure that has been made and cannot be recovered since it accord to the prior commitment. Incremental cost is the change in cost tied to a managerial decision associated with expansion of output or addition of new variety of product.

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FIXED AND VARIABLE COSTS Fixed costs are those which are fixed in volume for a certain given output. It does not vary with variation in the output for a certain scale. The fixed costs include the cost of managerial and istrative staff, depreciation of fixed assets, maintenance of land etc. Fixed costs are associated with the short run. Variable costs are those which vary with the variation in the total output. It include cost of raw material, cost of direct labor, running cost of fixed capital such as fuel, repairs, routine maintenance etc.

TOTal, Average and Marginal Costs

Total Cost Total cost is the total expenditure incurred on the production. It connotes both explicit and implicit money expenditure and include fixed and variable costs.

Average cost Average cost is obtained by dividing the total cost by the total output. AVERAGE COST = TC/Q

Average cost further can be categorized as average fixed cost (AFC) and average variable cost (AVC). AFC = TFC/Q AVC = TVC/Q

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Average cost curves

Marginal Cost Marginal cost is the change in the total cost for producing an extra unit of output.

MC  TC/Q

Marginal Cost Curve

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Chapter-IV: Business Forecasting INTRODUCTION Estimation of demand for a product in a forecast year/ period is termed as Demand forecast. Demand forecast is a must for a firm operating its business as today's market is competitive, dynamic and volatile.

PURPOSE AND NEED OF FORECASTING Forecasting is done in both for long term as well as short term. The purpose of the two however differs.

SHORT TERM: 

It helps in preparing suitable sales policy and proper scheduling of output in order to avoid over-stocking or costly delay in meeting the orders.



It helps in arriving at suitable price for the product and necessary modifications in advertising and sales techniques.

LONG TERM: Long run forecasts are helpful in proper capital planning. It helps in saving the wastages in material, m -hours, machine time and capacity.

Long run forecasting is used for new unit planning, expansion of the existing units, planning long run financial requirements and manpower requirements. Different set of variables is used in long run forecasts than in short term forecasts.

SPECIFIC PURPOSES OF DEMAND FORECASTING 

Better planning and allocation of resources



Appropriate production scheduling



Inventory control



Determining appropriate pricing policies

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

Setting of targets and establishing controls and incentives.



Planning a new unit or expanding existing one



Planning long term financial requirements



Planning Human Resource Development strategies.

STEPS INVOLVED IN FORECASTING 

Identification of objectives



Determining the nature of goods under consideration.



Selecting a proper method of forecasting.



Interpretation of results.

PERIOD OF FORECASTING 

Short run forecasting: In short run forecasting, we look for factors which bring fluctuation in demand pattern in the market for example weather conditions like monsoon affecting the demand.



Long run forecasting: It is done to ascertain the validity of trend. It is done for decision like diversification.

LEVELS OF FORECASTING 

Macroeconomic forecasting is concerned with business conditions of the whole economy. It is measured with the help of indices like wholesale price index, consumer price index.



Industry demand forecasting gives indication to firm regarding direction in which the whole industry will be moving. It is used to decide the way the firm should plan for future in relation to the industry.

 Firm demand forecasting is done for planning company’s overall operations like sales forecasting etc.  Product line forecasting helps the firm to decide which of the product or products should have priority in the allocation of firm's limited resources.

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

General purpose forecast helps the firm in taking general factors into consideration while forecasting for demand.

METHODS OF FORECASTING It is not unusual to hear a company's management speak about forecasts: "Our sales did not meet the forecasted numbers," or "we feel confident in the forecasted economic growth and expect to exceed our targets." In the end, all financial forecasts, whether about the specifics of a business, like sales growth, or predictions about the economy as a whole, are informed guesses. In this section, we'll look at some of the methods of business forecasting.

QUALITATIVE FORECAST This is forecasting that uses factors that cannot be directly measured. The estimates are made with a system of ratings to produce a figure. No verifiable data is used and it is based on human judgment and the system of ratings to produce a result. Qualitative forecasts include: Survey techniques and Opinion Pools. SURVEY TECHNIQUES There are various types of surveys you can choose from. Basically, the types of surveys are broadly categorized into two: according to instrumentation and according to the span of time involved. 

The types of surveys according to instrumentation include the questionnaire and the interview. o

Questionnaires: Typically, a questionnaire is a paper-and-pencil instrument that is istered to the respondents. The usual questions found in questionnaires are closed-ended questions, which are followed by response options. However, there are questionnaires that ask open-ended questions to explore the answers of the respondents.

o

An interview includes two persons - the researcher as the interviewer, and the respondent as

the

interviewee.

Between

the

two

broad

types

of

surveys, interviews are more personal and probing. Questionnaires do not provide the freedom to ask follow-up questions to explore the answers of the respondents, but interviews do. 25



On the other hand, the types of surveys according to the span of time used to conduct the survey are comprised of o

Cross-sectional surveys: Collecting information from the respondents at a single period in time uses the cross-sectional type of survey. Crosssectional surveys usually utilize questionnaires to ask about a particular topic at one point in time. For instance, a researcher conducted a cross-sectional survey asking teenagers’ views on cigarette smoking as of May 2010.

o

Longitudinal surveys: When the researcher attempts to gather information over a period of time or from one point in time up to another, he is doing a longitudinal survey. The aim of longitudinal surveys is to collect data and examine the changes in the data gathered.

OPINION POLLS

Opinion poll method aims at collecting opinions of those who are supposed to possess knowledge of the market e.g. sales representatives, professional marketing experts and consultants. Opinion poll methods include: 

Consumer survey method: In this method the consumers are ed personally to disclose their future purchase plans. This could be of two types-



o

Complete enumeration and

o

Sample survey.

Sales force opinion method: In this method people who are closest to the market are asked for their opinion on future demand. Then opinions of different people are compiled to get overall demand forecast. This method has advantage that it is based on firsthand knowledge of sales people and also it is cheap and easy. However the opinion of the concerned people could be biased or twisted for their own benefit. Therefore a final ratification has to be done by the head office.



Experts’ opinion method: In this method opinion of experts in the related field is solicited and the final forecast based on their opinion. A special case in this method is the Delphi Technique. In this method, different sets of experts are given the relevant problem without each knowing about the other and their opinions or conclusions are

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compared. If the opinion is matching then the opinion is accepted otherwise the experts are asked to sit together and arrive at a narrow range. Thus the experts giving a very high or a very low value are concerned and the group argues until it comes up with a narrow range of value. This process is continued till a sufficient range is reached. Then the mean of the upper and lower values is computed to reach a point estimate.

STATISTICAL FORECAST Statistical methods are complex set of methods of demand forecasting. These methods are used to forecast demand in the long term. In this method, demand is forecasted on the basis of historical data and cross-sectional data Historical data refers to the past data obtained from various sources, such as previous years’ balance sheets and market survey reports. On the other hand, cross-sectional data is collected by conducting interviews with individuals and performing market surveys. Unlike survey methods, statistical methods are cost effective and reliable as the element of subjectivity is minimum in these methods. Statistical forecast methods include:  Trend projection methods  Barometric methods  Regression methods  Econometric Models (Simultaneous equation method)

 Simultaneous equation method (Econometric Models)

TREND PROJECTION METHOD Under the trend method the time series data on the variable under forecast are used to fit a trend line or curve either graphically or by means of a statistical technique known as the Least Squares method. Trend projection method can be used when there is some sort of correlation between the two variables. It could be linear, logarithmic or power correlation. The linear regression model will take the form of Y = a + bX  Fitting a trend line by observation: This method involves the plotting of the data on the graph and estimating where the trend line lies. The line can be extrapolated and the forecast read from the graph.  Trend through least squares method: This method uses statistical formulae to 27

find the trend line which best fits the available data. The trend line is the estimating equation, which can be used for forecasting demand by extrapolating the line for future and reading the corresponding values of variables on the graph.  Time series analysis: This is an extension of linear regression which attempts to build seasonal and cyclical variations into the estimating equation. This method assumes that past data can be used to predict future sales. This is one of the most frequently used forecasting methods. It refers to the values of variable arranged chronologically by days, weeks, months, quarters or years. The first step in time series analysis is usually to plot past values of the variable that we seek to forecast on vertical axis and the time on the horizontal axis in order to visually inspect the movement of the time series over time. Its assumption is that the time series will continue to move as in the past. For this reason time series analysis is often referred as "native forecasting”.

BAROMETRIC METHODS Barometric methods are used to forecast or anticipate short term changes in economic activity by using leading economic indicators. These indicators are time series that tend to precede changes in the level of economic activity. There are only three types of indicators: 

Leading economic indicators: These indicators tend normally to anticipate turning points in a business cycle. There are certain problems associated with this method. The major problem is not choosing the technique but choosing the relevant indicator for the product in question. Secondly even if the relevant indicator is found out the changes in factors may render the indicator redundant over time. Thirdly the time lag between the indicator and forecast could be so small that it could become useless.

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Coincident indicators: These are indicators which move in step or coincide with movement in general economic activity or business cycle.

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Lagging indicator: These are indicators which break the movements in economic activity or business cycle.

REGRESSION METHOD It is one of the statistical tools to forecast demand. In this estimation, equations are established and tests can be carried out to observe any statistically significant. It involves following steps 

Identification of variables which influence the demand for the goods whose function is under estimation.

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Collection of historical data on all relevant variables.

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Choosing an appropriate form of the function.

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Estimation of the function

Regression method is popular because it is prescriptive as well as descriptive. Also it is not as subjective or objective as other methods. However if the variables chosen are wrong then the forecast will also be wrong. A typical demand equation could be:

FLUCTUATIONS IN TIME SERIES DATA  Changes occur in secular trend i.e. long run increase or decrease in data series.

CYCLICAL FLUCTUATIONS  There are the major expansions and contractions in most economic time series data that seem to re-occur every several years. A typical cycle could last 15-20 years.

SEASONAL VARIATION  This refers to regularly recurring fluctuations in economic activity during each year e.g. a typical factor could be weather and social customs.

IRREGULAR AND RANDOM VARIATION  This is the variations in the data series resulting from unique events like wars, natural disasters or strikes. The total variation in the time series is the result of all the above four factors operating together. They are usually examined separately by qualitative techniques.

RISKS IN DEMAND FORECASTING Demand forecasting faces two major risks 

Overestimation of demand



Underestimation of demand

One risk arises from entirely unforeseen events such as war, political upheavals and natural disasters. The second risk arises from inadequate analysis of the market. 

All these forecasting errors could possibly have been avoided through:

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

Carefully defining the market for the product to include all potential s of the market and considering the possibility of product substitution.



Dividing total industry demand into its components and analyzing each component separately.

Forecasting the main driver or of the product in each segment of the market and projecting how they are likely to change in the future.

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