Unit – I

INTRODUCTION TO ENGINEERING ECONOMICS

Economics:

Economics is the science that deals with the production and consumption of goods and services
and the distribution and rendering of these for human welfare.

The following are the economic goals.

 A high level of employment

 Price stability
 Efficiency
 An equitable distribution of income
 Growth

Some of the above goals are interdependent. The economic goals are not always complementary;
in many cases they are in conflict. For example, any move to have a significant reduction in
unemployment will lead to an increase in inflation.

Flow in an Economy:

The flow of goods, services, resources and money payments in a simple economy are shown in
Fig. 1.1. Households and businesses are the two major entities in a simple economy. Business
organizations use various economic resources like land, labour and capital which are provided by
households to produce consumer goods and services which will be used by them. Business
organizations make payment of money to the households for receiving various resources. The
households in turn make payment of money to business organizations for receiving consumer
goods and services. This cycle shows the interdependence between the two major entities in a
simple economy.
 Money payments for consumer goods and services

Consumer goods, services

Businesses Households
1. Consume final goods
1. Provide goods and
and services produced
services to consumers
by business and
2. Use resources, inputs 2. services
Provide productive
provided by inputs to business
households

Money payments for resources, rents, wages, salaries, interest and profit

Economic Resources: Land, Labour and Capital

Fig. 1.1 Flow of goods, services, resources and money payments in a simple
economy.
CONCEPT OF ENGINEERING ECONOMICS

Science is a field of study where the basic principles of different physical systems are formulated
and tested. Engineering is the application of science. It establishes varied application systems
based on different scientific principles.

Types of Efficiency:

Efficiency of a system is generally defined as the ratio of its output to input. The efficiency can
be classified into technical efficiency and economic efficiency.

Technical efficiency:

It is the ratio of the output to input of a physical system. The physical system may be a diesel
engine, a machine working in a shop floor, a furnace, etc.
𝑂𝑢𝑡𝑝𝑢𝑡
Technical efficiency (%) = 𝑥100
𝐼𝑛𝑝𝑢𝑡

The technical efficiency of a diesel engine is as follows:

𝐻𝑒𝑎𝑡 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑜𝑓 𝑀𝑒𝑐ℎ𝑛𝑖𝑐𝑎𝑙 energy Produced
Technical efficiency (%) = 𝑥100
𝐻𝑒𝑎𝑡 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑜𝑓 𝑓𝑢𝑒𝑙 𝑢𝑠𝑒𝑑
In practice, technical efficiency can never be more than 100%. This is mainly due to frictional
loss and incomplete combustion of fuel, which are considered to be unavoidable phenomena in
the working of a diesel engine.

Economic efficiency:

Economic efficiency is the ratio of output to input of a business system.

𝑂𝑢𝑡𝑝𝑢𝑡 𝑊𝑜𝑟𝑡ℎ
Economic efficiency (%) = 𝑥100 = 𝑥100
𝐼𝑛𝑝𝑢𝑡 𝐶𝑜𝑠𝑡

‘Worth’ is the annual revenue generated by way of operating the business and ‘cost’ is the total
annual expenses incurred in carrying out the business. For the survival and growth of any
business, the economic efficiency should be more than 100%.

Economic efficiency is also called ‘productivity’. There are several ways of improving
productivity.

 Increased output for the same input

 Decreased input for the same output
 By a proportionate increase in the output which is more than the proportionate increase in
the input
 By a proportionate decrease in the input which is more than the proportionate decrease in
the output
 Through simultaneous increase in the output with decrease in the input.

Increased output for the same input: In this strategy, the output is increased while keeping the
input constant.

Decreased input for the same output:. In this strategy, the input is decreased to produce the
same output.

Less proportionate increase in output is more than that of the input: Introducing a new product
into the existing product mix of an organization.

When proportionate decrease in input is more than that of the output: Dropping an uneconomical
product from the existing product mix.

Simultaneous increase in output and decrease in input: Let us assume that there are advanced
automated technologies like robots and automated guided vehicle system (AGVS), available in
the market which can be employed in the organization we are interested in. If we employ these
modern tools, then:
  There will be a drastic reduction in the operation cost. Initially, the cost on equipment
would be very high. But, in the long run, the reduction in the operation cost would break-
even the high initial investment and offer more savings on the input.
 These advanced facilities would help in producing more products because they do not
experience fatigue. The increased production will yield more revenue.

In this example, in the long run, there is an increase in the revenue and a decrease in the input.
Hence, the productivity ratio will increase at a faster rate.

Definition and Scope of Engineering Economics:

Definition:

Engineering economics deals with the methods that enable one to take economic decisions
towards minimizing costs and/or maximizing benefits to business organizations.

Scope:

Engineering economics are covered the elementary economic analysis, interest formulae, bases
for comparing alternatives, present worth method, future worth method, annual equivalent
method, rate of return method, replacement analysis, depreciation, evaluation of public
alternatives, inflation adjusted investment decisions, make or buy decisions, inventory control,
project management, value engineering, and linear programming.

Elementary Economic Analysis

Whether it is a business situation or a day-to-day event in somebody’s personal life, there is a
large number of economic decisions making involved. One can manage many of these decision
problems by using simple economic analysis.
For example, an industry can source its raw materials from a nearby place or from a far-off
place. In this problem, the following factors will affect the decision:

 Price of the raw material

 Transportation cost of the raw material
 Availability of the raw material
 Quality of the raw material

Consider the alternative of sourcing raw materials from a nearby place with the following
characteristics:

 The raw material is more costly in the nearby area.

 The availability of the raw material is not sufficient enough to support the operation of
the industry throughout the year.
  The raw material requires pre-processing before it is used in the production process. This
would certainly add cost to the product.
 The cost of transportation is minimal under this alternative.

On the other hand, consider another alternative of sourcing the raw materials from a far-off place
with the following characteristics:

 The raw material is less costly at the far off place.

 The cost of transportation is very high.
 The availability of the raw material at this site is abundant and it can support the plant
throughout the year.
 The raw material from this site does not require any preprocessing before using it
for production.
1. Material Selection For A Product/Substitution Of Raw Material
The cost of a product can be reduced greatly by substitution of the raw materials. Among
various elements of cost, raw material cost is most significant and it forms a major portion of the
total cost of any product. So, any attempt to find a suitable raw material will bring a reduction in
the total cost in any one or combinations of the following ways:
 Reduced machining/process time
 Enhanced durability of the product
 Cheaper raw material price
Therefore, the process of raw material selection/substitution will result in finding an alternate
raw material which will provide the necessary functions that are provided by the raw material
that is presently used. In this process, if the new raw material provides any additional benefit,
then it should be treated as its welcoming feature. This concept is demonstrated with numerical
problem given below

Example
In the design of a jet engine part, the designer has a choice of specifying either an aluminium
alloy casting or a steel casting. Either material will provide equal service, but the aluminium
casting will weigh 1.2 kg as compared with 1.35 kg for the steel casting.

The aluminium can be cast for Rs. 80.00 per kg. and the steel one for Rs. 35.00 per kg. The cost
of machining per unit is Rs. 150.00 for aluminium and Rs. 170.00 for steel. Every kilogram of
excess weight is associated with a penalty of Rs. 1,300 due to increased fuel consumption.
Which material should be specified and what is the economic advantage of the selection per
unit?
Solution
(a) Cost of using aluminium metal for the jet engine part:
Weight of aluminium casting/unit = 1.2 kg
 Cost of making aluminium casting = Rs. 80.00 per kg
Cost of machining aluminium casting per unit = Rs. 150.00
Total cost of jet engine part made of aluminium /unit
= Cost of making aluminium casting/unit + Cost of machining aluminium
casting/unit
= 80 1.2 + 150 = 96 + 150 = Rs. 246

(b) Cost of jet engine part made of steel/unit: Weight of steel casting/unit = 1.35 kg
Cost of making steel casting = Rs. 35.00 per kg
Cost of machining steel casting per unit = Rs. 170.00 Penalty of excess weight of steel
casting = Rs. 1,300 per kg
Total cost of jet engine part made of steel/unit
= Cost of making steel casting/unit + Cost of machining steel casting/unit +
Penalty for excess weight of steel casting
= 35 1.35 + 170 + 1,300(1.35 – 1.2)
= Rs. 412.25
DECISION The total cost/unit of a jet engine part made of aluminium is less than that for an
engine made of steel. Hence, aluminium is suggested for making the jet engine part. The
economic advantage of using aluminium over steel/unit is Rs. 412.25 – Rs. 246 = Rs. 166.25

2. Design Selection for a Product

a. The design modification of a product may result in reduced raw material

requirements, increased machinability of the materials and reduced labour.
b. Design is an important factor which decides the cost of the product for a specified
level of performance of that product.

Example
(Design selection for a process industry). The chief engineer of refinery operations is not
satisfied with the preliminary design for storage tanks to be used as part of a plant expansion
programme. The engineer who submitted the design was called in and asked to reconsider the
overall dimensions in the light of an article in the Chemical Engineer, entitled “How to
size future process vessels?”

The original design submitted called for 4 tanks 5.2 m in diameter and 7 m in height. From a
graph of the article, the engineer found that the present ratio of height to diameter of 1.35 is
111% of the minimum cost and that the minimum cost for a tank was when the ratio of height to
diameter was 4 : 1. The cost for the tank design as originally submitted was estimated to be Rs.
9,00,000. What are the optimum tank dimensions if the volume remains the same as for the
original design? What total savings may be expected through the redesign?
Solution
(a) Original design
Number of tanks = 4, Diameter of the tank = 5.2 m, Radius of the tank = 2.6 m, Height of
the tank = 7 m. Ratio of height to diameter = 7/5.2 = 1.35
Volume/tank = (22/7)r2 h = (22/7)(2.6)2 x7
= 148.72 m3
(b) New design

Cost of the old design = 111% of the cost of the new design (optimal design)
Optimal ratio of the height to diameter = 4:1
h:d=4:1
4d = h
d = h/4
r = h/8
2
Volume = (22/7)r h = 148.72 (since, the volume remains the same)
(22/7)(h/8)2h = 148.72
h = 14.47 m
r = h/8 = 14.47/8 = 1.81 m
Therefore,
Diameter of the new design = 1.81x2
= 3.62 m
Cost of the new design = 9,00,000 x (100/111)
= Rs. 8,10,810.81
Expected savings by the redesign = Rs. 9,00,000 – Rs. 8,10,810.81 = Rs. 89,189.19
Process Planning /Process Modification
While planning for a new component, a feasible sequence of operations with the least cost of
processing is to be considered. The process sequence of a component which has been planned in
the past is not static. It is always subject to modification with a view to minimize the cost of
manufacturing the component. So, the objective of process planning/process modification is to
identify the most economical sequence of operations to produce a component.

The steps in process planning are as follows:

 Analyze the part drawing to get an overall picture of what is required.

 Make recommendations to or consult with product engineers on product design changes.
 List the basic operations required to produce the part to the drawing or specifications.
 Determine the most practical and economical manufacturing method and the form or
tooling required for each operation.
 Devise the best way to combine the operations and put them in sequence.
  Specify the gauging required for the process.

Steps 3–5 aim to determine the most practical and economical sequence of operations to produce
a component. This concept is demonstrated with a numerical problem.

Example

The process planning engineer of a firm listed the sequences of operations as shown in Table to
produce a component.
Sequence Process sequence

1 Turning – Milling – Shaping – Drilling

2 Turning – Milling – Drilling
3 All operations are performed with CNC machine

The details of processing times of the component for various operations and their machine hour
rates are summarized in Table below.

Machine Hour Rates and Processing Times (minutes) for Example

Find the most economical sequence of operations to manufacture the component.

Solution (a) Cost of component using process sequence 1. The process sequence 1 of the
component is as follows:
Turning – Milling – Shaping – Drilling
The calculations for the cost of the above process sequence are summarized in Table.
Table Workings for Process Sequence 1
(b) Cost of component using process sequence 2. The process sequence 2 of the component is as
follows:
Turning – Milling – Drilling
The calculations for the cost of the above process sequence are given in Table
Table Workings for Process Sequence 2

(c) Cost of component using process sequence 3. The process sequence 3 of the component is as
follows:
Only CNC operations
The calculations for the cost of the above process sequence are summarized in Table
Table Workings for Process Sequence 3

The process sequence 2 has the least cost. Therefore, it should be selected for manufacturing the
component.
Managerial Economics : “Managerial Economics is the integration of economic theory with
Business practice for the purpose of facilitating decision making and forward planning By
management.” ___Spence and Siegel

“Managerial economics refers to the application of economic theory and tools of analysis of
decision science to examine how an organization can achieve its aims and objectives more
efficiently.” ____Salvatore

“Managerial economics is the application of economic theory and methodology to business

administration practice.” ___Brigham and Pappas.

Management Decision Problem

Economic Concept Decision Sciences Tools

Theory of Consumer Behaviors Mathematics

Theory of the firm Statistical Estimation

Theory of Market structure & Pricing Operations Research

Managerial Economics

Use of Economic Concepts and

Decision Science Tools to Solve
Managerial Decision Problems

Optimum Solution to Managerial Problems

Nature of Managerial Economics:

Important features of managerial economics are as under:

Similar to Micro Economics: Managerial economics studies about the firm and scarce
resources for maximizing output, finding solutions to the problem of the firm for maximizing
profit.
Operates against the backdrop of Macroeconomics: The Limiting conditions of
macroeconomics are same for managerial economics. So managerial economist can decide the
strategy to work considering these conditions such as inflation, government etc.

Normative Statement : The statements are usually based on moral attitude and value
judgements

Perspective actions : Managerial economics is goal oriented. The course of action is chosen
from available alternatives.

Applied in nature : The model reflects the real business situations hence are more useful for
decision making in diverse fields. Case study methods are also used to identify and understand
the problem

Interdisciplinary : Managerial Economics uses tools and techniques which are derived from
management economics, statistics, accountancy, sociology and psychology.

Scope of Managerial Economics: Managerial economics has close connection with economic
theory (micro-economics as well as macro-economic), operations research, statistics,
mathematics and the theory of decision-making. Managerial economics also draw together and
relates ideas from various functions areas of management like production, marketing, finance
and accounting, project management etc.

Demand analysis and forecasting: A business firm is an economic organism, which transforms
productive resources into goods that are to be sold in a market.

Cost analysis: The factors causing variations in cost must be recognized and allowed for, if
management is to arrive at cost estimates, which are significant for planning purposes.

Production and Supply analysis: Production analysis deals with different production functions
and other managerial uses. Supply analysis deals with various aspects of supply of a commodity.
Certain important aspects of supply analysis are supply schedule, and functions, law of supply
and its limitation, elasticity of supply of factors influencing supply.

Pricing decisions, policies and practices: The important aspects dealt with under this are price
determination in various market forms, pricing methods, differential pricing, product line pricing
and price forecasting.

Profit Management: Business firms are generally organized for making profits and in the long
run, profits provide the chief measure of success. In this connection, an important point worth
considering is the element of uncertainty existing about profits because of variations in costs and
revenues, which in turn are caused by factors both internal and external to the firm.
Meaning of Demand: Demand in economics is the desire for something plus willingness and
ability to pay a certain price in order to possess it. It means being both willing and able to buy
something just wanting something is not enough. Needing it desperately is also not acceptable
unless you have the money to pay. Thus, demand is a want for something supported by the
money to but it.

Demand Analysis : Demand analysis seeks to identify, analyze and measure the forces and
factors that determine sales.

Factor Influencing the Demand/Determinants of Demand :

Price of the commodity : The price of a given commodity is an important factor in influencing
its demand. If the price is very high, only a few persons can afford to buy it. Hence, the quantity
of the commodity bought at this high price will be low i.e. the commodity will have a lower
demand and vice versa.

Income of the consumer : Besides the price level, income of the consumer greatly determines
the demand for a commodity. If there is a change in the income of the consumer, then it will
reflect on the demand of the commodity he purchases. A rise in his income will lead to purchase
more units of the commodity and vice versa.

Size and composition of the population : If there is a change in the population of a given
market, there will be a change in demand. Rise in the population will result in increase in
demand and fall will lead to decrease.

Price of substitutes : In case of substitutes of a product, the change in the price of substitute will
affect the demand for the other product.

Price of complementary : The changes in the price of a complementary goods will affect the
demand for primary good.

Tastes and fashions : Changes in tastes and fashions of the society will effect the demand for a
product.

Advertisement and sales promotion : In today’s world, advertisement has a major role in
demand creation for a product. Advertisement creates the awareness about product, so the
consumer will be influenced and the demand for the product goes up.

Quality of product : Any product with proven high quality will have a greater demand.

Season and weather condition : Certain goods are seasonal in nature. They will be demand
only in a particular season. Weather condition also creates demand for some products.
Law of Demand : The relation of price to sales is known in economics as the law of demand.
The law of demand states that higher the price, lower the demand, and vice-versa other things,
remains the same.

Example:
D1 Demand Curve
Price Quantity
Rs.5 80 Units
Rs.4 100 Units
Rs.3 150 Units
Price
Rs.2 200 Units
D1

Quantity

Assumptions of the law:

Law is demand is based on certain assumptions:

1. This is no change in consumers taste and preferences.

2. Income should remain constant.
3. Prices of other goods should not change.
4. There should be no substitute for the commodity
5. The commodity should not confer at any distinction
6. The demand for the commodity should be continuous
7. People should not expect any change in the price of the commodity
Exceptions to the Law of Demand :

Veblen or Demonstration Effect: These are some goods, which are purchased mainly for their
‘snob appeal’. They are cases of what veblen, and American economist, called “Conspicuous
consumption”, He thought that some purchases were made not for the direct satisfaction, which
they yield, but for the impression, which they made on other people. EX : Diamonds

Speculative Effect: In the speculative market, a rise in prices is frequently followed by larger
purchases and a fall in prices by small purchases. When share prices rise, people expect further
rise and rush to buy when prices fall, they wait for further fall and stop buying. EX : TCS share
value in stock market
Giffen Goods: The Giffen goods/Inferior goods are exception to the law of demand. When the
price of an inferior good falls, the poor will buy less
and vise versa. Sir Robert Giffen has made a study
on expenditure pattern of workers in Ireland in the D1
th
19 century. He found that when there was an
increase in the price of potatoes; there was more Price
demand for it. This exceptional behavior was found
because of the following reason. Normally, the
working class in Ireland used to have potatoes and D1 Law of demand
meat as daily consumption, potato being the main exception curve
food. When there was an increase in the price of
potatoes, the same quantity was consumed, as it was Demand
an essential item. To buy the same quantity of
potato, more money had to be spent. As a result, less money was available for buying meat.
Due to that, the consumption of meat became less. This led to less satisfaction and less calorie
content in the food. People wanted to compensate this and have purchased more of potatoes.
Thus Giffen has indicated this position as a paradox which is against the normal operation of law
of demand.

Ignorance: Sometimes, the quality of the commodity is judged by its price. Consumers think
that the product is superior if the price is high as such they buy more at a higher price.

Fear of Shortage: During the times of emergency or war, people may expect shortage of a
commodity. At that time, they may buy more at a higher price to keep stocks for the future.

Necessaries: In the case of necessaries like rice, vegetables, etc., people buy more even at a
higher price.

Supply Definition:
Supply is defined as the quantity of a product that a producer is willing and able to supply onto
the market at a given price in a given time period.

Note: Throughout this study companion, the terms firm, business, producer and seller have the
same meaning.

Law of Supply:

The basic law of supply is that as the price of a commodity rises, so producers expand their
supply onto the market. A supply curve shows a relationship between price and quantity a firm is
willing and able to sell.
All factors influencing supply are being held constant except price. If the price of the good
varies, we move along a supply curve. In the diagram above, as the price rises from P1 to P2
there is an expansion of supply. If the market price falls from P1 to P3 there would be
a contraction of supply in the market. Businesses are responding to price signals when making
their output decisions.

Explaining the Law of Supply

There are three main reasons why supply curves for most products are drawn as sloping upwards
from left to right giving a positive relationship between the market price and quantity supplied:

The profit motive: When the market price rises (for example after an increase in consumer
demand), it becomes more profitable for businesses to increase their output. Higher prices send
signals to firms that they can increase their profits by satisfying demand in the market.

Production and costs: When output expands, a firm’s production costs rise, therefore a higher
price is needed to justify the extra output and cover these extra costs of production.

New entrants coming into the market: Higher prices may create an incentive for other
businesses to enter the market leading to an increase in supply.

Determinants of Supply:
When price changes quantity supplied will change. That is a movement along the same supply
curve. When factors other than price changes, supply curve will shift. Here are some
determinants of the supply curve.

1. Production cost:

Since most private companies’ goal is profit maximization. Higher production cost will lower
profit, thus hinder supply. Factors affecting production cost are: input prices, wage rate,
government regulation and taxes, etc.

2. Technology:

Technological improvements help reduce production cost and increase profit, thus stimulate
higher supply.

3. Number of sellers:

More sellers in the market increase the market supply.

4. Expectation for future prices:

If producers expect future price to be higher, they will try to hold on to their inventories and
offer the products to the buyers in the future, thus they can capture the higher price.

It is necessary that the managers need to know how much can be produced with a given
set of inputs.

Elasticity of Demand : Elasticity of demand is the measure of the degree of change in the
amount demanded of the commodity in response to a given change in price of the commodity,
price of some related goods, or changes in consumers income.

Types of demand Elasticity

1. Price elasticity of demand

2. Income elasticity of demand

3. Cross elasticity of demand

4. Advertising or promotional elasticity of demand

Price elasticity of demand: The ratio of percentage of changes in demand of a commodity to a

percentage changes in price of goods is called price elasticity.

Pr oportionate changes in quantity demand

Ep=
Pr oportionate changes in price of commod ity
 Q 2  Q1
Q1
Ep 
P2  P1
P1

Q
Q1
Ep 
P
P1

Q P
Ep   1
Q1 P

Q p
Ep   1
P Q1

Q1 = Quantity of demand before price change

Q2 = Quantity of demand after price change

P1 = Price charged before price change

P2 = Price charged after price change

Type of price elasticity

1. Perfectly elastic demand

2. Perfectly inelastic demand

3. Unit elasticity demand

4. Relatively elastic demand

5. Relatively inelastic demand

Perfectly elastic demand : E = 

It is one in which a small change in price will cause a large change in amount demanded. A
small rise in price reduces the demand to zero.

Price
Demand is Endless E= 

Perfectly Inelastic : E= 0

Demand is remains unchanged, whenever be the change in price

Price
Unit Elasticity demand : E = 1

The percentage of demand changes by exactly demand the same percentage as does the price
changes.
Demand

Price

Demand

Relatively Elastic Demand : E > 1

The demand changes by a larger percentage, than does the price changes.

Price

Demand
Relatively Inelastic Demand : E < 1

The demand changes by a small percentage than does the price changes.

Price

Demand

Income Elasticity of Demand :

Income elasticity of demand refers to the percentage change in amount demanded as a result of a
given percentage change income of a consumer.

Pr oportionate changes in quantity of demand

EI=
Pr oportionate changes in income of the consumer

Q 2  Q1
Q1
EI 
I 2  I1
I1

Q
Q1
EI 
I
I1

Q I
EI   1
Q1 I
 Q I
EI   1
I Q1

Q1 = Quantity of demand before income change

Q2 = Quantity of demand after income change

I1 = Original income

I2 = Change in income of the consumer

Type of Income Elasticity of demand :

1. Zero income elasticity

2. Negative income elasticity

3. Positive income elasticity

Zero Income Elasticity : Ei = 0

Where change in income will have no effect on the quantity demand

Ex : Salt Income

Demand
Negative Income Elasticity : Ei < 0

Where a given increase in the consumer’s income is followed by a decline in the quantity
demanded of a commodity

Income

Demand
Ex : An increase in income might lead to shift his demand for bidies to cigarettes

Positive Income Elasticity : Ei = 0

If an increase in income is associated with an increase in quantities demanded

1. Unity income elasticity of demand Ei = 1

2. Income elasticity of demand greater than unity Ei > 1

3. Income elasticity of demand less than unity Ei < 1

Cross Elasticity of Demand :

The effect of a change in the prices of related goods upon the demand for a particular commodity
may be determined by measuring the cross elasticity of demand.

Pr oportionate changes in quantity of demand of a particular commod ity

Ec 
Pr oportionate changes in price of related goods

Q A
QA
Ec 
PB
PB

Q A P
Ec   B
QA PB

∆QA = Change of demand of given goods

QA = Demand of given goods

∆PB = Change in price of related goods

PB = Price of related goods

Ex : Substitute goods Complementary goods

Price of Price of
Coffee Car

Demand for Tea Demand for petrol

Advertising or Promotional Elasticity of Demand :

This direct relationship between the amount of money spent on advertising and its impact on
sales.

Pr oportionate changes in quantity of demand for particular product X

Ea 
Pr oportionate changes in advertisme nt cos t

(Q 2  Q1 )
Q1
Ea 
(A 2  A1 )
A1

A1 = Amount spent on advertisement before change

A2 = Amount spent on advertisement after change

Demand Forecasting : Demand forecasting refers to an estimate of future demand for the
product. “It is an objective assessment of the future course of demand”. It is an vital role in
business decision making. The survival and prosperity of a business firm depend on its ability to
meet the consumers’ needs efficiently and adequately. Demand forecasting has an important
influence on production planning.

Type of Demand Forecasting :

Short – term demand forecasting : Short – term demand forecasting is for a limited period
usually for one year. It relates to policies regarding sales, purchase, price and finances taking
existing production capacity of the firm short term forecasting are essential for formulating
suitable price policies, If the business people expect a rise in the prices of raw materials or
shortages, they may buy early.
Long – term forecasting : In long – term forecasting the business should know that about the
long – term demand for the product planning of a new plant or expansion of an existing unit
depends on long – term demand.

Method of Demand Forecasting :

I. Survey Method : Under this method, information about the consumers’ requirement and
opinion of experts are collected by interviewing them. Survey method can be divided into three
types viz., consumers’ survey method, sales force opinion method and experts’ opinion method.

i) Consumers survey method : In this method, the consumers are contacted personally to know
about their plans and preferences regarding the consumption of the product. A list of all potential
buyers would be drawn and each buyer will be approached and asked how much he plans to buy
the listed product in future.

This method may be undertaken in three ways. Complete enumeration method, sample surveys
method and consumer’s end use method.

a) Complete enumeration method : Under this method all the consumers of the product are
interviewed based on which forecast is made. As first hand information is collected this method
is free from bias. However, this method is impracticable as the consumers are numerous and
scattered.

b) Sample survey method : In this method, a sample of customers is selected for interview. A
sample may be random sampling or stratified sampling. This method is easy, less costly and also
highly useful. Correct sampling and cooperation of the consumers is essential for the success of
this method.

c) End – use method : Under this method, the demand for the product from different sectors such
as industries, consumers, export and import are found out. This data helps in changing the future
course of demand. But for this method industries should provide their production plans and
input-out coefficients.

ii) Sale – Force Opinion method : The men who are closest to the market(viz., salesmen) are
questioned and heir responses (or reactions) are aggregated. The advantages of this method are
that it is cheap and easy, in the sense that it does not involve any elaborate statistical
measurement.

iii) Experts’ Opinion Method : Obtaining views from a group of specialists outside the firm has
possible advantages of speed and cheapness. This method is best suited in situations were
intractable changes are occurring, e.g., forecasting future technological states. It is possible that
in cases where basic data are lacking experts may give divergent views, but even then it is
possible for the manager to adopt his thinking on the basis of these views.
II. Statistical Methods : for forecasting the demand for goods and services in the long – run,
statistical and mathematical methods are used considering the past data.

i) Trend Projection Method : These are generally based on analysis of past sales patterns. These
methods dispense with the need for costly market research because the necessary information is
often already available in company files in terms of different times, that is, a timer series data.

a) Fitting a trend line: Under this method actual sales data is drawn on a chart and estimating by
observation where the trend line lies. That line can be extended further towards a future period
and the corresponding sales graph can be read from the graph.

b) Least square method: This method uses statistical data to find the trend line which best fits the
available data. Here it is assumed that there is proportional (linear) change in sales over a period
of time. In such a case, the trend line equation is in linear form. Where this assumption does not
hold good, the equation can be in non-linear form.

The estimating linear trend equation of sales is written as

S = x + y(T)

Where x and y have been calculated from past data S is sales and T is the year number for which
the forecast is made: to find the values of x and y, the following normal equations have to be
stated and solved:

∑S = N x + y ∑T

∑ST = x ∑T + y ∑ T2

Where S is the sales; T is the year number, n = number of years

c) Time Series Analysis : This method attempts to build seasonal and cyclical variation into the
estimating equation

S=a+b+c

S = Sales, a = Trend, b = Season trend, C = Cycle trend

d) Moving Average Method : This method is based on past sales data and it is used for short –
term forecasting and it is based on assumption that the future is the average of past performance.

ii) Barometric Techniques : Present events are used to predict the directions of change in future.
This is done with the help of economic and statistical indicators. Indicators like building
materials, personal income, agricultural income, employment, gross national income, industrial
production.

Ex : 1. Construction contracts sanctioned, to forecast demand for building

 Materials

2. Personal income for predicting the demand for consumer goods

3. Agriculture income to forecast the demand for agricultural inputs

iii) Simultaneous Equation Method : This method is more practical in the sense that it requires
to estimate the future values of only predetermined variables. It is an improvement over
regression method where as in regression equation, the value of both exogenous (Independent)
and endogenous (Dependent) variables have to be predicted. It is no better than regression
method. It inherits all the limitations of regression method. It is difficult to compute where the
number of equations is larger.

iv) Correlation and Regression Methods :

a) Correlation Method: Correlation describes the degree of association between two variables
such as sales and advertisement expenditure. When the two variables tend to change together,
then they are said to be correlated. The extent to which they are correlated is measured by
correlation coefficient. If the high values of one variable are associated with the high values of
another, they are said to be positively correlated.

b) Regress Analysis : This is a statistical technique by which the demand it forecasted with the
help of certain independent variables. There types of regression analysis.

i) Simple Regression : In this analysis is used when the quantity demanded is taken as a function
of a single independent variable

ii) Multiple Regression : In this analysis is used to estimate demand as a function of two or more
independent variables that varies simultaneously.

III. Other Methods :

i) Test Marketing : The manufactures favor to test their product or service in a limited market as
test – run before they launch their products nationwide. Based on the results of test marketing,
valuable lessons can be learnt on how consumer reacts to the given product and necessary
changes can be introduced to gain wider acceptability. To forecast the sales of a new product or
the likely sales of an established product in a new channel of distribution or territory, it is
customary to find test marketing in practice Ex: Automobile companies.

ii) Market Experimentation: This method involving giving a sum of money to each consumer
with which he is asked to shop around in a simulated market. Consumer behavior is then studied
by varying the price, quality, packing, advertisement, colour etc.

iii) Judgmental Approach : If the management is unable to use any of the above method they
have to make their own judgment in forecasting the demand
Ex : According to the anticipated changes of the budget, the demand can be estimated depending
upon the change expected, income levels and needs of the customers like Cell phone, Computers
etc.

Self-Study Material

Relationship of Managerial Economics with other branches of learning’s

Micro Economics: Managerial economics is concerned with optimization of certain objective

functions of a firm within given constraints. Obviously, the goals of business have to be
determined, resources assessed and their use pattern decided upon, to accomplish the goal of
business in the best possible manner.

Macro Economics: Macroeconomics deals with the concepts of business cycle, national income,
employment, investment etc. The macroeconomic concepts are used in managerial economic for
forcecasting the general business activities.

Accounting: Managerial economics draws heavily on him accounting records, which provide
an authentic source of information, as far as the statistics of production, marketing, finance, etc.
are, concerned accounting records provide a fund of information over a period of time that has
to be analyzed and sometimes classified according to the need of decision-making.

Mathematics: Estimation and modeling are the integral part of managerial economics for
decision-making and forward planning mathematics provides a set of tools, which includes
algebra, calculus, exponentials and vectors. These tools are used for managerial economic
analysis.

Statistics and Managerial Economics: Statistics are techniques used for analyzing cause and
effect relationship. Managerial economics aims at quantifying the past economic activity to
predict its future. Average, correlation, regression, time-series interpolation are popularly used
statistical techniques.

Operations Research and Managerial Economics: Both operations research and managerial
economics are focused for problem solving and decision-making. In addition, they are used for
building economic models.

Public Economics: The role of government interference by means of tax policy, fiscal policy,
monetary policy, trade policy, industrial policy etc., greatly affects the business activities of
every firm. Therefore public economics is also has vital association with the subject matter of
managerial economics.

Decision Making: The success of every management depends upon its correct decision-making.
The theory of decision-making has significance in managerial economics. The theory of
decision-making is concerned with the processes by which expectations under conditions of
uncertainty is formed.

Factors Governing Demand Forecasting : There are several factors which govern the
forecasting process. There are

a) Nature of Demand : Market demand for particular product or service is not a single number
but it is a function of a number of factors. For instance, higher volumes of sales can be realized
with higher levels of advertising or promotion efforts.

b) Types of Forecast : Base on the period under forecast, the demand forecast can be of two
types i) Short – run forecast ii) Long – run forecast

i) Short – run forecast : A short – range forecast of the total demand for a particular product
helps to provide a basis for ordering raw materials, to plan and schedule production activities,
to seek short – term finance, and so on.

ii) Long – run Forecast : A long – run forecast provides information for major strategic
decisions that result in extension or reduction of limiting resources. A long – run forecast can be
an effective basis to make an allocation for necessary long – run finance.

c) Forecasting Level : Forecasting may be at the firm level, industry level, national level or at
the global level.

Firm level means estimating the demand for the product and services offered by a single firm,

Industry level means the aggregate demand estimated for the goods and services of all the firms
constitutes the industry level.

National level means it is worked out based on level of income and saving of the consumers.

Global level means globalization and deregulation, the entrepreneurs have started exploring the
foreign markets for which the global level forecasts are utilized.

d) Degree of Orientation : Demand forecasts can be worked out based on total sales or
product/service – wise sales for a given time period. Forecasts in terms of total sales can be
viewed as general forecast whereas product/service – wise or region or customer segment – wise
forecast is referred to as specific forecast.

e) Nature of goods : The goods are classified into producer goods, consumer goods, consumer
durables and services. The patterns of forecasting in each of these differ.

f) New Products : It is relatively easy to forecast demand for established products or products
which are currently in use. If a firm wants to deal in detergents, it can find access to the industry
demand for the detergents and market share of each competitor. It is up to this individual new
firm and its ingenuity to create its own customer base by pulling customers of the other
competitors through strategy.