MANAGERIAL
ECONOMICS, 3E
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Chapter 6
Demand Forecasting
Lecture plan
Meaning of Demand Forecasting
Techniques of Demand Forecasting
Subjective Methods of Demand Forecasting
Survey methods
Expert opinion methods
Quantitative Methods of Demand Forecasting
Trend methods
Smoothing methods
Simulation
Statistical methods
Limitations of Demand Forecasting
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Objectives
To introduce the relevance of demand
forecasting in business.
To understand the types of demand
forecasting.
To explore qualitative techniques of
forecasting demand.
To understand quantitative and econometric
methods of demand forecasting.
To point out the limitations of demand
forecasting.
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Meaning of Demand Forecasting
Demand forecasting is the scientific and
analytical estimation of demand for a product
(service) for a particular period of time.
It is the process of determining how much of
what products is needed when and where.
It is said to be an operations research technique
of planning and decision making.
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Categorization of Demand
Forecasting
By Level of Forecasting
Firm (Micro) level: forecasting of demand for its
product by an individual firm.
decisions related to production and marketing.
Industry level: for a product in an industry as a whole.
insight in growth pattern of the industry
in identifying the life cycle stage of the product
relative contribution of the industry in national
income.
Economy (Macro) level: forecasting of aggregate
demand (or output) in the economy as a whole.
helps in various policy formulations at government
level.
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Categorization of Demand
Forecasting
Nature of goods
Capital Goods: Derived demand
demand for capital goods depends upon demand of
consumer goods which they can produce.
Consumer Goods: Direct demand
durable consumer goods: new demand or
replacement demand
Non durable consumer goods: FMCG
Time Period
Short Term (0 to 3 months): for inventory management
Medium Term (3 months to 2 years): for production
planning, purchasing, and distribution.
Long Term:may extend up to 10 to 20 years.
for capacity planning, long term capital requirement, and investment
decisions.
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Choice of a forecasting
technique
Choice of method depends on:
Imminent objectives of forecast, whether it is for a new
product, or to gauge impact of a new advertisement, etc.
Cost involved, cost of forecasting should not be more
than its benefits, here opportunity cost of resources will
also be important.
Time perspective, whether the forecast is meant for the
short run or the long run
Complexity of the technique, vis-à-vis availability of
expertise; this would determine whether the firm would
look for experts “in house” or outsource it
Nature and quality of available data, i.e. does the time
series show a clear trend or is it highly unstable.
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Techniques of Demand
Forecasting
Qualitative Quantitative
• Survey • Trend
• Expert • Smoothing
Opinion • Barometric
• Market methods
Simulation • Econometric
• Test techniques
Marketing
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Qualitative (Subjective) Methods:
Survey
1. Consumers’ Opinion Survey
Buyers are asked about their buying intentions of products, brand
preferences and quantities of purchase, response to an increase in the
price, or an implied comparison with competitor’s products.
Census Method: Involves contacting each and every buyer
Sample Method: Involves only representative sample of buyers;
more common method
Merits
Simple to administer and comprehend.
Suitable when no past data available.
Suitable for short term decisions regarding product and promotion.
Demerits
Expensive both in terms of resources and time.
Buyers may give incorrect responses.
Investigators’ bias regarding choice of sample and questions cannot be fully
eliminated.
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Survey
2. Sales Force Composite
Salespersons are in direct contact with the customers.
Salespersons are asked about estimated sales targets in their
respective sales territories for a given period of time.
Merits
Cost effective as no additional cost is incurred on collection of data.
Estimated figures are more reliable, as they are based on the
notions of salespersons in direct contact with their customers.
Demerits
Results may be conditioned by the bias of optimism (or pessimism)
of salespersons.
Salespersons may be unaware of the economic environment of the
business and may make wrong estimates.
This method is ideal for short term and not for long term
forecasting Copyright © 2018
Experts’ Opinion Method
Experts’ Opinion Method
i) Group Discussion: (developed by Osborn in 1953) Decisions may
be taken with the help of brainstorming sessions or by structured
discussions.
ii) Delphi Technique: developed by the Rand Corporation at the
beginning of the Cold War, to forecast impact of technology on
warfare.
Way of getting repeated opinion of experts without their face to face
interaction.
Consolidated opinions of experts is sent for revised views till conclusions
converge on a point.
Merits
Decisions are enriched with the experience of competent experts.
Firm need not spend time, resources in collection of data by survey.
Very useful when product is absolutely new to all the markets.
Demerits
Experts’ may involve some amount of bias.
With external experts, risk of loss of confidential information toCopyright
rival ©firms.
2018
Market Simulation
Firms create “artificial market”, consumers are instructed to shop with some
money.
“Laboratory experiment” ascertains consumers’ reactions to changes in price,
packaging, and even location of the product in the shop.
Grabor-Granger test:
Half of members are shown new product to see whether they would actually
buy it at various prices on a random price list and then are shown the existing
product. Other half is shown the existing product first and then the new
product to ascertain if a product would be bought at different prices.
Merits
Market experiments provide information on consumer behaviour regarding
a change in any of the determinants of demand.
Experiments are very useful in case of an absolutely new product.
Demerits
People behave differently when they are being observed.
In Grabor-Granger tests consumers may not quote the price they may pay.
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Test Marketing
Involves real markets in which consumers actually buy a
product without the consciousness of being observed.
Product is actually sold in certain segments of the market,
regarded as the “test market”.
Choice and number of test market(s) and duration of test are
very crucial to the success of the results.
Merits
Most reliable among qualitative methods.
Very suitable for new products.
Considered less risky than launching the product across a wide
region.
Demerits
Very costly as it requires actual production of the product, and in
event of failure of the product the entire cost of test is sunk.
Time consuming to observe the actual buying pattern of
consumers..
Extrapolation of figures for calculating demand in widely varying
markets across its geographical regions may not give accurate
results. Copyright © 2018
Quantitative Methods of Demand
Forecasting
Trend Projection
Statistical tool to predict future values of a variable on the
basis of time series data.
Time series data are composed of:
Secular trend (T): change occurring consistently over a long
time and is relatively smooth in its path.
Seasonal trend (S): seasonal variations of the data within a year
Cyclical trend (C): cyclical movement in the demand for a
product that may have a tendency to recur in a few years
Random events (R): have no trend of occurrence hence they
create random variation in the series.
Additive Form: Y = T + S + C + R………..(1)
Multiplicative Form: Y = T.S.C.R………….(2)
Log Y= log T + log S + log C + log R………….(3)
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Methods of Trend Projection
Graphical method
Past values of the variable on vertical axis and time on horizontal
axis and line is plotted.
Movement of the series is assessed and future values of the
variable are forecasted
simple but provides a general indication and fails to predict future
value of demand
200
Demand for mobiles (in lakhs)
180
160
140
120
100
80
60
40
20
0
2001 2002 2003 2004 2005
Year
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Methods of Trend Projection
Contd…
Least squares method
based on the minimization of squared deviations between the best
fitting line and the original observations given.
Estimates coefficients of a linear function.
Y=a+bX where a =intercept
and b =slope
The normal equations:
ΣY=na + bΣX
ΣXY= aΣX+ bΣX2
Once the coefficients of the trend equation are estimated, we can
easily project the trend for future periods.
Solving the normal equations:
Y
a= bX
(Y Y )( X X )
b= ( X X )2
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Methods of Trend Projection
Contd…
ARIMA method: also known as Box Jenkins
method
considered to be the most sophisticated technique of
forecasting as it combines moving average and auto
regressive techniques.
Stage One: trend in the series is removed with help of
‘differencing’, i.e. the difference between values at
adjacent period of time.
Stage Two: Various possible combinations are created on
basis of:
i. order of involvement of auto regressive terms;
ii. the order of moving average terms
iii. the number of differences of the original series. Combinations are
selected which provide an adequate fit to the series.
Stage Three: Parameter estimation is done using Least
Squares.
Stage Four: ‘Goodness of fit’ is tested and if it is not a good
fit then the whole process is repeated from Stage Two.
Stage Five: Once a ‘good fit’ is attained, its coefficients can
be used to forecast future demand. Copyright © 2018
Quantitative Methods :
Smoothing Techniques
Moving Average: forecasts on the basis of demand values
during the recent past.
D n= D
i 1
i where Di= demand in the ith period, n= number of periods in
the n
moving average
Weighted Moving Average: forecast the future value of
sales on the basis of weights given to the most recent
observations. The formula for computing weighted moving average
is given as:
n
w D
i 1
i i
D n= where Di= demand in the ith period, wi= weight for the ith
period, n= number of periods in the moving average.
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Smoothing Techniques
Contd…
Exponential Smoothing: assign greater weights to the
most recent data, in order to have a more realistic
estimate of the fluctuations. Weights usually lay between
zero and one
Ft+1=aDt+(1-a)Ft
where Dt+1= forecast for the next period, Dt=actual demand in the
present period, Ft=previously determined forecast for the present
period, and a=weighting factor, termed as smoothing constant.
New forecast equals old forecast plus an adjustment for
the error that had occurred in the last forecast
Ft+1=aDt+ a(1-a)Dt-1+ a(1-a)2Dt-2+ a(1-a)3Dt-3+...+a(1-a)t-1D1+ a(1-a)2Dt-2+ a(1-
a)tF1)
Ft+1 is thus a weighted average of all past observations.
The older the data, the smaller the weight. Copyright © 2018
Barometric Techniques
Contd….
Barometric Technique alerts businesses to changes
in the overall economic conditions.
Helps in predicting future trends on the basis of
index of relevant economic indicators especially
when the past data do not show a clear tendency of
movement in a particular direction.
Indicators may be
Leading indicators: economic series that typically go up
or down ahead of other series
Coincident indicators: move up or down simultaneously
with the level of economic activities
Lagging series : which moves with economic series after
a time lag.
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Regression Analysis
Contd…..
Simple (or Bivariate) Regression Analysis:
deals with a single independent variable that determines the
value of a dependent variable.
Demand Function: D = a+bP, where b is negative.
If we assume there is a linear relation between D and P, there
may also be some random variation in this relation.
Sum of Squared Errors (SSE) : a measure of the predictive accuracy
Smaller the value of SSE, the more accurate is the regression
equation.
Nonlinear Regression Analysis
Log linear function log D =A + B log P + e
where A and B are the parameters to be estimated and e
represents errors or disturbances.
Linear form of log linear function D* = a + b P* + e
where D*= log D and P*=log P Copyright © 2018
Regression Analysis
Contd…..
Multiple Regression Analysis:
D = a1+a2.P+a3.A+e
(where A = advertising expenditure incurred).
D^ = a^1 + a^2P + a^3A,
(where a1, a2 and a3 are the parameters and e is the random
error term (or disturbance), having zero mean).
Similar to simple regression analysis, multiple
regression analysis would aim at estimation of the
parameters a1, a2 and a3.
Choose such values of the coefficients that would
minimize the sum of squares of the deviations.
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Simultaneous Equations
Method
Based on the fact that in any economic decision
every variable influences every other variable.
Incorporates mutual dependence among variables.
It is a simultaneous and two way relationships,
A typical simultaneous equation model may comprise
of:
Endogenous variables: included in the model as dependent
variables
Exogenous variables: given from outside the model
Structural equations: which seek to explain the relation
between a particular endogenous variable and other
variables
Definitional equations: which specify relationships that are
considered to be true by definition Copyright © 2018
Summary
Forecasting is an operations research technique of planning and decision
making; demand forecasting is the scientific and analytical estimation of
demand for a product (service) for a particular period of time.
Demand forecasting can be categorized on basis of: i. the level of
forecasting, i.e. firm, industry and economy; ii. time period, i.e. short run
and long run iii. nature of goods, i.e. capital and consumer goods.
In consumers’ opinion survey buyers are asked about their future buying
intentions of products, their brand preferences and quantities of purchase.
Future demand level may also be ascertained by experts.
Demand forecasting may be done by market experiments conducted under
controlled or simulated conditions or in real markets.
Trend projection is a powerful statistical tool frequently used to predict
future values of a variable on the basis of time series data.
Smoothing techniques are used when the time series data exhibit little trend
or seasonal variations, but a great deal of irregular or random variation.
Econometric methods apply statistical tools on economic theories to
estimate economic variables.
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