Forecasting

One of the crucial aspects in which managerial economics differs from pure economic theory
lies in the treatment of risk and uncertainty. Traditional economic theory assumes a risk-
free world of certainty; but the real world business is full of all sorts of risk and uncertainty.
A manager cannot, therefore, afford to ignore risk and uncertainty. The element of risk is
associated with future which is indefinite and uncertain. To cope with future risk and
uncertainty, the manager needs to predict the future event. The likely future event has to
be given form and content in terms of projected course of variables, i.e. forecasting. Thus,
business forecasting is an essential ingredient of corporate planning. Such forecasting
enables the manager to minimize the element of risk and uncertainty. Demand forecasting
is a specific type of business forecasting.

Concepts of Forecasting:

The manager can conceptualize the future in definite terms. If he is concerned with future
event- its order, intensity and duration, he can predict the future. If he is concerned with
the course of future variables- like demand, price or profit, he can project the future. Thus
prediction and projection-both have reference to future; in fact, one supplements the other.
Suppose, it is predicted that there will be inflation (event). To establish the nature of this
event, one needs to consider the projected course of general price index (variable). Exactly
in the same way, the predicted event of business recession has to be established with
reference to the projected course of variables like sales, inventory etc.

Projection is of two types – forward and backward. It is a forward projection of data

variables, which is named forecasting. By contrast, the backward projection of data may be
named ‘back casting’, a tool used by the new economic historians. For practical managers
concerned with futurology, what is relevant is forecasting, the forward projection of data,
which supports the production of an event.

Thus, if a marketing manager fears demand recession, he must establish its basis in terms
of trends in sales data; he can estimate such trends through extrapolation of his available
sales data. This trend estimation is an exercise in forecasting.

Need for Demand Forecasting

Business managers, depending upon their functional area, need various forecasts. They
need to forecast demand, supply, price, profit, costs and returns from investments.

The question may arise: Why have we chosen demand forecasting as a model? What is the
use of demand forecasting?
The significance of demand or sales forecasting in the context of business policy decisions
can hardly be overemphasized. Sales constitute the primary source of revenue for the
corporate unit and reduction for sales gives rise to most of the costs incurred by the firm.

Demand forecasting is essential for a firm because it must plan its output to meet the
forecasted demand according to the quantities demanded and the time at which these are
demanded. The forecasting demand helps a firm to arrange for the supplies of the
necessary inputs without any wastage of materials and time and also helps a firm to
diversify its output to stabilize its income overtime.

The purpose of demand forecasting differs according to the type of forecasting.

(1) The purpose of the Short term forecasting:

It is difficult to define short run for a firm because its duration may differ according to the
nature of the commodity. For a highly sophisticated automatic plant 3 months time may be
considered as short run, while for another plant duration may extend to 6 months or one
year. Time duration may be set for demand forecasting depending upon how frequent the
fluctuations in demand are, short- term forecasting can be undertaken by affirm for the
following purpose;

 Appropriate scheduling of production to avoid problems of over production and

under- production.
 Proper management of inventories
 Evolving suitable price strategy to maintain consistent sales
 Formulating a suitable sales strategy in accordance with the changing pattern of
demand and extent of competition among the firms.
 Forecasting financial requirements for the short period.

(2) The purpose of long- term forecasting:

The concept of demand forecasting is more relevant to the long-run that the short-run. It is
comparatively easy to forecast the immediate future than to forecast the distant future.
Fluctuations of a larger magnitude may take place in the distant future. In fast developing
economy the duration may go up to 5 or 10 years, while in stagnant economy it may go up
to 20 years. More over the time duration also depends upon the nature of the product for
which demand forecasting is to be made. The purposes are;

 Planning for a new project, expansion and modernization of an existing unit,

diversification and technological up gradation.
 Assessing long term financial needs. It takes time to raise financial resources.
  Arranging suitable manpower. It can help a firm to arrange for specialized labour
force and personnel.
 Evolving a suitable strategy for changing pattern of consumption.

Steps in Demand Forecasting

Demand or sales forecasting is a scientific exercise. It has to go through a number of steps.
At each step, you have to make critical considerations. Such considerations are categorically
listed below:

1) Nature of forecast: To begin with, you should be clear about the uses of forecast data-
how it is related to forward planning and corporate planning by the firm. Depending upon its
use, you have to choose the type of forecasts: short-run or long-run, active or passive,
conditional or non-conditional etc.

2) Nature of product: The next important consideration is the nature of product for which
you are attempting a demand forecast. You have to examine carefully whether the product
is consumer goods or producer goods, perishable or durable, final or intermediate demand,
new demand or replacement demand type etc. A couple of examples may illustrate the
importance of this factor. The demand for intermediate goods like basic chemicals is derived
from the final demand for finished goods like detergents. While forecasting the demand for
basic chemicals, it becomes essential to analyze the nature of demand for detergents.
Promoting sales through advertising or price competition is much less important in the case
of intermediate goods compared to final goods. The elasticity of demand for intermediate
goods depends on their relative importance in the price of the final product.

Time factor is a crucial determinant in demand forecasting. Perishable commodities such as

fresh vegetables and fruits can be sold over a limited period of time. Here skilful demand
forecasting is needed to avoid waste. If there are storage facilities, then buyers can adjust
their demand according to availability, price and income. The time taken for such
adjustment varies from product to product. Goods of daily necessities that are bought more
frequently will lead to quicker adjustments. Whereas in case of expensive equipment which
is worn out and replaced after a long period of time, adaptation of demand will be spread
over a longer duration of time.

3) Determinants of demand: Once you have identified the nature of product for which
you are to build a forecast, your next task is to locate clearly the determinants of demand
for the product. Depending on the nature of product and nature of forecasts, different
determinants will assume different degree of importance in different demand functions.

In the preceding unit, you have been exposed to a number of price-income factors or
determinants-own price, related price, own income-disposable and discretionary, related
income, advertisement, price expectation etc. In addition, it is important to consider socio-
psychological determinants, specially demographic, sociological and psychological factors
affecting demand. Without considering these factors, long-run demand forecasting is not
possible.

Such factors are particularly important for long-run active forecasts. The size of population,
the age-composition, the location of household unit, the sex-composition-all these exercise
influence on demand in. varying degrees. If more babies are born, more will be the demand
for toys; if more youngsters marry, more will be the demand for furniture; if more old
people survive, more will be the demand for sticks. In the same way buyers’ psychology-his
need, social status, ego, demonstration effect etc. –also effect demand. While forecasting
you cannot neglect these factors.

4) Analysis of  factors &determinants: Identifying the determinants alone would not do,
their analysis is also important for demand forecasting. In an analysis of statistical demand
function, it is customary to classify the explanatory factors into (a) trend factors, which
affect demand over long-run, (b) cyclical factors whose effects on demand are periodic in
nature, (c) seasonal factors, which are a little more certain compared to cyclical factors,
because there is some regularly with regard to their occurrence, and (d) random factors
which create disturbance because they are erratic in nature; their operation and effects are
not very orderly.

An analysis of factors is specially important depending upon whether it is the aggregate

demand in the economy or the industry’s demand or the company’s demand or the
consumers; demand which is being predicted. Also, for a long-run demand forecast, trend
factors are important; but for a short-run demand forecast, cyclical and seasonal factors are
important.

5) Choice of techniques: This is a very important step. You have to choose a particular
technique from among various techniques of demand forecasting. Subsequently, you will be
exposed to all such techniques, statistical or otherwise. You will find that different
techniques may be appropriate for forecasting demand for different products depending
upon their nature. In some cases, it may be possible to use more than one technique.
However, the choice of technique has to be logical and appropriate; for it is a very critical
choice. Much of the accuracy and relevance of the forecast data depends accuracy required,
reference period of the forecast, complexity of the relationship postulated in the demand
function, available time for forecasting exercise, size of cost budget for the forecast etc.

6) Testing accuracy: This is the final step in demand forecasting. There are various
methods for testing statistical accuracy in a given forecast. Some of them are simple and
inexpensive, others quite complex and difficult. This stating is needed to avoid/reduce the
margin of error and thereby improve its validity for practical decision-making purpose.
Subsequently you will be exposed briefly to some of these methods and their uses.
Techniques of Demand Forecasting
Broadly speaking, there are two approaches to demand forecasting- one is to obtain
information about the likely purchase behavior of the buyer through collecting expert’s
opinion or by conducting interviews with consumers, the other is to use past experience as
a guide through a set of statistical techniques. Both these methods rely on varying degrees
of judgment. The first method is usually found suitable for short-term forecasting, the latter
for long-term forecasting. There are specific techniques which fall under each of these broad
methods.

Simple Survey Method:

For forecasting the demand for existing product, such survey methods are often employed.
In this set of methods, we may undertake the following exercise.

1) Experts Opinion Poll: In this method, the experts on the particular product whose
demand is under study are requested to give their ‘opinion’ or ‘feel’ about the product.
These experts, dealing in the same or similar product, are able to predict the likely sales of
a given product in future periods under different conditions based on their experience. If the
number of such experts is large and their experience-based reactions are different, then an
average-simple or weighted –is found to lead to unique forecasts. Sometimes this method is
also called the ‘hunch method’ but it replaces analysis by opinions and it can thus turn out
to be highly subjective in nature.

2) Reasoned Opinion-Delphi Technique: This is a variant of the opinion poll method.

Here is an attempt to arrive at a consensus in an uncertain area by questioning a group of
experts repeatedly until the responses appear to converge along a single line. The
participants are supplied with responses to previous questions (including seasonings from
others in the group by a coordinator or a leader or operator of some sort). Such feedback
may result in an expert revising his earlier opinion. This may lead to a narrowing down of
the divergent views (of the experts) expressed earlier. The Delphi Techniques, followed by
the Greeks earlier, thus generates “reasoned opinion” in place of “unstructured opinion”;
but this is still a poor proxy for market behavior of economic variables.

3) Consumers Survey- Complete Enumeration Method: Under this, the forecaster

undertakes a complete survey of all consumers whose demand he intends to forecast, Once
this information is collected, the sales forecasts are obtained by simply adding the probable
demands of all consumers. The principle merit of this method is that the forecaster does not
introduce any bias or value judgment of his own. He simply records the data and
aggregates. But it is a very tedious and cumbersome process; it is not feasible where a
large number of consumers are involved. Moreover if the data are wrongly recorded, this
method will be totally useless.

4) Consumer Survey-Sample Survey Method: Under this method, the forecaster selects
a few consuming units out of the relevant population and then collects data on their
probable demands for the product during the forecast period. The total demand of sample
units is finally blown up to generate the total demand forecast. Compared to the former
survey, this method is less tedious and less costly, and subject to less data error; but the
choice of sample is very critical. If the sample is properly chosen, then it will yield
dependable results; otherwise there may be sampling error. The sampling error can
decrease with every increase in sample size

5) End-user Method of Consumers Survey: Under this method, the sales of a product
are projected through a survey of its end-users. A product is used for final consumption or
as an intermediate product in the production of other goods in the domestic market, or it
may be exported as well as imported. The demands for final consumption and exports net of
imports are estimated through some other forecasting method, and its demand for
intermediate use is estimated through a survey of its user industries.

Complex Statistical Methods:

We shall now move from simple to complex set of methods of demand forecasting. Such
methods are taken usually from statistics. As such, you may be quite familiar with some the
statistical tools and techniques, as a part of quantitative methods for business decisions.

(1) Time series analysis or trend method: Under this method, the time series data on
the under forecast are used to fit a trend line or curve either graphically or through
statistical method of Least Squares. The trend line is worked out by fitting a trend equation
to time series data with the aid of an estimation method. The trend equation could take
either a linear or any kind of non-linear form. The trend method outlined above often yields
a dependable forecast. The advantage in this method is that it does not require the formal
knowledge of economic theory and the market, it only needs the time series data. The only
limitation in this method is that it assumes that the past is repeated in future. Also, it is an
appropriate method for long-run forecasts, but inappropriate for short-run forecasts.
Sometimes the time series analysis may not reveal a significant trend of any kind. In that
case, the moving average method or exponentially weighted moving average method is
used to smoothen the series.

(2) Barometric Techniques or Lead-Lag indicators method: This consists in

discovering a set of series of some variables which exhibit a close association in their
movement over a period or time.

For example, it shows the movement of agricultural income (AY series) and the sale of
tractors (ST series). The movement of AY is similar to that of ST, but the movement in ST
takes place after a year’s time lag compared to the movement in AY. Thus if one knows the
direction of the movement in agriculture income (AY), one can predict the direction of
movement of tractors’ sale (ST) for the next year. Thus agricultural income (AY) may be
used as a barometer (a leading indicator) to help the short-term forecast for the sale of
tractors.
Generally, this barometric method has been used in some of the developed countries for
predicting business cycles situation. For this purpose, some countries construct what are
known as ‘diffusion indices’ by combining the movement of a number of leading series in the
economy so that turning points in business activity could be discovered well in advance.
Some of the limitations of this method may be noted however. The leading indicator method
does not tell you anything about the magnitude of the change that can be expected in the
lagging series, but only the direction of change. Also, the lead period itself may change
overtime. Through our estimation we may find out the best-fitted lag period on the past
data, but the same may not be true for the future. Finally, it may not be always possible to
find out the leading, lagging or coincident indicators of the variable for which a demand
forecast is being attempted.

3) Correlation and Regression: These involve the use of econometric methods to

determine the nature and degree of association between/among a set of variables.
Econometrics, you may recall, is the use of economic theory, statistical analysis and
mathematical functions to determine the relationship between a dependent variable (say,
sales) and one or more independent variables (like price, income, advertisement etc.). The
relationship may be expressed in the form of a demand function, as we have seen earlier.
Such relationships, based on past data can be used for forecasting. The analysis can be
carried with varying degrees of complexity. Here we shall not get into the methods of
finding out ‘correlation coefficient’ or ‘regression equation’; you must have covered those
statistical techniques as a part of quantitative methods. Similarly, we shall not go into the
question of economic theory. We shall concentrate simply on the use of these econometric
techniques in forecasting.

We are on the realm of multiple regression and multiple correlation. The form of the
equation may be:

DX = a + b1 A + b2PX + b3Py

You know that the regression coefficients b 1, b2, b3 and b4 are the components of relevant
elasticity of demand. For example, b1 is a component of price elasticity of demand. The
reflect the direction as well as proportion of change in demand for x as a result of a change
in any of its explanatory variables. For example, b 2< 0 suggest that DX and PX are inversely
related; b4 > 0 suggest that x and y are substitutes; b3 > 0 suggest that x is a normal
commodity with commodity with positive income-effect.

Given the estimated value of and bi, you may forecast the expected sales (D X), if you know
the future values of explanatory variables like own price (P X), related price (Py), income (B)
and advertisement (A). Lastly, you may also recall that the statistics R2 (Co-efficient of
determination) gives the measure of goodness of fit. The closer it is to unity, the better is
the fit, and that way you get a more reliable forecast.

The principle advantage of this method is that it is prescriptive as well descriptive. That is,
besides generating demand forecast, it explains why the demand is what it is. In other
words, this technique has got both explanatory and predictive value. The regression method
is neither mechanistic like the trend method nor subjective like the opinion poll method. In
this method of forecasting, you may use not only time-series data but also cross section
data. The only precaution you need to take is that data analysis should be based on the
logic of economic theory.

(4) Simultaneous Equations Method: Here is a very sophisticated method of forecasting.

It is also known as the ‘complete system approach’ or ‘econometric model building’. In your
earlier units, we have made reference to such econometric models. Presently we do not
intend to get into the details of this method because it is a subject by itself. Moreover, this
method is normally used in macro-level forecasting for the economy as a whole; in this
course, our focus is limited to micro elements only. Of course, you, as corporate managers,
should know the basic elements in such an approach.

The method is indeed very complicated. However, in the days of computer, when package
programmes are available, this method can be used easily to derive meaningful forecasts.
The principle advantage in this method is that the forecaster needs to estimate the future
values of only the exogenous variables unlike the regression method where he has to
predict the future values of all, endogenous and exogenous variables affecting the variable
under forecast. The values of exogenous variables are easier to predict than those of the
endogenous variables. However, such econometric models have limitations, similar to that
of regression method.