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

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.

Examples
General Motors, Ford, DaimlerChrysler, Nissan: all use

estimates of demand in making decisions about how many units of each model to produce and what prices to charge for different car models. Managers a the national headquarters of Dominos Pizza need to estimate how pizza demand in United States is affected by a downturn in the economy: take-out food business tends to prosper during recession At HCA, the short run and the long run estimates of patient load(demand) in its various geographic markets is crucial for making expansion plans. All electric utilities employ economists and statisticians to estimate the current demand for electricity.

Meaning of Demand Forecasting

An estimate of sales in dollars or physical units for a

specified future period under a proposed marketing plan.

American Marketing Association

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. An operations research technique of planning and decision making.

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.

Categorization of Demand Forecasting

By 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 By Time Period Short Term (0 to 3 months): for inventory management and scheduling. Medium Term (3 months to 2 years): for production planning, purchasing, and distribution. Long Term (2 years and more): may extend up to 10 to 20 years.
for capacity planning, facility location, and strategic planning, long term capital

requirement, and investment decisions.

Choice of a forecasting technique

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--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.

Techniques of Demand Forecasting

Subjective (Qualitative) methods: rely on human judgment and

opinion.

Buyers Opinion Sales Force Composite Market Simulation Test Marketing Experts Opinion Group Discussion Delphi Method

Quantitative methods: use mathematical or simulation models

based on historical demand or relationships between variables.

Trend Projection Smoothing Techniques Barometric techniques Econometric techniques

Subjective Methods of Demand Forecasting

Consumers Opinion Survey
Buyers are asked about future buying intentions of products, brand

preferences and quantities of purchase, response to an increase in the price, or an implied comparison with competitors products.
Census Method: Involves contacting each and every buyer Sample Method: Involves only representative sample of buyers

Problems
Selection of a representative sample: This sample has the

same characteristics as the population as a whole. Random sampling is generally used for the same.
Eg.1 If 52% of the population is female and if 35% have

annual incomes over $65000,then a representative sample should have approx. 52% females and 35% persons with income over $65000.This is very difficult to obtain.

Eg.2
What can happen if the sample drawn is not random

occurred during the Presidential campaign in 1948 in America. A survey was performed that predicted an overwhelming victory for Thomas Dewey . In fact, Harry Truman won the election. The problem with the survey was that the sample was drawn from a subscription list of a particular magazine. The subscribers were not representative of the entire population of the US, they were instead a subgroup of the voting population and had imp. common characteristics. Thus biased sample biased results.

Eg. 3
In 1936 also there was a election forecast error, a popular

magazine predicted Franklin Roosevelt would lose the election, but it was wrong because the pollsters used telephone survey and only wealthy people were able to afford phone at that time.
Today election forecasting has become so accurate because

of advanced sampling technique employed by the pollsters

Problem 2 Response bias: The difference between the response given by an

individual to a hypothetical question and the action the individual takes when the situation actually occurs. Many a times the questions may be such that the respondents give what they view as a socially acceptable response rather than revealing their true preference. Eg.1 Past surveys by food manuf. Have yielded bad results because of response bias. On the basis of the results of these surveys food manufacturers develop new products. But as noted by the Wall street journal, there is one big problem People dont always tell the truth, nobody likes to admit that he likes junk food So, a response bias exist in such surveys. Asking a sweet eater how many sweets he eats is like asking an alcoholic if he drinks much!!!!!!!!!!!

Problem 3
Simply unable to answer accurately the question

posed:
Eg.1 A firm is doing a survey to find out the elasticity of

demand for its products, it is interested to know the response of the consumers to incremental changes in price and some other variable. If the firm needs to know how the consumer would react to such things as 1,2,or 3 percent inc (or dec) in a price or a 5 per cent inc (or dec) in advertising expenditures. Most of the people interviewed are not able to answer these questions precisely.

 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.

Subjective Methods of Demand Forecasting

Sales Force Composite

Contd

Salespersons are in direct contact with the customers. Salespersons are

asked about estimated sales targets in their respective sales territories in 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

Marketand a difficult technique experiments studies and Expensive

Analyst hold everything constant except the price of the product. Under this method the firm first selects the some areas as

representative markets-3/4 cities having similar features vizpopulation, income levels, cultural and social backgrounds, occupational distribution, choices and preferences of consumers. Then, they carry out market experiments by changing prices, advertisements expenditure and other controllable variables in demand function under assumption that other things remain same. The controlled variables may be changed over time either simultaneously in all the markets or in selected markets. After these changes are introduced the changes in demand over a period of time ( week, fortnight or a month) are recorded. On the basis of data elasticity co- efficients are computed. These are then used to predict the future demand for the product

 In field experiments the researchers wont be able to change

the price of goods and actually observe the behavior of the consumers Caselet: Some economists at Texas A&M were interested in estimated the price elasticity of the demand for electric energy. They recruited a sample of 100 households to participate in their experiment. Objective of the study: to observe these households weekly consumption of electric power. After establishing the households baseline level of usage the researchers experimentally changed the price of the electric power for part of their sample by paying rebates for reductions in weekly usage

 For example in one of the subgroups the researchers

paid the household 1.3 cents for every kilowatthour(kwh) reduction in weekly usage. At the time this study was conducted, the cost of electric power to the residential consumers was 2.6 cents per kwh Now, for this subgroup the price of consuming an additional kwh was increased: to consume an additional kwh, the household not only had to pay 2.6 cents but also had to forgo the rebate of 1.3 cents it could have received had it conserved rather than consumed electricity. Hence, for the subgroup, price of electricity increased by 50 per cent from 2.6 to 3.9 cents per kwh

 Other subgroups were given other rebate schedules. And

one group the control group was given no rebate. The researchers could then actually measure the reduction in electricity consumption due to experimentally imposed price increase by comparing the change in the consumption of the subgroup receiving rebate with the change in consumption of the control group. Results for the experiment study indicated that the maximum price elasticity of the residential demand for electricity was 0.32. i.e residential demand for electricity was price inelastic. However, researchers indicated that this study measured extremely short run elasticity.

Subjective Methods of Demand Forecasting

Experts Opinion Method

Contd

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 to rival firms.

Subjective Methods of Demand Forecasting

Market Simulation

Contd..

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.

Subjective Methods of Demand Forecasting

Test Marketing

Contd.

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.

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)

Quantitative Methods:
Methods of Trend Projection
Contd
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 200 simple but provides a general indication and fails to predict future value of 180 demand 160
Demand for mobiles (in lakhs)
140 120 100 80 60 40 20 0 2001 2002 2003 Year 2004 2005

Quantitative Methods:
Methods of Trend Projection
Least squares method
based on the minimization of squared deviations between the best

Contd

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: Y=na + bX XY= aX+ bX2 Once the coefficients of the trend equation are estimated, we can easily project the trend for future periods. Solving the normal equations: a= b X Y b=
(Y Y )( X X )

(X X )

Quantitative Methods:
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.

Quantitative Methods : Smoothing Techniques

Moving Average: forecasts on the basis of demand values during
the recent past. Dn=
D where Di= demand in the ith period, n= number of periods in the n
i 1 i 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:
w D
i 1 i n

Dn=

where Di= demand in the ith period, wi= weight for the ith period, n= number of periods in the moving average.

Quantitative Methods : 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.

Quantitative Methods : 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.

Quantitative Methods

Simple (or Bivariate) Regression Analysis:

Contd..

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

Quantitative Methods
Multiple Regression Analysis:
D = a1+a2.P+a3.A+e

Contd..

(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.

Quantitative Methods

Contd

Problems Associated with Regression Analysis

Multicollinearity: when two or more explanatory variables in the

regression model are found to be highly correlated the estimated coefficients may not be accurately determined.
Heteroscedasticity: Classical regression models assume that the

variance of error terms is constant for all values of the independent variables in the model; i.e. variables are homoscedastic.
Specification errors: Omission of one or more of the independent

variables, or when the functional form itself is wrongly constructed or estimate a demand function in linear form, though the function should have been nonlinear.
Identification problem: where the equations have common variables,

like a demand supply model.

Quantitative Methods
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

Limitations of Demand Forecasting

Change in Fashion: Is an inevitable consequence of advancement of

civilization. Results of demand forecasting have short lasting impacts especially in a dynamic business environment.
Consumers Psychology: Results of forecasting depend largely on

consumers psychology, understanding which itself is difficult.

Uneconomical: Requires collection of data in huge volumes and their

analysis, which may be too expensive for small firms to afford. Estimation process may take a lot of time, which may not be affordable.
Lack of Experienced Experts: Accurate forecasting necessitates

experienced experts, who may not be easily available. Forecasting by less experienced individuals may lead to erroneous estimates.
Lack of Past Data: Requires past sales data, which may not be

correctly available. Typical problem in case for a new product.

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. Techniques of demand forecasting depend upon information on three questions: a. What do people say? b. What do people do? c. What have people done? 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 with the help of brainstorming or by structured discussions or even by discussing without face to face interaction. Demand forecasting may also be done by market experiments conducted under controlled or simulated conditions or in real markets in which consumers actually buy a product without the awareness of being observed.

Summary
Trend projection is a powerful statistical tool frequently used to predict future values of a variable on the basis of time series data. Most time series data have components like seasonal trend, cyclical trend, secular trend and random events. Trend projection can be done by graphical method, least square method and ARIMA (Box Jenkins) method Smoothing techniques are used when the time series data exhibit little trend or seasonal variations, but a great deal of irregular or random variation. The most popular smoothing methods include moving average, weighted moving average and exponential smoothing. In barometric forecasting we construct an index of relevant economic indicators and forecast future trends on the basis of these indicators. Econometric methods apply statistical tools on economic theories to estimate economic variables. Regression analysis relates a dependant variable to one or more independent variables in the form of a linear equation. Regression can be linear, nonlinear and multiple. Simultaneous equations method incorporates mutual dependence among variables.