Introduction toDemand Forecasting part one
- 2. MEANING OF DEMAND FORECASTING Demand results in sales which constitutes the primary source of revenue for the business. A forecast is a prediction or estimation of a future situation, under given conditions. Demand forecasting predicts the future trend of sales given the present state of demand determinants. Demand forecasting is different from demand estimation in the sense that the former predicts about the future trend of sales while the latter tries to find out expected present sales level, given the present state of demand determinants. Forecast can be both physical as well as financial in nature and are used mostly for planning purposes.
- 3. PURPOSE OF DEMAND FORECASTIN G • Forecasting is done for both the long run as well as short run. The purposes of the two, however, are different. • In a short-run forecast, seasonal patterns are of prime importance. Such a forecast helps in preparing suitable sales policy and proper scheduling of output to avoid over-stocking or costly delays in meeting the orders. Besides giving an idea of likely demand, short- run forecasts also help in arriving at suitable prices for the products and in deciding about necessary modifications in advertising and sales techniques. • Long-run forecasts are helpful in proper capital planning. When installing production capacity, an element of flexibility in their availability must be ensured to take care of planned and expected changes in production. Long-term planning thus helps in saving the wastage in material, manhours, machine-time, and capacity. Long- run forecasting is usually used for ‘new unit’ planning, expansion of the existing units, and planning long-run financial requirements and manpower requirements.
- 4. DETERMINING THE SCOPE OF A FORECASTING EXERCISE • Before taking up a forecasting exercise, one must know the specific purpose for which the predictions are sought. The sales forecasts can have differing interpretations and applications, depending upon the purpose of the forecast. Defining the scope of the forecasting exercise is, therefore, a necessary pre-requisite. • There are at least 6 considerations that need to be taken care of while determining the scope of a forecasting exercise: • Period of forecast • Level of forecast • General purpose or specific purpose forecasts • Forecasts of established products or new products • Type of commodity for which forecast is to be undertaken • Miscellaneous factors to be included or not.
- 5. • Period of forecast: • As a first step, one must decide about the length of the period for which the forecasting exercise is taken up. The periods are usually divided into (a) Short-run (b) medium term (c) long-run. • Short-run forecasting: In the case of short-run forecasting, one is looking for the factors that bring fluctuations in the demand pattern in the market. The most important factor in this regard may be the weather conditions. As the weather conditions influence the demand for consumer goods, it indirectly affects the demand for machinery, equipment, raw materials, etc., needed to produce these consumer goods. Thus, seasonal factors are the ingredients of short-run forecasts. • Medium-term forecasting: In the case of medium-term forecasting, experience and sound judgment are more important than statistical forecasting. The medium-term forecasts can assist in the decision about the timing of an activity, like advertising expenditure. These forecasts also contribute to the control or revision of the decisions based on long-run forecasts. The main feature of medium-term forecasts is the trend. The direction of the trend has important implications for subjects like employee recruitment and training, etc. • Long-run forecasting: In the long run, the validity of the trend itself must be ascertained. If the trend is likely to change for the worse, this would have implications for the firm’s entire long-term strategy, it could suggest the wisdom of diversification policy for the firm. For long-run forecasts, reliance is usually placed on statistical techniques, though judgment remains an asset in identifying the variables that are mainly controllable and are likely to influence future sales. In the very long-run analysis, one must include variables relating to socio-psychological aspects particularly an analysis of the inter-relationship of economic, psychological, and sociological factors determining consumer behaviour.
- 6. • Levels of forecast: • Sales forecasting may be undertaken at any one of the following levels: • Macroeconomic forecasting: It is concerned with business conditions over the whole economy. These business conditions are measured with the help of some appropriate indices like those relating to national income, industrial production, wholesale prices, etc. These indices are provided by official and non-official agencies, and these can be treated as basic assumptions on which to base the demand forecasts. • Industry demand forecasting: Such forecasts can give indications to a firm regarding the direction in which the whole industry will be moving. These forecasts, based on surveys of consumer intentions and analysis of statistical trends, are generally supplied by trade associations to their members. The business may use such forecasts to compare the trends of industry sales with its own current and expected sales and thus determine its market share. • Firm demand forecasting: A big firm would like to do forecasting of its products independent of the rest of the firms in the industry. Such forecasting reveals whether the company is well placed to maintain or even better its share in the market. • Product line forecasting: It helps to decide which of the products or products should have priority in the allocation of the firm’s limited resources.
- 7. General purpose or specific purpose forecasts: Though a general forecast is useful for a firm, it will be even more helpful if the general forecast is broken down into specific forecasts with respect to commodities, area of sale, domestic and export markets. Forecasts of established or new products: Problems and methods of forecasting differ in these two cases . For the established products past sale trends and competitive conditions are known, while this is not the case for new products, hence suitable forecasting methods need to be adopted in this regard. Type of commodity for which forecast is to be undertaken: Economists broadly classify good into three categories – capital goods, consumer durables and non-durable goods. For each of these categories of goods there would be distinctive demand patterns. Miscellaneous factors to be included or not: The forecaster should decide how much the sociological and psychological factors are going to enter the forecasting exercise. To be more effective, this exercise must also include the factors like the features peculiar to the product and the market, nature of competition, impact of uncertainty and risk and the consequent errors in accuracy, etc.
- 8. STEPS INVOLED IN DEMAND FORECASTING • The following steps are necessary to have an efficient forecast of demand: • Step 1: Identification of objective • Step 2: Determining the nature of the goods under consideration • Step 3: Selecting a proper method of forecasting • Step 4: Interpretation of results • This can be explained as follows: • Identification of objective: It is necessary to be clear about what one wants to get from the forecast. The purpose of the exercise may be the estimation of one or more aspects, like quantity and composition of demand, price to be quoted, sales planning, inventory control, etc. The approach to the problem will accordingly differ.
- 9. • Determining the nature of goods under consideration: Different categories of goods have their distinctive demand patterns. It is, therefore, necessary to determine the class in which the goods fall. These categories are capital goods, consumer durables, and non-durables. This will help us in identifying the approach of the forecasting exercise and in determining the variables to be considered for forecasting. • Selecting a proper method of forecasting: The selection of an appropriate method of forecasting is related to the objective of forecasting, the type of data available, the period for which the forecast is to be made, etc. For example, if the data shows cyclical fluctuations, the use of a linear trend will not be suitable. Similarly, general trends may be more useful for long- run forecasting, while seasonal patterns will be more important for short-term forecasts. • Interpretation of results: Mere preparation of forecast does not lead the management anywhere. Interpretation of results is of equal importance. The efficiency of a forecast depends largely upon the efficiency in the interpretation of its results. Most of the time, the forecasted results are to be well-supported by the background factors that have not entered the exercise of forecasting. Further, we need to frequently revise the forecasts in light of changing circumstances because forecasts are, in the first instance, made on the assumption of continuation of past events.
- 10. SIGNIFICANC E OF DEMAND FORECASTS • The significance of demand forecasting is shown in the following points: • Fulfilling objectives • Preparing the budget • Stabilizing employment and production • Expanding organizations • Taking managerial decisions • Evaluating performance • Helping the government • This is explained in the following manner:
- 11. • Fulfilling objectives: Implies that every business unit starts with certain pre-decided objectives. Demand forecasting helps in fulfilling these objectives. An organization estimates the current demand for its products and services in the market and moves forward to achieve the set goals. • Preparing the budget: Plays a crucial role in making the budget by estimating costs and expected revenues. • Stabilizing employment and production: Helps a firm to control its production and recruitment activities. Producing according to the forecasted demand of products helps to reduce the wastage of the resources of the firm. This further helps the organization to hire human resources as per the requirement. • Expanding organizations: Implies that demand forecasting helps in deciding about the expansion of the business. If the expected demand for products is higher, then the organization may plan to expand further. On the other hand, if the demand for products is expected to fall, the organization may cut down the investment in the business. • Taking managerial decisions: Helps in making critical decisions, such as deciding the plant capacity, determining the requirements of raw materials, and ensuring the availability of labor and capital. • Evaluating performance: Helps in making corrective decisions, for example, if the demand for the firm’s products is low, it may take corrective actions to improve the level of demand by enhancing the quality of its products or spending more on publicity and advertising. • Helps the government: It enables the government to coordinate import and export activities and plan international trade. It could also pertain to boosting the level of production in the country.
- 12. DETERMINANTS OF DEMAND FORECASTING • Goods can broadly be classified into three categories as follows: • Durable consumer goods • Non-durable consumer goods • Capital goods • While forecasting demand for each of these categories, we keep in mind different considerations because different types of goods have their own distinctive demand patterns. • This is explained in detail in the following slides.
- 13. • Consumer durables: Each consumer durable has a special market for its product, which in turn has its peculiarities. So, forecasting demand for individual products in such cases requires special techniques adapted to meet these peculiarities. Moreover, the demand for consumer durables falls into two categories: replacement demand and new demand. Forecasts should be made separately for both. The special difficulties or peculiarities in forecasting in case of consumer durables are as follows: • Changes in size and characteristics of population. • Saturation limit of the market • Existing stock of the goods • Replacement demand vs. New demand • Income level of the consumers • Consumer credit outstanding • Tastes and scales of preferences of consumers • The forecaster of consumer durables, therefore has to use to different techniques to predict his future level of sales.
- 14. • Non-durable consumer goods: These include those consumer goods which can only be used once, e.g., food, beverages, tobacco, etc. Demand for such goods is basically influenced by the following factors: purchasing power (or disposable income) of the consumers (Yd), price of the commodity (P) as well as population and its characteristics (S). Symbolically, it is D = f(Yd, P, S) • Capital goods or producer’s goods: Capital goods are defined as those goods which help in further production of goods. Capital goods include factory buildings, machinery, equipment, tools, etc. Capital goods are, therefore, demanded only when there is a demand for the goods which these capital goods help in producing. In other words, demand for a capital good is a derived demand, which will depend upon the profitability, level of capacity utilisation and wage rates in the industries using the capital good. Moreover, demand for a capital good is of two kinds: • Replacement demand • New demand
- 15. • The following information is needed for estimating capital good’s demand: • Growth possibilities of the industries using the capital goods. • The norm of consumption of capital goods per unit of installed capacity. It is assumed that the norms of consumption often remain stable. However, in practise one finds cases where shortages arise, like in case of construction of bridges where mild steel is sometimes used when constructional steel is not available. Thus, though the norms usually remain stable but they are sometimes violated too. • The extent of excess capacity in the industry using the producer’s goods. • The forecast of demand for the good which the producer’s goods help in producing. • The existing stock of the producer’s goods. • The age-distribution of the existing stock of producer’s goods • The rate of obsolescence. • The availability of funds and costs of funds to the firms using the producer’s good. • The nature of tax provisions on re-equipment. • The prices of substitutes and complementary goods. • The market structure within which the producer’s good operates.