CHAPTER 4

FORECASTING DEMAND1

Learning Objectives: This chapter will discuss the different methods and techniques of
forecasting can that be used by the firms in their decision-making. At the end of this topic,
the readers should be able to discuss why business and economic forecasting is of great
importance to the firms and able to explain the circumstances under which different
methods should be used.

The major role of forecasting is to reduce the uncertainty, which faced by both private and
public organizations when conducting business activities. In order to ser reasonable targets for
its objectives, corporate management must have available and relevant forecasts, both for the
short-run and long-term terms. It can limit or control the uncertainties by predicting changes in the
economic variables of costs, price, sales, and interest rates. Accurate forecasting can assist in
the development of strategies to promote profitable trends and to reduce the harm from
unprofitable ones. A forecast is merely a prediction concerning future outcomes.

Forecasting methods often blended with qualitative and quantitative techniques.

Qualitative forecasting is based on judgments of individuals or groups. The results may be in the
form of some numerical values but they are not based on historical data. This technique normally
forecasts directions of movements including expert opinions, opinion polls and surveys.

On the other hand, quantitative forecasting method, utilizes a vast amount of historical
data or cross-sectional data as basis for prediction. Quantitative techniques can be naïve as in
time series prediction or they can be causal (explaining cause and effect) as in econometric
modelling.

4.1 Qualitative Forecasting Technique

Qualitative techniques that forecast direction of movements include surveys, opinion polls
and use of comparative statistics with demand and supply curves.

a. Expert Opinion
There are various types of techniques that fit into this category. Only a few is listed in
this section.

(1) Jury of executive opinion

In this technique, a forecast is generated by experts (corporate executives and
managers) in meetings or workshops.

(2) Opinions of Sales

Sales representatives with vast experience can be a source of a good forecast.
However, the drawback is that salespeople may be too optimistic or pessimistic
about their sales prospects. Furthermore, they may be unaware of the broader
economic patterns which may affect demand.

1
Discussions of this chapter were gathered from Samuelson, W.F. and Marks, S.G. (2012). Managerial Economics,
7th Edition, John Wiley & Sons, Inc.
 (3) Delphi Method
This technique is a form of expert opinion forecasting that uses a series written
questions and answers to obtain a consensus among experts on a forecast when
experts do not meet and agree on a forecast.

b. Opinion Polls
Opinion poll is a forecasting in which sample populations are surveyed to determine
consumption trends. This method may be able to assist us to identify trends. However,
the choice of sample is important to avoid biasness in the responses. Furthermore,
questions used in the poll must be simple and clear.

c. Market Research
Market research is closely related to opinion polls. Normally, we use market research
to indicate not only why the consumer is or is not buying a particular product, but also
who the consumer is and how he is using the product. Also, we want to know that
product attributes and what factors or characteristics the consumer thinks are
important in the purchasing decisions.

4.2 Quantitative Forecasting Technique

The quantitative techniques attempt to forecast the precise number/value for an economic
variable.

4.2.1 Time-Series Models

Time-series models seek to predict outcomes simply by extrapolating past behavior into
the future. Time-series patterns can be broken down into the following four categories.

1. Trends
2. Business cycles
3. Seasonal variations
4. Random fluctuations

A trend is a steady movement in an economic variable over time. On top of such trends
are periodic business cycles. Economies experience periods of expansion marked by rapid
growth in gross domestic product (GDP), investment, and employment. Then economic growth
may slow and even fall. A sustained fall in (real) GDP and employment is called a recession.

Seasonal variations are shorter demand cycles that depend on the time of year.
Seasonal factors affect tourism and air travel, tax preparation services, clothing, and other
products and services. Seasonal variations in time series occur during the year and they tend to
appear regularly from year to year. The seasonal effect can be added to a time series with
methods such as the ratio-to-trend method. Daily, weekly, monthly, or quarterly data provide
trends. But if a particular part of the season is above or below the trend, the forecast is adjusted
up or down by that percentage.

Finally, one should not ignore the role of random fluctuations. In any short period of time,
an economic variable may show irregular movements due to essentially random (or
unpredictable) factors. Random fluctuations and unexpected occurrences are inherent in almost
all time series. No model, no matter how sophisticated, can perfectly explain the data. These
random factors are usually unpredictable such as natural disasters and a sudden increase in
salaries.

Forecasts suffer from the same sources of error as estimated regression equations. These
include errors due to (1) random fluctuations, (2) standard errors of the coefficients, (3) equation
misspecification, and (4) omitted variables. In addition, forecasting introduces at least two new
potential sources of error. First, the true economic relationship may change over the forecast
period. An equation that was highly accurate in the past may not continue to be accurate in the
future. Second, to compute a forecast, one must specify values of all explanatory variables. For
instance, to predict occupancy rates for its hotels in future years, Disney’s forecasters certainly
would need to know average room prices and expected changes in income of would-be visitors.
In this sense, its forecasts are conditional—that is, they depend on specific values of the
explanatory variables. Uncertainty about any of these variables (such as future regional income)
necessarily contributes to errors in demand forecasts. Indeed, an astute management team may
put considerable effort into accurately forecasting key explanatory variables.

In light of the difficulties in making economic predictions, it is important to examine how

well professional forecasters perform. First, forecast accuracy has improved over time as a result
of better data and better models. Second, many economic variables still elude accurate
forecasting. To be useful, any prediction also should report a margin of error or confidence interval
around its estimate. One way to appreciate this uncertainty is to survey a great many forecasters
and observe the range of forecasts for the same economic variable. (But even this range
understates the uncertainty. A significant portion of actual outcomes falls outside the surveyed
range; that is, the outcomes are higher than the highest forecast or lower than the lowest.) Third,
the time period for making forecasts matters. On average, accuracy falls as the forecasters try to
predict farther into the future. The time interval forecasted also matters. (Forecasts of annual
changes tend to be more accurate than forecasts of quarterly changes.) Fourth, no forecaster
consistently outperforms any other. Rather, forecast accuracy depends on the economic variable
being predicted, how it is measured, and the time horizon. But the differences in accuracy across
the major forecasters are quite small. Overall, macro models performed better than purely
extrapolative models, but, for many economic variables, the advantage (if any) is small.

4.2.2 Smoothing Technique

Smoothing techniques are another type of time-series forecasting model which assumes
that an underlying pattern can be found in the historical values of a variable that is being
forecasted. It is assumed that these historical observations represent not only the underlying
pattern but also random variations.

a. Moving Average
The forecast for the next period is the average of the last several periods. Moving
averages assume that there is no secular trend (long term changes in an economic
time series variable). A moving average of the past N periods can be used to predict
the next period. The forecast is the average of data from w periods prior to the forecast
data point.

b. Exponential Smoothing
The forecast is the weighted average of the forecast and the actual value from the
prior period.
 c. Barometric Techniques
Sometimes managers may wish to know the future of the economy of the specific
product. Barometric forecasting models are developed and used primarily to identify
potential future changes in general business conditions, rather than conditions for a
specific industry or firm. However, they can give a good indication of the future of the
industry and to some extent, the product.

Barometric models search for patterns among different variables over time. Consider
a firm that produces oil drilling equipment. Management naturally would like to forecast
demand for its product. It turns out that the seismic crew count, an index of the number
of teams surveying possible drilling sites, gives a good indication as to changes in
future demand for drilling equipment. For this reason, we call the seismic crew a
leading indicator of the demand for drilling equipment.

Economic indicator is a form of barometric method of forecasting in which economic

data are formed into indexes to reflect the state of the economy. We can use indexes
of leading, coincident, composite, diffusion, and lagging indicators to forecast changes
in economic activities. The success of the indicator approach, however, is highly
dependent on our ability to identify the historical economic data series, whose
directions not only correlate but precede those of the series to be predicted. We usually
use more than one indicator since using only one indicator may not be reliable.

Decision-Making Principles

1. Decisions are only as good as the information on which they are based. Accurate
demand forecasts are crucial for sound managerial decision making.
2. The margin of error surrounding a forecast is as important as the forecast itself.
Disasters in planning frequently occur when management is overly confident of its
ability to predict the future.
3. Important questions to ask when evaluating a demand equation are the following: Does
the estimated equation make economic sense? How well does the equation track past
data? To what extent is the recent past a predictable guide to the future?
4.3 Quantitative Forecasting Technique using Econometric Models

Econometric models use statistical techniques to and economic theories to explain and
estimate relationships of variables. Thus, these can be classified as casual or explanatory
methods.

Econometric modelling is a combination of economic theory, statistical analysis, and

mathematical method to explain economic relationships and scenarios. Econometric models may
vary in their level of complexity from simple singe-equation model using simple or multiple linear
regression to extremely complex such as systems of equations (two to three stage least squares
will be needed and will not be discuss in this module).

The specification and estimation of demand function using econometric models using
regression were discussed in the previous chapter. The results of the estimation can be used in
forecasting.
 The use of econometric models in forecasting has several advantages over the other
forecasting techniques:

1. In econometric models, we can identify independent variables (which are the factors
or determinants) that we can manipulate for demand forecasting such as prices,
income, advertising expenses and others.
2. Econometric models predict not only the direction of change in the economic data
series but also the magnitude or size of that change.
3. Econometric models are easily adaptable in that, model can be modified by re-
estimating existing parameters, adding new variables, and developing new
relationship to improve future forecasts.
Regression Using Spreadsheets

Most spreadsheet programs can run multiple-regression programs. In this section we

review the steps of running a regression using Microsoft’s Excel spreadsheet program using the
airline example in the text.

Simple Regression

Step 1: Enter the data. Suppose the average number of coach seats is the dependent variable
and the average price is the independent variable. The data for both of these variables
must be entered into the spreadsheet as columns, as the table below shows.
Step 2: Call up the regression program. The method for calling up a regression program may vary
a bit depending on the version of the program. In Excel, calling up the regression program
involves these steps: Under the Data menu select Data Analysis, then select Regression,
and click OK. A regression dialog box will appear, such as the one depicted in the table
below. The following steps show how to complete this box.
Step 3: Designate the columns of data to be used in the regression. The regression program has
to be told where to find the data. This is done by entering the cells in the boxes labeled “Y
Input Range” and “X Input Range.” The Y input range refers to the dependent variable. In
our case, the Y data range from cell A3 to cell A18. Thus, we could simply type A3:A18
into the box.
 Alternatively, we could select the range, pointing the mouse at A3, clicking, holding, and
dragging to cell A18. There will appear in the Input Range box the entry $A$3:$A$18. (Do not
worry about the dollar signs.) If you wish to include the column label in cell A2, simply select the
range $A$2:$A$18. Then click on the label box. (In our example, we chose to include the label.)
The advantage of using the label is it will appear in the output statistics, making these statistics
easier to read.

The X Input Range refers to the independent variable. In our case, the X Input Range is
from cell B3 to cell B18. To input the cells for this range, repeat the procedure described above.

Step 4: Inform the program where you want the output. The regression program needs to be told
where to put the output. This is known as the output range. Simply type in a cell name
(or point and click). The program will start with that cell and work to the right and down.
It really does not matter where you put the output except that you do not want to put it
over the data, thereby destroying the data. Thus, you should put the output either below
or to the right of the data. We specified F2 as the output range. Some programs, such as
Excel, will allow you to put the output in a separate spreadsheet.

Step 5: Run the regression. Simply click OK. For the airline example, the program produces the
output shown in the next table.
Multiple Regression

Performing multiple-regression analysis involves virtually the same steps as performing

simple regression. Suppose there are other data such as income and competitors’ price as
explanatory variables were added to the airline’s own price. The first step is to enter the income
and competitive price data in columns C and D of the spreadsheet. After calling up the regression
menu, we again enter cells A2 to A18 for the Y range. However, next we enter cells B2 to D18 for
the X range. (We designate the three columns of data by selecting the upper left and the lower
right cells of the range containing the data. All explanatory variables must be listed in adjacent
columns.) The regression program recognizes each column of data as a separate explanatory
variable. Next, we specify the output range to begin in cell F2. Finally, we execute the regression
program by clicking OK. The multiple-regression output is displayed in next table.