Managerial Economics Chapter-4: Demand and Demand Forecasting

CHAPTER FOUR
DEMAND AND DEMAND FORECASTING
4.1 Introduction
Business enterprise needs to know the demand for its product. Any business organization must
know current demand for its product in order to avoid underproduction or over production. The
current demand should be known for determining pricing and promotion policies so that it is
able to secure optimum sales or maximum profit.

4.2 Demand Analysis and Forecasting

Unless and until knowing the demand for a product how can we think of producing that product.
Therefore, demand analysis is something which is necessary for the production function to
happen. Demand analysis helps in analyzing the various types of demand which enables the
manager to arrive at reasonable estimates of demand for product of his company. Managers
not only assess the current demand but he has to take into account the future demand also.

4.3 Demand Forecasting

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.

Accurate demand forecasting is essential for a firm to enable it to produce the required
quantities at the right time and to arrange well in advance for the various factors of
production. Forecasting helps the firm to assess the probable demand for its products and plan
its production accordingly.

Demand Forecasting refers to an estimate of future demand for the product. It is an objective
assessment of the future course of demand.

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Managerial Economics Chapter-4: Demand and Demand Forecasting

4.4. Methods of Forecasting

There are several methods which have been used to make forecasts of future phenomena. The
extent to which one method will be superior to another depends on the specific circumstances.
Forecasting methods are classified as qualitative and quantitative.

4.4.1 Qualitative forecasting

In some situation, forecasts rely solely on judgment and opinion to make forecasts. If
management must have a forecast quickly; there may not be enough time to gather and analyze
quantitative data. At other times, especially when political and economic conditions are
changing, available data may be obsolete and more up to date information might not yet be
available. Short term forecasting depends heavily on the qualitative method. Qualitative
forecasting relies on one or more individuals to generate forecasts without using mathematical
models. It is subjective in nature. Some of the common qualitative methods of forecasting are:

1. Opinion Survey method: This method is also known as Sales- Force –Composite method or
collective opinion method. Under this method, the company asks its salesmen to submit estimate
for future sales in their respective territories. This method is more useful and appropriate because
the salesmen are more knowledgeable about their territory.
2. Expert Opinion: Apart from salesmen and consumers, distributors or outside experts may
also be used for forecast.
3. Delphi Method: It is a sophisticated method to arrive at a consensus. Under this method, a
panel is selected to give suggestions to solve the problems in hand. Both internal and external
experts can be the members of the panel. Panel members are kept apart from each other and
express their views in an anonymous manner. 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
4. Consumer Interview method: The most direct method of estimating the demand for a
product in the short-run is to interview the consumers and ask them what quantity of a product
they would be planning to buy at alternative prices over a given period of time. This is also
known as opinion survey method or direct interview method. This method is ideal and it gives
firsthand information, but it is costly and difficult to conduct.

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Managerial Economics Chapter-4: Demand and Demand Forecasting

4.4.2. Quantitative Forecasting Method

Quantitative forecasting method use mathematical models to represent relationship among

relevant variables based on historical data or known relationship. The models are then used in
conjunction with historical data to forecast demand (or some other quantity). There are many
formal and less formal statistical methods of forecasting. These consist of statistical or
mathematical techniques which are used to forecast the demand for a product in the long- period.
In opposite to qualitative approach, quantitative models are objective in their very nature.

A) Trend projection method

This is also known as time series analysis. A firm that has been existence for long period will
have accumulated considerable data on sales pertaining to different time periods. Such data can
be analyzed in order to establish the nature of trends in sales over a period so that possible trend
in future can be inferred. The past trend is projected in order to interpret the future trend. Such
data when arranged chronologically yield time series. A trend line can be fitted through a series
either usually or by means of statistical techniques such as the method of least square

The focus of time-series analysis is to identify the components of change in the data.
Traditionally, these components are divided into four categories: Trend, Seasonality,
Cyclical patterns and Random fluctuations.

 A trend is a long-term increase or decrease in the variable. For example, the time series
of population in a given country can exhibits an upward trend, while the trend for
endangered species, such of birds or animals can show a downward trend.
 The seasonal component represents changes that occur at regular intervals. A large
increase in sales of umbrellas during the rainy season would be an example of
seasonality.
 Analysis of a time series may suggest that there are cyclical patterns, defined as
sustained periods of high values followed by low values. Business cycles fit this
category.
 Finally, the remaining variation in a variable that does not follow any discernable pattern
is due to random fluctuations.

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Managerial Economics Chapter-4: Demand and Demand Forecasting

Various methods can be used to determine trends, seasonality, and any cyclical patterns in time-
series data. However, by definition, changes in the variable due to random factors are not
predictable. The larger the random component of a time series, the less accurate the forecasts
based on those data.

Example: Suppose a manufacturer of transistors in Addis Ababa decides to forecast the sales of
his products during the next year by trend projection method. Assume the price of commodity
increase by one birr each year. He collects data on his sales for the past five years as follows;

Year ( ) ( )

1989 50 1
1990 60 2
1991 55 3
1992 70 4
1993 75 5

The trend line and projection equation are given as;

= + , where ‘Y’ is sales volume and ‘X’ is price

Year = − = − =( − )
1989 50 1 -12 -2 24 4
1990 60 2 -2 -1 2 1
1991 55 3 -7 0 0 0
1992 70 4 8 1 8 1
1993 75 5 13 2 26 4
Sums 310 15 0 0 60 10

∴ = = 62, and = =3

∑( − )( − ) ∑
= == = =
∑( − ) ∑
= − ∴ = − ( )=
Therefore, the fitted regression equation (i.e., OLS regression line) is:

= +

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Managerial Economics Chapter-4: Demand and Demand Forecasting

Using the equation, we can find out trend values for the previous years and estimate the sales for
1994.
1989 = 44 + 6 (1) = 44 + 6 = 50

1990 = 44 + 6 (2) = 44 + 12 = 56

1991 = 44 + 6 (3) = 44 + 18 = 62

1992 = 44 + 6 (4) = 44 + 24 = 68

1993 = 44 + 6 (5) = 44 + 30 = 74

= + ( ) = + =

Thus, forecast sales for 1994 would be 80 thousand based on trend projection equation.

B) Averaging Methods

These methods utilize historical data for calculating average of the past demand. This average is
then used as a forecast. Different ways of calculating an average for short range forecast include
the following given below;

i) Simple average method; in this method an average of past data in which the demands of all
previous periods are equally weighted, is calculated.

Example: Demand of an item in a firm has been 180, 160, 170 and 190 items in each of the last
four quarters. Forecast the demand of this item for the current quarter based on simple average
method?

Solution;
Forecast for current quarter based on simple average would be;

180 + 160 + 170 + 190 700

= = =
4 4

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Managerial Economics Chapter-4: Demand and Demand Forecasting

ii) Simple moving average; A simple moving average is a simple arithmetic average of a set of
observed values, from the present time period to a certain time period in the past and then using
that average as the forecast for the immediate future. In this method number of past periods to be
used in the calculation are first decided and held constant. In this method also, equal weight age
is given to all the periods. To keep the number of periods constant, some old data are discarded
while new (present) values are added.

‘ ’
=

Example; Demand for generating sets of a particular size in the past six months, in a firm was as
follows;
January 300
February 350
March 400
April 400
May 450
June 500

Forecast the demand for July, based on (i) 6 months moving average (ii) 4 moving month’s
average and (iii) 3 months moving average?

Solution;

300 + 350 + 400 + 400 + 450 + 500

= = 400
6

400 + 400 + 450 + 500

= = 437. 5
4

400 + 450 + 500

= = 450
3

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Managerial Economics Chapter-4: Demand and Demand Forecasting

iii) Weighted moving average; This method incorporates some weights of old demand. Greater
weight is given to the more recent data.

Weighted ‘n’ period moving average forecast for the period (t +1) = sum of demand times a
weighted factor over desired periods in the moving average.

Example; From the monthly data given below, compute a weighted three months moving
average for July, where the weights are 0.5 for the latest month, 0.3 weights and 0.2 for the other
months respectively.
January – 300
February – 350
March – 400

April – 400
May – 450
June -500
Solution;

A three-month weighted moving average forecast for July;

= ( ) + ( ) + ( )

= (0.5 500) + (0.3 450) + (0.2 400)

= 250 + 135 + 80

C) Exponential Smoothing

The forecast can be based on the old calculated forecast and the new data. The weight given to
latest actual demand is called a smoothing constant and is represented by the Greek letter alpha
(α). It is always expressed as a decimal from 0 to 1. In general, the formula for calculating the
new forecast is:
= ( )( ) + ( − )( )

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Managerial Economics Chapter-4: Demand and Demand Forecasting

Example: The old forecast for May was 220, and the actual demand for May was 190. If alpha is
0.15, calculate the forecast for June. If June demand turns out to be 218, calculate the forecast for
July.

Solutions

= (0.15) (190) + (1 − 0.15) (220) = 215.5

= (0.15) (218) + (0.85) (215.5) = 215.9

 As an alternate formula you can use the previous forecast plus a percentage of the difference
between that forecast and the actual value of the series at that point.

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