UNIT-3

Forecasting

customer demand for products and services is a proactive process of determining what products are needed where, when, and in what quantities. Consequently, demand forecasting is a customerfocused activity. forecasting is also the foundation of a companys entire logistics process. It supports other planning activities such as capacity planning, inventory planning, and even overall business planning.

Demand

Demand forecasting is predicting or anticipating the future demand for a product or a service at some future date on the basis of certain present & past behavior patterns of some related events.
Micro level Industry level Macro level

Scope of forecasting depends upon the area of operation in the present & proposed in future. The necessary trade-off has to struck between the cost of forecasting & benefits flowing from such forecasting.

THE FORECAST

Step 6 Monitor the forecast Step 5 Prepare the forecast

Step 4 Gather and analyze data Step 3 Select a forecasting technique

Step 2 Establish a time horizon Step 1 Determine purpose of forecast

Short term demand forecasting

1) 2) 3)

4)
5)

6)

Evolving production policy Determining price policy Evolving purchase policy Fixation of sales targets Short term financial policy Regular availability of labor force

Long term demand forecasting

1)

2)
3)

Business planning ( Business Planning) Man power planning Long term financial planning

 Very first requisite of business is planning &

planning requires forecasting.

For the effective allocation of resources.
Information about the likely future demand in

order to pursue optimal pricing strategy.

For

determining the competitive strategy.

&

implementing

the

QUALITATIVE METHODS

Survey of buyers intention Collective opinion method Expert opinion method Business Barometer

QUANTITATIVE METHODS

Trend Projection Graphical Method Least square method Controlled experiments Study of general economic environment.

 Employs sample survey techniques for gathering

data. Data is collected from end users of goods consumer, producer, mixed. Data portrays biases and preferences of customers. Useful when bulk of sale is made by industrial producers who generally have firm future plans. Ideal for short and medium term demand forecasting, is cost effective and reliable.

 ADVANTAGES

Helps in approximating future without past data.

requirements even

Accurate method as buyers needs and wants are clearly identified & catered to. Most effective way of assessing demand for new firms.
People may not know what they are going to purchase They may report what they want to buy, but not what they are capable of buying Customers may not want to disclose real information

LIMITATIONS

Effects of derived demand may make forecasting difficult

Opinions from marketing & sales specialists are compiled.

2 types of targets estimated ambitious targets. conservative targets. Combines expertise of higher level management & sales executives. Best suited in the circumstances where intractable changes are occurring.

 LIMITATIONS
POWER STRUGGLES MAY OCCUR BETWEEN SPECIALISTS.

CONSENSUS MAY NOT BE REACHED IN GOOD TIME.

DIFFERENCES AND PREJUDICES IN OPINIONS MAY ALSO EXIST.

 FEATURES

Panel of experts in same field with experience & working knowledge. Combines input from key information sources. Exchange of ideas and claims. Final decision is based on majority or consensus, reached from experts forecasts.

ADVANTAGES
Can be undertaken easily without the use of elaborate statistical tools. Incorporates a variety of extensive opinions from expert in the field.

 LIMITATIONS
JUDGEMENTAL BIASES

for example

Availability heuristic:- Involves using vivid or

accessible events as a basis for the judgment.

Law of small numbers:-People expect

information obtained from a small sample to be typical of the larger population.

Competitive biases
Over reliance on personal opinions. Possibility of undue influence in certain cases.

Statistical inadequacy:- Lack of statistical and

quantifiable data or figures to substantiate the forecasts made.

 Represents the indicators of various economic

phenomenon. Some of important indicators: Gross Domestic Production

Employment
Wholesale prices

Industrial production
Consumer credit Disposable personal income

Stock prices.

 Panel of experts is selected.

One co-ordinator is chosen by members of

the jury Anonymous forecasts are made by experts based on a common questionnaire. Co-ordinator renders an average of all forecasts made to each of the members. 3 consequences- diversion, consensus or no agreement. 2 to 3 cycles are undertaken. Convergence and diversion is acceptable. Forecasts are revised until a consensus is reached by all.

 ADVANTAGES
Eliminates need for group meetings.
Eliminates biases in group meetings

Participants can change their opinions anonymously.

LIMITATIONS
Time consuming -reaching a consensus takes a lot of

time. Participants may drop out.

QUANTITATIVE METHODS

 TREND ANALYSIS
Past

data is used to make future predictions . Known or Independent variables are used for predicting Unknown or dependent variables, using the trend equation- Predictive analysis Based on trend equation, we find Line of Best Fit and then it is projected in a scatter diagram, dividing points equally on both sides

 TREND EQUATION

Y^ = a + bX + E
Y^ = Estimated value of Y a = Constant or Intercept b = slope of trend line X = independent variable E = Error term

= EXPLAINED VARIATION

1-

= UNEXPLAINED VARIATION

Explained variation - means the extent to which the independent variable explains the relative change in the dependent variable. Higher the explained variation, lower the error value leading to accurate forecast

 Data from a number of consecutive past

periods is combined to provide forecast for coming periods. Higher the amount of previous data, better is the forecast.
Since the averages are calculated on a

moving basis, the seasonal and variations are smoothened out.

cyclical

 Trend

line can be fitted through a series graphically.

Old values of sales for different areas are plotted

on a graph & a free hand curve is drawn passing through as many point as possible.
Direction of free hand curve shows the trend.

 Merits: It is very simple method.

More flexible than that of the rigid mathematical function.

More dynamic & dramatic.

Graphs attractive to see.

Comparison is made easy.

Limitations: Highly subjective

Mathematical curve can be expressed through formulae only.

Requires a skilled analyst to draw curve with reasonable

accuracy. Fully accuracy not possible. Might give misleading result. Graphs cannot be quoted in support of some important statements.

 Based on the assumptions that the past rate of

change of the variable, under study will continue in the future. Mathematical procedure for fitting a line to a set of observed data points, sum of squared differences between the calculated & observed value is minimized. Used to find a trend line which best fits the available data. Very popular coz it is simple & in-expensive. LIMITATIONS: Requires greater care to select the trend. Predictions based on the long term variations.

 It is a statistical technique for quantifying the

relationship between variables. In simple regression analysis, there is one dependent variable (e.g. sales) to be forecast and one independent variable. The values of the independent variable are typically those assumed to "cause" or determine the values of the dependent variable. Curvy linear relationship between dependent & independent variables.
STEPS IN REGRESSION ANALYSIS:1.Identification of variables influencing demand for product under estimation. 2.Collection of historical data on variables. 3.Choosing an appropriate form of function 4.Estimation of the function.

Y=
Where

Y= value being forecasted

= constant value

= coefficients of regression

= independent variable

 Merits: Helps in studying the dependence of one variable on the other variable. Studies the possible causes of rise or fall in demand. Used in policy formulation to solve various problems. Highly useful method for research.

Limitations: Applicability is only possible in linear dependence. The result may not accurate from the method. It is assumed that the same relationship still exist between the variables under study.

 Effort is made to vary separately certain determinants of

demand which can be manipulated eg. Price, advertising, etc..

Other factors remain constant. Effect of price, advertising, packaging, etc. on sales can be

assessed by either varying them over different markets or by varying them over different periods in the same market.
Market division should be homogenous in regards to taste,

income, etc.
Limitations:Used less coz this method is costly & time consuming. Difficulty in taking what factors as constant & what factors be regarded as variable. Difficult to satisfy the condition of homogeneity of market.

 It is the study of general behavior of the economy.

There are certain lead indicators & there are others which

appear after a lag.

Economic indicators precede the changes in the economic

activity & hence are studied for predicting of future changes.

The indicators are:Leading Economic Indicators:- precede the changes in the economic activity, help in knowing the direction of future changes. Coincidental Indicators:- Indicators coincide with the movement or changes in the economic activities. Lagging Indicators:- Lag the movements or the changes occurring in the economic activities.

Common indicators:- Personal & agricultural income, GNP, Agricultural

& industrial production, Level of employment, Inflation & deflation, share market trend, bank activities like deposits , finance, etc.

The use of this approach bases demand forecasting on certain economic indicators, eg., 1. Construction contracts sanctioned for the demand of building materials, say, cement; 2. Personal income for the demand of consumer goods; 3. Agricultural income for the demand of agricultural inputs, implements, fertilizers, etc,; and 4. Automobile registration for the demand of car accessories, petrol, etc. Steps for economic indicators: 1. See whether a relationship exists between the demand for the product and certain economic indicators. 2. Establish the relationship through the method of least squares and derive the regression equation. (Y= a + bx) 3. Once regression equation is derived, the value of Y (demand) can be estimated for any given value of x. 4. Past relationships may not recur. Hence, need for value judgement.

Higher revenues
Sales maximization Reduced investments for safety stocks Improved production planning

Early recognition of market trends Better market positioning

Improved customer service levels

 Supply side is equally important as demand side.

Refers to the quantity of a product which the producer is

willing & able to sell at a given price per unit of time. Cost of production, function of technology of production & prices of inputs. Concerned with the supply side of the market. Relates physical output to physical inputs or factors of production. Categories of Inputs (factors of production)

Labor Materials Capital Entrepreneurship

 We study the least-cost combination of factors

inputs, factor productivity & returns to scale. Major objectives of a firm: Meeting final consumer needs.
Maximise profits, to gain or maintain market share, to

achieve a target returns on investment, or any combination thereof.

Inputs the factors of production classified as: Land all natural resources of the earth not just terra firma!
Price paid to acquire land = Rent

Labour all physical and mental human effort involved in

production
Price paid to labour = Wages

Capital

buildings, machinery and equipment not used for its own sake but for the contribution it makes to production
Price paid for capital = Interest

Indicates the highest output that a firm can produce

for every specified combination of inputs given the state of technology. Shows what is technically feasible when the firm operates efficiently. shows a technical or engineering relationship between the physical inputs & physical outputs of a firm, for a given state of technology. Function, means the precise relationship that exists between one dependent variable & many independent variables.

 Firm can more easily adjust its inputs in the long run (LR)

than in the short run (SR) Short run: a period of time so brief that at least one factor of production is fixed Fixed input: a factor that cannot be varied practically in the SR Variable input: a factor whose quantity can be changed readily during the relevant time period Long run: lengthy enough period of time that all inputs can be varied Short-run production: one variable input: Labor (L)
one fixed input: Capital (K)

thus, firm can increase output only by using more labor

 service

assembles computers for a manufacturing firm it with the necessary parts, such as computer chips and disk drives

firm

manufacturing firm supplies

assembly firm's capital is

fixed: eight workbenches fully equipped with tools, electronic probes, and other equipment for testing computers can vary labor

 Indicates a functional relationship between physical

inputs & output of a firm. The form of production function of a firm is determined by the state of technology. The production function is always in relation to a period of time. Production function is purely a technical relationship. Output in the production function is the result of joint use of factors of productions. Differ from firm to firm due to type of technology, type of product & extent of availability of different resources.

 COBB-DOUGLAS PRODUCTION FUNCTION:-

States that about 75% of the increase in manufacturing

production due to labor input & remaining 25% due to capital input.
Can also be estimated by regression analysis by first covering

it into log form:Log Q= Log A= Log L + log K (A, , are positive constants)

Properties of Cobb Douglas Function:a)

The sum of the exponents of Cobb-Douglas production function that is , a+b measures the return to scale: If a+b = 1, returns to scale is constant If a+b>1, returns to scale is increasing If a+b <1, returns to scale is decreasing. According to cobb-douglas production function, marginal product of a factor depends on its amount used in production. The exponents of labour & capital in Cobb-Douglas production function measure output elasticities of labor & capital respectively.
Cobb-Douglas production function can be extended to include more than 2 factors. 3 4 2 Q= AL k + D + G +F When the sum of exponents ( + ) in the 2 factors, labor & capital, in the cobb-douglas production function is equal to unity.

b)
c) d)

b)

 Fixed proportion, the amount of a productive factors required

to produce a one unit of a product remain fixed irrespective of the level of production proportion form.
Possibility of substitution of the factors of production is ruled

out.
As it mostly happens in long run, its is called as long-rum

production function.
The amount of a factor required to produce a unit of a product

can be varied by substituting some other factors in its place, is variable proportion form.
A given amount of commodities can be produced by several

alternative combinations of factors.

As it happens in the short-run, called as short-run production

function.

 A production function is homogeneous of degree 1 is the most

common form of linear production function.

All the factors of production are increased in same proportion,

output also increases in the same proportion.

It represents the case of constant returns to scale.

Expansion path of the linear homogenous production function

is always a straight line which arises from the origin.

 Product or output refers to the volume of goods

produced by a business firm during a specified period of time.

Economist viewpoint of product: Total Product Marginal Product

Average Product

Total Product:- Total quantity of goods produced

by a firm during a specified period of time.

 Total quantity of goods produced by a firm during

a specified period of time. Can only be raised by increasing the quantity of the variable factor. Rate of increase in total product varies at different levels of employment of factor of production coz of the applicability of law of variable proportions. Increase in the variable factor of production will not always increase the total production. Eg. Employment of workers beyond capacity will create over crowding.

 Addition

to the total production by the employment of an extra unit of variable factor. Important to know how production changes as a variable unit, say L changed. Rate of change in output as labor is increased by 1 unit, holding all other factors constant, called as marginal product of labor.

MPn= TPn - TPn-1

TP= total product
n = number of variable factor units MPn= Marginal product of nth variable factor unit.

 AP of a variable factor is total product divided by

the number of units of the variable factor employed. Eg. taking labor as variable factor:AP= TP/L Useful in intra-industry comparisons of labor productivity, wages revision.

TOTAL PRODUCT

MARGINAL PRODUCT
Increases

AVERAGE PRODUCT
Increases, but at a lower rate than that of the MP Continues to increase & becomes maximum

STAGE 1

First increases at increasing rate.

Then increases at diminishing rate

Reaches the max. point & begins to diminish Continues to diminish & becomes equal to zero Becomes negative

STAGE 2

Continues to increase at diminishing rate & becomes maximum Diminishes

Becomes equal to MP & then begins to diminish Continues to diminish but will always greater than zero

STAGE 3

 Initially was called the Law of diminishing returns by

Marshall.
Also called as Law of Proportionality.
Deals with the short-run & there are 2 types of factor of

production i.e. Fixed factors & variable factors.

Describe the input-output relation in a situation when the

output is increased by increasing the quantity of one input, keeping the other inputs constant.
As per Leftwitch, The law of variable proportion state

that if the input of one resource is increased by equal increments per unit of time while the inputs of other resources are held constant, TP will increase but beyond some point the resulting output increases will become smaller & smaller.

 As per Stigler, As equal increments of one

input are added, the inputs of other productive services being held constant, beyond a certain point the result in increment of product will decrease i.e., the marginal product will diminish. Professor Samuelson An increase in some inputs relative to other fixed inputs will, in a given state of technology cause output to increase; but after a point the extra inputs will become less & less.

 It is assumed that the state of technology remains

unaltered. Assumed that of the various inputs employed in production some atleast must be kept constant. Specially operates in the short run coz here some factors are fixed & the proportions of others has to be varied. Assumed that the variable resources is applied unit by unit & each factor unit is homogenous or identical in nature. Assumed that it is possible to use various amounts of a variable factor with fixed factor of production.

Production Schedule Using Varying Amounts of Labo

Number of Workers

Total Product (In Units)

Marginal Product (In Units)

0 1 2 3 4 5 6 7 8
9 10

0 14 42 75 112 150 180 203 216

207 190

0 14 28 33 37 38 30 23 13
-9 -17

Stage I (Increasing Returns)

Stage II (Diminishing Returns)

Stage III (Negative Returns)

Production Function Using Variable Amounts of Labor

250

Stage-2
200

TP

Total Production (In Units)

Stage-3
150

Stage-1
100

Series1

50

AP

0 1 2 3 4 5 6 7 8 9 10 Variable Input (Number of Workers)

MP

STAGE 1:- INCREASING RETURNS In this Stage TP is initially increasing at an increasing rate & then starts increasing at an decreasing rate. AP rises throughout in this stage. MP initially increases & then starts falling. Increase in AP & MP coz the factor are underutilised.

STAGE 2:-DIMINISHING RETURNS Decreasing but positive AP & MP. Law of diminishing returns operates in this stage. Shows the decrease in the efficiency of labor. STAGE 3:- NEGATIVE RETURNS MP becomes negative as well as TP starts decreasing. Efficiency of labors decreases resulting in decline in AP.

 There are 2 important reasons for increasing

returns:1. Indivisibility:

Generally fixed factors are indivisible. Cant be divided in smaller units which will result in total or partial loss in efficiency. Means due to technological requirement a minimum amount of that factor must be employed. Initially the supply of fixed factor is too large & it is indivisible, when the units of variable factors are increased & combined with this fixed factor, the latter is utilised better & more fully. Results in increasing returns till best proportion is not achieved.

2. Specialisation: Greater the quantity of variable factor, greater the scope

of specialisation. It include greater skills, productivity, efficiency, the avoidance of waste of time in shifting from one task to another, employment of best person suited for the particular type of work, etc. Improves the quality of product & also saves time.

 Average product & Marginal product will diminish,

because, the indivisible factor is being used too fully, i.e. in non-optimal proportion with the variable factor. Also arises as after some time, the firm will have to use inferior factor units, when superior ones are used up.

 A stage reached when the total product declines &

the marginal product declines. Is due to the fact that number of the units of variable factors become too excessive relative to the fixed factor.

 Has the universal application & find place in

number of economic principles like principle of substitution, Marginal Utility Theory of value, Marginal Productivity Theory of Distribution, etc. Law applies as much as to agriculture as in industries. Application of law of variable proportion is inevitable & all prevading.

 Is the geometric representation of the production

function.
Q= f(L,K) Curve drawn by plotting all the alternative combinations for a given level of output. The curve which is the locus of all possible combinations is called Isoquant or Iso-product curve. The isoquant curve is bowed inward because of the law of diminishing marginal productivity.

Labor A B C D E F 3 4 6 10 15 20

Machines Pairs of Earrings 20 15 10 6 4 3 60 60 60 60 60 60

 Isoquant map a set of isoquant curves that show

technically efficient combinations of inputs that can produce different levels of output.
Each isoquant corresponds to a specific level of output &

shows different ways, all technologically efficient, of providing that quantity of output.
Slope downward & convex to the origin.

Curvature of an Isoquant is significant becausse it indicates

the rate at which K & L can be substituted for each other while a constant level of output is maintained.
2 isoquants dont intersect each other as it is no possible to

have 2 output level for a particular input combinations.

 Isoquant are downward slopping, means if a farm

wants to use more labor then it must use less of capital to produce the same level of output or to be on the same isoquant. Isoquants are convex to the origin, i.e., it has diminishing slope. Isoquants never cross each other. Isoquant which lies to the right & above another isoquant represents higher level of output.

 The slope of an isoquant shows the rate at which L can

be substituted for K. Or the rate at which two factors are substituted for each other.
- slope = marginal rate of technical substitution (MRTS)

MRTS > 0 and is diminishing for increasing inputs of

labor.

Slope of isoquant: K MP L L MP K

FIGURE

The Slope of an Isoquant Is Equal to the Ratio of MPL to MPK

 Increase in one input is possible only at the cost of

some other input i.e. units of capital diminishes, units of labor increases. MRTS had a diminishing tendency. MRTS decreases coz capital & labor are not perfect substitute of each other.

 Maximasation of profits possible through minimum

firms cost. The firm will choose the combination of inputs that is least costly. The least costly way to produce any given level of output is indicated by the point of tangency between an isocost line and the isoquant corresponding to that level of output. When the firm producing desired output with the factor combination having the least cost, it is said to be in equilibrium. It is a stage when a producer had no tendency either to expand or contract his output.

 Determined with the help of producers isoquant & iso-cost

lines.
Isoquant curve shows different combinations of the factors

of production each of which can produce a specified level of output.

Iso-cost line represents the various levels of outlay given by

the prices of two factors.

Isocost Lines Showing the Combinations of Capital and Labor Available for $5, $6, and $7

Isocost Line Showing All Combinations of Capital and Labor Available for $25

K TC / PK PL L TC / PL PK

Slope of isocost line:

 How does output respond to increases in all

inputs together? Suppose that all inputs are doubled, would output double? Returns to scale have been of interest to economists since the days of Adam Smith RTS is the degree of responsiveness of output to a proportionate change in the quantity of all inputs.

 Smith identified two forces that come into

operation as inputs are doubled

greater division of labor and specialization of

labor loss in efficiency because management may become more difficult given the larger scale of the firm

 Increasing returns to scale:- If output increases

more than the proportionate change to the increase in all inputs. Constant returns to scale:- If all inputs are increased by some proportion, output also increases by the same proportion. Decreasing returns to scale:- If increase in output is less than proportionate to the increase in all inputs.

 Property of a production function whereby output

rises more than in proportion to an equal increase in all inputs. f(2L, 2K) > 2f(L, K).

 Specialization Use of specialized machinery.

Economics of large scale.

Indivisibility.

 All the factors of production are increased in a

given proportion, the output also increases in the same proportion. Means increasing or decreasing in the input, same proportional change increase or decrease in the output.
f(2L, 2K) = 2f(L, K).

 Output increases in the smaller proportion than

increase in all inputs. f(2L, 2K) < 2f(L, K).

Causes: Diseconomies of large scale production. Exhaustible natural resources. External diseconomies.

TECHNICAL ECONOMIES
MANAGERIAL ECONOMIES

ECONOMIES OF SUPERIOR TECHNIQUES ECONOMIES OF INCREASED DIMENSIONS ECONOMIES OF LINKED PROCESS

PROFESSIONAL MANAGERS MECHANICAL DEVICES LOWER OVERHEAD BETTER CONDITIONS

FINANCIAL ECONOMIES
MARKETING ECONOMIES

FINANCIAL REPUTATION ECONOMICAL FINANCING TRADING ON EQUITY PLOUGHING BACK OF PROFITS

CONTROL OVER DISTRIBUTION SERVICES OF EXPERTS ADVERTISING COMPETITION

COMMERCIAL ECONOMIES

LARGE SCALE BUYING ECONOMY IN SELLING

TRANSPORTATION & STORAGE ECONOMIES

DIVISION OF LABOR & SPECIALIZATION

RISK BEARING ECONOMIES

DIVERSIFICATION OF OUTPUT MARKET SOURCES OF SUPPLY PROCESS OF MANUFACTURE

 These are economies made outside the firm as a result of

its location, and occur when:

A local skilled labour force is available. Specialist, and local back-up firms can supply parts or

services. An area has a good transportation network. An area has an excellent reputation for producing a particular. Availability of cheaper banking & financial services. Development of specialised marketing agencies & facilities of joint publicity. Provision of adequate power, water & electricity. Interaction with other concerns in R n D by pooling manpower & financial resources. Easy availability of marker information.

Capital
Scale A 5

Land
3

Labour
4

Output
100

TC

AC

Scale B

10

300

Assume each unit of capital = $5.00, Land = $8.00 and

Labour = $2.00 Calculate TC and then AC for the two different scales (sizes) of production facility What happens and why?

Capita Land l Scale A 5 3

Labour Outpu t 4 100

TC 57

AC $0.57

Scale B

10

300

114

$0.38

Doubling the scale of production (a rise of 100%) has led to an increase in output of 200%

therefore cost of production per unit has fallen

Dont get confused between Total Cost and Average Cost Overall costs will rise but unit costs can fall Why?

 These occur when the firm has become too large

and inefficient. As the firm increases production, eventually average costs begin to rise because:

The disadvantages of the division of labour take effect

too many people doing different jobs add to costs. Management becomes out of touch with the shop floor and some machinery becomes over-manned- costs increase. Decisions are not taken quickly and there is too much form filling. Lack of communication in a large firm means that management tasks sometimes get done twice. Poor labour relations may develop in large companies.

 These occur when too many firms have located in

one area. Unit costs begin to rise because:

Local labour becomes scarce and firms now have to offer

higher wages to attract new workers. Land and factories become scarce and rents begin to rise. Local roads become congested and so transportation costs begin to rise.