Demand Forecasting

Demand Estimation Techniques

Qualitative - Consumer Surveys - Market Experiments - Consumer Clinics - Virtual Shopping

Quantitative - Statistical Techniques Regression

Every decision maker has to plan for the future and a reliable prediction helps reduce uncertainty of the environment in which managerial decisions are made.

Consumer Surveys:  It involves gathering of information about consumer behavior from a sample of consumers which is analyzed and then further projected onto the population.  Surveys are conducted to assess consumers perception of various aspects, such as new variations in products, variations in prices of the product and related products, new variations in services provided etc.  The drawback of this method is that the consumer has to respond to hypothetical situations.

 .  The seller gathers information on the behavior of the consumers in this representative market. Market experiments: Seller of a product introduces variations and tries it out in a representative market.  This is a high cost technique.  Advantage of market experiments are that they can be conducted on a large scale to ensure validity of results and consumers are not aware that they are a part of experiments.

 These are laboratory experiments. Participants have an incentive to purchase the commodity as they are usually allowed to keep the goods purchased. Consumer Clinics: Consumers are asked to act in a simulated situation.  . wherein they are given a certain sum of money and made to indulge in buying and their behavior is observed.

packaging. – Prices. displays and promotions are changed in subsequent trips and consumer reaction recorded. – By doing so. – Sample customers are asked to take a series of trips through the simulated virtual store. this method eliminates the high cost in terms of time and money involved in consumer clinics. . Virtual Shopping – A representative sample of consumers shop in a virtual store simulated on the computer screen.

Steps in Demand Estimation Exercise . The number of data items required is governed by the optimal sample size though it is known that the larger the better. Identification of variables: We are required to identify the variable which affect the demand function for a particular product.   Drawback of relying on direct methods such as surveys is that the data can be unrealistic. The demand for the subject matter of the study is the dependent variable. A more effective method is to rely on historical data. Collecting historical data: Next step involves collecting past data on each of the variables.

It could be linear or exponential. More than one specific form is required to arrive at the best possible form that captures the relationship. A set of techniques which uses historical data and enables us to estimate the demand relationships. However.  . is covered under the subject matter of econometrics. the most common is linear.Steps in Demand Estimation Exercise  Specification of the model.

Steps in Demand Estimation Exercise (contd…) Identification of variables  Collection of Past data on the independent variables  Mathematical specification of the relationship: The most common form of estimation is a linear relationship  Estimation of the parameters  Using these estimates to arrive at estimates of variables  .

c. given that all other variables remain unchanged.b.Specification of the model Take the case of an auto manufacturer:  Linear Relationship:  Qd=a-bPX+cPY-dPS+eI+fA +u – – – – Qd – Quantity demanded of coffee brand X PX – Price of coffee brand X PY – Price of competitive brand of coffee PS – price of sugar – Y – Income – A – Advertising expenditure of Coffee brand X – a. e*I/Q for income elasticity where b and e are the slope co-efficients.d. . – U – error term – Elasticity in a linear model is b*P/Q for price elasticity.e and f are the parameters and gives the amount by which Qd will change for a unit change in the respective variable.

Multiple Exponential Model  Qd P = aPbPcompcadvowndadvcompeYf is the price of commodity X.c. advcomp is the advertising expenditure of the competitor and Y is the income  b. Elasticities are constant and is the estimated value of the parameter. .d. advown is the advertising expenditure of the company.and f are the parameters. Pcomp is the price of the competitors product.e.

‘u’ is the error term.  . ‘b’ is the slope.  Y = a + BX + u Where Y is the dependent variable (Petrol consumption) X is the independent variable (distance traveled) ‘a’ is the intercept .A Simple Linear Regression Model Case where demand is stated as that between the dependent variable and only one independent variable is a simple linear regression model.  Regression analysis attempts to fit the best possible linear relationship between the dependent and the independent variable.

say 15 kms. per litre and distance is 150 kms. Deterministic model:  When fuel efficiency is constant and given. no intercept. no error.Two models of simple regression Deterministic and Probabilistic 1. The graph is a perfect straight line relationship between Y and X. .   The equation becomes Y = 0.7 is fuel efficiency = 1/15).7X ( 0. Petrol consumption is 10 litres.

Probabilistic model  When there is no deterministic relationship. lts. but a series of data as follows: Trip Distance Fuel kms consum ption. A 200 14 B C 100 300 6.5 22 .

 Next step is the estimation wherein regression analysis essentially tries to fit the best possible linear relationship to past data. due to other factors.Probabilistic models At times. and using the relationship thus established to arrive at future estimates of dependable variable  . like road condition. the data is slightly scattered from the linear line.07X +u. u is called error term and has some statistical properties. time etc.  To take care of this deviation an error term is factored in: Equation becomes Y = 0.

 Sales .  There are again two types of data  i) Time Series ii) Cross section  Sales of cars over the past five years is an example of time series data.Regression …. of cars in metros of India during 2007-08 is an example of cross-sectional data.

 Estimating the parameters of the model: Method of ordinary least squares (OLS). the estimate procedure sets out to estimate the parameters of the model. ie.Regression ….  Based on either time series or cross sectional data. the slope b and intercept a resp. . wherein the method draws a line through the scatter of data in such a way that sum of the squared deviations of each of the points from the line is minimized.

Graphical Representation R2 = 1 R2 = 0 .

Coefficient of Determination Coefficient of determination is defined as the proportion of the total variation or dispersion in the dependent variable that is explained by the variation in the independent or explanatory variable.  Coefficient of determination determines how well a regression line fits the scatter of points:  . In our eg: variation in petrol consumption due to distance traveled.

4. 40% of the total deviations is explained by the regression  (R2) =0Regression is unable to explain any part of the total derivation.  .  If R2 = 0. the best fit.Coefficient of Determination Coefficient of Determination (R2) = Regression Sum of Squares (RSS) / Total Sum of Squares (TSS)  If R2 = 1.

a time series data gives a regression with a higher R2than cross sectional data. the better it would be.  All other things remaining same.Coefficient of Determination  There is no established objective level for a good established R2. .  Ratio of RSS to TSS is a good measure of goodness of fit and the higher this is.

test is the test of statistical significance of regression equation as a whole.T test is the test used to establish whether the regression co-efficient estimated from the sample data can be assumed to be reflective of the population. F .

Problems in using Regression Multicollinearity – where there is dependency amongst independent variables. Thus data capturing demand in each of these periods is an outcome of demand and supply and not price changes alone. This refers to the situation in which two or more explanatory variables in the regression analysis are highly correlated.  Identification problem : It happens in case of times series data generally. supply curve might react. Over time with shift of demand curve.  .

. Variable might be considered statistically significant. when it may not be so. Autocorrelation increases chances of null hypothesis being rejected when it may not be the case.Problems in using Regression  Auto correlation occurs when the dependent variable is related to an independent variable in a specific pattern.

. not concerned about underlying factors and their behavior.Forecasting of demand     Involves projecting the values of the present to a future point in time. It is a difficult task. Statisticians have worked out some models for the purpose. Distinction between estimation and forecast: A forecast is a projection of the relevant variable. Aim of economic forecasting is to reduce the risk or uncertainty that the firm faces in it’s short term operational decision making and in planning for it’s long term growth.

Forecasting…  Demand estimation involves primarily understanding the underlying factors or variables and their behavior and effects on the relevant variable. It attempts to understand why and to what extent is the estimate influenced by a variable or a group of variables.  . Demand forecast does not go into such relationships. it only attempts to project future demands.

Demand forecasting A demand forecast has to be knit into the rest of the system.  Even with these considerations forecast may be far different from real situation All rights reserved . and should not be taken in isolation like:  Capacity installation or expansion  Hiring of labor and other related activities  Changes into political and economic environment  It should be based on thorough knowledge and data relating to the past.

weekly.Economic Forecasting Forecasting refers to the process of analyzing available information regarding economic variables and relationships and then predicting the future values of certain variables of interest to the firm or economic policymakers. It could be daily.  . quarterly. annual or five / ten or twenty years. monthly.  Forecasts can be short run or long run.

trough and an expansion. A business cycle consists of four parts – peak. Cyclical factors / business cycle are those related to fluctuations in the general level of economic activity. population growth rate. Eg : change in consumer tastes. contraction. Seasonal Factors are those related to a specific season of the year that affect the economic variable in question. Business Cycle Peak Contraction Expansion Index Of Business activity Trough Time .Factors affecting economic variables    Trend Factors are those factors which reflect movements in economic variable over time.

Forecasting Techniques Opinion polls and market research  Expert opinion  Surveys  Trend Analysis  Projection Techniques  Econometric Models  .

Forecasting Techniques (contd. Market research uses the technique extensively to gather information on consumers behavior in the marketplace with respect to a specific product or product category. market related etc. Expert Opinion involves seeking the opinion of experts on a subject matter. The issues could be political.   . Forecasts are generated by a group of expert executives. economic. Such polls are useful in detecting future trends and changes in trends which quantitative techniques might not be able to capture.)    Opinion Polls – Opinion polls are conducted on various issues. product related.

After each round. Thus. It is believed that during this process the range of the answers will decrease and the group will converge towards the "correct" answer. Finally. the process is stopped after a pre-defined stop criterion (e. achievement of consensus.)      The Delphi method is a systematic. stability of results) and the mean or median scores of the final rounds determine the results . number of rounds.Forecasting Techniques (contd. a facilitator provides an anonymous summary of the experts’ forecasts from the previous round as well as the reasons they provided for their judgments.g. interactive forecasting method which relies on a panel of independent experts. The carefully selected experts answer questionnaires in two or more rounds. participants are encouraged to revise their earlier answers in light of the replies of other members of the group.

family size.Forecasting Techniques (contd. if the independent variables used as data are forecasts.) Surveys  Econometric Models: These give an estimate of the dependent variable (which could also be a forecast). interest rates and index of industrial production could be used to forecast the demand for automobiles  . Eg: The demand of automobiles which is a function of disposable income.

)  Trend analysis relies on historical data to predict the future. – Models that use only trend analysis might not be that useful as against those which also take into consideration seasonal and cyclical factors. . – The simplest form of forecasting using trend analysis is the projection into the future of the current value of an economic variable. – Eg: One might forecast that next year sales would be a function of sales in the existing year or alternately next year sales would be a function of this year’s sales and the change in sales between this year and last year. It is the use of historical data to discern a long run trend.Forecasting Techniques (contd…. Or a forecaster might predict next year sales based on sketching a line that appears to best fit the historical data.

Eg: Manufacturing and trade sales . Eg: Increase in building permits can be used to forecast an increase in housing construction.Forecasting Techniques (contd…)  Barometric Forecasting involves the use of current values of certain economic variable called indicators to predict the future values of other economic variables. – Variables whose current changes give an indication of future changes in other variable are called leading indicators. – Variables whose changes coincide with changes in other economic variable are called coincident variables.

Forecasting Techniques (contd…) Barometric Forecasting (cont…) – Variables whose changes follow changes in other economic variables are called lagging indicators. changes in leading indicators consistently precede changes in values of other variables. These indicators need to satisfy some criteria if they are to be used as indicators. – Each of the categories is consolidated into an index. . – Ideally. Average duration of unemployment. that is how many months of change in the direction of the index is necessary as a predecessor of a turn in economic activity. and these indices are used as forecasters.

Compound growth rate 2. P(1+i)n=F Eg:A marketing manager has the following data.Time series projection using least square method – Compound Growth Rate : This technique is used to predict the future value of a variable if the variable is expected to increase at a constant rate. 1.)  Projection Techniques: There are three kinds of projection techniques. of years is 10.75 (1+i)10=1. The underlying principle is of compound interest ie. No.Forecasting Techniques (contd.Visual time series projection 3.75 i=6% . The sales for year 1990 are 4000 and for year 2000 are 7000. What is the compound annual sales growth rate? P(1+i)n=F (1+i)n=F/P=7000/2000=1.

) – Visual Time Series projection : This technique plots the data and on the basis of the same a trend is projected through these data points. Rt ) where Yt is the actual value of the data in time series Tt is the trend component at time ‘t’ St is the seasonal component at time ‘t’ Ct is the cyclical component at time ‘t’ Rt is the random component at time ‘t’ . cyclical and random components. The function could be additive or multiplicative. – Least square method of time series projection: This method ascertains how the dependent variable moves with time and time becomes the independent variable. St .Forecasting Techniques (contd. – Yt = f (Tt . This takes into account trend. Ct . This method is better than the compound growth rate as it considers data between the two end points. seasonal.

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