One of the crucial aspects in which managerial economics differs from pure economic theory lies in the treatment of risk and uncertainty. Traditional economic theory assumes a risk-free world of certainty; but the real world business is full of all sorts of risk and uncertainty. A manager cannot, therefore, afford to ignore risk and uncertainty. The element of risk is associated with future which is indefinite and uncertain. 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. Demand forecasting is a specific type of business forecasting.
Concepts of Demand Forecasting
The manager can conceptualize the future in definite terms. If he is concerned with future event- its order, intensity and duration, he can predict the future. If he is concerned with the course of future variables- like demand, price or profit, he can project the future. Thus prediction and projection-both have reference to future; in fact, one supplements the other. Suppose, it is predicted that there will be inflation (event). To establish the nature of this event, one needs to consider the projected course of general price index (variable). Exactly in the same way, the predicted event of business recession has to be established with reference to the projected course of variables like sales, inventory etc.
Forecast is different from prediction. Forecast is an estimate of future events and trends and is arrived at by systematically combining past data and projecting it forward in a predetermine a manner. Prediction is a similar, but more general term. Prediction is an estimate of future events and trends in a subjective manner without taking into account the past data. The subjective considerations may not emerge from any predetermined analysis or approach.
Projection is of two types – forward and backward. It is a forward projection of data variables, which is named forecasting. By contrast, the backward projection of data may be named ‘back casting’, a tool used by the new economic historians. For practical managers concerned with futurology, what is relevant is forecasting, the forward projection of data, which supports the production of an event.
Thus, if a marketing manager fears demand recession, he must establish its basis in terms of trends in sales data; he can estimate such trends through extrapolation of his available sales data. This trend estimation is an exercise in forecasting.
Time Horizon of Demand Forecasting
Market and demand analysis of various types are undertaken to meet specific requirements of planning and decision making. For example, short-term decisions in production planning, distribution etc and selling individual products would require short-term forecast, up-to one year time horizon, which must he fairly accurate for specific product items. For long-term planning, time horizon being four to five years, information required from demand analysis would be for broad product groups for facilitating choice of technology, machine tools and other hardware’s and their location. Longer-term forecasting is also undertaken to determine trends in technology development so as to choose the technology for backing up and funding its research and development.
Levels of Demand Forecasting
Demand forecasting in managerial economics can be at the level of a firm or an industry or at the national or national or international level:
- Firm Level: If the exercise aims at forecasting demand of firm’ s products locally at state, region or national level, it is a micro-level of demand forecasting. Sometimes, forecasts are required for company’ s products in specific industry or market segment.
- Industry Level: Such a demand forecasting exercise focuses on an industry as a whole for the region and/or national level. These forecasts may be undertaken by a group of companies or by industry/trade associations.
- National Level: Demand forecasts at national level include parameters like national income, expenditure, index of industrial and/or agricultural production etc. Estimating aggregate demand of products at national level facilitates governmental decisions for imports, exports, pricing policy etc.
- International Level: Companies operating in multinational markets would require similar forecasting of demands for its products, trends in consumption etc at international level Managerial Economists play a leading role in masterminding these forecasts at firm, industry, national and international levels. Time horizon of these demand forecasts usually varies from 1 to S years and in rare instances upto 10 years.
Need for Demand Forecasting
Business managers, depending upon their functional area, need various forecasts. They need to forecast demand, supply, price, profit, costs and returns from investments.
The question may arise: Why have we chosen demand forecasting as a model? What is the use of demand forecasting?
The significance of demand or sales forecasting in the context of business policy decisions can hardly be overemphasized. Sales constitute the primary source of revenue for the corporate unit and reduction for sales gives rise to most of the costs incurred by the firm.
Demand forecasting is essential for a firm because it must plan its output to meet the forecasted demand according to the quantities demanded and the time at which these are demanded. The forecasting demand helps a firm to arrange for the supplies of the necessary inputs without any wastage of materials and time and also helps a firm to diversify its output to stabilize its income overtime.
The purpose of demand forecasting differs according to the type of forecasting.
1. The Purpose of the Short Term Forecasting
It is difficult to define short run for a firm because its duration may differ according to the nature of the commodity. For a highly sophisticated automatic plant 3 months time may be considered as short run, while for another plant duration may extend to 6 months or one year. Time duration may be set for demand forecasting depending upon how frequent the fluctuations in demand are, short- term forecasting can be undertaken by affirm for the following purpose;
- Appropriate scheduling of production to avoid problems of over production and under- production.
- Proper management of inventories
- Evolving suitable price strategy to maintain consistent sales
- Formulating a suitable sales strategy in accordance with the changing pattern of demand and extent of competition among the firms.
- Forecasting financial requirements for the short period.
2. The Purpose of Long Term Forecasting
The concept of demand forecasting is more relevant to the long-run that the short-run. It is comparatively easy to forecast the immediate future than to forecast the distant future. Fluctuations of a larger magnitude may take place in the distant future. In fast developing economy the duration may go up to 5 or 10 years, while in stagnant economy it may go up to 20 years. More over the time duration also depends upon the nature of the product for which demand forecasting is to be made. The purposes are;
- Planning for a new project, expansion and modernization of an existing unit, diversification and technological up gradation.
- Assessing long term financial needs. It takes time to raise financial resources.
- Arranging suitable manpower. It can help a firm to arrange for specialized labour force and personnel.
- Evolving a suitable strategy for changing pattern of consumption.
Importance of Demand Forecasting
Why demand forecasting is needed in a business? Forecasting product demand is crucial to any supplier, manufacturer, or retailer. Forecasts of future demand will determine the quantities that should be purchased, produced, and shipped. Demand forecasts are necessary since the basic operations process, moving from the suppliers’ raw materials to finished goods in the customers’ hands, takes time. Most firms cannot simply wait for demand to emerge and then react to it. Instead, they must anticipate and plan for future demand so that they can react immediately to customer orders as they occur. In other words, most manufacturers “make to stock” rather than “make to order” – they plan ahead and then deploy inventories of finished goods into field locations. Thus, once a customer order materializes, it can be fulfilled immediately – since most customers are not willing to wait the time it would take to actually process their order throughout the supply chain and make the product based on their order. An order cycle could take weeks or months to go back through part suppliers and sub-assemblers, through manufacture of the product, and through to the eventual shipment of the order to the customer.
Firms that offer rapid delivery to their customers will tend to force all competitors in the market to keep finished good inventories in order to provide fast order cycle times. As a result, virtually every organization involved needs to manufacture or at least order parts based on a forecast of future demand. The ability to accurately forecast demand also affords the firm opportunities to control costs through leveling its production quantities, rationalizing its transportation, and generally planning for efficient logistics operations.
In general practice, accurate demand forecasts lead to efficient operations and high levels of customer service, while inaccurate forecasts will inevitably lead to inefficient, high cost operations and/or poor levels of customer service. In many supply chains, the most important action we can take to improve the efficiency and effectiveness of the logistics process is to improve the quality of the demand forecasts.