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 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.
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.
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.