ME Session 8 Demand Estimation & Click to edit Master subtitle style Demand Forecasting

Why Demand Estimation & Forecasting?

A computer dealer would like to know the implications of a reduction in excise duties, lower prices & rising GNP on demand for personal computers. A cigarette manufacturer would be interested in knowing the impact of increase in excise duties on cigarettes on its sell. A firm would like to know how much would its sales decline when the rival producer reduces the price. An automobile mfg wd like to know how much increase in his sales of cars is possible by advertising more

Why Demand Estimation & Forecasting

1.

2.

3.

4. 5.

6.

DF- predicting future demand for a product Planning & scheduling production purchase of raw material, finances, ad. Sales forecasting-To avoid under or overproduction Inventory control- raw material, spare parts, semi finished parts, etc. Long term investment plans, growth plans Stability smoothening business operations through counter cyclical & seasonally adjusted business programmes. Economic planning & Policy making

Significance of Demand Forecasting

Short run (up to 1yr) Evolving sales policy Determining price policy Determining purchase policy Fixing sales target Inventory mgt Short term financial planning

Long Term forecasting

Business planning Manpower planning Long term financial planning Diversification/ Expansion Mergers and Acquisition Vertical / Horizontal growth

Demand Forecasting
Micro level: Firm, specific product, etc Industry level: Demand forecasting for the industry- Industry association, Trade associations Macro level: Macro indicators such as agg demand, cons exp, etc

Major Steps in Demand Estimation

Specification of demand functions Adopting the form of Demand function Choice of Statistical Technique Data collection Empirical process: Estimation of parameters Result reporting: Testing the results Interpretation & Evaluation

Forecasting Techniques
Qualitative forecasting is based on judgments of individuals or groups. Quantitative forecasting utilizes significant amounts of prior data as a basis for prediction. Nave forecasting projects past data without explaining future trends. Causal (or explanatory) forecasting attempts to explain the functional relationships between the dependent variable and the independent variables.

Survey Methods or qualitative forecasts

Mainly used for short-term forecasts or introduction of new product, modifying the product or supplementing the quantitative forecasts. Survey Methods: 1:Consumer survey, 2: Opinion Poll of Experts Consumer Survey Complete Enumeration Survey Sample Survey End-use method

Objectives of Market surveys

Total market demand Firms share in market demand Consumers income,age, sex, education Elasticities of demand price & income Impact of sales promotion effort on demand Consumers preference, habits, tastes, etc. Consumers intensions & expectations Consumers reaction towards product improvement Consumers attitude towards substitutes & complementary commodities

Techniques of forecasting demand : survey method cont..

Sample survey method:Direct interview or mailed qs of a sample consumers Advantages : less costly, less time consuming, useful in estimating short term demand Limitations: can be used where market is localised,

Techniques of forecasting demand : survey method cont..

The end-use method: Used for forecasting demand for inputs - building up schedule of probable agg demand for inputs by consuming industries & various other sectors. Stages : 1) identifying possible users 2) Fixing suitable technical norms of consumption of the product under study 3) Application of norms to the end use 4) To aggregate the product wise & end usewise content of the item for which demand is to be forecast.

Techniques of forecasting demand : survey method

Complete Enumeration Method Demand estimation of almost all the potential consumers is assessed by contacting them personally. Major limitations: costly- money, time Limited success only where consumers are concentrated in one locality May not be reliable as consumers preferences may change.

Opinion Poll Method

Expert opinion, sales executives, marketing experts, Market studies & experiments a) Expert Opinion b) Simple Method and Delphi Method c) Market Studies and Experiments d) Market tests and Laboratory Tests

Opinion Poll Method

Expert opinion method: Opinion of sales representatives, marketing experts,etc. Limitation: subjective judgment, inadequate judgment b) Delphi method: Experts are provided information on estimates made by other experts & consensus is taken for final forecast.
a)

Opinion Poll Method cont..

c) Market studies & experiments: Firms select some areas of representatives of some markets & experiment by changing prices, ad expen & other controlled variables. d) Market tests and Laboratory Tests: Consumers are given some money to buy in a stipulated store with varying prices, packages, displays, etc. Limitation : expensive, unreliable as they can be carried on a short scale, based on controlled conditions, tinkering with prices may affect the market permanently.

Forecasting Method: Graphical Method

Under this method, annual sales data is plotted on a graph paper & a line is drawn through the plotted points. Then a free hand line is also drawn so that the total distance between the line & the points is minimum. Limitation : less reliable though very simple & least expensive

Forecasting Techniques
Economic Indicators: A barometric method of forecasting designed to alert business to changes in economic conditions.
Leading, coincident, and lagging indicators One indicator may not be very reliable, but a composite of leading indicators may be used for prediction.

Forecasting Techniques
Leading Indicators predict changes in future economic activity
Average hours, manufacturing Initial claims for unemployment insurance Manufacturers new orders for consumer goods and materials Building permits, new private housing units Stock prices, 500 common stocks Interest rate

Forecasting Techniques
Coincident Indicators identify peaks and troughs in economic activity
Employees on nonagricultural payrolls Industrial production Manufacturing and trade sales

Lagging Indicators confirm upturns and downturns in economic activity

Wage rate Commercial and industrial loans outstanding Ratio, consumer installment credit outstanding to personal income Change in consumer price index

Trend projection: Least Square Method

Applied by established company with strong data base and MIS. Assumption to use this method is that the past trend will hold good in future also. Whatever factors influence the sales in the past will continue to operate in future also to the same extent and same number. Also known as nave method Only two variables Time and sales, population and sale) are taken into account

Least Square Method cont..

When a time-series data reveals a rising trend in sales straight line equation is used. Following equations are used: S = a+bT, S= na+ b T, ST=a T+b T2 a, b are constants, a is vertical intercept and b is the rate of growth in sales.

Least Square Method cont..

1. Least squares technique is used to estimate coefficients of a function by fitting a line through the data so that the sum squared deviations ; ie (Y-Y^)2 is minimised 2. The values of a estimates the vertical intercept or the estimated value of Y when X = 0. The value of b estimates the change in Y for a one unit change in X. 3. Estimates of the coefficients of the function Y = a + bX are given in the following equations:

b=

( X
t= 1 n

)(Y Y) X t
1

X ( X t )
t= 1

1 a =Y bX

Least squares method

Y = a + bX The best estimate of coefficients of a linear function is to fit the line through the data points so that the sum of squared vertical distances from each point to the line is minimised. Y = na + b 1X 1XY = a 1X + b 1 X2 Here a & b are constants which determine the line. The constant a determines the point where the line cuts the Y axis. The constant b determines the slope of the line.

Least Square Method cont..

X 1 2 3 4 5 15 Y 10 12 15 14 15 66 XY 10 24 45 56 75 210 X2 1 4 9 16 25 55

Least Square Method cont..

Y = na + b 1X ie 66 = 5a + 15b 1XY = a 1X + b 1 X2 ie 210 = 15 a + 55b Solving these we get a= 9.6 & b =1.2 The regression line of Y on X is Y=9.6 + 1.2 X If we want to estimate Y when X = 6 Y = (9.6) + 1.2(6) = 16.8

Ordinary Least Squares (OLS)

Estimation Example
Yt
11 11 11 11 11 11 11 11 11 11 111
1 Yt = 11
t =1 n

T im e
1 1 1 1 1 1 1 1 1 11
n =1 1 X =
n n

Xt
11 1 11 11 11 11 11 11 11 11 111
1 X t = 11
t =1 n

Xt X
-1 -1 -1 1 -1 1 1 1 1 1

Yt Y
-1 -1 1 -1 -1 -1 1 1 1 1 11
X ) 1 = 11 X )(Yt Y ) = 111

( X t X )(Yt
11 11 1 1 1 1 1 1 11 11 111

Y ) ( X t X1 )
1 1 1 1 1 1 1 1 1 1 11

(X
t =1 n

1 11 1 1 b= = .11 1 1 1 1 .111) .1 a = 1 (1 1)( 1 = 1 1

X t 11 1 = =1 1 1 1 t =1 n

Y =

Yt 11 1 = =1 1 1 1 t =1 n

(X
t =1

Ordinary Least Squares (OLS)

Estimation Example
n =1 1
X = X t 11 1 = =1 1 1 1 t =1 n
n n

X
t =1
n t =1 n

= 11 1
1

Y
t =1

= 11 1

Y =

Yt 11 1 = =1 1 1 1 t =1 n

(X (X
t =1

X ) = 11 X )(Yt Y ) = 111

1 = 11 1 1 b = .11 1 1

1 .111) a = 1 (1 1)( 1 = 1 1 .1

Least Square Method cont..

Treatment of fluctuations in sales which may take place because of secular, cyclical, random influences and seasonal variations is done. Cyclical swings are uncertain and of different duration cannot be examined in trend forecasting.So also Random factors.

Statistical Method
Regression equation: linear, additive
Y = a + b1X1 + b2X2 + b3X3 + b4X4 Y: dependent variable, amount to be determined a: constant value, y-intercept Xn: independent, explanatory variables, used to explain the variation in the dependent variable bn: regression coefficients (measure impact of independent variables)

Regression Results
Regression Results
Negative coefficient shows that as the independent variable (Xn) changes, the quantity demanded changes in the opposite direction. Positive coefficient shows that as the independent variable (Xn) changes, the quantity demanded changes in the same direction. Magnitude of regression coefficients is measured by elasticity of each variable.

Regression Results
Steps for analyzing regression results
Check signs and magnitudes Compute elasticity coefficients Determine statistical significance

Forecasting:Regression Analysis
Year 1 1 1 1 1 1 1 1 1 1 1 X 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 Y 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

Scatter Diagram

Regression Analysis

Measuring Regression Model Significance

Standard Error of the Estimate (SEE) reflects degree of scatter about the regression line.

2009, 2006 SouthWestern, a part of Cengage

Goodness of Fit
Correlation shows degree of concurrence.
r = 1 means perfect correlation. r = 0 means no correlation.

Coefficient of determination, R2.

R2 = 100% means perfect fit. R2 = 0% means no relation.

Corrected coefficient of determination

Adjusts R2 downward for small samples.

Goodness of fit
R2 = Variations Explained by Regression Total Variations of Y It seldom equals 0 or 100. R2 = 87.8 % means 87.8% of the variations are explained by the variations in independent variables covered in the equation.

Judging Variable Significance

t statistics compare sample characteristics to the standard deviation of that characteristic.
t > 2 implies a strong effect of X on Y (95% conf.). t > 3 implies a very strong effect of X on Y (99% conf.)

2009, 2006 South-

Box Jenkins Method

This Techniques is used in case of time serious which depicts monthly or seasonal variation with some degree of regularity. (Sales of Woolen cloth, Greeting cards etc.,) This method analyzes the time series data with the help of Auto-regression,moving average and auto regressive moving average models.

Box Jenkins Method cont..

Three steps in Box Jenkins method 1) To eliminate trend in time series data 2) Identifying seasonality in the stationary time series. 3) Predict sales in the intended period by auto regressive ,moving average model and auto regressive moving average model

Steps in Demand Estimation

Model Specification: Identify Variables Collect Data Specify Functional Form Estimate Function Test the Results

Class activity
Forecast the demand for X for next two years by using least square method. Year Sales of X 1991 45 1992 56 1993 78 1994 46 1995 75

Interpret the results:

Sales = $20.065 + $6.062 R &D (0.31) (91.98) R2 = 99.8 F = 8460.40

Interpret the results

Qdx = 0.02248 0.2243Px + 1.345Y +0.103Py (1.19) (-3.98) (2.69) (0.13)
R2 = 0.75 What would be the quantity demanded if Px = Rs.10, Y = Rs. 9,000 and Py = Rs. 15 Is demand elastic or inelastic? What effect would a price increase have on total revenue? Are the two goods substitutes or complements? Which independent variables are statistically significant?