Methods of demand forecasting

Demand Forecasting is the systematic and scientific estimation of future demand for a product
or service. In today’s VUCA world, it has become crucial to the success of a business as
decisions have to be taken to ensure the long term sustainability of the enterprise. Simply put,
estimating the sales proceeds or the demand for a particular product in the future is called as
demand forecasting. There are several methods of demand forecasting applied in terms of

a) Cost of preparing the forecast and the ensuing benefits from its use
b) The lead time in decision-making i.e. the amount of time that elapses between the
beginning and the end of a decision making process.
c) Time period of the forecast i.e. short term or long term
d) Level of accuracy required
e) Quality and availability of data
f) Level of complexity of the relationships to be forecast

Demand forecasting is a difficult exercise in a highly globalized world where trade and demand,
production, labor markets, financial markets etc interact and are interdependent on each other in
manifold ways. This noodle bowl structure has thus made nations and the global economy
increasingly susceptible to frequent financial and economic crises and sluggish growth rates.
Making estimates for future under all of the changing conditions is a Herculean task. Consumer
behavior is highly unpredictable because it is motivated and influenced by multifarious forces.
There is no single easy method or formula which enables business managers to predict the future.
Economists and statisticians have developed several methods of demand forecasting over the
years. Each of these methods has its relative benefits and limitations. Selection of the right
method is imperative to have accurate demand forecasts. In demand forecasting, a judicious
amalgamation of statistical skill and rational judgement is needed. Mathematical and statistical
techniques and tools are essential in classifying relationships and analyzing data, but they are in
no way an alternative for rational judgement which is a prime requisite for good forecast. The
judgement should be based upon available facts and the personal bias of the forecaster should not
prevail. Therefore, a mid way approach should be followed between mathematical techniques
and sound judgement or pure guess work.

Broadly demand forecasting can be classified into two methods : Qualitative and Quantitative.
We will examine them and their sub techniques in this essay.
Qualitative
When quantitative data is not available surveys and opinion polls are often used to make short
term forecasts. They are also used to supplement quantitative techniques anticipating changes in
consumer tastes and expectations about the future business environment. New product
development also uses qualitative forecasts to gauge acceptability.

Surveys
In this method, the target group of consumers is directly approached to disclose their future
purchase plans. It is a fairly direct method of estimating demand in short run. This method is
implemented by interviewing all consumers or a selected group of consumers out of the relevant
population. The firm may go for either complete enumeration or sample surveys. If a commodity
under consideration is an intermediate product then industries using it as an end product are
surveyed.

i. Complete Enumeration Method : In this method the firm has to do door to door survey
for the forecast period by contacting all the households in the area.
Advantages : first hand, unbiased complete information
Disadvantages : Requires lot of manpower, resources and time. At times consumer may
not express opinion properly or misguide surveyors.
ii. Sample Survey and Test Marketing : Some representative households are selected from
the target group population on random basis as samples and their opinion is taken as the
generalised opinion, based on the basic assumption that the sample truly represents the
population. A variant of this method is test marketing. Product testing basically involves
placing the product with a number of users for a specific period. Their reactions to the
product are then noted estimate of likely demand is made from the results obtained.
These are suitable for development of new products or re-launch of radically modified
old products for which no prior data exists.
Advantage : The assumption that if the sample is the true representative, there is likely to
be no significant difference in the results obtained by the survey.Also method is cheaper
and less arduous.
Disadvantage : Complete information not obtained.
iii. Input-Output / End Use Method : This method is used for industries involved in B2B
sales. Here sales of the product under consideration is projected as the basis of demand
survey of industries using the product as an intermediate product. The end user demand
estimation of the intermediate product involves multiple final good industries using this
product at home and abroad. This also helps us to understand inter-industry’ relations.
The major hurdle in this method is not in its operation but in the collection and
presentation of the data.
Few surveys specific to India are : Index of Industrial Production(IIP), Business World’s
Marketing White Book and National Sample Survey(NSS)

Opinion Polls
In this method, firm can forecast demand by polling experts within and outside the organization

i. Executive Polling : Opinions are sought from the top management from different
discipline i.e., marketing, finance, production etc. and estimates for future demands are
made. To avoid a bandwagon effect (similarity of opinions) Delphi technique is used
where a panel of experts with rich expertise, wide range of knowledge and experience
are interrogated through a sequence of questionnaires in which the responses to one
questionnaire are used to make subsequently questionnaire. Therefore any information
available to some experts and not to others is passed on, enabling all experts to have
access to complete information for forecasting.\
ii. Sales Force Polling : In this method, opinion of the salesmen is sought. Also known as
“grass roots approach”, it is a bottom-up method requiring each sales person in the
company to make individual forecasts for his or her particular sales territory. These
forecasts are discussed and agreed upon by the sales manager. The sum of all forecasts
then becomes the sales forecast for the organization. The advantages of this method are
that it brings out the collective wisdom of the salesmen besides being easy and cheap, not
involving any elaborate statistical treatment.

Quantitative
Time Series Analysis
The time series data of sales of a product usually shows some variation because of systematic
forces. It may show a trend due to the effect of certain basic demand influencing factors like
population, capital, technology etc. Cyclical variations in sales may be indicators of changing
business cycles. There could be variations based on seasonal changes in demand. Random
factors like strike, political factors may also contribute to change in demand. Time series analysis
provides techniques by which all these variations and their effects on demand are isolated
and identified.
Trend Projection: This method assumes that factors liable for the past trends in the variables to
be projected will continue to play their role in the future in the same manner and extent as in the
past while determining the variable’s magnitude and direction. In predicting demand for a
product, trend projection method is applied to long term-series data. A long existing firm can
obtain such data from its departments and books of accounts, while new firms can obtain data
from old firms operating in the same industry. The trend projection method includes three
techniques

a) Graphical Method : It is a simple statistical method in which annual sales data are
plotted on a graph, and a line is drawn through these plotted points such that
distance between points and the line is the minimum. It is assumed that future
sales will assume the same trend followed by past sales records. Although this
method is simple and inexpensive, it is not considered to be reliable because
extension of the trend line may involve subjectivity and personal bias of the
researcher.
b) Least Square Method : The trend-line is fitted in time-series using statistical data
to determine the trend of demand. The form of trend equation to be fitted to time-
series data can be determined either by plotting sales data or trying different
forms of the equation that best fits the data. Once the data is plotted, it shows
several trends. The most common types of trend equations are:
Linear Trend Equation: Demand for the product is increasing over time at a
constant rate.
Quadratic Trend Equation: The marginal time increment of demand varies
linearly with time, meaning that total sales increases (or decreases) first and then
decreases (or increases) showing a turning point on the sales-time graph.
Logarithmic Trend Equation: Time Elasticity of demand is constant.
Exponential Trend Equation: Rate of growth of demand is constant over time.
c) Box Jenkins Method : Box-Jenkins method is used for short-term predictions and
projections and is often used with stationary time-series sales data. A stationary
time-series data is one which doesn’t reveal long term trend. Simply put, Box-
Jenkins method is used when time-series data reveal monthly or seasonal
variations that reappear with some degree of regularity. For example, estimating
demand of woolly hats. First trend in the series is removed by ‘differencing’,i.e.
the difference between values at adjacent periods of time. Then various possible
combinations are created on basis of:
 order of involvement of auto regressive terms;
 the order of moving average terms and
 the number of differences of the original series.

Combinations are selected on the basis of autocorrelation function(ACF) and

partial autocorrelation function(PACF) which provide an adequate fit to the
 series(i.e if it is Auto Regressive(AR),Moving Average(MA), Auto
Regressive Moving Average(ARMA) or Auto Regressive Integrated Moving
Average(ARIMA)). At the next stage parameter estimation is done using
Least Squares or Maximum Likelihood Estimation(MLE) depending on the
type of series. Then Goodness of Fit is tested and if it is not a good fit then the
whole process is repeated with another combination. Once a ‘good fit’ is
attained, it’s coefficients is used to forecast future demand.

Smoothing Techniques
In this method values of time series are predicted on basis of past values only. Smoothing
techniques are useful when time series data exhibit a great deal of random variation but not much
trend or seasonal variations. Smoothing techniques include :

Moving Averages : Simple moving averages of weighted moving averages can forecast on the
basis of demand during recent past.

is used the determine which moving average gives

us the best fit.

Exponential Smoothing : assign greater weights to recent data, in order to have a more realistic
estimate of fluctuations. Weights usually range between 0 and 1.

New forecast is equal to old forecast plus an adjustment for the error that had occurred in the last
forecast.

Barometric Methods

The Barometric Method of Forecasting was developed to forecast the trend in the overall
economic activities and the demand prospects. It was first developed in 1920’s, but was
abandoned due to its failure to predict the Great Depression of 1930’s. The Barometric technique
was revived, reformed and developed further by the National Bureau of Economic Research
(NBER), USA in the late 1930’s.

It is based on the approach of developing an index of relevant economic indicators and

forecasting future trends by analyzing the movements in the selected indicators. A single time-
series of several indicators is developed to study future trend. These can be classified as:

a) Leading Series : Leading series constitutes indicators which move up or down

ahead of some other series. Some examples are net business investment index, a
new order for durable goods, change in the value of inventories, corporate profits
after tax, etc.
b) Coincidental Series : It include indicators which move up and down
simultaneously with general level of economic activities. Example: rate of
unemployment, sales recorded by manufacturing, retail, and trading sectors, gross
national product at constant prices.
c) Lagging Series : It consists of those indicators, which after some time-lag follows
the change. Examples : outstanding loan, labor cost per unit production, lending
rate for short-term loans, etc.

Indicators are chosen on the following criteria :

 economic significance of the indicator; such as greater the significance the greater is the
score of the indicator
 time series- statistical adequacy; a higher score is given to the indicator provided with
adequate statistics.
 conformity with movement in overall economic activities
 immediate availability of the time series data
 consistency of the series to the turning points in overall economic activities
 smoothness of the series

In this method there is considerable variability in lead time. It gives little indication of magnitude
of forecast change in economic activity. It should be used with econometric forecasting to
estimate the magnitude of change in economic activity.

Econometric Methods
These methods uses statistical tools and economic theories together to estimate the targeted
economic variables and forecast the intended variables.

There are two types of econometric methods

A. Single Equation Models : Regression analysis is the most common method used to
forecast the demand for a product. This method combines economic theory with
 statistical tools of estimation. Economic theory is applied to specify demand determinants
and nature of relationship between product’s demand and its determinants. Through
economic theory, a general form of a demand function is determined and statistical
techniques are applied to estimate values of parameters in the specified equation. In
regression, the first and the foremost thing is to determine the demand function. While
specifying demand functions for several commodities, we may come across many
commodities whose demand depends mostly on a single independent variable. For
example, if in a city, the demand for items like tea and coffee is found to depend mostly
on the population of the city, then the demand functions of these items are said to
be single-variable demand functions dependent on population only. On the other hand,
if it is found out that demand for commodities like sweets, ice-creams, fruits, vegetables,
etc., depends on a number of variables like commodity’s own price, the price of
substitute goods, household incomes, population, etc. then such demand functions are
called as multi-variable demand functions. Thus, for single variable demand function,
the simple regression equation is used while for multiple variable functions, multi-
variate equation is used for estimating the demand for a product.
We estimate the target variable using one single equation consisting of a dependent
variable, independent variable(s) and random error term. For example, we fit regression
line of sales on price and advertising expenditure.

The problem with such models might be heteroscadasticity, multicollinearity,

specification error and misidentification.
B. Simultaneous Equation Model : In case where the explanatory economic variables are
so interdependent on each other that unless one is defined the other variables cant be
determined, a single-equation regression model is inadequate to define the problem. And
thus a system of simultaneous equations is used to forecast the variable. A typical
simultaneous equation model might consist of endogenous variables, exogenous
variables, structural equations and definitional equations.

Input Output Forecasting

Input-Output method of forecasting was first introduced by Wassily Leontief. It uses Input-
Output Tables to example interdependence among various industries and sectors of economy. It
shows output of each industry as inputs by other industries and for final consumption and thus it
can be used for forecasting the demand for products.