UNIT-3

Forecasting customer demand for products and services is a proactive process of determining what products are needed where, when, and in what quantities. Consequently, demand forecasting is a customer–focused activity.

Demand forecasting is also the foundation of a company’s entire logistics process. It supports other planning activities such as capacity planning, inventory planning, and even overall business planning.

Demand forecasting is predicting or anticipating the

future demand for a product or a service at some future date on the basis of certain present & past behavior patterns of some related events.

Micro level Industry level Macro level

Scope of forecasting depends upon the area of operation in the present & proposed in future.

The necessary trade-off has to struck between the cost of forecasting & benefits flowing from such forecasting.

THE FORECAST

Step 6 Monitor the forecast Step 5 Prepare the forecast

Step 4 Gather and analyze data

Step 3 Select a forecasting technique Step 2 Establish a time horizon Step 1 Determine purpose of forecast

Short term demand forecasting 1) Evolving production policy

2) Determining price policy

3) Evolving purchase policy

4) Fixation of sales targets

5) Short term financial policy

6) Regular availability of labor force

Long term demand forecasting 1) Business planning ( Business Planning)

2) Man power planning

3) Long term financial planning

Very first requisite of business is planning & planning requires forecasting.

For the effective allocation of resources.

Information about the likely future demand in order to pursue optimal pricing strategy.

For determining the & implementing the competitive strategy.

QU

AL

ITA

TIV

E M

ET

HO

DS

• Survey of buyers’ intention

• Collective opinion method

• Expert opinion method

• Business Barometer

QU

AN

TIT

AT

IVE

ME

TH

OD

S

• Trend Projection

• Graphical Method

• Least square method

• Controlled experiments

• Study of general economic environment.

Employs sample survey techniques for gathering data.

Data is collected from end users of goods - consumer, producer, mixed.

Data portrays biases and preferences of customers.

Useful when bulk of sale is made by industrial producers who generally have firm future plans.

Ideal for short and medium term demand forecasting, is cost effective and reliable.

ADVANTAGES Helps in approximating future requirements even

without past data.

Accurate method as buyers needs and wants are

clearly identified & catered to.

Most effective way of assessing demand for new

firms.

LIMITATIONS People may not know what they are going to purchase

They may report what they want to buy, but not what they

are capable of buying

Customers may not want to disclose real information

Effects of derived demand may make forecasting difficult

Opinions from marketing & sales specialists

are compiled.

2 types of targets estimated-

ambitious targets.

conservative targets.

Combines expertise of higher level

management & sales executives.

Best suited in the circumstances where

intractable changes are occurring.

LIMITATIONS

POWER STRUGGLES MAY OCCUR BETWEEN

SPECIALISTS.

CONSENSUS MAY NOT BE REACHED IN GOOD

TIME.

DIFFERENCES AND PREJUDICES IN OPINIONS

MAY ALSO EXIST.

FEATURES

Panel of experts in same field with experience & working knowledge.

Combines input from key information sources.

Exchange of ideas and claims.

Final decision is based on majority or consensus, reached from expert’s forecasts.

ADVANTAGES Can be undertaken easily without the use of elaborate

statistical tools.

Incorporates a variety of extensive opinions from expert in the field.

LIMITATIONS JUDGEMENTAL BIASES

for example

Availability heuristic:- Involves using vivid or

accessible events as a basis for the judgment.

Law of small numbers:-People expect

information obtained from a small sample to be typical of the larger population.

Competitive biases Over reliance on personal opinions.

Possibility of undue influence in certain cases.

Statistical inadequacy:- Lack of statistical and

quantifiable data or figures to substantiate the forecasts made.

Represents the indicators of various economic phenomenon.

Some of important indicators:-

Gross Domestic Production

Employment

Wholesale prices

Industrial production

Consumer credit

Disposable personal income

Stock prices.

Panel of experts is selected.

One co-ordinator is chosen by members of

the jury

Anonymous forecasts are made by experts

based on a common questionnaire.

Co-ordinator renders an average of all

forecasts made to each of the members.

3 consequences- diversion, consensus or no agreement.

2 to 3 cycles are undertaken.

Convergence and diversion is acceptable.

Forecasts are revised until a consensus is reached by all.

ADVANTAGES Eliminates need for group meetings.

Eliminates biases in group meetings

Participants can change their opinions anonymously.

LIMITATIONS Time consuming -reaching a consensus takes a lot of

time.

Participants may drop out.

QUANTITATIVE METHODS

TREND ANALYSIS

Past data is used to make future

predictions .

Known or Independent variables are

used for predicting Unknown or

dependent variables, using the trend

equation- “ Predictive analysis”

Based on trend equation, we find Line

of Best Fit’ and then it is projected in a

scatter diagram, dividing points equally

on both sides

TREND EQUATION

Y^ = a + bX + E

Y^ = Estimated value of Y

a = Constant or Intercept

b = slope of trend line

X = independent variable

E = Error term

= EXPLAINED VARIATION

1 - = UNEXPLAINED VARIATION

Explained variation - means the extent to which the independent

variable explains the relative change in the dependent variable.

Higher the explained variation, lower the error value leading to

accurate forecast

Data from a number of consecutive past

periods is combined to provide forecast

for coming periods. Higher the amount of

previous data, better is the forecast.

Since the averages are calculated on a

moving basis, the seasonal and cyclical

variations are smoothened out.

Trend line can be fitted through a series graphically.

Old values of sales for different areas are plotted on a graph & a free hand curve is drawn passing through as many point as possible.

Direction of free hand curve shows the trend.

Merits:- It is very simple method.

More flexible than that of the rigid mathematical function.

More dynamic & dramatic.

Graphs attractive to see.

Comparison is made easy.

Limitations:- Highly subjective

Mathematical curve can be expressed through formulae only.

Requires a skilled analyst to draw curve with reasonable accuracy.

Fully accuracy not possible.

Might give misleading result.

Graphs cannot be quoted in support of some important statements.

Based on the assumptions that the past rate of change of the variable, under study will continue in the future.

Mathematical procedure for fitting a line to a set of observed data points, sum of squared differences between the calculated & observed value is minimized.

Used to find a trend line which best fits the available data.

Very popular coz it is simple & in-expensive.

LIMITATIONS:- Requires greater care to select the trend.

Predictions based on the long term variations.

It is a statistical technique for quantifying the relationship between variables. In simple regression analysis, there is one dependent variable (e.g. sales) to be forecast and one independent variable. The values of the independent variable are typically those assumed to "cause" or determine the values of the dependent variable.

Curvy linear relationship between dependent & independent variables.

STEPS IN REGRESSION ANALYSIS:- 1.Identification of variables influencing demand for product under

estimation.

2.Collection of historical data on variables.

3.Choosing an appropriate form of function

4.Estimation of the function.

Y = xαWhere

Y= value being forecasted

= constant value

= coefficients of regression

= independent variable

x

Merits:- Helps in studying the dependence of one variable on the

other variable.

Studies the possible causes of rise or fall in demand.

Used in policy formulation to solve various problems.

Highly useful method for research.

Limitations:- Applicability is only possible in linear dependence.

The result may not accurate from the method.

It is assumed that the same relationship still exist between the variables under study.

Effort is made to vary separately certain determinants of demand which can be manipulated eg. Price, advertising, etc..

Other factors remain constant.

Effect of price, advertising, packaging, etc. on sales can be assessed by either varying them over different markets or by varying them over different periods in the same market.

Market division should be homogenous in regards to taste, income, etc.

Limitations:- Used less coz this method is costly & time consuming.

Difficulty in taking what factors as constant & what factors be regarded as variable.

Difficult to satisfy the condition of homogeneity of market.

It is the study of general behavior of the economy.

There are certain lead indicators & there are others which appear after a lag.

Economic indicators precede the changes in the economic activity & hence are studied for predicting of future changes.

The indicators are:- Leading Economic Indicators:- precede the changes in the economic

activity, help in knowing the direction of future changes.

Coincidental Indicators:- Indicators coincide with the movement or changes in the economic activities.

Lagging Indicators:- Lag the movements or the changes occurring in the economic activities.

Common indicators:- Personal & agricultural income, GNP, Agricultural

& industrial production, Level of employment, Inflation & deflation, share market trend, bank activities like deposits , finance, etc.

The use of this approach bases demand forecasting on certain economic indicators, eg.,

1. Construction contracts sanctioned for the demand of building materials, say, cement;

2. Personal income for the demand of consumer goods;

3. Agricultural income for the demand of agricultural inputs, implements, fertilizers, etc,; and

4. Automobile registration for the demand of car accessories, petrol, etc.

Steps for economic indicators:

1. See whether a relationship exists between the demand for the product and certain economic indicators.

2. Establish the relationship through the method of least squares and derive the regression equation. (Y= a + bx)

3. Once regression equation is derived, the value of Y (demand) can be estimated for any given value of x.

4. Past relationships may not recur. Hence, need for value judgement.

Higher revenues

Sales maximization

Reduced investments for safety stocks

Improved production planning

Early recognition of market trends

Better market positioning

Improved customer service levels

Supply side is equally important as demand side.

Refers to the quantity of a product which the producer is willing & able to sell at a given price per unit of time.

Cost of production, function of technology of production & prices of inputs.

Concerned with the supply side of the market.

Relates physical output to physical inputs or factors of production.

Categories of Inputs (factors of production) Labor Materials Capital Entrepreneurship

We study the least-cost combination of factors inputs, factor productivity & returns to scale.

Major objectives of a firm:- Meeting final consumer needs.

Maximise profits, to gain or maintain market share, to achieve a target returns on investment, or any combination thereof.

Inputs – the factors of production classified as: Land – all natural resources of the earth – not just ‘terra

firma’! Price paid to acquire land = Rent

Labour – all physical and mental human effort involved in production Price paid to labour = Wages

Capital – buildings, machinery and equipment not used for its own sake but for the contribution it makes to production Price paid for capital = Interest

Indicates the highest output that a firm can produce for every specified combination of inputs given the state of technology.

Shows what is technically feasible when the firm operates efficiently.

shows a technical or engineering relationship between the physical inputs & physical outputs of a firm, for a given state of technology.

“ Function”, means the precise relationship that exists between one dependent variable & many independent variables.

Firm can more easily adjust its inputs in the long run (LR) than in the short run (SR)

Short run: a period of time so brief that at least one factor of production is fixed

Fixed input: a factor that cannot be varied practically in the SR

Variable input: a factor whose quantity can be changed readily during the relevant time period

Long run: lengthy enough period of time that all inputs can be varied

Short-run production:-

one variable input: Labor (L)

one fixed input: Capital (K)

thus, firm can increase output only by using more labor

service firm assembles computers for a manufacturing firm

manufacturing firm supplies it with the necessary parts, such as computer chips and disk drives

assembly firm's capital is fixed: eight workbenches fully equipped with tools, electronic probes, and other equipment for testing computers can vary labor

Indicates a functional relationship between physical inputs & output of a firm.

The form of production function of a firm is determined by the state of technology.

The production function is always in relation to a period of time.

Production function is purely a technical relationship.

Output in the production function is the result of joint use of factors of productions.

Differ from firm to firm due to type of technology, type of product & extent of availability of different resources.

COBB-DOUGLAS PRODUCTION FUNCTION:-

States that about 75% of the increase in manufacturing production due to labor input & remaining 25% due to capital input.

Can also be estimated by regression analysis by first covering it into log form:- Log Q= Log A= Log L + log K (A, , are positive constants)

Properties of Cobb Douglas Function:- a) The sum of the exponents of Cobb-Douglas production function that

is , a+b measures the return to scale:

If a+b = 1, returns to scale is constant

If a+b>1, returns to scale is increasing

If a+b <1, returns to scale is decreasing.

b) According to cobb-douglas production function, marginal product of a factor depends on its amount used in production.

c) The exponents of labour & capital in Cobb-Douglas production function measure output elasticities of labor & capital respectively.

d) Cobb-Douglas production function can be extended to include more than 2 factors.

Q= AL k + D + G + F

b) When the sum of exponents ( + ) in the 2 factors, labor & capital, in the cobb-douglas production function is equal to unity.

β2 β3 β4

Fixed proportion, the amount of a productive factors required to produce a one unit of a product remain fixed irrespective of the level of production proportion form.

Possibility of substitution of the factors of production is ruled out.

As it mostly happens in long run, its is called as long-rum production function.

The amount of a factor required to produce a unit of a product can be varied by substituting some other factors in its place, is variable proportion form.

A given amount of commodities can be produced by several alternative combinations of factors.

As it happens in the short-run, called as short-run production function.

A production function is homogeneous of degree 1 is the most common form of linear production function.

All the factors of production are increased in same proportion, output also increases in the same proportion.

It represents the case of constant returns to scale.

Expansion path of the linear homogenous production function is always a straight line which arises from the origin.

Product or output refers to the volume of goods produced by a business firm during a specified period of time.

Economist viewpoint of product:- Total Product

Marginal Product

Average Product

Total Product:- Total quantity of goods produced by a firm during a specified period of time.

Total quantity of goods produced by a firm during a specified period of time.

Can only be raised by increasing the quantity of the variable factor.

Rate of increase in total product varies at different levels of employment of factor of production coz of the applicability of law of variable proportions.

Increase in the variable factor of production will not always increase the total production. Eg. Employment of workers beyond capacity will create over crowding.

Addition to the total production by the employment of an extra unit of variable factor.

Important to know how production changes as a variable unit, say L changed.

Rate of change in output as labor is increased by 1 unit, holding all other factors constant, called as marginal product of labor.

MPn= TPn - TPn-1

TP= total product

n = number of variable factor units

MPn= Marginal product of nth variable factor unit.

AP of a variable factor is total product divided by the number of units of the variable factor employed.

Eg. taking labor as variable factor:-

AP= TP/L

Useful in intra-industry comparisons of labor productivity, wages revision.

TOTAL PRODUCT MARGINAL PRODUCT

AVERAGE PRODUCT

STAGE 1 First increases at increasing rate.

Increases Increases, but at a lower rate than that of the MP

Then increases at diminishing rate

Reaches the max. point & begins to diminish

Continues to increase & becomes maximum

STAGE 2 Continues to increase at diminishing rate & becomes maximum

Continues to diminish & becomes equal to zero

Becomes equal to MP & then begins to diminish

STAGE 3 Diminishes Becomes negative Continues to diminish but will always greater than zero

Initially was called the Law of diminishing returns by Marshall.

Also called as Law of Proportionality.

Deals with the short-run & there are 2 types of factor of production i.e. Fixed factors & variable factors.

Describe the input-output relation in a situation when the output is increased by increasing the quantity of one input, keeping the other inputs constant.

As per Leftwitch,“ The law of variable proportion state that if the input of one resource is increased by equal increments per unit of time while the inputs of other resources are held constant, TP will increase but beyond some point the resulting output increases will become smaller & smaller”.

As per Stigler, “ As equal increments of one input are added, the inputs of other productive services being held constant, beyond a certain point the result in increment of product will decrease i.e., the marginal product will diminish”.

Professor Samuelson “ An increase in some inputs relative to other fixed inputs will, in a given state of technology cause output to increase; but after a point the extra inputs will become less & less”.

It is assumed that the state of technology remains unaltered.

Assumed that of the various inputs employed in production some atleast must be kept constant.

Specially operates in the short run coz here some factors are fixed & the proportions of others has to be varied.

Assumed that the variable resources is applied unit by unit & each factor unit is homogenous or identical in nature.

Assumed that it is possible to use various amounts of a variable factor with fixed factor of production.

Production Schedule Using Varying Amounts of Labor

Number

of

Workers

Total

Product

(In Units)

Marginal

Product

(In Units)

0

1

2

3

4

5

0

14

42

75

112

150

0

14

28

33

37

38

Stage I

(Increasing

Returns)

6

7

8

180

203

216

30

23

13

Stage II

(Diminishing

Returns)

9

10

207

190

-9

-17

Stage III

(Negative

Returns)

Production Function Using Variable Amounts of Labor

0

50

100

150

200

250

1 2 3 4 5 6 7 8 9 10

Variable Input (Number of Workers)

To

tal

Pro

du

cti

on

(In

Un

its

)

Series1Stage-1

Stage-2

Stage-3

MP

AP

TP

STAGE 1:- INCREASING RETURNS

In this Stage TP is initially increasing at an increasing rate & then starts increasing at an decreasing rate.

AP rises throughout in this stage.

MP initially increases & then starts falling.

Increase in AP & MP coz the factor are underutilised.

STAGE 2:-DIMINISHING RETURNS

Decreasing but positive AP & MP.

Law of diminishing returns operates in this stage.

Shows the decrease in the efficiency of labor.

STAGE 3:- NEGATIVE RETURNS

MP becomes negative as well as TP starts decreasing.

Efficiency of labors decreases resulting in decline in AP.

There are 2 important reasons for increasing returns:-

1. Indivisibility:- Generally fixed factors are indivisible.

Cant be divided in smaller units which will result in total or partial loss in efficiency.

Means due to technological requirement a minimum amount of that factor must be employed.

Initially the supply of fixed factor is too large & it is indivisible, when the units of variable factors are increased & combined with this fixed factor, the latter is utilised better & more fully.

Results in increasing returns till best proportion is not achieved.

2. Specialisation:- Greater the quantity of variable factor, greater the scope

of specialisation.

It include greater skills, productivity, efficiency, the avoidance of waste of time in shifting from one task to another, employment of best person suited for the particular type of work, etc.

Improves the quality of product & also saves time.

Average product & Marginal product will diminish, because, the indivisible factor is being used too fully, i.e. in non-optimal proportion with the variable factor.

Also arises as after some time, the firm will have to use inferior factor units, when superior ones are used up.

A stage reached when the total product declines & the marginal product declines.

Is due to the fact that number of the units of variable factors become too excessive relative to the fixed factor.

Has the universal application & find place in number of economic principles like principle of substitution, Marginal Utility Theory of value, Marginal Productivity Theory of Distribution, etc.

Law applies as much as to agriculture as in industries.

Application of law of variable proportion is inevitable & all prevading.

Is the geometric representation of the production function.

Q= f(L,K)

Curve drawn by plotting all the alternative combinations for a given level of output.

The curve which is the locus of all possible combinations is called Isoquant or Iso-product curve.

The isoquant curve is bowed inward because of the law of diminishing marginal productivity.

Labor Machines Pairs of Earrings

A 3 20 60

B 4 15 60

C 6 10 60

D 10 6 60

E 15 4 60

F 20 3 60

Isoquant map – a set of isoquant curves that show technically efficient combinations of inputs that can produce different levels of output.

Each isoquant corresponds to a specific level of output & shows different ways, all technologically efficient, of providing that quantity of output.

Slope downward & convex to the origin.

Curvature of an Isoquant is significant becausse it indicates the rate at which K & L can be substituted for each other while a constant level of output is maintained.

2 isoquants don’t intersect each other as it is no possible to have 2 output level for a particular input combinations.

Isoquant are downward slopping, means if a farm wants to use more labor then it must use less of capital to produce the same level of output or to be on the same isoquant.

Isoquants are convex to the origin, i.e., it has diminishing slope.

Isoquants never cross each other.

Isoquant which lies to the right & above another isoquant represents higher level of output.

The slope of an isoquant shows the rate at which L can be substituted for K.

Or the rate at which two factors are substituted for each other.

MRTS > 0 and is diminishing for increasing inputs of labor.

- slope = marginal rate of technical

substitution (MRTS)

Slope of isoquant:

K

L

MP

MP

L

K

FIGURE The Slope of an Isoquant Is Equal

to the Ratio of MPL to MPK

Increase in one input is possible only at the cost of some other input i.e. units of capital diminishes, units of labor increases.

MRTS had a diminishing tendency.

MRTS decreases coz capital & labor are not perfect substitute of each other.

Maximasation of profits possible through minimum firm’s cost.

The firm will choose the combination of inputs that

is least costly.

The least costly way to produce any given level

of output is indicated by the point of tangency

between an isocost line and the isoquant

corresponding to that level of output.

When the firm producing desired output with the factor combination having the least cost, it is said to be in equilibrium.

It is a stage when a producer had no tendency either to expand or contract his output.

Determined with the help of producer’s isoquant & iso-cost

lines.

Isoquant curve shows different combinations of the factors of production each of which can produce a specified level of output.

Iso-cost line represents the various levels of outlay given by the prices of two factors.

Isocost Lines Showing the

Combinations of Capital and Labor

Available for $5, $6, and $7

Isocost Line Showing All Combinations

of Capital and Labor Available for $25

Slope of isocost

line:

K

L

L

K

P

P

PTC

PTC

L

K

/

/

How does output respond to increases in all inputs together?

Suppose that all inputs are doubled, would output double?

Returns to scale have been of interest to economists since the days of Adam Smith

RTS is the degree of responsiveness of output to a proportionate change in the quantity of all inputs.

Smith identified two forces that come into operation as inputs are doubled

greater division of labor and specialization of labor

loss in efficiency because management may become more difficult given the larger scale of the firm

Increasing returns to scale:- If output increases more than the proportionate change to the increase in all inputs.

Constant returns to scale:- If all inputs are increased by some proportion, output also increases by the same proportion.

Decreasing returns to scale:- If increase in output is less than proportionate to the increase in all inputs.

Property of a production function whereby output rises more than in proportion to an equal increase in all inputs.

f(2L, 2K) > 2f(L, K).

Specialization

Use of specialized machinery.

Economics of large scale.

Indivisibility.

All the factors of production are increased in a given proportion, the output also increases in the same proportion.

Means increasing or decreasing in the input, same proportional change increase or decrease in the output.

f(2L, 2K) = 2f(L, K).

Output increases in the smaller proportion than increase in all inputs.

f(2L, 2K) < 2f(L, K).

Causes:- Diseconomies of large scale production.

Exhaustible natural resources.

External diseconomies.

• ECONOMIES OF SUPERIOR TECHNIQUES

• ECONOMIES OF INCREASED DIMENSIONS

• ECONOMIES OF LINKED PROCESS

TECHNICAL ECONOMIES

• PROFESSIONAL MANAGERS

• MECHANICAL DEVICES

• LOWER OVERHEAD

• BETTER CONDITIONS

MANAGERIAL ECONOMIES

• FINANCIAL REPUTATION

• ECONOMICAL FINANCING

• TRADING ON EQUITY

• PLOUGHING BACK OF PROFITS

FINANCIAL ECONOMIES

• CONTROL OVER DISTRIBUTION

• SERVICES OF EXPERTS

• ADVERTISING

• COMPETITION

MARKETING ECONOMIES

• LARGE SCALE BUYING

• ECONOMY IN SELLING COMMERCIAL ECONOMIES

TRANSPORTATION & STORAGE ECONOMIES

DIVISION OF LABOR & SPECIALIZATION

• DIVERSIFICATION OF

• OUTPUT

• MARKET

• SOURCES OF SUPPLY

• PROCESS OF MANUFACTURE

RISK BEARING ECONOMIES

These are economies made outside the firm as a result of its location, and occur when: A local skilled labour force is available. Specialist, and local back-up firms can supply parts or

services. An area has a good transportation network. An area has an excellent reputation for producing a particular. Availability of cheaper banking & financial services. Development of specialised marketing agencies & facilities of

joint publicity. Provision of adequate power, water & electricity. Interaction with other concerns in R n D by pooling manpower

& financial resources. Easy availability of marker information.

Assume each unit of capital = $5.00, Land = $8.00 and Labour = $2.00

Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility

What happens and why?

Capital Land Labour Output TC AC

Scale A 5 3 4 100

Scale B 10 6 8 300

Capital

Land Labour Output

TC AC

Scale A 5 3 4 100 57 $0.57

Scale B 10 6 8 300 114 $0.38

Doubling the scale of production (a rise of 100%) has led to an

increase in output of 200%

therefore cost of production per unit has fallen

Don’t get confused between Total Cost and Average Cost

Overall ‘costs’ will rise but unit costs can fall

Why?

These occur when the firm has become too large and inefficient. As the firm increases production, eventually average costs begin to rise because:

The disadvantages of the division of labour take effect-

too many people doing different jobs add to costs. Management becomes out of touch with the shop floor

and some machinery becomes over-manned- costs increase.

Decisions are not taken quickly and there is too much form filling.

Lack of communication in a large firm means that management tasks sometimes get done twice.

Poor labour relations may develop in large companies.

These occur when too many firms have located in one area. Unit costs begin to rise because: Local labour becomes scarce and firms now have to offer

higher wages to attract new workers. Land and factories become scarce and rents begin to rise. Local roads become congested and so transportation

costs begin to rise.