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1. What will be the effect on sales if a firm decides to raise the price of its
product, say by 5 percent?
2. How large a reduction in price of a product is required to increase
sales, say by 25 percent.
It has been found by some empirical studies that business firms often fail to
take elasticity into account while taking decisions regarding prices, or they
give insufficient attention to the coefficient of price elasticity. No doubt, the
main reason for this is that they don’t have means to calculate price
elasticity for their product, since sufficient data regarding past prices and
quantity demanded at those prices are not available. Even if such data are
available, there are difficulties of interpretation of it because it is not clear
whether the changes in quantity demanded were the result of changes in
price alone or changes in some other factors determining the demand.
However, recently big corporate business firms have established their
research departments which estimate the coefficient of price elasticity from
the data concerning past prices and quantities demanded. Further, they are
also using statistical techniques to isolate the price effect of the quantity
demanded from the effects of other factors.
Applications of Cross Elasticity of Demand for
Business Decision Making
On the other hand, the demand for products with low income elasticity will
not be greatly affected by the fluctuations in aggregate economic activity.
During booms the demand for their products will not increase much and
during recessions it will not decrease sharply. Therefore, the firms with low
income elasticity for their products would not be much interested in
forecasting future business activity. Remember it is generally necessities for
which demand is not much income elastic. However, there is one good thing
for the firms which face low income elasticity. They are to a good extent
recession-proof. In the periods of recession, their incomes do not fall to the
extent of decline in aggregate income. Of course, to share the benefits of
increasing national income firms currently producing products with low
income elasticity would try to enter the industries demand for whose
products is highly income elastic as this would ensure better growth
opportunities.
Demand Forecasting
‘Forecasting is like trying to drive a car blind-folded and following direction
given by a person who is looking out of the back-window.’ –Philip Kotler
Introduction
The area of production planning and control is one in which the firm
concerns itself with means for the attainment of two objectives: the
production of required quantities of a given product and the production of
these quantities at appropriate times. This means that the producer must
anticipate the future demand for his product and, on this basis, provide the
production capacity which will be required. This call for forecasting the future
demand of a given product, translating this forecast into the demand it
generates for various production facilities and arranging for the procurement
of these facilities.
The discussion of demand forecasting is divided into seven sections. The first
describes the meaning, nature and the vital role played by demand forecasts
in the operations of business. The second deals with the types of forecasting
which arise out of the planning needs of business firms. The third explores
the various approaches to demand forecasting. The fourth explains the
major determinants of demand. The fifth deals with the major methods
adopted in estimating future demand. The sixth explains the forecasting
methods for new products. The last discusses how forecasts and forecasting
methods can be evaluated in terms of their accuracy and costs.
1. Meaning, Nature and the Role Played by Demand Forecasts in the
Operations of Business
More often than not, one finds forecasting decisions which have an important
influence on production planning operations being made by store-keepers or
stockroom clerks with little or no procedural or policy guidance.
Determination of the types of forecast required and establishment of
procedures governing generation of these forecasts are fundamental steps in
the organization of a well-conceived production control system.
From the point of the view of the time span and from the planning
requirements of business firms, demand forecasting can be classified under
two headings: short-term demand forecasting and long-term demand
forecasting.
Short-term Forecasting
Short-term forecasting is limited to short periods, usually not exceeding an
year. It relates to policies regarding sales, purchasing pricing and finances.
Here the reference is only to the existing production capacity of the firm.
Long-term Forecasting
In short-term forecasting a company is concerned only about the use of its
existing production capacity. But when questions of long-term planning are
involved the businessman must know something about the long-term
demand for his products. Thus the planning of a new production unit or the
expansion of an existing unit must start with an analysis of the long-term
demand potential of the products in question. A multi-product firm must
ascertain not only the total demand situation, but also the demand for
different items. This will involve the study of consumer preferences and
trends, the economy, and technological developments and trends. Once the
demand potential is assessed, it will be easier for the company to engage in
long-term financial planning. Again, manpower planning for existing as well
as new firms must be based on long-term forecasts of the company’s
growth.
When forecasts covering long periods are made, the probability of error is
high. Competent forecasts predict the conditions that are likely to prevail in
the near future with comparative confidence, and with a relatively high
degree of accuracy; the results are much less reliable when they attempt to
forecast conditions over longer periods. This is because; as the period
becomes longer certain factors that forecasters take into account in making
their estimates become more volatile. It is very difficult to predict over
extended periods such items as the probable costs of production, the trend
of prices and the changing nature of competition. Moreover, the longer the
term covered by the prediction, the more likely it is that unanticipated
events such as international conflicts including wars, periods of major
depression and prosperity and inventions and technological advances will
upset the calculations.
It is a function of the top management in each firm to make its own decision
regarding the span of time to be covered by demand forecast. It is safer to
forecast for longer periods, when the volume of demand has held fairly
constant from year to year. If demand has been erratic for reasons that are
largely unexplainable, the forecasting period should be shorter.
3. Approach to Forecasting
The following four distinct steps must be kept in view in dealing with any
demand forecasting problems:
Once a product forecast for the whole industry is available, it is easy for the
company to estimate its share of the market. Analysis of past data can
indicate the trends in market share among the competitors.
Demand forecasts for the company may be made based on either of these
assumptions. And often companies prepare alternative forecasts based on
them.
4. Determinants of Demand
a) Purchasing Power
One of the major determinants of demand is the purchasing power
of the consumer and this is determined by the income or rather
disposable personal income (Personal income minus direct taxes
and other deductions, if any) of the consumer. In Nepal, data on
disposable income is not directly available. The Central Statistical
Organization has not yet started the publication of data on
disposable income. Indirect estimates can, however, be obtained
from the published data.
b) Price
The importance of price of a particular product and its substitutes in
determining the demand has always been emphasized by
economists. A measure of the price-demand relationship for a
product is given by the concept ‘elasticity of demand’. Concepts
such as price elasticity, income elasticity, cross elasticity, etc. of
demand are used in economic analysis.
c) Demography
Experience shows that demand for a product is determined by
certain population characteristics also. For example, a study of the
demand for lipsticks must take into account the number of women
by age. Again, in a study of the demand of tyers, the population
consists of the number of cars, buses, trucks and other motor
vehicles in use. This shows that demography does not necessarily
relate exclusively to human population. In fact, its use is in
differentiating between total market demands on the one hand and
‘market segments’ on the other. The segments represent divisions
of the total market into homogenous groups. The idea is to
construct one or more segments that are considered to be
important elements affecting the demand for the product.
Demographic or population groups can be defined in terms of
educational background, sex, age, income, social status, geographic
location, etc. The segment, if quantified, can be used as an
independent variable affecting the demand for the product in
question.
i. Time-use characteristics;
ii. Use-facilities characteristics; and
iii. Demographic characteristics.
i. Time-use characteristics
Consumer durables have got extended use and as such they are never
used up in a single act as are match-sticks or ice-cream. This feature
enables the consumers to go on using them by repairing if necessary,
or to scrap them and get new ones. Experience shows that
emergencies such as war or scarcity force people to postpone
replacement of durable goods and thereby to lower the effective
scrapping rate. The decisions to replace goods are influenced also by
considerations such as social prestige and status, income and product
obsolescence.
ii. Use-Facilities characteristics
Generally durable goods require special facilities for their use. For
example, to use a car, or truck, one needs to have roads and petrol or
diesel stations. Again, to use a refrigerator or a radio, one needs
electricity. The existence and growth of such facilities is an important
variable in determining the volume of sales or quantity demanded of
the products in question. Hence, due consideration must be given in
choosing the variables influencing the demand for durable consumer
goods.
The total demand for durable goods, in fact, is the sum of two
demands: a new owner demand and a replacement demand. The new
owner demand will increase the stock of the goods. Replacement
demand tends to grow with the growth in the total stock with
consumers and at times it may even exceed the new stock with
consumers and at times it may even exceed the new demand. For
certain well established products, life expectancy tables are made
available in advanced countries in order to estimate the average or
near average replacement rates.
Capital goods
Capital goods are ‘produced means of further production’. They are used to
facilitate the production of other goods. Examples are machinery of all kinds,
factor buildings etc. The demand for capital goods is a case of ‘derived
demand’. Hence, the demand for capital goods depends upon the
profitability of the industries using the capital goods, the ratio of production
to capacity in user industries, the level of wage rates, the policy of the
Government, business prospects, etc. Where the wage rates go exceptionally
high, the management will have an added tendency to go for labor-saving
equipment.
In the case of particular capital goods, demand will depend on the specific
markets they serve and the end uses for which they are bought. The
demand for textile machinery, for instance, will be determined by the
expansion of textile industry in terms of new units and replacement of
existing machinery. Therefore, demand forecasts for capital goods will have
to take into account new demand as well as replacement demand.
Two types of data are required for forecasting the demand for capital goods,
intermediate or industrial goods. They are