DEMAND ESTIMATION and FORECASTING

STATISTICAL METHODS

Trend projection method

Method of moving averages
Barometric methods
Simultaneous equation method

Trend Projection Method

This method is based on analysis of past patterns of sales or production
as the case may be. A firm, which has been in existence for quite a long
time, will have accumulated considerable data regarding sales/
production for a number of years.
Such data is arranged
chronologically with regular intervals of time. This type of data is
called Time Series. The time series shows effective demand for the
product during the period of past ten or fifteen years. On the basis of
the data, a graph can be drawn and this is called a sales/production
curve. The sales curve shows fluctuations and turning points in
demand. If the turning points are few and their interval is widely
spread over, firm forecasting becomes possible.
Time series refer to the data over a period of time, during which time
fluctuation may occur. Therefore, the time series has four types of
components namely,

Secular trends
Seasonal Variation
Cyclical variation
Random variation
Secular trend refers to the general tendency of the data and it is
knows as long period or secular trend. This can be upward or
downward, depending upon the behaviour.
Seasonal variations refer to changes which occur during a climatic
season or a festival season. It may be that of festival season like

Deepavali or Dussherra etc. Normally, these changes, which are

repetitive in character, are related to a 12-month period.
Cyclical variations refer to the changes arising out of booms and
depressions.
Random variations refer to changes, which occur unnoticed like
famines, floods, earthquake, etc. These cannot be predicted.
The real problem in forecasting is to separate and measure each of these
four factors. When a forecast is made, the seasonal, cyclical and
random factors are eliminated from the data and only the secular trend
is used. The trend in time series can be estimated by using any one of
the following methods.
The free hand method
The trend projection method
The moving average method

The Trend Projection Method

In the time-series or trend projection analysis, past data of sales are
taken to determine the nature of existing trend and then this trend is
extrapolated into the future and thus a forecast is made.
Suppose a producer of toilet soap decides to forecast the next years
sales of his product using this method. The data for the last five years is
as follows:
Sales of X Company
Years

1986
1987
1988
1989
1990

Sales in Rs. Lakhs

45
52
48
55
60

This data is plotted on a map which is shown in the following diagram:

In the graph, it can be seen that sales have fallen in 1988 and then have
increased. It shows that sales are fluctuating. But during the whole
period, the sales trend is upward.
The common technique used in constructing the line of best fit is by the
method of least squares. The trend is assumed to be linear.
The equation for the straight-line trend is: Y = a+ bx, where a is the
intercept and b shows the impact of the independent variable. We
have to estimate the values of a and b. This we do by least square
equations which incidentally enables us to fit the trend line as well.
In the above table, which is a time series data set, sales are the
dependent variable Y and t or time or the years are the independent
variable. Since sales vary with time, the time periods will be the
independent variable X.

The Y intercept and the slope of the line are found by making
appropriate substitutions in the following normal (least square)
equations.
Y = na + b x. (1)
XY = a x + b x2. (2)
Year
1986
1987
1988
1989
1990
n=5

Sales Rs. In
Lakhs
45
52
48
55
60
y 260

X
1
2
3
4
5
x=15

X2

XY

1
4
9
16
25
2
x =55

45
104
114
220
300
xy=813

In the table below, we find the magnitudes of required quantities from

the original data given above.
Substituting the above values in the two normal equations, we get the
following:
Y = na + b x. (1)
260 = 5a + 15b (3)
XY = a x + b x2.

(2)

813 = 15a +55b ( 4)

Solving equations (3) and (4) we get b = 3.3

Applying b value we get a in the following manner:
260= 5a +15 (3.3)
260= 5a + 49.5
a =42.1
Therefore the equation of the line of best fit is : Y= 42.1 + 3.3X
Using the equation, we can find the trend values for the previous years
and estimates of the sales for 1991. The trend values and estimates are
as follows:
4

Y 1986 = 42.1 +3.3 (1)=45.4

Y 1987 = 42.1 +3.3 (2)=48.7
Y 1988 = 42.1 +3.3 (3)=52.0
Y 1989 = 42.1 +3.3 (4)=55.3
Y 1990 = 42.1 +3.3 (5)=58.6
Y 1991 = 42.1 + 3.3 (6)=61.9
The above is the trend line and is marginally different from the earlier
table. An example is trend sale for 1988.
Based on the trend projection equation illustrated above, the forecast sales
for the year 1991 is Rs. 61.9.
Merits and Demerits
The trend projection method is very popular in business circles on
account of simplicity and lesser cost.
The basic idea in this method is that past data serves as the guide for
future sales.
The limitation is that this is not helpful when the trend line itself
undergoes a turning point.

Moving Averages
The MA can also be used to develop trend lines.
The calculations depend upon whether the period should be odd or
even.
In the case of odd periods like (5,7,9), the average of the observations is
calculated for a given period and the calculated value is written in front
of central variable for the period, say 5 years. The average of the values
of five years is calculated and recorded against the third year. In the
case of five yearly moving averages, the first two years and the last two
years of the data will not have any average value.

If the period of observation is even, say four years, then the average of
the four yearly observations is written between second and third year
values. After this, centering is done by finding the average of paired
values.
Take the following examples:
The following are the annual sales of clothes during the period of 19932003. How will we find out the trend of the sales using (1) 3 yearly
moving averages, (2) 4 yearly moving averages and (3) forecast the
value for 2005.

Year
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004

Sales in Rs. Lakhs

12
15
14
16
18
17
19
20
22
25
24

Demand Analysis
Solution: 3 yearly period:
e.g: The value of 1994 + value of 1995 + value of 1996
12 + 15 +14 = 41 written at the capital period 1995 of the years 1994,
1995 and 1996

Year

Sales in
Rs. Lakhs

3 Yearly
moving total

1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004

12
15
14
16
18
17
19
20
22
25
24

(-)
41
45
48
51
54
56
61
67
71
-

3 Yearly moving
Average
trend values
41/3=13.7
45/3=15
48/3=16
51/3=17
54/3=18
56/3=18.7
61/3=20.2
67/3=22.3
71/3=23.7
-

Four yearly moving averages

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Year

Sales in Rs.
Lakhs

1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004

12
15
14
16
18
17
19
20
22
25
24

4 yearly
Moving total
moving total of pairs of
yearly total
57
63
65
70
74
78
86
91
-

120
128
135
144
152
164
177
-

4 yearly
moving
average
trend values
120/8 =15
128/8 =16
135/8 =16.9
144/8 =18
152/8 =19
164/8 =20.5
177/8 =22.1
-

57 = the value of 1994 + value of 1995 + value of 1996, value of 1997

= 12+15+14+16
= 57 written against 1996
120 =57 +63, 128 = 16 + 65 written in the center of 1994, 1995, 1996 ,
1997 .
The MA is different from the original data in that it evens out inter-annual
fluctuations
Forecast for the year 2005
The trend values from the previous tables can be plotted on graph
which is as shown below. Trend line for 3 yearly and 4 yearly moving
averages may be virtually the same. Use a free hand method to go to
2005 in case the dataset pertains to the period from 1995.

Advantages of this Method

This method is simple and can be applied easily. Secondly, it is based on
mathematical calculations and finally this is more accurate to plot the
secular trends.
Disadvantages of this Method
The disadvantage of moving average method is that it gives equal
weightage to the data related to the different periods in the past. It
cannot be applied if some observations are missing.

Regression method
The sales of any commodity does not depend only on time . It may be
associated with competitors, advertising, ones own advertising, change
in population, income and size of the family, environmental factors, etc.
The nature of relationship between these factors can be used and future
sales can be forecast. Regression analysis denotes methods by which the
relationship between quantity demanded and one or more independent
variables (income price of the commodity, prices of related commodities
advertisement expenses, etc.) can be estimated.
Trend Projection by Regrestion Method

This is a mathematical tool, with this, adapting Method of Least

Squares a trend line can be fixed to know the relationship between
time and demand/sales. Based on this trend line sales/ demand can be
projected for future years.
This is an inexpensive method of forecasting. The data will be available
with the organization and based on this data, demand or sales can be
projected for subsequence years. Following illustrations will give an
idea as to how demand can be projected under Least Square Method.
ILLUSTRATION1:
Year:
Sales
(Rs. In crores)

1998

1999

2000

2001

2002

240

280

240

300

340

From this data project the sales for 2003, 2004, 2005.

Solution

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First we have to calculate required values. They are (i) Time Deviation,
(ii) Deviation Squares, (iii) Product of time deviation and sales.

Year
N

Sales
(Rs. In
crores)

(y)
1998
240
1999
280
2000
240
2001
300
2002
340
X=5
y=1400
The equation is y=a+bx.

Time
deviation
TD squared
from middle
year 2000
(x)
(x2)
-2
4
-1
1
0
0
+1
1
+2
4
x =0
x2=10

Product of
Time
Deviation and
sales
(xy)
-480
-280
-760
0
+300
+680 +980
xy=220

In this equation a is an independent variable and b exhibits rate of

growth.
Now, we have to find out the value of a and b.
a= y = 1400 = 280
n
5
b=xy = 220 = 22
x2 10
Now applying values to regression equation, the equation will be
y=280+22x.
From this we can ascertain sales projection from 2003, 2004, and 2005.
For the year 2003 =280 +22(3) =Rs.346 crores.
2004 =280 + 22(4) =Rs.368 crores.
2005 =280 + 22(5) =Rs.390 crores.

Simple Linear Regression:

Apply a price and predict sales Non time series Data set
In case of linear trend in the dependent variable, a straight line to the
data can be fit in, whose general form would be: Sales = a + b price.
11

The straight-line regression equation can be fit in either graphically or

least square method. In the graphical method, the sets of data of two
variables (sales and income) on a graph are plotted and a scatter
diagram can be obtained.

The regression in line can be approximated by sketching it free hand in

such a manner that the line passes through the middle of the scatter.
In the least square method of estimating the regression line, S= a+(-) bP,
the value of constants, a and b can be estimated with the help of a
following formula:

12

Example
Fit a linear regression line to the following data and estimate the
demand at price Rs.30.
Year 1981 82
Price
15 15
Pi
Sales
Si in 52
46
1000
Units

83
12

84
26

85
18

86
12

87
8

88
38

89
26

90
19

91
29

92
22

38

37

37

37

34

25

22

22

20

14

Solution:
Find the values of a and b and then the following table is constituted:
Pi
15
15
12
26
18
12
8
38
26
19
29
22
Pi 240

Si
52
46
38
37
37
37
34
25
22
22
20
14
Si 384

Pi2
225
225
144
676
324
144
64
1444
676
361
841
484
2
Pi 5708

Si2
2704
2116
1444
1369
1369
1369
1156
625
484
484
400
196
2
Si 13716

SiPi
780
690
456
962
666
444
272
950
572
418
580
308
SiPi7098

Then we will have

b= n Si Pi Si P1 = 12(7098) (384) (240)
n Pi2 (Pi)2
12(5708) (240)2
= - 6984 = - 0.641
10896
a = Si b Pi =[384 (240)(-0.641) ] / 12 = 44.82
n
13

The equation of the regression line is as:

S= 44.82 0.641 P
If price is Rs 30/- in the equation, the corresponding sales level (S) is:
S = 44.82 0.641 * 30 = 25.29 thousand units.
Thus apply different values of Price and find out values of sales
Barometric Method
Barometric method is an improvement over trend projection method.
In the trend projection method, the future is some sort of an extension
of the past, while in the barometric method; events of the present are
used to predict the future demand.
This is done by using certain
economic and statistical indicators. The barometric techniques use time
series to predict variables. The barometric techniques using time series,
which when combined in certain ways, provide direction of change in
the economy or in industries. These are called barometers of a market
change.
This method may also be called Economic Indicator method. The
economic indicators will help in estimating the demand for product at a
future date. There are three types in this.

Leading Indicators
There are leading indicators, which serve as useful guide for forecasting
the demand for some products. The sales of baby milk can be forecast
with the help of birth of children in the past five years. There is a
correlation between the demand for baby milk and the birth rate of
children. If the indicator is known, the sale forecast may be made on
that basis.
Coincident Indicators

14

There are certain indicators which coincide with the rise or fall of
general economic activity. The coinciding indicators are the gross
national product index of industrial production, retail sales and labour
force in the economy.

Diffusion Indices
These indices help the forecasters in relying on the leading indicators
used. These indices move up and down behind some other series.
The following indicators are used in assessing the future demand for
certain products:
Indicator
Demand for the Product
Construction Contracts
Demand for building materials
Increased prices of agricultural Demand for agricultural inputs
commodities
A rise in disposable income
Demand for consumer goods
Automobile registration
Demand for petrol
In the barometric method, it is necessary to find out the existence of any
relation between the indicator and the demand for the product. After
establishing the relationship through the method of least squares, we
have to derive the regression equation. If the relationships is linear, the
equation will be Y = a +bx. Once the equation is derived, the demand
for the product can be estimated.

Application of Leading Indicator Method Using Regressions

A nontime series based regression function

15

A refrigerator manufacturing company observes that there is a

relationship between the consumers disposable personal income index
and purchase of refrigerators by them.
The following data is available to the firm:
Year
Consumer DPI
Index(x)
2000
100
2001
120
2002
150
2003
160
2004
220

Refrigerator Sold (y)

100
140
150
170
200

From this data, compute the possible demand for the year 2005, if the
index would be 250
Solution
Regression equation of y on x (Y = Sales & X = DPI index)
Y= a +bx Adopting simultaneous equations, find out the value of a
and b
y =na +b x (i)
xy = ax + b x2 (ii)

Year

DPI Index
(x)

1994
1995
1996
1997
1998
N=5

100
120
150
160
220
x =750

Sales of
Square of
Product of
2
Refrigerator
DP II (X )
DPI and
(y)
Sales (xy)
100
10,000
10,000
140
14,400
16,800
150
22,500
22,500
170
25,600
27,000
200
48,400
44,000
2
y= 760
x =1,20,900 xy=1,20,500

Y= a +bx Adopting simultaneous equations, find out the value of a

and b
y =na +b x (i)
760 = 5a +750b (1)
16

xy = ax + b x2 (ii)

1,20,500 =750a + 120, 900 b (2)

Computation of Values
By attributing values to the above equations
760 = 5a +750b (1)
1,20,500 =750a + 120, 900 b (2)
to bring equations to common base multiply it by 150
114000 =750a + 112500 b
120500 =750a + 120900 b
-6500 = 8400b
thus b = 6500 8400 = 0.77
Substituting the value of b in equation (iii)
760 =5a + 750 (0.77)
760 = 5a + 577.5
5a = 182.5
a =36.5
Thus Y = 36.5 +0.77 X
If the index would be 250 for 1999 the number of refrigerators sold
would be: =36.5 + 0.77 (250)=36.5 + 192.5 = 229 numbers

Some other methods of demand forecasting:

Market research method
Exponential smoothing method
Simulation method

---------------------------

17

THE PRINCIPLES OF REGRESSION EQUATIONS

( PYNDINCK et al )
Least Square Method
By Least-Square method we mean the criterion of best fit used to choose
values for regression parameters usually by minimizing the sum of
squared residuals between the actual values of the dependent variables
and the fitted values.
SE and t Test
For a regression to be fool proof, we need to do two statistical tests:
(1) The standard error test where we estimate the Standard Deviation of
the regression error and
(2) t test to accept or reject the hypothesis that a parameter value is 0
or that it has no impact on the dependent variable as estimates had
supposed.
R2 Value
A regression equation is contingent upon R 2 value which brings out the
percentage of variation in the dependent variable that is accounted by
explanatory variables. A high R2 value of 0.94 indicates that the
independent variables in an equation account for 94% of the variations
of the dependent variable.
However high R2 values may be misleading especially for time series
data which show substantial upward growth and high R 2. Sometimes
high R2 also comes for variables that are not related at all in terms of
common sense. Example car sales and wheat prices may yield high R2.

18

Finally regressions may also suffer from specification problems. We

may not include variables that need to be have included or could
incorporate variables which are mutually dependent.
A typical regression equation reads as follows:
Y = b0 + b1X1 + +bkXk
Or say
S= b0 + b1 Pi

where

S is sale and P is Price

When put in the form of a graph it represents a scatter of points with

sales on the vertical axis and price on the horizontal. The fitted
regression line is drawn through the data points. The fitted value for
sales associated with any particular value for the price values P i is given
by
^ ^ ^
Si = b0 + b1Pi

S
^
Residual (Si - Si)
A
B

^ ^ ^
Si = b0 + b1 Pi

19

A practical estimation may look like the following:

S = -25.5 + 0.57P
But there may be the need to specify more than one independent
variable
Also in regression equations there are two problems, which require to be
addressed through statistical tests. The first problem is to have a test
for determining standard error for the estimated parameters.
This can be done by dividing the SD of the estimated parameter by the
square root of the number of observations.
Assuming normal distribution where an area within 1.96 SE is equal to
95% of the total area we can state the following:
^
^
b + 1.96 * (SE of b)
If a 95% confidence interval contains 0 then the true parameter will be
actually 0 even if the estimate is not. This means that the corresponding
independent variable will not affect the dependent variable even if we
had thought that way.
To test the hypothesis that a true parameter is 0 we look at the tstatistic which may be defined for parameter b as
^
t=
b
^
Standard error of b
If the t statistic is less than 1.96, the 95% confidence interval around b
must include 0.
20

This means that we cannot reject the hypothesis that the true parameter
b equals 0.
Therefore we may conclude that our estimate is not statistically
significant.
However if the t statistic is greater than 1.96 in absolute value we
reject the hypothesis that b = 0 and call our estimate statistically
significant.

Finally the equation would look like the following:

^
S = 51.1
(9.4)
t = 5.44

- 0.42P
(0.13)
- 3.23

+0.046I
(0.006)
7.67

- 0.84R
(0.32)
- 2.63

We can calculate the SD from this and also comment on its statistical
significance
Interpretation
The SE is given within brackets. For instance for P, SE = 0.13
which is very small relative to coefficient 0.42. In fact we can be 95%
certain that the true value of the price coefficient is 0.42 + or 1.96
SE or 1.96 * 0.13 = 0.25 +. (The true value of the coefficient could
range between 0.17 and 0.67.)
In this range there is no 0. Therefore the effect of price is both
significantly different from 0 and negative. (It is also statistically
significant)
The t value of 3.23 for P is equal to 0.42 / 0.13. Because this
exceeds 1.96 in absolute value, we conclude that the price is a significant
determinant of sales.

21

(Reason for t value to be linked to 1.96 is as follows:

If for P , SE = 0.42 then the t value will be 1. If SE is 0.5 then t
value will be less than 1. If SE is 0.25, than t value will be 1.68 and if
SE is 0.22, then the t value will be 1.90. And finally if SE is 0.214, then
the true value of the co-efficient could be 0 as well. The t value will
be 1.96 which means that the actual value could include 0. It is clear
that when value of SE ranges from 0.25 to 0.5 or more, the SD is so
much (since SE is high when SD/ n is high) and it may include the
value 0. In other words a high SE means high SD and the parameter
itself could have zero value).

Applying Statistical Tests to Regression Exercises in Part - I

In Part I we estimated a few sales functions and estimated (forecasted
demand) based on least square principles. One function which was
estimated was based on the following time series data:
Years

Sales in Rs. Lakhs

1991
1992
1993
1994
1995

45
52
48
55
60

The function estimated was as follows:

Y = 42.1 + 3.3X

(1)

Here we can estimate the SE of 3.3 by first finding out the SD of the
estimated parameters and dividing the SD by 5 (number of
22

observations) . (SD will be used as a benchmark for comparing the

estimated value of X in the above equation, against the observed values
mentioned in the table above.)
Based on the SE so derived we can estimate the t values by dividing 3.3
by SE.
In this manner we can derive the equation above in terms of the SE and
t values and thus determine whether they are statistically significant or
not.

23