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Demand risk is a potential hazard that all businesses must face during the course of normal operations. Each business relies on forecasting tools to determine how much of a product it should produce. Demand risk refers to the idea that these forecasts may not accurately predict the amount of product that customers are willing and able to buy. The risk for a business is that it may produce too much or too little product to meet demand, resulting in lost profits and wasted sales opportunities. Companies continuously strive to cut demand risk through more effective forecasting and projection techniques.
Companies face two basic types of demand risk when it comes to producing various products. First, there is the risk that the company will overestimate demand and manufacture more of a good than they will be able to sell. This leaves the business stuck with surplus inventory that ties up resources and warehouse space. Eventually, the company may be forced to cut prices in order to sell these products, which can result in reduced profits or even a net financial loss.
The other major type of demand risk is that the business could underestimate demand. This results in insufficient production levels, resulting in a shortage. While this may seem less damaging than an inventory surplus, it still represents a lost opportunity for the firm. Given that economic and financial theories assume that firms attempt to maximize profits, a demand forecast that's too low is still recognized as a lost profit and an inefficiency.
Demand risk should not be confused with supply risk, though the two concepts can have similar effects on a business. Supply risk occurs further up along a manufacturer's supply chain. A supply risk means that a business could face losses due to an inability to secure adequate supplies, even when demand forecasts are accurate and in line with actual demand.
Companies have two basic options for minimizing demand risk. The first is to invest in better forecasting tools that allow the firm to more accurately predict demand. This could involve collecting better data from customers, or simply aggregating and analyzing this data more effectively. It also requires reviewing historical demand trends, and keeping an eye out for potential economic changes in the future that could impact demand. For example, a rise in the unemployment rate could be a sign that demand for certain types of goods will soon fall, as people will have less money to spend overall.
Another technique used to reduce demand risk is to change the way products are manufactured. Rather than forecasting demand for some period in the future, then using that data to control production, firms are turning to techniques like just-in-time manufacturing. Under this type of manufacturing plan, a company does not begin producing a product until it receives an order from the customer. This requires firms to maximize the speed and efficiency of the entire company, from order takers to line workers. It may also not be appropriate for all product types.