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Demand Forecasting. It covers the Qualitative and Quantitative aspects of Demand Forecasting in Operations Management.

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info)

Demand Forecasting

Demand forecasting

Introduction & Need for Forecasting:

Demand forecasting is the activity of estimating the

quantity of a product or service that consumers will purchase in

future. The primary goal of management is to match supply to

demand. Having a forecast of demand is essential for determining

how much capacity or supply will be needed to meet the demand.

Furthermore, the forecasting exercise directly leads to detailed

production planning year.

The forecasting exercise also helps in establishing

performance targets for the year for various departments such as

production, materials, and marketing, as well as in the setting up

of control system. Forecasts are the basis for budgeting, planning

capacity, sales, production and inventory, personnel, purchasing,

and more. Forecasts play an important role in the planning

process because they enable managers to anticipate the future so

they can plan accordingly.

Two aspects of forecasts are important, one is the expected

level of demand & the other is the degree of accuracy that can be

assigned to a forecast. The expected level of demand can be a

function of some structural variation, such as a trend or seasonal

variation. Forecast accuracy is a function of the ability of

forecasters to correctly model demand, random variation, and

sometimes unforeseen events.

Features of a Good Forecast: The Forecast should be Timely.

The Forecast should be Accurate.

The Forecast should be Reliable.

The Forecast should be in Meaningful Units.

The Forecasting technique should be Simple to understand &

Easy to use.

FORECASTING METHODS

After gathering data from the primary and secondary

sources, the analysts then attempt to forecast the demand levels

in the future. The tools that are available for forecasting can be

divided into two broad categories:

1. Qualitative methods

2. Quantitative methods

Qualitative Methods

In qualitative type of demand forecasting, the accuracy of

forecasting depends on the ability of the person and hence it is

subject to personal bias and therefore it should not be used to

great extent.

The well known qualitative demand forecasting techniques are:

1. Delphi Technique

2. Sales Force Opinions

3. User Expectation Method/Survey of Buyer Intentions Method

1. Delphi Technique:

Delphi method is a structured communication technique or

method, originally developed as a systematic,

interactive forecasting method which relies on a panel of experts.

In this method a group of experts are sent questionnaires

through mail. The responses received are summarized without

disclosing the identities. Further mails are sent for clarification in

cases of extreme views. The process is repeated till the group

reaches to a reasonable agreement.

Delphi is based on the principle that forecasts (or decisions)

from a structured group of individuals are more accurate than

those from unstructured groups. The technique can also be

adapted for use in face-to-face meetings, and is then called mini-

used for business forecasting and has certain advantages over

other structured forecasting approaches.

Delphi seems to have these advantages over other forecasting

approaches:

1. Participants reveal their reasoning.

2. It is easier to maintain confidentiality.

3. Potentially quicker forecasts if experts are readily available

A method commonly used by companies for short-term

forecasts is to take advantage of their field staff's intimate

knowledge of customers' needs and market conditions by asking

them to forecast the company's sales for their respective areas

for the coming season or year.

3. User Expectation Method/Survey of Buyer Intentions

Method

According to this method, the various users of the product

under forecasting are listed first, then their individual likely

demand of the product is ascertained, and from that data, the

demand forecast for those products is consolidated. This method

is alternatively known as 'Survey of buyers' intentions'. The

survey will give an idea of the total possible consumption of the

product, the buying plans of the users and the possible market

share for the company doing the survey. The user survey can be

made either on a sampling basis or on a census basis depending

on the size of the user group to be covered.

Quantitative Methods

to represent relationship among related variables based on

historical data. These methods are sometimes referred to as

objective forecasting methods because the underlying

assumptions of the forecasting model and the data used can

stated independent of the user. Thus if two individuals use the

same model and same data, they should get the same forecast.

1. Moving average Method

A time series forecast can be as simple as using demand in

the current period to calculate demand in the next period. This is

sometimes called intuitive forecast. For e.g. if demand is 100

units this week, the forecast for next weeks demand is 100 units.

If demand turns out to be 90 units instead, then the following

weeks demand is 90 units, and so on. This type of forecasting

method does not take into account historical demand behavior, it

relies only on demand in the current period. It reacts directly to

the normal, random movements in demand.

values during the recent past to develop a forecast. This tends to

smooth out, the random increases and decreases of a forecast

that uses only one period. The simple moving average is useful

for forecasting demand that is stable and does not display any

definite demand behavior such as seasonal pattern.

Moving averages are computed for specific periods, such as

three months or five months, depending on how much the

forecaster desires to smooth the demand data. The longer the

moving average period, the smoother it will be.

The formula for computing the simple moving average is

n

MAn =

Di

i =1

Di = demand in period of i

n = number of period in the moving average

Example:

restaurants and catering services within a 100 mile radius of its

warehouse. The food supply business is competitive, and the

ability to deliver orders promptly is a factor in getting new

customers and keeping old ones. The manager of the company

wants to be certain enough drivers and vehicles are available to

deliver orders promptly and they have adequate inventory in

stock. Therefore, the manager wants to be able to forecast the

number of orders that will occur during the next months.

From the records of delivery orders, management has

accumulated the following data for the past 10 months, from

which it wants to compute three and five months moving average.

Orde

r per

Mon mont

ths

hs

Janu

ary

120

Febr

uary

90

Marc

h

100

April

75

May

110

June

50

July

75

Aug

ust

130

Sept

emb

er

110

Octo

ber

90

Solution:

Let us assume that it is the end of October. So the forecast

resulting from either the three or five months moving average is

basically for the next month in the sequence I.e. November.

The MA is computed from the demand for order for the prior three

months in the sequence according to the following formula.

MA3 =

No . of months

MA3 =

90+110+130

3

The five month moving average is computed from the prior five

months of demand data as follow:

MA5 =

No . of months

MA5 =

90+110+130+75+ 50

5

The three and five month moving average forecasts for all the

months of demand data are shown in the following table.

Months

January

Februar

y

March

April

May

June

July

August

Septem

ber

October

Order per

months

three months

moving average

five month

moving average

120

90

100

75

110

50

75

130

103.3333333

88.33333333

95

78.33333333

78.33333333

99

85

82

110

90

85

105

88

95

Novemb

er

110

91

does not react to variation that occur for a reason, such as

seasonal effects. It is basically a mechanical method, which

reflects historical data in a consistent way.

The moving average method does have the advantage of being

easy to use, quick and relatively inexpensive. In general this

method can provide a good forecast for the short run but it should

not be pushed too far into the future.

2. Exponential Smoothing

Exponential smoothing is one of the most widely used

quantitative forecasting technique. It is short range time series

type that forecasts sales for the next time period. It is similar to

moving average type that includes data of prior months in the

average, the only difference being in moving average the prior

data is given same weight. Whereas in Exponential smoothing the

weight is distributed throughout the data. Example: A ten month

moving average method basically puts 10% weight on each of the

last 10 month data & zero to before that unlike exponential

smoothing weight distribution on the same data will be different

like 10%, 9%, 8% etc. This is exactly what exponential smoothing

does.

In exponential Smoothing the recent figure is assigned the

highest weightage & it decreases as we move towards the older

figures. This is done with the help of a smoothing constant which

is denoted by (Alpha). Value of can lie between zero & one.

It determines the level of smoothing & speed of reaction to

differences between forecast and actual occurrences. The value of

constant is determined by the nature of the product, length of the

period and also the managers sense.

Exponential smoothing is most used of all forecasting

techniques as only little data is required for the forecast. Namely:

the most recent forecast, actual demand for the period &

smoothing constant. Reasons for being accepted widely are:

1. Its models are accurate.

2. Formulating the model is easy.

3.

4.

5.

6.

Little computation is required to use the model.

Computer storage requirements are small.

Tests for accuracy are easy to compute.

Steps:

1.

2.

3.

4.

Determine value of .

First forecast is not defined (F1=N.D.).

Second forecast is first actual sale (F2=D1).

Now use the formula to calculate rest of the forecasts

Fn = Dn-1 + (1-) Fn-1

5. Then calculate:

a. Mean Absolute Deviation (M.A.D.)

b. Mean Absolute Percentage Error (M.A.P.E.)

c. Mean Square Error (M.S.E.)

Problem:

Calculate: Mean Absolute Deviation (M.A.D.), Mean Absolute

Percentage Error (M.A.P.E.), Mean Square Error (M.S.E.) for the

following data using exponential smoothing.

Months

Actual

Sales

2

3

4

5

6

7

8

9

10

11

12

13

248

240

254 243 251 260 249 261 268 254 265 270 ?

Solutio

n:

0.7

Actual

Month

Sales

s

(Di)

1

240

2

248

3

254

4

243

5

251

6

260

7

249

8

261

9

268

10

254

11

265

12

270

13

M.A.D.

M.A.P.E.

M.S.E.

(Fi)

Exp(0.

7)

240.00

245.60

251.48

245.54

249.36

256.81

251.34

258.10

265.03

257.31

262.69

267.81

8.58

3.34

75.98

Error

Abs

Error

Abs. %

Error

Error Square

8.00

8.40

-8.48

5.46

10.64

-7.81

9.66

9.90

-11.03

7.69

7.31

8.00

8.40

8.48

5.46

10.64

7.81

9.66

9.90

11.03

7.69

7.31

3.23

3.31

3.49

2.17

4.09

3.14

3.70

3.69

4.34

2.90

2.71

64.00

70.56

71.91

29.77

113.14

60.98

93.26

97.95

121.68

59.15

53.40

Regression can be defined as a functional relationship

between two or more correlated variables. It is used to predict

one variable given the other. The relationship is usually developed

from observed data. The linear regression line is of the form Y = a

+ bX, where Y is the value of the dependent variable that we are

solving for, a is the Y intercept, b is the slope, and X is the

independent variable. (In time series analysis, X is units of time)

Linear regression is useful for long-term forecasting of major

occurrences and aggregate planning.

The major restriction in using linear regression forecasting is,

as the name implies, that past data and future projections are

assumed to fall about a straight line.

Least Squares Method for Linear Regression

The least squares equation for linear regression is Y = a + bX

Where, Y = Dependent variable computed by the equation

y = The actual dependent variable data point (used below)

a = y intercept, b = Slope of the line, X = Time period

The least squares method tries to fit the line to the data that

minimize the sum of the sum of the squares of the vertical

distance between each data point and its corresponding point on

the line. If a straight line is drawn through general area of the

points, the difference between the point and the line is y - Y. The

sum of the squares of the differences between the plotted data

points and the line points is

(y1 Y1) + (y2 Y2) + .. + (y12 Y12) The best line to use is

the one that minimizes this total. As before, the straight line

graph. In the least squares method, the equations for a and b are

points. We discuss the procedure to fit a straight line by the least

squares method.

Example: Aroma Drip coffee Inc. produces commercial coffee

machines that are sold all over the world. The companys

production facility has operated at near capacity for over a year

now. Wayne Conners, the plant manager thinks that sales growth

will continue, and he wants to develop long range forecasts to

help plan facility requirements for the next 3 years. Sales records

for the past 10 years have been compiled:

Annual sales

Year

Annual

(in (in

1000)

sales

1000)

1

1000

2

1300

1800

2000

2000

Year

6

2000

2200

2600

2900

10

3200

Solution:-

Year

1

2

3

4

5

6

7

8

9

10

Totals

Annua

l sales

(y)

1000

1300

1800

2000

2000

2000

2200

2600

2900

3200

y=21

00

Time

period

(x)

1

2

3

4

5

6

7

8

9

10

x=55

xy

1

4

9

16

25

36

49

64

81

100

x=3

85

1000

2600

5400

8000

10000

12000

15400

20800

26100

32000

xy=133

300

a= ( x y x xy ) /( n x ( x )

b=( xy x y )/

n x ( x )

a=(385*21000)b=(10*13330)a=913.33

3

b=215.75

8

(55*133300)/(10*385-55)

(21000*55)/(825)

For next three years forecast will be

Y11=913.333+215.758*11

=3290 thousand units

Similarly,

Y12=3500,

Y13=3720 thousand units.

Evaluation of Quantitative Methods

All the three methods are based on availability of past data.

The moving average method is very simple to set up but has

some limitations. If there is a significant change in the pattern, it

reacts slowly. For instance, when there is a gradual shift in the

This is because it weighs all the past periods of data equally.

In Exponential Smoothening, the impact of is to a great

extent on the forecast. A lower value of indicates that the

forecast is not responsive to the demand, whereas a higher value

of makes the forecast responsive to the demand. In other

words, by choosing a higher value for , the model weighs recent

demand points more.

Due to the above reasons, the two methods provide a capability

to project demand without any significant pattern. While they are

useful for short-term forecasting, demand in the modern term of

12 months often has a significant patterns. The regression

method is based on the line equation and it is ideal for picking up

time series data. Once the line equation is formed, the whole

forecast can be plotted. It will always be linear straight line and

hence is not suited for forecasting dynamic demand forecasting.

Regression method should never be used for demand forecasting

unless there is actual linear data present.

determine future demand. The quantitative methods are easy to

understand, simple to use and not costly unless the data

requirements are substantial. They also have exhibited a good

track record of performance for many companies that have used

them. For these reasons regression methods and specially time

series are popular.

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