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Demand Forecasting Shashank Tiwari (shashank@tiwari.

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.

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

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-

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

Delphi or Estimate-Talk-Estimate (ETE). Delphi has been widely


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

2. Sales Force Opinions


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

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

Quantitative forecasting methods use mathematical models


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.

The simple moving average method uses several 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:

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

The ABC produce company sells and delivers food produce to


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.

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

The MA is computed from the demand for order for the prior three
months in the sequence according to the following formula.
MA3 =

The of last 3 months


No . of months

MA3 =

90+110+130
3

MA3 = 110 orders for November


The five month moving average is computed from the prior five
months of demand data as follow:
MA5 =

The of last 5 months


No . of months

MA5 =

90+110+130+75+ 50
5

MA5 = 91 orders for November


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

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

Novemb
er

110

91

The advantages of the moving average method is that it


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.

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

3.
4.
5.
6.

User can understand how the model works.


Little computation is required to use the model.
Computer storage requirements are small.
Tests for accuracy are easy to compute.

Illustration of forecasting using Exponential Smoothing


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 ?

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

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

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

3. Demand forecasting using Regression Method


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

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

equation is Y = a + bX. Previously we determined a & b from the


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

Where a = Y intercept, b = slope of the line, n = number of data


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:-

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

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)

Regression Equation is therefore Y = 913.333+215.758X


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

Demand Forecasting Shashank Tiwari (shashank@tiwari.info)

demand in June, it could react to the change only by September.


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.

Conclusion: We have presented several methods of forecasting useful to


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.