Demand Forecasting

Demand Forecasting and Its Importance

Forecasting demand is a process of estimating future demand for a product. Forecasted demand is a predicted volume
of sales in the future based historical data and information and other determining variables. The forecasted values serve
as guide in managerial decisions.

Forecasting demand reduces the degree of risk and uncertainty in decision-making. The scientific procedure used makes
the prediction more accurate and reliable. Business decision makers should not rely on “gut-feels” only.

Forecasting is an integral part of business planning. Sales forecasts are translated into production resource forecasts.
Short-range forecast enables managers to plan on labor by skill class, machine capacities, cash needed, and inventories.
Medium-range forecast is necessary to determine workforce, department capacities, purchased materials, and
inventories. Long-range forecasts provides lead time to plan for factory capacities, capital funds, and facility needs.
Eventually, business strategies are determined on the basis of these plans.

Qualitative Forecasting Techniques

Forecasting techniques range from the very naïve and inexpensive to very sophisticated and expensive ones.

Forecasts can be qualitative or quantitative. Qualitative forecasting technique includes the following:

1. Executive Committee Consensus. Knowledgeable executives from various departments within the organization
form a committee to develop sales forecasts. The committee may use many inputs from all parts of the
organization and may have staff analysts to assist them. Outside market experts could also be pooled. To avoid
bandwagon effect, the Delphi Method can be used. In this method, executives unanimously answer series of
questions on successive rounds then feedback is provided without identifying the expert responsible for the
opinion. This is to get the consensus forecasts.
2. Survey of Sales Force. Estimates of future regional sales are obtained from individual sales force. Their inputs
to the forecasts is considered valuable because they are closest to the market.
3. Consumer Surveys. Estimates of future sales are obtained directly from customers. Individual customers are
surveyed to determine what quantities of product they intend to purchase in each future time period.
4. Historical Analogy. This method ties the estimate of future sales of a product to knowledge of a similar
product’s sales. Knowledge of one product’s sales during various stages of its product life cycle is applied to
estimate sales for a similar product. This method may be particularly useful in forecasting sales of new products.

Quantitative Forecasting Techniques

Quantitative techniques of forecasting can be grouped into two major categories: extrapolation or trend projection and
causal forecasting.

Extrapolation assumes that past patterns will be maintained in the future. Time series analysis and trend analysis are
sophisticated extrapolation which assume that all forces affecting a certain variable changes uniformly through time.
The variable to be forecast has behaved according to a specific pattern in the past and that this pattern will continue in
the future. For this reason, time-series analysis is referred to as “naïve” forecasting.

Sources of Time-series Data Variations

• Time-series data fluctuate or vary over time. Possible sources of variation are:

1. Secular Trend. This refers to long-run increase or decrease in the data series. Rising trends over the years may
be brought about by population growth. While a declining trend can be due to an introduction of an improved
substitute.
 2. Cyclical Fluctuations. These are major expansions and contractions in most economic time series that seem to
recur every several years. For example, housing construction industry follows long cyclical swings lasting from
15-20 years.

3. Seasonal Variations. This is a regular recurring fluctuations in economic activity during each year. For example,
retails sales boom during the last quarter because of the holiday season.

4. Irregular or Random Influences. Variation in the data series resulting from natural disasters, pandemic Covid19,
and other unforeseen occurrences.

Trend Projection

The simplest form of time-series analysis is projecting the past trend by fitting a straight line to the data or using
regression analysis.

The linear regression model will be in the form of

St = So + bt

where:

St = is the value of the time series to be forecasted for period t

So = is the estimated value of the time series (the constant of the regression) in the base period (i.e. at t = 0)

b = is the absolute amount of growth per period

t = is the time period in which the time series is to be forecasted

Table 3.1. Quarterly Sales of Electricity

(in million kilowatt hours, 1988 – 1991)

Time 1988.1 1988.2 1988.3 1988.4 1989.1 1989.2 1989.3 1989.4

Period

Quantity 11 15 12 14 12 17 13 16
Demanded

Time 1990.1 1990.2 1990.3 1990.4 1991.1 1991.2 1991..3 1991.4

Period

Quantity 14 18 15 17 15 20 16 19
Demanded

• Fitting a regression line to the electricity sales data from 1 st quarter of 1988 (t=1) to 4th quarter of 1991 (t=16),
the estimated regression equation is

St = 11.90 + 0.394t , R2 = 0.50

(Note: Pls check procedure in determining values of parameters using OLS in the previous chapter Slide #34)

Based on the past trend, electricity sales can be forecast as

S17 = 11.90 + 0.394(17) = 18.60 for 1st quarter of 1992

S18 = 11.90 + 0.394(18) = 18.99 for 2nd quarter of 1992

S19 = 11.90 + 0.394(19) = 19.39 for 3 rd quarter of 1992

S20 = 11.90 + 0.394(20) = 19.78 for 4th quarter of 1992

Figure 3.1. Trend Projection

• Figure 3.1. shows how the actual data fits in the regression line. It can be noticed that first and third quarters
data of each year are below the trend line while 2 nd and 4th data are above the trend line. These exhibit strong
seasonal variations.

Adjusting the Trend for Seasonal Variation

To adjust the trend forecast for the seasonal variation, we use the ratio-to trend method. The steps are as follows:

Step 1. Compute for the trend value by substituting the value of t corresponding the quarter under consideration.
For example,

S1 = 11.90 + 0.394(1) = 12.20 - forecasted sales for 1 st quarter of 1988

S5 = 11.90 + 0.394(5) = 13.87 - forecasted sales for 1 st quarter of 1989

Step 2. Find the ratio of the actual value of each quarter during year to the forecasted value. For example for 1 st quarter
1988,

1988.1 = 11.00 / 12.29 or 0.895

Step 3. Get the average ratio for the quarter by adding all ratios for, say, 1 st quarter of 1988 to 1991and divide it by
four periods. So for

1st Quarter = 0.887

 2nd Quarter = 1.165

3rd Quarter = 0.907

4th Quarter = 1.042

Step 4. Multiply the forecasted trend by this ratio as shown below:

S17 = 18.60(0.887) = 16.50 in the 1 st quarter of 1992

S18 = 18.99(1.165) = 22.12 in the 2 nd quarter of 1992

S19 = 19.39(0.907) = 17.59 in the 3 rd quarter of 1992

S20 = 19.78(1.042) = 20.61 in the 4 th quarter of 1992

Table 3.2. Calculation of the Seasonal Adjustment

• As you compare the unadjusted forecasted values as shown in Figure 3.1 with adjusted trend for seasonal
variation follows the pattern of the actual data wherein it is below the line during 1 st and 3rd quarters and above
the line on the 2nd and 4th quarter (Check the encircled dots). This indicates that the forecast is more accurate
upon adjustment for seasonal variation

Smoothing Techniques

• Smoothing techniques predict future values of a time series on the basis of some average of its past values.

• This is useful when the time series exhibit little trend or seasonal variations but a great deal of irregular or
random variation.

• The two smoothing techniques are moving average and exponential smoothing.

Moving Averages

• The forecasted value of a time series in a given period (monthly, quarterly or yearly) is equal to the average
value of the time series in a number of previous periods.
 • An example for 3-quarter and 5-quarter moving averages forecasts are illustrated in Table 3.3 to compare
results. For example, the forecast for period 4 is calculated as the summation of actual data for the first 3
quarters divided by 3:

F4 = (A1 + A2 + A3)/3 = (20 + 22 + 23)/3 = 21.67

Table 3.3. 3-Quarter and 5-Quarter Moving Average Forecasts

• In order to decide which of these forecasts is better, the root-mean-square error (RMSE) is estimated using the
formula.

The forecast with smallest RMSE result will be chosen. In this example, the 3-quarter moving average forecast RMSE is
2.95, while the 5-quarter moving average forecast RMSE is 2.99. This means that we are a little more confident with the
forecasted market share of 21.33 (3-quarter moving average) than with 20.6 (5-quarter moving average) for the 13 th
period.

Exponential Smoothing

• Using moving averages in forecasting is giving equal weight to all observations in computing the average, even
though intuitively we expect more recent observation to be more important. Exponential smoothing overcomes
this objection.
 • With the exponential smoothing, the forecast for period t + 1 (Ft+1) is a weighted average of the actual and
forecasted values of the time series period t.

• The value of the time series at period t (At) is assigned a weight (w) which ranges from 0 – 1, and the forecast
for period t (Ft) is assigned the weight of 1 – w. The greater the value of w, the greater is the weight given to
the value of the time series in period t as opposed to previous period .

• The forecast of the time series in period t + 1 is

Ft+1 = wAt + (1 – w)Ft

• Two things should be done first before using the above formula:

a. Assign a value of the initial forecast. This may be equal to the mean value of the entire observed time-series data.
So,

Ft = (20+22+23+24+18+23+19+17+22+23+18+23)/12

Ft = 21

b. Assign on the value of w (weight of At). In this example w=.3 and

w=.5 are used.

• After this, the values Ft+1 are computed using w =.3 and w=.5. Then the corresponding root-mean-square-error
(RMSE) are compared. Again, the forecast with the smallest RMSE is chosen.

Table 3.4 Exponential Forecasts with w=.3 and w=.5

Causal Forecasting

• Causal forecasting consider independent or explanatory variables other than time. There must be an element of
causality between the dependent and independent variable. Some examples of variables that may explain
variations on car sales are:
 a. Car sales may increase as its price decreases.

b. Easier terms (low interest rate) offered by financing banks may increase car sales.

c. More advertising expenses for cars may result to higher sales.

d. An increase In price of gasoline may decrease car sales.

• Simple linear regression in causal forecasting uses the general form,

Y = a + bx

(Note: the same procedure is used in demand estimation in determining the values of parameters.)

• Multiple regression analysis in causal forecasting is used if one economic indicator does not show very strong
relationship. For example, car sales will not dependent on its price alone(b1). It is also affected by price of
gasoline (b2), advertising efforts(b3), financing terms offered by banks (b4), etc. So the function is stated as

Y = a + b1x1 + b2x2 + b3x3 + b4x4 + ….+bnxn

The determination of these parameters may use Statistical Programs for Social Scientists (SPSS)

Factors to Consider in Selecting Forecasting Method

A firm may use several different forecasting methods to anticipate future actions. It will likely use different methods
during the life cycle of a single product. In selecting the forecasting method, the following are to be considered:

1. The availability and accuracy of historical data

2. Degree of accuracy expected from the prediction

3. Cost of developing the forecasting

4. Length of the prediction period

5. Time available to make the analysis

6. Complexity of factors affecting future operations