TOPIC 2 Topic: Demand Forecasting

 Introduction
 Why Forecasting is Essential
 Qualitative Approaches
 Quantitative Approaches
 Simple Linear Regression
 Coefficient of Correlation (r)
 Coefficient of Determination (r2)
 Ranging Forecasts
 Evaluating Forecast-Model Performance
 Short-Range Forecasting Methods
 Criteria for Selecting a Forecasting Method
 Monitoring and Controlling a Forecast Model
 Forecasting in Small Businesses and Start-up Ventures

Why This Topic?

In this topic, students will learn how demand forecasting is very valuable in businesses because employers
can gain information about their potential in the current market scheme.

By the end of the topic, students should be able to understand the calculation methods used for the forecast
and how they assist the business planning, budgeting, and goal setting to meet the customer’s demand.

Introduction

In operations management, the starting point for planning is to estimate the demand for products and
services. To solve this, the management team developed sales forecasts based on the estimated demand.

Therefore, the sales forecasts become inputs to the business strategy and production resource forecasts.

Why Forecasting is Essential

In operations management, forecasting is essential because it gives the ability to make informed decisions
and develop a strategy that will bring in profits to the business. The strategy consists of plans within the facility
to ensure that there are no marginal errors or a place for improvement.

For example, a new facility planning may take some time to design and build a new production process that
is more efficient than the current process that the company uses.

Production planning refers to companies planning to come up with new products since the demand varies
from month to month.

Besides that, there is a workforce scheduling that demands staff services. This can vary at any time, and it is
the company’s responsibility to develop a proper work schedule in advance for the employees.

So far, there are two methods to approach the forecast. They are the qualitative and quantitative
approaches, which will be explained in the next section.

Qualitative Approaches

This method is based on judgments about factors that underlie the demand for a particular product or service.
Rather than statistics, this approach does not require any history of either product or service, making it useful
to analyse new products and services.

The approach varies from scientific conduct to intuitive guesses about the business's future. It is only
appropriate depending on the product’s life cycle stage, which was mentioned in the previous lesson.

© UNITAR International University 1

 Quantitative Approaches

This approach is based on the assumption that the “forces” that generated the past demands will generate
the future demands. This is measured through all of the past data that has been collected during the past
demand.

By analysing the pattern, it will provide a basis to forecast future demands. Most of the approaches fall into
the category of time series analysis, which is a set of numbers where the sequence is important. For example,
the number of movie tickets sold from January to April.

Through time series analysis, it can identify the patterns that can be used to develop a forecast. Time series
consists of trends, cycles, seasonality and random fluctuations. Trends refer to an upward or downward slope
on the line. The cycle is a data pattern that covers a handful of years before it is repeated. Seasonality is a
data pattern that repeats itself over a period of one year or less. Finally, the random fluctuation results from
unexplained causes found in the data.

Sometimes, this forecast may be recorded in a short period of time or a long range. Long-range refers to a
time span that lasts more than a year. Businesses need to support strategic decisions in regard to the planning
of products, facilities and processes.

There are different types of measurements used in the quantitative approach, which will be individually
discussed from the formulas used and what are the results by the end of the approach.

Simple Linear Regression

Linear refers to a straight line. In terms of analysis, it establishes a relationship between a dependent variable
and at least one independent variable. For a simple linear regression, there can only be one independent
variable.

If the data is a time series, the independent variable is the time period while the dependent variable is
whatever the company wishes to forecast. It is common in

To calculate the linear equation, the formula is:

Y = a + bX

Y is a dependent variable, X is the independent variable, a is where the y-axis intercept while b is the slope of
the regression line.

The a and b are constant values that are calculated by the formulas below:

Once both of the constant values are registered, a future value of X can be entered into the regression
equation and a corresponding value of Y can be calculated.

© UNITAR International University 2

In terms of business, linear regression represents a class of forecasting models called causal forecasting
models.

If there are two or more independent variables, multiple regression analysis will be used.

Coefficient of Correlation (r)

The coefficient of correlation is represented by r. It explains the importance of the relationship between X and
Y.

The sign of r shows the direction of the relationship while the absolute value of r shows the strength of the
relationship. It is important to know that the sign of r is always the same as the sign of b.

Unlike both the value of a and b, r can take on any value between -1 and +1. If the number is positive, then
the value of r presents a perfect relationship where the x increases while the y increases. A perfect negative
relationship of r has the x increase while the y decrease.

If the r becomes 0, then there is no existing relationship between x and y. Anything in between can result in a
weak positive or a strong negative relationship. The formula to find r can be seen below:

Coefficient of Determination (r2)

The coefficient of determination, r2, is the square of the coefficient of correlation. This modification of r allows
students to shift from the subjective measures of a relationship to a specific measure.

To determine r2, a formula is used to explain the variation to the total variation.

Ranging Forecasts

The forecasts for future periods are only through estimations and are subject to error. To overcome the
uncertainties in the data, most companies develop best-estimate forecasts where the ranges within can
capture the actual data that are likely to fall.

Ranges of a forecast are defined by the upper and lower limits of a confidence interval. They could be
estimated by the given formula below:

© UNITAR International University 3

Y is the best-estimated forecast, the t represents the number of standard deviations from the mean of the
distribution. t provides a probability of exceeding the limits of the data through chance. Finally, syx is the
standard error of the forecast, which can be calculated by using the given formula below:

A short-range forecast has a short time span that ranges from a few days to a few weeks. This trend may have
little effect on how short the duration is. The main component of this data is random fluctuations.

Evaluating Forecast-Model Performance

In order to evaluate the short-range forecasting models, there are three characteristics to consider. They are
the impulse response, noise-dampening ability and accuracy.

Both the impulse response and noise-dampening ability exchange with each other. This is through how they
could respond to the quick data changes that cause a great deal of random fluctuation or noise. Noise
dampening refers to the forecast having little period-to-period fluctuation. Impulse response, on the other
hand, refers to the forecast immediately detecting changes in the data.

Accuracy is used for judging the performance of a forecasting approach. This means the measurement is to
understand how the forecast values match the actual values. This needs to be monitored in order to assess
the confidence in the forecasts. Changes in the market may require the business to re-evaluate this approach
to achieve accuracy. So far, accuracy can be measured in several ways such as the standard error of the
forecast, mean absolute deviation (MAD) and the mean square error (MSE).

The mean absolute deviation (MAD) can be measured with this formula:

Mean square error (MSE) is calculated with this formula:

MSE = (syx)2

A small value for Syx means that the data points are grouped around the line where the range of error is small.
When the forecast errors are normally distributed, both the MAD and S yx are related in this formula:

MSE = 1.25 (MAD)

© UNITAR International University 4

 Short-Range Forecasting Methods

So far, there are four methods for short-range forecasting. They are the simple moving average, weighted
moving average, exponential smoothing and exponential smoothing with a trend. These methods will be
explained further in the later sections.

A simple moving average is an averaging period (AP) that is selected in the data. The forecast for the next
period is through calculating the arithmetic average of the AP. The reason why it is a “simple” average is that
each period used to calculate the average is equally weighted.

Weight moving average is another variation of the simple moving average where the weights used to
calculate the average are not equal. This allows the recent demand data to have a greater effect on the
moving average. In this case, the weights must add to 1.0 and decrease in value with the age of the data.
The distribution will determine the impulse response of the forecast.

Exponential smoothing is formed by the weights that are exponentially distributed. The forecast is calculated
through the sum of the old forecast and a portion of the forecast error seen in the formula below:

a represents the smoothing constant between 0.0 and 1.0. A large a provides a high impulse response
forecast while a small a provides a low impulse response forecast.

Exponential smoothing with trend refers to the data moving towards the medium-range forecast, where the
trend becomes important. By incorporating a trend into the exponentially smoothed forecasts, it forms a
double exponential smoothing. The estimates for both the average and trend are smoothed.

 The formula for exponential smoothing with the trend is:

FTt is the forecast with the trend in the period. The St-1 is the smoothed forecast (average) in period t-1and
finally, Tt-1 equals the smoothed trend estimate in period t-1.

Other formulas such as smoothing the average is:

Smoothing the trend is:

The a represents the smoothing constant for the average while the b represents the smoothing constant for
the trend.

Criteria for Selecting a Forecasting Method

© UNITAR International University 5

In most cases, businesses have to add criteria when selecting a forecasting method. They are cost and
accuracy, data availability, time span, nature of products and services, and impulse response and noise
dampening.

Cost and accuracy refer to how both of these criteria can trade off with each other at a cost. A high-
accuracy approach can have disadvantages such as using more data to get an accurate result since they
are difficult to obtain, it takes a longer time to use, and the models are too expensive to operate.

The data available is only necessary if it needs to be forecast for a new product through market research.

The time span is based on what operations resource is being forecast and what it serves in the company. For
example, when a company has short-term staffing needs, it is best to forecast with exponential smoothing or
the moving average model. Another would be estimating a long-term factory capacity need through
regression or the executive-committee consensus method.

The nature of products and services refers to the cost and volume of the product/service. This part discusses
how long is the product/service in its life cycle and how much demand is there over the years.

Finally, impulse response and noise dampening are about achieving a balance between how responsive the
forecasting model is to the changes in the demanded data and the desire to contain the chance variation
(noise) in the data.

Monitoring and Controlling a Forecast Model

In order to control a forecast model with sufficient data, a tracking signal (TS) is used. It measures the
cumulative forecast error over n periods in terms of the mean absolute deviation (MAD). Therefore, the
calculation to obtain sufficient data is:

If the forecasting model is well, the TS should be around zero. It indicates the direction of the forecasting error
where if the TS is positive, the forecasts increase whereas if the TS is negative, then the forecasts decrease.

The TS’s value can be used to trigger new parameter values of a model which will correct the model’s
performance. If the limits are too narrow, the parameter values will change constantly. If the limits are too
wide, the parameter value will not change but will affect the accuracy of the result.

Forecasting in Small Businesses and Start-up Ventures

For small businesses, forecasting can be difficult and could lead the company to fail if the selected forecasts
do not correlate with the business's marketing plan.

First, there are not enough staff to forecast, creating insufficient data. It is especially difficult if the said sstaffare
inexperienced in terms of their skills to develop a good forecast.

Not all businesses have a data-rich environment, causing a problem in forecasting any new products or
services.

Areas that can forecast sufficient data must have a large facility such as a consulting company or a
government agency in a state.

- end of lesson content –

© UNITAR International University 6