Demand Forecasting

Demand Forecasting
• A forecast is an estimate of the
occurrence and magnitude of a
future event by systematically
combining and casting forward in a
predetermined way data about the
past.
Need for Forecasting
• Forecasting is an important input to corporate
long run planning
• Forecasting is an important component of
strategic and operational planning and provides
basis for budgetary planning and cost control
• It establishes the link between planning and
controlling systems.
Selection of a Forecasting Model

• Dependent Vs Independent Demand

• The time horizon for the forecast (short-
term, intermediate- term or long-term)
• Level of detail or how much aggregation
there will be (product or product group,
company’s division or the entire company)
• Number of items
• Nature of demand pattern ( stable and
unstable)
• Cost of forecasting and accuracy.
Types of Forecasts

• Qualitative (Judgmental)

• Quantitative
– Time Series Analysis
– Causal Relationships
– Simulation
A Classification of Basic Forecasting Methods
Qualitative Approaches

• Usually based on judgments about causal factors that

underlie the demand of particular products or
services
• Do not require a demand history for the product or
service, therefore are useful for new
products/services
• Approaches vary in sophistication from scientifically
conducted surveys to intuitive hunches about future
events
• The approach/method that is appropriate depends on
a product’s life cycle stage
 Qualitative Methods

• Executive Judgment
• Historical analogy
• Market research
• Survey of sales force
• Survey of customers
• Delphi method
• Nominal group technique
Delphi Method

Developed by Rand Corporation in 1950s

l. Choose the experts to participate representing a

variety of knowledgeable people in different areas
2. A coordinator through a questionnaire (or E-mail),
obtain forecasts (and any premises or qualifications
for the forecasts) from all participants
3. He summarizes the results and redistribute them to
the participants along with appropriate new questions
4. Repeat Step 3 as necessary till consensus is reached
and distribute the final results to all participants
Time Series Analysis

• Time series forecasting models try to

predict the future based on past data
• You can pick models based on:
1. Time horizon to forecast
2. Data availability
3. Accuracy required
4. Size of forecasting budget
5. Availability of qualified personnel
Components of Demand

• Average demand for a period of time

• Trend (General pattern of change over time eg.
Linear, exponential etc.)
• Seasonal element (Any regular pattern recurring
within a time period of not more than a year)
• Cyclical elements ( Arise from the changes in
economy as it moves from phases of growth and
decline)
• Random variation
Example of Linear and Nonlinear Trend Patterns
 Some Time Series Techniques

• Simple Moving Average

• Weighted Moving Average
• Exponential Smoothing
• Regression Analysis
• Trend Projections
Simple Moving Average Formula

• The simple moving average model assumes an

average is a good estimator of future behaviour
• The formula for the simple moving average is:

A
A t-1 +
+ A
A t-2 +
+ AAt-3 +...+A
+...+At-n
FFtt == t-1 t-2 t-3 t-n
nn
Ft = Forecast for the coming period
N = Number of periods to be averaged
A t-1 = Actual occurrence in the past period for up to “n”
periods
Simple Moving Average Problem

A
A t-1 ++ A
A t-2 ++ A At-3 +...+A
+...+At-n
FFtt == t-1 t-2 t-3 t-n
nn
Week Demand
1 650 Question:
Question:What
Whatarearethe
the3-week
3-weekand
and6- 6-
week
weekmoving
movingaverage
averageforecasts
forecastsfor
for
2 678 demand?
demand?
3 720 Assume
Assumeyouyouonly
onlyhave
have33weeks
weeksandand66
4 785 weeks
weeksofofactual
actualdemand
demanddatadatafor
forthe
the
5 859 respective forecasts
respective forecasts
6 920
7 850
8 758
9 892
10 920
11 789
12 844
Calculating the moving averages gives us:
Week Demand 3-Week 6-Week
1 650 F4=(650+678+720)/3
2 678
=682.67
3 720 F7=(650+678+720
4 785 682.67 +785+859+920)/6
5 859 727.67
=768.67
6 920 788.00
7 850 854.67 768.67
8 758 876.33 802.00
9 892 842.67 815.33
10 920 833.33 844.00
11 789 856.67 866.50
12 844 867.00 854.83
©The McGraw-Hill Companies, Inc., 2004
 Plotting
Plottingthe
themoving
movingaverages
averagesandandcomparing
comparing
them
themshows
showshow
howthe
thelines
linessmooth
smooth out
outto
toreveal
reveal
the
theoverall
overallupward
upwardtrend
trendin
inthis
thisexample
example

1000
900
Demand
800
Demand

3-Week
700
6-Week
600
500 Note
Notehow
howthethe
1 2 3 4 5 6 7 8 9 10 11 12 3-Week
3-Weekisis
Week smoother
smootherthan
than
the
theDemand,
Demand,
and
and6-Week
6-Weekisis
even
evensmoother
smoother
 Weighted Moving Average Formula

While
While the
the moving
moving average
average formula
formula implies
implies an an equal
equal
weight
weight being
being placed
placed on on each
each value
value that
that isis being
being averaged,
averaged,
the
the weighted
weighted moving
moving average
average permits
permits an
an unequal
unequal
weighting
weighting on
on prior
prior time
time periods
periods
The
The formula
formula for
for the
the moving
moving average
average is:
is:

FFt t == w
w11A
At-1 + w A t-2 ++ w
t-1 + w22 At-2 w33A
At-3 +...+w A t-n
t-3 +...+wnn At-n

nn
wwt ==weight
t weightgiven
occurrence
givento
totime
timeperiod
period“t”
“t” 
ww ==11
ii
occurrence(weights
(weightsmust
mustadd
addtotoone)
one) i=1
i=1
Weighted Moving Average Problem Data

Question:
Question:Given
Giventhetheweekly
weeklydemand
demandand
andweights,
weights,what
whatisis
the
theforecast
forecastfor
forthe
the44thperiod
th
periodor
orWeek
Week4?
4?

Week Demand Weights:

1 650
2 678 t-1 .5
3 720 t-2 .3
4 t-3 .2

Note
Notethat
thatthe
theweights
weightsplace
placemore
moreemphasis
emphasison
onthe
the
most
mostrecent
recentdata,
data,that
thatisistime
timeperiod
period“t-1”
“t-1”
Weighted Moving Average Problem Solution

Week Demand Forecast

1 650
2 678
3 720
4 693.4

F4 = 0.5(720)+0.3(678)+0.2(650)=693.4
Exponential Smoothing Model

FFtt == FFt-1
t-1
+
+ (A
(A t-1
t-1
-
- F
F )
t-1)
t-1
Where :
Ft  Forcast value for the coming t time period
Ft - 1  Forecast value in 1 past time period
At - 1  Actual occurance in the past t time period
  Alpha smoothing constant
Or
Ft = At-1 + (1-  Ft-1
Exponential Smoothing Problem (1) Data

Week Demand Question:

Question:Given
Giventhethe
1 820 weekly
weekly demand
demand data,
data,
2 775 what
whatare
arethe
the
exponential
exponential
3 680
smoothing
smoothing forecasts
forecasts
4 655
for
for periods
periods2-10
2-10using
using
5 750 =0.10 and =0.60?
=0.10and =0.60?
6 802 Assume
AssumeFF11=A =A11
7 798
8 689
9 775
10
Answer:
Answer:The
Therespective
respectivealphas
alphascolumns
columnsdenote
denotethe
theforecast
forecastvalues.
values. Note
Note
that
thatyou
youcan
canonly
onlyforecast
forecastone
onetime
timeperiod
periodinto
intothe
thefuture.
future.
Week Demand 0.1 0.6
1 820 820.00 820.00
2 775 820.00 820.00
3 680 815.50 793.00
4 655 801.95 725.20
5 750 787.26 683.08
6 802 783.53 723.23
7 798 785.38 770.49
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28
Exponential Smoothing Problem Plotting

Note
Notehow
howthat
thatthe
thesmaller
smalleralpha
alpharesults
resultsin
inaa smoother
smootherline
line
in
inthis
thisexample
example

900
800 Demand
Demand

700 0.1
600 0.6
500
1 2 3 4 5 6 7 8 9 10
Week
Exponential Smoothing
Advantages
• More accurate
• Formulation of the model is easy
• User can understand how the model works
• Little computation is required to use the
model
• Computer storage requirements are small
• Tests for accuracy can be done easily
Simple Linear Regression
• Linear regression analysis establishes a
relationship between a dependent variable
and one or more independent variables.
• In simple linear regression analysis there
is only one independent variable.
• If the data is a time series, the
independent variable is the time period.
• The dependent variable is whatever we
wish to forecast.
 Simple Linear Regression

• Regression Equation
This model is of the form:
Y = a + bX
Y = dependent variable
X = independent variable
a = y-axis intercept
b = slope of regression line
Simple Linear Regression Formulas for Calculating “a” and “b”

aa == yy-- bx
bx

xy
 xy -- n(y)(x)
n(y)(x)
bb == 22 22
xx -- n(x
 n(x))
Simple Linear Regression Problem Data

Question:
Question:Given
Giventhe
thedata
databelow,
below,what
whatisisthe
thesimple
simplelinear
linear
regression
regressionmodel
modelthat
thatcan
canbe
beused
usedto
topredict
predictsales
salesin
infuture
future
weeks?
weeks?

Week Sales
1 150
2 157
3 162
4 166
5 177
 30

Answer:
Answer: First,
First, using
using the
thelinear
linear regression
regressionformulas,
formulas, we
we
can
can compute
compute“a” “a”and
and“b”
“b”
Week Week*Week Sales Week*Sales
1 1 150 150
2 4 157 314
3 9 162 486
4 16 166 664
5 25 177 885
3 55 162.4 2499
Average Sum Average Sum

bb==

 xy
xy--n( n(y)(x)
y)(x) 2499
= 2499 --5(162.4)(3)
5(162.4)(3) 
63
63= 6.3
= 10 = 6.3
 x - n(x )
x 22
- n(x ) 22
55  5( 9
55  5(9 ) ) 10

aa== yy--bx
bx==162.4
162.4--(6.3)(3)
(6.3)(3)==143.5
143.5
 31

The resulting regression model

is: Yt = 143.5 + 6.3x
Now if we plot the regression generated forecasts against the
actual sales we obtain the following chart:
180
175
170
165
160 Sales
Sales

155 Forecast
150
145
140
135
1 2 3 4 5
Period
Coefficient of Correlation (r)
• The coefficient of correlation, r, explains
the relative importance of the relationship
between x and y.
• The sign of r shows the direction of the
relationship.
• The absolute value of r shows the strength
of the relationship.
• r can take on any value between –1 and
+1.
 Coefficient of Correlation (r)
• r is computed by:

n xy   x  y
r
n x 2  (  x )2  n y 2  ( y )2 
 Coefficient of Correlation (r)
• Meanings of several values of r:
-1 a perfect negative relationship (as x goes up, y
goes down by one unit, and vice versa)
+1 a perfect positive relationship (as x goes up, y
goes up by one unit, and vice versa)
0 no relationship exists between x and y
+0.3 a weak positive relationship
-0.8 a strong negative relationship
 Incorporating Trend and Seasonal
Components

• Determine the seasonality index

SI = Seasonal demand/ Average demand
• Deseasonalize the original data (Divide the original
data by SI
• Develop least square regression line for the
deseasonalized data
• Project the regression line through the period to be
forecast
• Create final forecast by adjusting the regression line
by the seasonal factor
Exercise
• For the following data use seasonalised time series regression
analysis to develop a forecast for next year's quarterly sales
revenues for personal computers:
•  
• QUARTERLY SALES ($ MILLION)
•
────────────────────────────────────
• YEAR Q1 Q2 Q3 Q4
• ──────────────────────────────────────────────────────
─────
• 1 9.2 5.4 4.3 14.1

• 2 10.3 6.4 5.4 16.0

• ──────────────────────────────────────────────────────
─────
Step 1

First, compute the seasonal indexes:

═════════════════════════════════════════════════════════════════
QUARTERLY SALES ($ MILLION)
──────────────────────────────────── ANNUAL
YEAR Q1 Q2 Q3 Q4 TOTAL
─────────────────────────────────────────────────────────────────
1 9.2 5.4 4.3 14.1 33.0
2 10.3 6.4 5.4 16.0 38.1
─────────────────────────────────────────────────────────────────
TOTALS 19.5 11.8 9.7 30.1 71.1
QUARTER AVERAGE 9.75 5.90 4.85 15.05 8.8875
─────────────────────────────────────────────────────────────────
SEASONAL INDEX (SI) 1.097 .664 .546 1.693
═════════════════════════════════════════════════════════════════
 
SIQ1 = 9.75/8.8875, SIQ2 = 5.9/8.8875, SIQ3 = 4.85/8.8875
 
Next, deseasonalize the data by dividing each observation by its SI:
═══════════════════════════════════════════════════════════
QUARTERLY SALES ($ MILLION)
────────────────────────────────────
YEAR Q1 Q2 Q3 Q4
────────────────────────────────────────────────────────────
1 8.39 8.13 7.88 8.33
2 9.39 9.64 9.89 9.45
════════════════════════════════════════════════════════════

Next, perform time series regression on the deseasonalized data:

════════════════════════════════════════════════════════════
YEAR QUARTER x y x2 xy
────────────────────────────────────────────────────────────
1 1 1 8.39 1 8.39
2 2 8.13 4 16.26
3 3 7.88 9 23.64
4 4 8.33 16 33.32
2 1 5 9.39 25 46.95
2 6 9.64 36 57.84
3 7 9.89 49 69.23
4 8 9.45 64 75.60
──────────────────────────────────────────────────────────
Totals 36 71.10 204 331.23
══════════════════════════════════════════════════════════
x = 36, y = 71.10, x2 = 204, xy= 331.23, n = 8
 
x2y - xxy 204(71.10) - 36(331.23)
a = ─────────── = ─────────────────
nx2 - (x)2 8(204) - (36)2
 
14,504.40 - 11,924.28 2,580.12
a = ─────────────── = ────────── = 7.679
1,632 - 1,296 336
 
nxy - xy 8(331.23) - 36(71.10)
b = ────────── = ────────────────
nx2 - (x)2 336
 
2,649.84 - 2,559.6
b = ───────────── = .26857
336

Y8 = a + bX8 = 7.679 + .26857(X)

 

Next, compute the deseasonalized forecasts for periods 9 - 12:

 
Y9 = 7.679 + .26857(9) = 10.096
Y10 = 7.679 + .26857(10) = 10.365
Y11 = 7.679 + .26857(11) = 10.633
Y12 = 7.679 + .26857(12) = 10.902
Next, use the seasonal indexes to seasonalize the forecasts:
══════════════════════════════════════════════════════════
SEASONALIZED
DESEASONALIZED FORECASTS
QUARTER SI FORECASTS ($ MILLION)
(1) (2) (3) [COL 2 X COL 3]
──────────────────────────────────────────────────────────
 
Q1 1.097 10.096 11.08
Q2 .664 10.365 6.88
Q3 .546 10.633 5.81
Q4 1.693 10.902 18.46
 
Causal Methods for Forecasting
• Regression analysis (Forecast is caused by the
occurrence of other events)
• Econometric models (attempts to describe some
sector of the economy by a series of interdependent
equations
• Input/output models ( Indicate the change that a
producer industry might expect because of the
purchasing changes by another industry)
• Leading indicators ( Statistics that move in the same
direction as the series being forecast but move
before the series.
 Chapter 11 Forecasting and Demand Planning
• Forecast error (et) is the difference between the
observed value of the time series and the forecast,
or At – Ft.
• Mean Square Error (MSE) n 2
(et )
t=1
Mean Square Error =
n
• Mean Absolute Deviation Error (MAD) n

|e |
t=1
t

Mean Absolute Error =

n
MAD Example

Month Sales Forecast Abs Error

1 220 n/a
2 250 255 5
3 210 205 5
4 300 320 20
5 325 315 10

40

nn


 AA --FF
tt tt
40
MAD
MAD==
t=1
t=1 == 40 ==10
nn 44 10
Computer Software for Forecasting
• Examples of computer software with forecasting
capabilities
– Forecast Pro
–
Primarily for
Autobox
– SmartForecasts for Windows forecasting
– SAS
– SPSS
– SAP Have
– Minitab Forecasting
– POM Software Library modules