Supply Chain Management

(2nd Edition)

Chapter 7
Demand Forecasting
in a Supply Chain

© 2004 Prentice-Hall, Inc. 7-1

 Outline
 The role of forecasting in a supply chain
 Characteristics of forecasts
 Components of forecasts and forecasting methods
 Basic approach to demand forecasting
 Time series forecasting methods
 Measures of forecast error
 Forecasting demand at Tahoe Salt
 Forecasting in practice

© 2004 Prentice-Hall, Inc. 7-2

 Role of Forecasting
in a Supply Chain
 The basis for all strategic and planning decisions in a
supply chain
 Used for both push and pull processes
 Examples:
– Production: scheduling, inventory, aggregate planning
– Marketing: sales force allocation, promotions, new production
introduction
– Finance: plant/equipment investment, budgetary planning
– Personnel: workforce planning, hiring, layoffs
 All of these decisions are interrelated

© 2004 Prentice-Hall, Inc. 7-3

 Characteristics of Forecasts
 Forecasts are always wrong. Should include
expected value and measure of error.
 Long-term forecasts are less accurate than short-
term forecasts (forecast horizon is important)
 Aggregate forecasts are more accurate than
disaggregate forecasts

© 2004 Prentice-Hall, Inc. 7-4

 Forecasting Methods
 Qualitative: primarily subjective; rely on judgment and
opinion
 Time Series: use historical demand only
– Static
– Adaptive
 Causal: use the relationship between demand and some
other factor to develop forecast
 Simulation
– Imitate consumer choices that give rise to demand
– Can combine time series and causal methods

© 2004 Prentice-Hall, Inc. 7-5

 Components of an Observation
Observed demand (O) =
Systematic component (S) + Random component (R)
Level (current deseasonalized demand)

Trend (growth or decline in demand)

Seasonality (predictable seasonal fluctuation)

• Systematic component: Expected value of demand
• Random component: The part of the forecast that deviates
from the systematic component
• Forecast error: difference between forecast and actual demand

© 2004 Prentice-Hall, Inc. 7-6

 Time Series Forecasting
Quarter Demand Dt
II, 1998 8000
III, 1998 13000 Forecast demand for the
IV, 1998 23000 next four quarters.
I, 1999 34000
II, 1999 10000
III, 1999 18000
IV, 1999 23000
I, 2000 38000
II, 2000 12000
III, 2000 13000
IV, 2000 32000
I, 2001 41000
© 2004 Prentice-Hall, Inc. 7-7
 Time Series Forecasting

50,000
40,000
30,000
20,000
10,000
0

7, 2 7, 3 7, 4 8, 1 8, 2 8, 3 8, 4 9, 1 9, 2 9, 3 9, 4 0, 1
9 9 9 9 9 9 9 9 9 9 9 0

© 2004 Prentice-Hall, Inc. 7-8

 Forecasting Methods
 Static
 Adaptive
– Moving average
– Simple exponential smoothing
– Holt’s model (with trend)
– Winter’s model (with trend and seasonality)

© 2004 Prentice-Hall, Inc. 7-9

 Basic Approach to
Demand Forecasting
 Understand the objectives of forecasting
 Integrate demand planning and forecasting
 Identify major factors that influence the demand
forecast
 Understand and identify customer segments
 Determine the appropriate forecasting technique
 Establish performance and error measures for the
forecast

© 2004 Prentice-Hall, Inc. 7-10

 Time Series
Forecasting Methods
 Goal is to predict systematic component of demand
– Multiplicative: (level)(trend)(seasonal factor)
– Additive: level + trend + seasonal factor
– Mixed: (level + trend)(seasonal factor)
 Static methods
 Adaptive forecasting

© 2004 Prentice-Hall, Inc. 7-11

 Static Methods
 Assume a mixed model:
Systematic component = (level + trend)(seasonal factor)
Ft+l = [L + (t + l)T]St+l
= forecast in period t for demand in period t + l
L = estimate of level for period 0
T = estimate of trend
St = estimate of seasonal factor for period t
Dt = actual demand in period t
Ft = forecast of demand in period t

© 2004 Prentice-Hall, Inc. 7-12

 Static Methods
 Estimating level and trend
 Estimating seasonal factors

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 Estimating Level and Trend
 Before estimating level and trend, demand data
must be deseasonalized
 Deseasonalized demand = demand that would
have been observed in the absence of seasonal
fluctuations
 Periodicity (p)
– the number of periods after which the seasonal cycle
repeats itself
– for demand at Tahoe Salt (Table 7.1, Figure 7.1) p = 4

© 2004 Prentice-Hall, Inc. 7-14

 Time Series Forecasting
(Table 7.1)
Quarter Demand Dt
II, 1998 8000
III, 1998 13000 Forecast demand for the
IV, 1998 23000 next four quarters.
I, 1999 34000
II, 1999 10000
III, 1999 18000
IV, 1999 23000
I, 2000 38000
II, 2000 12000
III, 2000 13000
IV, 2000 32000
I, 2001 41000
© 2004 Prentice-Hall, Inc. 7-15
 Time Series Forecasting
(Figure 7.1)

50,000
40,000
30,000
20,000
10,000
0

7, 2 7, 3 7, 4 8, 1 8, 2 8, 3 8, 4 9, 1 9, 2 9, 3 9, 4 0, 1
9 9 9 9 9 9 9 9 9 9 9 0

© 2004 Prentice-Hall, Inc. 7-16

 Estimating Level and Trend
 Before estimating level and trend, demand data
must be deseasonalized
 Deseasonalized demand = demand that would
have been observed in the absence of seasonal
fluctuations
 Periodicity (p)
– the number of periods after which the seasonal cycle
repeats itself
– for demand at Tahoe Salt (Table 7.1, Figure 7.1) p = 4

© 2004 Prentice-Hall, Inc. 7-17

 Deseasonalizing Demand

[Dt-(p/2) + Dt+(p/2) +  2Di] / 2p for p even

Dt = (sum is from i = t+1-(p/2) to t+1+(p/2))

 Di / p for p odd
(sum is from i = t-(p/2) to t+(p/2)), p/2 truncated to lower integer

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 Deseasonalizing Demand
For the example, p = 4 is even
For t = 3:
D3 = {D1 + D5 + Sum(i=2 to 4) [2Di]}/8
= {8000+10000+[(2)(13000)+(2)(23000)+(2)(34000)]}/8
= 19750
D4 = {D2 + D6 + Sum(i=3 to 5) [2Di]}/8
= {13000+18000+[(2)(23000)+(2)(34000)+(2)(10000)]/8
= 20625

© 2004 Prentice-Hall, Inc. 7-19

 Deseasonalizing Demand
Then include trend
Dt = L + tT
where Dt = deseasonalized demand in period t
L = level (deseasonalized demand at period 0)
T = trend (rate of growth of deseasonalized demand)
Trend is determined by linear regression using deseasonalized
demand as the dependent variable and period as the
independent variable (can be done in Excel)
In the example, L = 18,439 and T = 524

© 2004 Prentice-Hall, Inc. 7-20

 Time Series of Demand
(Figure 7.3)

50000
40000
Demand

30000 Dt
20000 Dt-bar

10000
0
1 2 3 4 5 6 7 8 9 10 11 12
Period

© 2004 Prentice-Hall, Inc. 7-21

 Estimating Seasonal Factors
Use the previous equation to calculate deseasonalized
demand for each period
St = Dt / Dt = seasonal factor for period t
In the example,
D2 = 18439 + (524)(2) = 19487 D2 = 13000
S2 = 13000/19487 = 0.67
The seasonal factors for the other periods are
calculated in the same manner

© 2004 Prentice-Hall, Inc. 7-22

 Estimating Seasonal Factors
(Fig. 7.4)
t Dt Dt-bar S-bar
1 8000 18963 0.42 = 8000/18963
2 13000 19487 0.67 = 13000/19487
3 23000 20011 1.15 = 23000/20011
4 34000 20535 1.66 = 34000/20535
5 10000 21059 0.47 = 10000/21059
6 18000 21583 0.83 = 18000/21583
7 23000 22107 1.04 = 23000/22107
8 38000 22631 1.68 = 38000/22631
9 12000 23155 0.52 = 12000/23155
10 13000 23679 0.55 = 13000/23679
11 32000 24203 1.32 = 32000/24203
12 41000 24727 1.66 = 41000/24727

© 2004 Prentice-Hall, Inc. 7-23

 Estimating Seasonal Factors
The overall seasonal factor for a “season” is then obtained by
averaging all of the factors for a “season”
If there are r seasonal cycles, for all periods of the form pt+i, 1<i<p,
the seasonal factor for season i is
Si = [Sum(j=0 to r-1) Sjp+i]/r
In the example, there are 3 seasonal cycles in the data and p=4, so
S1 = (0.42+0.47+0.52)/3 = 0.47
S2 = (0.67+0.83+0.55)/3 = 0.68
S3 = (1.15+1.04+1.32)/3 = 1.17
S4 = (1.66+1.68+1.66)/3 = 1.67

© 2004 Prentice-Hall, Inc. 7-24

 Estimating the Forecast
Using the original equation, we can forecast the next
four periods of demand:

F13 = (L+13T)S1 = [18439+(13)(524)](0.47) = 11868

F14 = (L+14T)S2 = [18439+(14)(524)](0.68) = 17527
F15 = (L+15T)S3 = [18439+(15)(524)](1.17) = 30770
F16 = (L+16T)S4 = [18439+(16)(524)](1.67) = 44794

© 2004 Prentice-Hall, Inc. 7-25

 Adaptive Forecasting
 The estimates of level, trend, and seasonality are
adjusted after each demand observation
 General steps in adaptive forecasting
 Moving average
 Simple exponential smoothing
 Trend-corrected exponential smoothing (Holt’s
model)
 Trend- and seasonality-corrected exponential
smoothing (Winter’s model)

© 2004 Prentice-Hall, Inc. 7-26

 Basic Formula for
Adaptive Forecasting
Ft+1 = (Lt + lT)St+1 = forecast for period t+l in period t
Lt = Estimate of level at the end of period t
Tt = Estimate of trend at the end of period t
St = Estimate of seasonal factor for period t
Ft = Forecast of demand for period t (made period t-1 or earlier)
Dt = Actual demand observed in period t
Et = Forecast error in period t
At = Absolute deviation for period t = |Et|
MAD = Mean Absolute Deviation = average value of At

© 2004 Prentice-Hall, Inc. 7-27

 General Steps in
Adaptive Forecasting
 Initialize: Compute initial estimates of level (L0), trend (T0), and
seasonal factors (S1,…,Sp). This is done as in static forecasting.
 Forecast: Forecast demand for period t+1 using the general
equation
 Estimate error: Compute error Et+1 = Ft+1- Dt+1
 Modify estimates: Modify the estimates of level (Lt+1), trend
(Tt+1), and seasonal factor (St+p+1), given the error Et+1 in the
forecast
 Repeat steps 2, 3, and 4 for each subsequent period

© 2004 Prentice-Hall, Inc. 7-28

 Moving Average
 Used when demand has no observable trend or seasonality
 Systematic component of demand = level
 The level in period t is the average demand over the last N periods (the N-
period moving average)
 Current forecast for all future periods is the same and is based on the
current estimate of the level
Lt = (Dt + Dt-1 + … + Dt-N+1) / N
Ft+1 = Lt and Ft+n = Lt
After observing the demand for period t+1, revise the estimates as follows:
Lt+1 = (Dt+1 + Dt + … + Dt-N+2) / N
Ft+2 = Lt+1

© 2004 Prentice-Hall, Inc. 7-29

 Moving Average Example
From Tahoe Salt example (Table 7.1)
At the end of period 4, what is the forecast demand for periods 5 through
8 using a 4-period moving average?
L4 = (D4+D3+D2+D1)/4 = (34000+23000+13000+8000)/4 = 19500
F5 = 19500 = F6 = F7 = F8
Observe demand in period 5 to be D5 = 10000
Forecast error in period 5, E5 = F5 - D5 = 19500 - 10000 = 9500
Revise estimate of level in period 5:
L5 = (D5+D4+D3+D2)/4 = (10000+34000+23000+13000)/4 = 20000
F6 = L5 = 20000

© 2004 Prentice-Hall, Inc. 7-30

 Simple Exponential Smoothing
 Used when demand has no observable trend or seasonality
 Systematic component of demand = level
 Initial estimate of level, L0, assumed to be the average of all historical data
L0 = [Sum(i=1 to n)Di]/n
Current forecast for all future periods is equal to the current estimate of
the level and is given as follows:
Ft+1 = Lt and Ft+n = Lt
After observing demand Dt+1, revise the estimate of the level:
Lt+1 = Dt+1 + (1-)Lt
Lt+1 = Sum(n=0 to t+1)[(1-)nDt+1-n ]

© 2004 Prentice-Hall, Inc. 7-31

 Simple Exponential Smoothing
Example
From Tahoe Salt data, forecast demand for period 1 using exponential smoothing
L0 = average of all 12 periods of data
= Sum(i=1 to 12)[Di]/12 = 22083
F1 = L0 = 22083
Observed demand for period 1 = D1 = 8000
Forecast error for period 1, E1, is as follows:
E1 = F1 - D1 = 22083 - 8000 = 14083
Assuming  = 0.1, revised estimate of level for period 1:
L1 = D1 + (1-)L0 = (0.1)(8000) + (0.9)(22083) = 20675
F2 = L1 = 20675
Note that the estimate of level for period 1 is lower than in period 0

© 2004 Prentice-Hall, Inc. 7-32

 Trend-Corrected Exponential
Smoothing (Holt’s Model)
 Appropriate when the demand is assumed to have a level and trend in
the systematic component of demand but no seasonality
 Obtain initial estimate of level and trend by running a linear
regression of the following form:
Dt = at + b
T0 = a
L0 = b
In period t, the forecast for future periods is expressed as follows:
Ft+1 = Lt + Tt
Ft+n = Lt + nTt

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 Trend-Corrected Exponential
Smoothing (Holt’s Model)
After observing demand for period t, revise the estimates for level and trend as
follows:
Lt+1 = Dt+1 + (1-)(Lt + Tt)
Tt+1 = (Lt+1 - Lt) + (1-)Tt
 = smoothing constant for level
 = smoothing constant for trend
Example: Tahoe Salt demand data. Forecast demand for period 1 using Holt’s
model (trend corrected exponential smoothing)
Using linear regression,
L0 = 12015 (linear intercept)
T0 = 1549 (linear slope)

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 Holt’s Model Example (continued)
Forecast for period 1:
F1 = L0 + T0 = 12015 + 1549 = 13564
Observed demand for period 1 = D1 = 8000
E1 = F1 - D1 = 13564 - 8000 = 5564
Assume  = 0.1,  = 0.2
L1 = D1 + (1-)(L0+T0) = (0.1)(8000) + (0.9)(13564) = 13008
T1 = (L1 - L0) + (1-)T0 = (0.2)(13008 - 12015) + (0.8)(1549)
= 1438
F2 = L1 + T1 = 13008 + 1438 = 14446
F5 = L1 + 4T1 = 13008 + (4)(1438) = 18760

© 2004 Prentice-Hall, Inc. 7-35

 Trend- and Seasonality-Corrected
Exponential Smoothing
 Appropriate when the systematic component of demand
is assumed to have a level, trend, and seasonal factor
 Systematic component = (level+trend)(seasonal factor)
 Assume periodicity p
 Obtain initial estimates of level (L0), trend (T0), seasonal
factors (S1,…,Sp) using procedure for static forecasting
 In period t, the forecast for future periods is given by:
Ft+1 = (Lt+Tt)(St+1) and Ft+n = (Lt + nTt)St+n

© 2004 Prentice-Hall, Inc. 7-36

 Trend- and Seasonality-Corrected
Exponential Smoothing (continued)
After observing demand for period t+1, revise estimates for level, trend, and
seasonal factors as follows:
Lt+1 = (Dt+1/St+1) + (1-)(Lt+Tt)
Tt+1 = (Lt+1 - Lt) + (1-)Tt
St+p+1 = (Dt+1/Lt+1) + (1-)St+1
 = smoothing constant for level
 = smoothing constant for trend
 = smoothing constant for seasonal factor
Example: Tahoe Salt data. Forecast demand for period 1 using Winter’s model.
Initial estimates of level, trend, and seasonal factors are obtained as in the static
forecasting case

© 2004 Prentice-Hall, Inc. 7-37

 Trend- and Seasonality-Corrected
Exponential Smoothing Example (continued)
L0 = 18439 T0 = 524 S1=0.47, S2=0.68, S3=1.17, S4=1.67
F1 = (L0 + T0)S1 = (18439+524)(0.47) = 8913
The observed demand for period 1 = D1 = 8000
Forecast error for period 1 = E1 = F1-D1 = 8913 - 8000 = 913
Assume  = 0.1, =0.2, =0.1; revise estimates for level and trend for
period 1 and for seasonal factor for period 5
L1 = (D1/S1)+(1-)(L0+T0) = (0.1)(8000/0.47)+(0.9)(18439+524)=18769
T1 = (L1-L0)+(1-)T0 = (0.2)(18769-18439)+(0.8)(524) = 485
S5 = (D1/L1)+(1-)S1 = (0.1)(8000/18769)+(0.9)(0.47) = 0.47

F2 = (L1+T1)S2 = (18769 + 485)(0.68) = 13093

© 2004 Prentice-Hall, Inc. 7-38

 Measures of Forecast Error
 Forecast error = Et = Ft - Dt
 Mean squared error (MSE)
MSEn = (Sum(t=1 to n)[Et2])/n
 Absolute deviation = At = |Et|
 Mean absolute deviation (MAD)
MADn = (Sum(t=1 to n)[At])/n
 = 1.25MAD

© 2004 Prentice-Hall, Inc. 7-39

 Measures of Forecast Error
 Mean absolute percentage error (MAPE)
MAPEn = (Sum(t=1 to n)[|Et/ Dt|100])/n
 Bias
 Shows whether the forecast consistently under- or overestimates
demand; should fluctuate around 0
biasn = Sum(t=1 to n)[Et]
 Tracking signal
 Should be within the range of +6
 Otherwise, possibly use a new forecasting method
TSt = bias / MADt

© 2004 Prentice-Hall, Inc. 7-40

 Forecasting Demand at Tahoe Salt
 Moving average
 Simple exponential smoothing
 Trend-corrected exponential smoothing
 Trend- and seasonality-corrected exponential
smoothing

© 2004 Prentice-Hall, Inc. 7-41

 Forecasting in Practice
 Collaborate in building forecasts
 The value of data depends on where you are in the
supply chain
 Be sure to distinguish between demand and sales

© 2004 Prentice-Hall, Inc. 7-42

 Summary of Learning Objectives
 What are the roles of forecasting for an enterprise and
a supply chain?
 What are the components of a demand forecast?
 How is demand forecast given historical data using
time series methodologies?
 How is a demand forecast analyzed to estimate
forecast error?

© 2004 Prentice-Hall, Inc. 7-43