Chapter 3 Demand

Forecasting
James Kaconco
0772 653191
 Chapter Objectives
• By the end of the chapter students should be in position
to
1. Define Forecast and List fields in which forecasts are
applied
2. List elements of a good forecast
3. List and explain components of forecasts
4. List the principles of forecasting
5. Apply forecasting methods (qualitative and
quantitative)
6. Determine forecast accuracy
 Forecasting Defined & Areas of
Application
• Forecast: statement about the future; value of a variable of interest
(occurrence, timing and magnitude of uncertain events).
– Managers of business firms attempt to predict how much of
their product will be demanded in the future
– Forecasts results in more accurate inventory and the smooth
operations of business organizations
– Forecasts provide information that can assist managers in
guiding future activities towards meeting organizational goals
• Forecasts are used to plan the utilization of a productive
system and focuses on:
– Plan the system (long-range plans) - used for location, capacity, and
new-product decisions
– Plan the use of the system (short-range plans) - such as those for
production-and-inventory control, labor levels, and cost controls–can rely
more on recent history
– Provide future goals (customer satisfaction, technological changes, etc)
 Forecasting Objectives and Uses
• Forecast Objectives
– Improve customer satisfaction (how much inventory to carry)
– Better use of capacity (based on demand forecast, personnel
level required)
– Improved profitability (efficient operations - cost of raw
materials)

• Areas of forecast applications

– Production / operations
– New product development and Human Resource
– Marketing
– Finance and accounting
– IT and MIS
– Sports betting
 Elements of a good Forecast

1. Reliable: It should work consistently

2. Accurate: Degree of accuracy should be stated
3. Meaningful: It should be expressed in meaningful
units
4. Written: To guarantee use of the same information
and to make easier comparison to actual results.
5. Timely: Forecasting horizon must cover the time
necessary to implement possible changes
6. Easy to use: Users should be comfortable working
with the forecast
 Components of Forecasts
1. Time Frame: How far in the future to forecast
(Short, Medium and or Long)
2. Demand Behavior
a.Trend is a gradual, long-term, up-or-down movement of demand (positive,
negative, stagnant)
b.Cyclic is an up-and-down repetitive movement in demand (covers a period of
more than a year)
c.Seasonality is an up-and-down, repetitive movement within a trend occurring
periodically (follows seasons within a year, weeks in a month, days in a week,
hours in a day)
d.Random variations are movements that are not predictable and follow no
pattern (and thus are virtually unpredictable).
• Promotions
• Disasters
• Negative publicity
• Regulations
 Forecasting Principles
1. Forecasts are always wrong; forecasting is rarely
perfect (deviation is expected).
2. Every forecast should include an estimate of error.
Errors follow a normally distributed curve
3. Forecasts are more accurate for groups of products
than the forecast for individual items.
4. Forecast are more accurate for shorter than longer
time periods
5. Forecasting techniques assume that there is some
degree of stability in the system, and what happened
in the past will continue to happen in the future
6. Many types of forecasting models exist; each differ in
complexity and amount of data needed
 Forecasting Methods
• Qualitative methods – Subjective or Judgmental
methods
– Forecast generated subjectively or educated guesses
• based on experience and personal insights of forecaster
• Results may differ from individual to individual
– Used when there is need to make quick forecast
– Used when historical data is not available (new products and
technologies)
– Techniques Include: executive opinions, sales-force opinions,
consumer surveys, and the Delphi method
• Quantitative methods – Objective methods:
– Forecasts generated through mathematical modeling and heavily
depend on historical data
– Techniques include: time series, regression, and casual
(associative) methods
 Qualitative or Subjective Methods

• Based on intuition and informed opinion

Type Characteristics Strengths Weaknesses
Executive A group of managers Good for strategic or One person's opinion
opinion meet & come up with new-product can dominate the
a forecast forecasting forecast

Market Uses surveys & Good determinant of It can be difficult to

research interviews to identify customer preferences develop a good
customer preferences questionnaire

Delphi Seeks to develop a Excellent for Time consuming to

method consensus among a forecasting long-term develop
group of experts product demand,
technological
changes, and
 Quantitative or Objective Methods
• Time Series Models:
– A time series is a set of observations of a variable at regular
intervals over time.
• Independent variable is time (t)
• Dependent variable is demand (D)
– Time series model: assumes information needed to generate a
forecast is contained in a time series of data
– Assumes the future will follow same patterns as the past (trend,
cyclical, seasonal, random or irregular)
• Causal Models or Associative Models
– Explores cause-and-effect relationships
• Independent variable is cause other than time eg promotion,
regulation, income, etc
• Dependent variable is demand (D)
– Uses leading indicators (other than time) to predict the future
demand
• E.g. housing starts and appliance sales
 Time Series Models
• Time series methods are statistical techniques that
make use of historical data accumulated over a period
of time.
1. Naive
2. Simple Mean
3. Moving Average
4. Weighted Moving Average
5. Exponential smoothing
6. Adjusted exponential smoothing
7. Regression Model
8. Seasonality model
 Naïve Method
• The most simplest method
• Method is good for historical level patterns
• Forecast for tomorrow is demand of today
Ft+1 = Dt
ORDERS
MONTH PER MONTH FORECAST
Jan 120 -
120
Feb 90 90
100
Mar 100 75
110
Apr 75 50
75
May 110 130
110
Nov
June -
50 90
Time Series: Simple Mean or
Average

n
 Dt
t= 1
MAn =
n
where

n =number of periods in
the moving average
Dt =demand in period t
Time Series Model: Moving Average:
MA(n)
 Uses fixed number of period values during the recent
past to develop a forecast
• Fixed number of periods to consider in determining the
average is n
• The average moves while keeping (n) constant
• Each new demand value added pushes the oldest data
point out of the list
• Moving averages can smooth out fluctuations in any data
• More responsive to a trend but still lags behind actual data
• All data values contribute equally to the forecast
• Note:
– Moving average of order n=1 is the naïve method
 3-month Moving Average
(average of the last recent 3 periods is used as
forecast for next period)
ORDERS MOVING
AVERAGE 3
MONTH
Jan
PER
120 –  Di
MONTH i=1
– MA3 =
Feb 90 – 3
103.3
Mar 100 88.3 90 + 110 + 130
95.0
= 3
Apr 75 78.3
78.3
= 110 orders for Nov
May 110 85.0
105.0
June 50 110.0

July 75

Aug 130
 5-month Moving Average
(average of the last recent 5 periods is used as
forecast for next period)
ORDERS MOVING
AVERAGE 5
MONTH
Jan
PER
120 –  Di
MONTH i=1
– MA5 =
Feb 90 – 5
–
Mar 100 – 90 + 110 + 130+75+50
= 5
99.0
Apr 75 85.0
82.0 = 91 orders for Nov
May 110 88.0
95.0
June 50 91.0

July 75

Aug 130

Sept 110
Advantages and Disadvantages of
Moving Average method
• Advantages:
– Easy to use
– Quick to generate forecast
– Inexpensive
– Can provide forecast for short run (time)

• Disadvantages
– Does not react well to fluctuations that occur for a reason
– Requires large storage space (multiple items)
– Not suitable for medium and long run (time) forecast
 Time Series Models: Weighted
Moving Average: WMA(n)
• Previous demand data is weighted
• Fixed (n) periods are considered in forecast
• All weights must add to 100% or 1
e.g. for n = 3; weights might be 0.5, 0.3, 0.2;
n =2 weights might be 0.8, 0.2
• Recent data is assigned most weight, weight decrease
with historical data
– Weights are subjectively determined
• Each new demand value displaces the oldest data point
• Differs from the simple moving average that weighs all
periods equally - more responsive to trends
• Weighted average of recent n periods is used as
forecast for next period
• It further smoothens out demand fluctuations
 Weighted Moving Average
• Adjusts moving average method to more closely
reflect data fluctuations

n
WMAn =  Wi Di
i=1
where
Wi = the weight for period i,
between 0 and 100
percent
 W = 1.00
i
 Time Series: Exponential
Smoothing
• Method is an averaging method that weights
the most recent past data more strongly
than more distant past data.
– Reacts to both previous (demand and forecast)
data
 Need just three pieces of data to start:
 Last period’s forecast (Ft); initialization
 Last periods actual value (Dt)
– Smoothing coefficient, (α), is a number between 0
and 1 that enters multiplicatively into each
forecast but whose influence on demand declines
exponentially as the data become older.
Exponential Smoothing: Formula
and Initialization

Ft +1 = Dt + (1 - )Ft
where:
Ft +1 = forecast for next period
Dt = actual demand for present period
Ft = previously determined forecast for
present period
= weighting factor, smoothing constant
Effect of Smoothing Constant

 Range: 0  1
 And α is subjectively determined
If = 0.2, then Ft +1 = 0.2Dt + 0.8Ft

If = 0, then Ft +1 = 0Dt + 1Ft = Ft

Forecast does not reflect recent data

If = 1, then Ft +1 = 1Dt + 0Ft =Dt

Forecast based only on most recent data
 Exponential Smoothing (α=0.30)

PERIOD MONTH F2 = D1 + (1 - )F1

DEMAND
= (0.30)(37) + (0.70)(37)
1 Jan 37
= 37
2 Feb 40
F3 = D2 + (1 - )F2
3 Mar 41 = (0.30)(40) + (0.70)(37)
= 37.9
4 Apr 37
F13 = D12 + (1 - )F12
5 May 45 = (0.30)(54) + (0.70)(50.84)
= 51.79
6 Jun 50

7 Jul 43

8 Aug 47
 Exponential Smoothing
FORECAST, Ft + 1
PERIOD MONTH DEMAND ( = 0.3) ( = 0.5)
1 Jan 37 – –
2 Feb 40 37.00 37.00
3 Mar 41 37.90 38.50
4 Apr 37 38.83 39.75
5 May 45 38.28 38.37
6 Jun 50 40.29 41.68
7 Jul 43 43.20 45.84
8 Aug 47 43.14 44.42
9 Sep 56 44.30 45.71
10 Oct 52 47.81 50.85
11 Nov 55 49.06 51.42
12 Dec 54 50.84 53.21
13 Jan – 51.79 53.61
 Time Series Models: Seasonality
• Data is provided in seasons
• Calculate the total demand per season and for all
periods
• Calculate a seasonal index for each season
– Divide the actual demand of each season by
the total demand for all periods
• Forecast demand for the next year or period
using any of the time series models.
• Allocate the forecast to seasons using the
seasonality indices.
 Example - Seasonality
• Class example continued
Quarters
Period (t) Q1 Q2 Q3 Q4
1 42 24 22 32
2 31 16 14 29
3 33 21 14 32
4 27 17 11 20
5 41 21 17 31

Quarters
Forecast (Ft)
Exponential
Demand Smoothing (α Error
Period (t) Q1 Q2 Q3 Q4 (D t) = 0.6) (e t)
1 42 24 22 32 120 120.0 0.0
2 31 16 14 29 90 120.0 -30.0
3 33 21 14 32 100 102.0 -2.0
4 27 17 11 20 75 100.8 -25.8
5 41 21 17 31 110 85.3 24.7
6 35.2 20.0 15.7 29.1 100.1
Total 174 99 77.6 144 495
Index 0.35 0.20 0.16 0.29
 Measuring Forecast Error
• Forecast error is the deviation of the actual
from the forecast values.
– Errors will vary from plus to minus,
• over-forecasts = negative errors (forecast is biased high) and
• under-forecasts = positive errors (forecast is biased low)
– Errors tend to average out near zero if the forecast
is on target.
– Forecasts are never perfect
• Measuring forecast error:
e t = Dt – F t
– Errors help to determine reliability of forecasting
method
 Measuring Forecasting Accuracy
• Mean Absolute Deviation  actual  forecast
(MAD) MAD 
n
– measures the total error in a forecast
without regard to sign
• Cumulative Forecast Error
(CFE) CFE   actual  forecast 
– Measures any bias in the forecast

• Mean Square Error (MSE)  actual - forecast 2

MSE 
– Penalizes larger errors n
– Should be zero

CFE
• Tracking Signal TS 
– Measures if your model is working MAD
– Normally distributed

• Mean Absolute Percent

Deviation (MAPD)
– Measures absolute error as a
percentage of demand