CHAPTER 3 – DEMAND FORECASTING

Faculty of International Economic Relations

University of Economics and Law

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CONTENTS

 Forecasting characteristics
 Forecasting methods
 Time-series forecasting models
 Forecasting errors
 Forecasting issues

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FORECASTING CHARACTERISTICS

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FORECASTING CHARACTERISTICS

 Forecast is always inaccurate  should include expected value and

measure of error
 Long-term forecasts are less accurate than short-term forecasts
Trumpet of Doom
Fo re c ast Erro r R ange o ve r Tim e

P e rc e ntage
Fo re c as t 0
Erro r

0 Tim e U ntil Fo re c as t Eve nt

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FORECASTING CHARACTERISTICS

 Aggregate forecasts are more accurate than disaggregate forecasts

 Law of Large Number: As volume increases, relative variability
decreases
 The farther up the supply chain, the greater the distortion of
information

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FORECASTING METHODS

 Qualitative: primarily subjective; rely on judgment and opinion

 Time series: use historical demand only
 Causal: use the relationship between demand and some other
factors to develop forecast
 Simulation
o Imitate consumer choices that give rise to demand
o Can combine time series and causal methods

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FORECASTING COMPONENTS (TIME SERIES)

Observed demand (O) =

Systematic component (S) + Random component (R)
 Systematic component: expected value of demand
o Level: current deseasonalized demand
o Trend: growth or decline in demand
o Seasonality: predictable seasonal fluctuation
 Random component: The part of the forecast that deviates from the
systematic component
 Forecast error: difference between forecast and actual demand
 Naïve Techniques & Averaging Techniques

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MOVING AVERAGE

A t-1 + A t-2 + A t-3 +...+A t- n

Ft =
n

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

 Used when demand has no observable trend or seasonality

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MOVING AVERAGE

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

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MOVING AVERAGE

950
900
850
800
Demand
Demand

750
3 Week
700
6 Week
650
600
550
500
1 2 3 4 5 6 7 8 9 10 11 12
Week

fewer n  more responsive  more accurate

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SIMPLE EXPONENTIAL SMOOTHING FORECAST

FFtt == FFt-1
t-1
+
+ (A
(A t-1
t-1
-
- F
F )
t-1)
t-1

Where :
Ft  Forecast v alue for the coming t time period
Ft - 1  Forecast v alue in 1 past time period
At - 1  Actual occurance in the past t tim e period
  Alpha smoothing constant

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SIMPLE EXPONENTIAL SMOOTHING FORECAST

Week Demand Question:

Question:Given
Giventhe
theweekly
weeklydemand
demand
1 820 data,
data,what
whatare
arethe
theexponential
exponential
2 775 smoothing
smoothingforecasts
forecastsfor
forperiods
periods2-
2-
3 680 10
10using
usingalpha
alpha==0.10
0.10and
andalpha
alpha==
4 655 0.60?
0.60?
Assume
AssumeFF1=D
=D1
5 750 1 1

6 802
7 798
8 689
9 775
10

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SIMPLE EXPONENTIAL SMOOTHING FORECAST

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

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SIMPLE EXPONENTIAL SMOOTHING FORECAST

850

800

750
Demand
Demand

700
0.1
650
0.6
600

550

500
1 2 3 4 5 6 7 8 9 10
Week

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TREND-ADJUSTED EXPONENTIAL SMOOTHING FORECAST

¿
¿
𝑇 𝑡 =𝛽 (𝐹 𝑡 − 𝐹 𝑡 −1 )+(1 − 𝛽)𝑇 𝑡 −1

𝐹 𝑡 :𝑒𝑥𝑝𝑜𝑛𝑒𝑛𝑡𝑖𝑎𝑙𝑙𝑦 𝑠𝑚𝑜𝑜𝑡h𝑒𝑑 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝑡h𝑒 𝑑𝑎𝑡𝑎 𝑠𝑒𝑟𝑖𝑒𝑠𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑡

𝑇 𝑡 :𝑒𝑥𝑝𝑜𝑛𝑒𝑛𝑡𝑖𝑎𝑙𝑙𝑦 𝑠𝑚𝑜𝑜𝑡h𝑒𝑑𝑡𝑟𝑒𝑛𝑑𝑖𝑛𝑝𝑒𝑟𝑖𝑜𝑑 𝑡
𝐴𝑡 :𝑎𝑐𝑡𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑 𝑖𝑛𝑝𝑒𝑟𝑖𝑜𝑑𝑡
¿
¿

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TREND-ADJUSTED EXPONENTIAL SMOOTHING FORECAST

Assume that the forecast of Period 1 is 27 units and its trend is 0.

Alpha= 0.3; Beta= 0.6. The actual demand of Period 1 turned out to
be 30 units.
1. Calculate the forecast of Period 2.
2. The actual demand of Period 2 is 34 units. Calculate the forecast
of Period 3.

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LINEAR REGRESSION

^ ^𝑥
^ +𝑏
𝑦 =𝑎
^𝑦 : 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 𝑓𝑜𝑟 𝑑𝑒𝑝𝑒𝑛𝑑𝑒𝑛𝑡 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑦
𝑥:𝑖𝑛𝑑𝑒𝑝𝑒𝑛𝑑𝑒𝑛𝑡 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑥,𝑢𝑠𝑒𝑑𝑡𝑜 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 𝑦
𝑎^ : 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑𝑖𝑛𝑡𝑒𝑟𝑐𝑒𝑝𝑡𝑡𝑒𝑟𝑚 𝑓𝑜𝑟 𝑡h𝑒𝑙𝑖𝑛𝑒
^
𝑏:𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑠𝑙𝑜𝑝𝑒𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑓𝑜𝑟 𝑡h𝑒 𝑙𝑖𝑛𝑒

^
𝑏=
∑ 𝑥𝑦 − 𝑛 𝑥 𝑦
∑ 𝑥2 − 𝑛 𝑥2
^𝑥
^ = 𝑦 −𝑏
𝑎

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LINEAR REGRESSION

Month Demand
1 8
2 12
3 25
4 40
5 50
6 65
7 36
8 61
9 88
10 63
11 ?
12 ?
13 ?

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TREND-CORRECTED EXPONENTIAL SMOOTHING (HOLT’S MODEL)

𝐷𝑡 =𝑎𝑡 +𝑏
𝐹 𝑡 +1=𝐿𝑡 + 𝑇 𝑡

¿
𝑇 𝑡 +1= 𝛽( 𝐿𝑡 +1 − 𝐿𝑡 )+(1 − 𝛽) 𝑇 𝑡
𝐿𝑡 : 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝑜𝑓 𝑙𝑒𝑣𝑒𝑙𝑖𝑛𝑝𝑒𝑟𝑖𝑜𝑑 𝑡
𝐿0 𝑎𝑛𝑑𝑇 0 𝑎𝑟𝑒 𝑜𝑏𝑡𝑎𝑖𝑛𝑒𝑑 𝑓𝑟𝑜𝑚𝑟𝑒𝑔𝑟𝑒𝑠𝑠𝑖𝑜𝑛!

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TREND-CORRECTED EXPONENTIAL SMOOTHING (HOLT’S MODEL)

Japan National Tourist Organization has reported a constant increase in

number of visitors to Japan during the last ten years. For example, the
number of visitors to Japan from other Asian countries during the period of
2002–2007 has been 3,417,774; 3,511,513; 4,208,095; 4,627,478;
5,247,125; and 6,130,262 annually. Forecast the number of visitors for 2008
using trend-corrected exponential smoothing with Alpha = 0.1, Beta = 0.2.

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TIME SERIES WITH SEASONALITY (WITHOUT TREND)

1. Compute the average historical demand each season

2. Compute the average demand over all months
3. Compute a seasonal index for each season (Step 1/ Step 2)
4. Estimate next year’s total annual demand
5. Estimate demand for each month in the next year (Step 4/n * Step 3)

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TIME SERIES WITH SEASONALITY (WITHOUT TREND)

Month Year 1 Year 2 Year 3

Jan 80 85 105
Feb 70 85 85
Mar 80 93 82
Apr 90 95 115
May 113 125 131 Year 4’s forecast: 1,200 units
Jun 110 115 120
Jul 100 102 113
Aug 88 102 110
Sep 85 90 95
Oct 77 78 85
Nov 75 82 83
Dec 82 78 80

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TIME SERIES WITH SEASONALITY (WITHOUT TREND)

140

120

100

80

60

40

20

0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Year 1 Year 2 Year 3

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TREND- AND SEASONALITY-CORRECTED EXPONETIAL SMOOTHING (WINTER’S
MODEL)

𝐹 𝑡 +1=(𝐿𝑡 +𝑇 𝑡 )𝑆𝑡 +1
¿
𝑇 𝑡 +1= 𝛽( 𝐿𝑡 +1 − 𝐿𝑡 )+(1 − 𝛽) 𝑇 𝑡
𝑆 𝑡 +𝑝+1=𝛾 (𝐷𝑡 + 1 /𝐿𝑡 +1 )+(1 −𝛾)𝑆 𝑡 +1

¿
¿
¿

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TREND- AND SEASONALITY-CORRECTED EXPONETIAL SMOOTHING (WINTER’S
MODEL)

1. De-seasonalize demand
2. Run linear regression to estimate level and trend
3. Estimate seasonal factors
4. Calculate the forecast for any period

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FORECAST ERRORS

e t = A t  Ft
Where :
et  Forecast error for period t
At  Actual demand for period t
Ft  Forecast for period t

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FORECAST ERRORS

Mean Squared Error Mean Absolute Deviation (MAD)

n
n
|e |
e 2
t MAD  t 1
t

MSE  t 1 n
n

Mean Absolute Percentage Error (MAPE)

100 n et
MAPE  
n t 1 At

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SELECTING THE SMOOTHING CONSTANT

Period Demand Simple exponential smoothing forecast:

1 180  Alpha = 0.1
2 168  Alpha = 0.5
3 159
 Forecast of Period 1 = 175
4 175
 Which alpha is preferred?
5 190
Hints: MSE and MAD
6 205
7 180
8 182

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TRACKING SIGNAL

e t
TS  t 1
MAD

If TS [6, 6]  There is bias in the forecast

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TRACKING SIGNAL

3.0
2.5
Period Demand Forecast 2.0
1 90 100 1.5

2 95 100 1.0

3 115 100 0.5

0.0
4 100 110 0 1 2 3 4 5 6 7
-0.5
5 125 110
-1.0
6 140 110 -1.5
-2.0
-2.5

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FORECASTING REMARKS

 No single technique works best in every situation

 Should use more than one forecasting method
 Factors to consider: cost, accuracy, the data availability & software,
time needed to gather & analyze data
 The higher the accuracy, the higher the cost

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FORECASTING PROCESS

 Determine purpose of forecast

 Establish a time horizon
 Select a forecasting technique
 Obtain, clean, and analyze data
 Make a forecast
 Monitor the forecast

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 CHAPTER 3 – DEMAND FORECASTING

THANK YOU!

33 Het begint met een idee