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Demand Planning and Forecasting Session 3

Demand Forecasting Methods-1 By K. Sashi Rao Management Teacher and Trainer

Forecasting in Business Planning
Inputs
Market Conditions Competitor Action Consumer Tastes Products Life Cycle Season Customers plans

Economic Outlook
Business Cycle Status Leading Indicators-Stock Prices, Bond Yields, Material Prices, Business Failures, money Supply, Unemployment

Forecasting Method(s) Or Model(s)
Management Team

Outputs Estimated Demands for each Product in each Time Period Other Outputs

Other Factors
Legal, Political, Sociological, Cultural Processor

Forecast Errors Feedback

Sales Forecast Forecast and Demand for Each Product In Each Time Period

Production Capacity Available Resources Risk Aversion Experience Personal Values and Motives Social and Cultural Values Other Factors

Forecasting Methods

Forecasting

Qualitative Or Judgmental

Quantitative Or Statistical

Projective

Causal

Forecasting Basics
‡ Types
± Qualitative --- based on experience, judgment, knowledge; ± Quantitative --- based on data, statistics;

‡ Methods
± Naive Methods --- using ball-park numbers; or assuming future demand same as before ± Formal Methods --- systematic methods thereby reduce forecasting errors using:
‡ time series models (e.g. moving averages and exponential smoothing); ‡ causal models (e.g. regression)

we can use that understanding to develop a demand forecast. ‡ ‡ ‡ . They seek to establish product demand relationships to relevant factors and/or variables e. Test marketing is an example of this approach. EXPERIMENTAL APPROACHES: When an item is "new" and when there is no other information upon which to base a forecast. is to conduct a demand experiment on a small group of customers and extrapolated to the wider population. hot weather to cold drinks consumption.g. If we can understand what that reason (or set of reasons) is. TIME SERIES APPROACHES: A time series is a collection of observations of welldefined data items obtained through repeated measurements over time. They could be experts or opinion leaders.Forecasting Approaches(1) ‡ JUDGEMENTAL APPROACHES: The essence of the judgmental approach is to address the forecasting issue by assuming that someone else knows and can tell you the right answer. RELATIONAL/CAUSAL APPROACHES: There is a reason why people buy our product.

Forecasting Approaches(2) ‡ In general. judgment and experimental approaches tend be more qualitative ‡ While relationship/causal and time series approaches tend be more quantitative ‡ Still. these qualitative methods are also scientifically done with results that are expressed in indicative numbers and broad trends ‡ Time series/causal methods are completely based on statistical methods and principles .

therefore are useful for new products/services Approaches vary in sophistication from scientifically conducted surveys to intuitive hunches about future events.Qualitative Approach ‡ Qualitative Approach 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. The approach/method that is appropriate depends on a product s life cycle stage ‡ Qualitative Methods Educated guess Executive committee consensus Delphi method Survey of sales force Survey of customers Historical analogy Market research .

suppliers.managers. customers. citizen groups or voter groups for election polls ‡ Sales Force Composites. bankers and shareholders ‡ Historical analogy. this could be for product demand or sales forecasting . also for opinion surveys amongst employees.this involves a bottom up method where each individual/respondent contributes to the overall result.where the similar bottom up approach is used for building up sales forecasts on any criteria like region-wise or product wise sales territory groupings from sales force personnel ‡ Consensus of Executive Opinion -normally used in strategy formulation by sought opinions from key organizational stakeholders.used for forecasting new product demand as similar to the previously introduced new product benefiting from its immediacy that same demand influencing factors will apply .Forecasting Methods -judgmental approach(a) ‡ Surveys .

Their replies are analyzed. administering and integrating member views into a meaningful whole ‡ Course Booklet has a separate chapter on the Delphi method( page 107 onwards) . difficulties do exist in planning. the final panel forecast is considered as fairly accurate and authentic ‡ Yet.Forecasting Methods -judgmental approach(b) ‡ Consensus thro Delphi method especially for new product developments and technology trends forecasting ‡ It is the most formal judgmental method and has a well defined process and overcomes most of the problems of earlier consensus by executive opinion ‡ This involves sending out questionnaires to a panel of experts regarding a forecast subject. summarized. By going thro such an iterative process say 3-4 times. processed and redistributed to the panel for revisions in light of other s arguments and viewpoints.

Forecasting Methods -judgmental approach(c) Method Short term accuracy POOR POOR TO FAIR VERY GOOD POOR FAIR TO GOOD Medium term accuracy POOR POOR TO FAIR GOOD FAIR TO GOOD FAIR TO GOOD Long term accuracy VERY POOR POOR FAIR FAIR TO GOOD FAIR TO GOOD Cost Personal insights Panel consensus Market survey Historical analogy Delphi method VERY LOW LOW VERY HIGH MEDIUM HIGH .

and newly thro internet modes.based on selected and accepted individuals/families on their buying behavior .thro extensive formal market research using personal or mail interviews.Forecasting Methods . customer attitudes. gives extensive clues on buying factors.experimental approach ‡ Customer surveys. patterns and expenditures captured using electronic means direct from retailer sales data.often used after product development but before national launches by starting in a selected target market/geography to understand any problems or issues to fine-tune marketing plans and avoid costly mistakes before going in a big way ‡ Customer buying data bases. brand loyalty and brand switching and response to promotional offers .particularly used in initial stages of product development and design to match product attributes to customer expectations ‡ Test marketing. also build demand models for a new product by an aggregated approach ‡ Consumer panels.

age. we need to find the nature and extent of these causes/relationships in mathematical terms as regression( linear/multiple)equations ‡ Once done. sex etc to consumer needs/wants/expectations( dependent variables) ‡ Before linking these. disposable incomes.relationship/causal approach(1) ‡ Its basic premise is that relationships exist between various independent demand variables( like population.Forecasting Methods . income. they can be used to forecast the dependent variable for available independent variables ‡ Various types of causal methods follow in next slide .

driven by keyed-in product sales forecasts. introduction/growth/maturity/decline) particularly in short life cycle sectors like fashion and technology . to reflect market realities and imitate customer choices ‡ Life-cycle models which recognize product demand changes during its various stages(i.e.Forecasting Methods . again in macro-economic situations ‡ Simulation models used to establish raw materials and components demand based on MRP schedules .relationship/causal approach(2) ‡ Econometric models like discrete choice and multiple regression models used in large-scale or macro-level economic forecasting ‡ Input-output models used to estimate the flow of goods between markets and industries.

g. and any random/unexplained noise where actual value= underlying pattern+ random noise) . uses historical demand/sales data to determine future demand ‡ Basic assumptions are that : ‡ Past data/information is available ‡ This data/information can be quantified ‡ Past patterns will continue into the future and projections made( though in reality may not always be the case !) ‡ They involve statistical methods of understanding and explaining patterns in time series data( like constant series e. growing expenditure with incomes.g. annual rainfall. seasonal series e.time series approach(1) ‡ Fundamentally. umbrella demand during rainy season. trends e.g.Forecasting Methods .

Forecasting Methods -time series approach(2) ‡ Static elements: ‡ ‡ ‡ ‡ Trend Seasonal Cyclical Random ± ± ± ± Moving average Simple exponential smoothing Exponential smoothing (with trend) Exponential smoothing (with trend and seasonality) ‡ Adaptive elements: 7-15 .

technology or long term movement ‡ Seasonal component.erratic.Time Series -static elements ‡ Trend component.regular up and down fluctuations due to weather and/or seasons whose pattern repeats every year ‡ Cyclical component. residual fluctuations due to random events or occurrences like one time drought or flood events . unsystematic. due to population.repeated up and down movements. due to economic or business cycles lasting beyond one year but say every 5-6 years ‡ Random component.persistent overall downward or upward pattern.

taking only past 3 months data as relevant for forecasting for next quarter with same weightage.time series approach(3) ‡ Basic concepts involved are those of moving averages and exponential smoothing ‡ A simple average forecast method is usable if past pattern is very stable. hence are of limited use ‡ A moving average takes the average over a fixed number( by choice) of previous periods ignoring older data periods giving a sense of immediacy to the data used e. Its handicaps are overcome by exponential smoothing ‡ Exponential smoothing is based on idea that as data gets older it becomes less relevant and should be given a progressively lower weightage on a non-linear basis .Forecasting Methods . but very few time series are stable over long periods. later improved by weighted moving averages with unequal weightage ‡ All moving averages suffer in that(a) all historically used data are given same /unequal weight and (b) works well only when demand is relatively constant.g.

Store 3 years of data (63 million data points). Update forecasts monthly. ± ± ± ± ± 70.Forecasting Examples ‡ Examples from Projects: ± ± ± ± ± ± Demand for tellers in a bank. .000 items. Traffic flow at a major junction Pre-poll opinion survey amongst voters Demand for automobiles or consumer durables Segmented demand for varying food types in a restaurant Area demand for frozen foods within a locality ‡ Example from Retail Industry: American Hospital Supply Corp. 25 stocking locations. 21 million forecast updates per year.

Components of an Observation Observed demand (O) = Systematic component (S) + Random component Level (current deseasonalized demand) (R) 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 7-19 .

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 7-20 .

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 7-21 .

Adaptive Forecasting ‡ The estimates of level. 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) 7-22 . trend.

only a certain amount of historical data is relevant to the future. all past periods were given equal weightage. and this process is repeated for subsequent periods ‡ In above example. implying that we can ignore all observations older than some specified age ‡ A moving average uses this approach by taking average demand over a fixed number of previous periods( say 3 as in below example) ‡ Example: If product demand is 150.Moving Averages(1) ‡ This is the simplest model of extrapolative forecasting ‡ Since demand varies over time. then forecast for 4th month is (150+130+125)/3= 135. 130 and 125 over the last 3 months. then forecast for 5th month is (130+125+135)/3= 130. If actual demand in 4th month is 135 as forecasted( their differences are forecasting errors which will discuss later). which can then be differentially weighted to give more importance to most recent periods .

Moving Averages(2) ‡ 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 7-24 .

. 3 2 1 today .Moving Averages(3) ‡ Include n most recent observations ‡ Weight equally ‡ Ignore older observations weight 1/n n ..

Problem when 1000's of items are being forecast. ‡ Issues with moving average forecasts: ± ± ± ± All n past observations treated equally. Requires that n past observations be retained.  Dt 1 n ) n 1 t Ft 1 ! D §n i n i !t 1 ‡ Note that the n past observations are equally weighted.Moving Averages(4) ‡ Forecast Ft is average of n previous observations or actual Dt : 1 Ft 1 ! ( Dt  Dt 1  . . Observations older than n are not included at all.

Moving Averages(5) Internet Unicycle Sales 450 400 350 300 250 200 150 100 50 0 Apr-01 Sep-02 Jan-04 May-05 Oct-06 Feb-08 Jul-09 Nov-10 Apr-12 Aug-13 n=3 Units Month .

Simple Moving Averages(6) example Month Chosen 3 months moving average Jan Feb Mar Apr May June July Aug Sep 24500 27000 19950 26000 21200 18900 17500 19000 18525 23817 24317 22383 22033 19200 18467 Actual Sales Forecast .

‡ Idea is to give more importance to most recent observations ‡ But problems relate to the logic of deciding the number of past periods and the given differential weightage ‡ Generally.10)= 75+39+15= 129.30+130x0.60.9.60+ 130x0.10)= 127.Weighted Moving Averages(1) ‡ This is to overcome the lacuna of ALL past periods being given SAME importance ‡ Here. and further forecast for 5th month as (129x0.60+125x0.30 and 0. then forecast for 4th month is ( 125x0. and so on .30+ 150x0. 0. then a smaller n and using weightage factors is better .10( totaling 1 or 100%) . if not. let us take past periods weightage as 0. different past periods are given different weightage ‡ In same earlier example.. if the demand is stable. then larger n values are chosen.

25 Jan Feb Mar Apr May June July Aug Sep 24500 27000 25500 26000 21200 18900 17500 19000 18525 25700 26100 23715 21365 18845 Actual Sales Forecast .45.immediate past as 0. then 0.30 and then 0.Weighted Moving Averages(2)-example Month Chosen 3 months moving average Weightage.

Moving Averages. they can be used for forecasting . then time series data patterns need looking into ‡ These data patterns relate to trend.closing remarks ‡ All moving average methods( besides exponential smoothing to be taken up later) focus on short term forecasting and provide such capability without consideration of any time series patterns ‡ But when medium term( say 1 year) or long term( 5 years or more) forecasting needed. cyclical. seasonal and random forms( as introduced earlier) ‡ Once these patterns are extracted from a given time series data .

98 .Time Series Patterns(1) 50. 98 . 98 . 7-32 1 .000 20.000 0 4 1 2 2 3 3 4 1 2 3 4 99 . 99 . 97 .000 40. 97 . 99 . 97 . 00 . 98 . 99 .000 30.000 10.

Time Series Patterns(2) 50000 40000 Demand 30000 20000 10000 0 1 2 3 4 5 6 7 8 9 10 11 12 Period Dt Dt-bar 7-33 .

Time Series Patterns(3) .

Time Series Patterns(4) .

product sales is dependent on its price ‡ Need to identify the independent and dependent variables ‡ Causal forecasting is illustrated by linear regression .Causal Forecasting(1) ‡ Basic idea is to use a cause or a relationship between and amongst variables as a forecasting method e.g.

Gradient r ( >0) r (<0) Intercept q Independent variable S .Linear Regression ‡ It looks for a relationship of the form: ‡ Dependent variable(P)= q+ r multiplied by independent variable (S) or P= q+ r S where: ‡ q= intercept and r= gradient of the line Dependent ‡ Variable P .

example ‡ A manufacturer of critical components for two wheelers is interested in forecasting the trend in demand during the next year as a key input to its annual planning exercise.Linear Regression . We need to develop a linear regression equation to extract the trend component of the time series and use it for predicting the future demand for components . Information on past demand is available for last three years( next slide).

Q3 Year 2.) ACTUAL DEMAND(Y) .Q4 Period Number(X) 1 2 3 4 5 6 7 8 9 10 11 12 360 438 359 406 393 465 387 464 505 618 443 540 example(contd.Q1 Year 2 -Q2 Year 2.Q4 Year 3.Linear Regression ACTUAL DEMAND FOR LAST THREE YEARS( in 000 units) PERIOD Year 1.Q4 Year 2.Q3 Year 1.Q2 Year 1.Q1 Year 3.Q3 Year 3.Q2 Year 3.Q1 Year 1.

Q4 Year 3.Q3 Year 3.Q2 Year 3.Q1 Year 2 -Q2 Year 2.) XY XX X PERIOD Number 1 2 3 4 5 6 7 8 9 10 11 12 Y ACTUAL DEMAND(Y) 360 438 359 406 393 465 387 464 505 618 443 540 360 876 1078 1625 1965 2790 2709 3712 4545 6180 4873 6480 1 4 9 16 25 36 49 64 81 100 121 144 SUM 78 5379 37193 650 .Linear Regression Period PERIOD Year 1.Q4 example(contd.Q2 Year 1.Q1 Year 3.Q1 Year 1.Q3 Year 1.Q4 Year 2.Q3 Year 2.

91+ 15.25 ‡ Then the gradient r = 37193-(12x6.59S ‡ Thus Forecast for Year 4 Q1= 346.59 ‡ The intercept q = 448.5/143= 15.59x14= 565 ‡ Forecast for Year 4 Q3= 346.91+ 15.91 ‡ Final regression equation is P= 346.91+ 15.59x13= 550 ‡ Forecast for Year 4 Q2= 346.91+ 15.25-15.50= 346. the regression coefficients are worked out as X= 78/12= 6.Linear Regression example(contd.50x448.59x16= 596 .50x6.50 and Y= 5379/12= 448.50)= 2229.25)/650(12x6.91+ 15.) ‡ Linear regression equation P= q+ rS ‡ Using method of least squares.59x15= 581 ‡ Forecast for Year 4 Q4= 346.59x6.

Multiple Regression ‡ When there are many independent variables involved which influence a dependent variable then issues become complicated ‡ Then not only linear regression equations are required but also multiple regression analysis is involved where the interdependency of the various independent variables are taken into account ‡ These involve complex statistics beyond the scope of this course ‡ For their practical use. SPSS and other software packages . advanced techniques and tools are available thro MS Excel tools.