Demand Forecasting

5 - 1
Section Objectives

After completing this section, you should be able to:

1. List the features of a good forecast.
2. Outline the steps in the forecasting process.
3. Compare and contrast qualitative and quantitative approaches to
forecasting.
4. Identify three qualitative forecasting methods.
5. Briefly describe averaging techniques, trend and seasonal techniques
and regression analysis, and solve typical problems.
6. Describe two measures of forecast accuracy.
7. Describe two ways of evaluating and controlling forecasts.
Demand Forecasting
5 - 2
Features of Forecasts
1. Causal System. Forecast techniques generally assume that the
same underlying causal system that existed in the past will
continue to exist in the future.
2. Forecast Error. Forecasts are rarely perfect; actual results usually
differ from predicted values.
3. Group Forecasts. Forecasts for groups of items tend to be more
accurate than forecasts for individual items because forecasting
errors among items in a group usually have a canceling effect.
4. Accuracy and Time. Forecast accuracy decreases as the time
period covered by the forecast (i.e. the time horizon) increases.
Generally, short-term forecasts must deal with fewer uncertainties
than long-term forecasts.
Demand Forecasting
5 - 3
Forecast Process
The process of forecasting has four clearly definable steps:
1. Determine the purpose of the forecast. The use to which the forecast will
be used will determine both the technique to be used and the frequency
with which the forecast has to be updated.
2. Establish a time horizon. How far forward are we interested in
forecasting? Next week? Next month? Next year? Next 20 years? The
choice of horizon affects the choice of technique and this, in turn,
determines the amount of data and effort needed to prepare the forecast.
3. Prepare the forecast. This involves four steps:
a. Identify the assumptions in the forecast model you propose to use.
b. Gather the data.
c. Analyze the data.
d. Forecast.
4. Monitor the results. It is necessary to monitor forecast results to
determine whether certain underlying factors in the model have
undergone change. Has the trend weakened? Strengthened? Is the
seasonal variation the same as in prior periods?

Demand Forecasting
5 - 4
Types of Forecasts
1. Qualitative - consists mainly of subjective inputs such as human
factors, personal opinions or hunches which may be difficult or
impossible to quantify.
2. Quantitative - involve the extension of historical data or
development of associative models.
Time Series - extension of historical data by identifying
patterns in the past that might reasonably be expected to
continue in the future.
Causal models - development of an association between the
variable we are interested in forecasting and one or more
variables that might explain the variable of interest.

Demand Forecasting
5 - 5
Classification of Forecasting Models
Trend
Projection
Trend and
Seasonal
Simple Moving
Averages
Weighted Moving
Averages
Moving
Averages
Simple Exponential
Smoothing
Exponential Smoothing
with Trend
Exponential Smoothing
with Seasonal Variation
Exponential Smoothing
with Trend and Seasonal
Exponential
Smoothing
Smoothing
Methods
Time Series
Models
Causal or
Regression Models
Statistical
Expert
Opinion
Market
Surveys
Delphi
Method
Judgemental
Forecasting
Demand Forecasting
5 - 6
Operations Forecasting: Uses and Methods
Uses of
Forecasting for
Operations
Time
Horizon
Accuracy
Required
Management
Level
Forecasting
Methods
Location Long Medium Top
Qualitative
and Causal
Capacity Planning:

Facilities

Equipment


Long

Medium


Medium

High


Top

Middle


Qual. & Causal

Causal & T.S.
Scheduling / MRP Short Highest Lower Time Series
Order Processing Short Highest Lower Time Series
Demand Forecasting
5 - 7
Qualitative Forecasting Methods
Executive Opinion. Forecasts that are based on the judgment and
experience of managers.
Sales Force Composite. Forecasts compiled from estimates of
demand made by members of a companys sales force
Consumer Surveys. A forecasting method that seeks input from
customers regarding future purchasing plans for existing products
or services.
Market Research. This method tests hypothesis about new products
or services or new markets for existing products or services.
Delphi Method. A forecasting technique using a group process that
allows experts to make forecasts.
Demand Forecasting
5 - 8
Quantitative Forecasting Methods
These can be broken into two main categories:
1. Time Series (TS) Models. A forecasting approach in which future
values of a series can be estimated from past values of the series.
Driving forward by looking at the rear view mirror. Types of TS
models include:
Simple Average / Moving Average / Weighted Moving Average
Exponential Smoothing: Single, Trend, Seasonal, and Trend
and Seasonal
Trend Projection
2. Associative (Causal) Models. A forecasting method which
identifies related variables that can be used to predict values of the
variable of interest. The essential element is the development of
an equation that summarizes the effects of predictor variables.
The primary method of analysis is known as regression.
Demand Forecasting
5 - 9
Time Series Models
A time series is a time-ordered sequence of observations taken at regular
intervals over a period of time. Analysis of a time series requires an
identification of the underlying behaviour of the series. This behaviour
may have four patterns:

1. Trend refers to a gradual, long-term movement in the data.
Population shifts, changing incomes and cultural changes often
account for such movements.
2. Seasonality refers to short-term, fairly regular variations that are
generally related to weather factors or to human-made factors such
as holidays.
3. Cycles are wavelike variations of more than one years duration.
These are often related to a variety of economic and political factors.
4. Irregular variations are due to unusual circumstances such as severe
weather conditions, strikes or a major change in a product or service.
They do not reflect typical behaviour, and they should be removed
from the data before any analysis is done.
5. Random variations are the residual variations that remain after al the
other behaviours have been accounted for.
Demand Forecasting
5 - 10
Application of Forecasting Methods
Combination of Components
in the Series

Objectives
Models Often
Appropriate
No trend (horizontal trend), no seasonal variation;
i.e. a stable variation with random fluctuation
No trend, but seasonal variation
Trend, but no seasonal variation
Trend and seasonal variation
Patterns of changes not related to time
To average out
randomness and
find average
To determine seasonal
pattern and project it or
average out seasonality
Short term projection

Long term projection
To project trend and
seasonal variation
around it
To identify variables
that explain level
of demand
Simple moving average
Weighted moving average
Single exponential smoothing
Simple moving average

Time series decomposition
Double exponential smoothing

Time series decomposition
Triple exponential smoothing

Time series decomposition
Simple linear regression
Curvilinear regression
Multiple regression
Demand Forecasting
5 - 11
Seasonal Variations
200
300
400
500
600
700
Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec
2000
2001
2002
2003
2004
2005
The data in the graph is monthly sales for a six-year period. Each year is
graphed on top of the preceding one.

Question: What time series patterns exist in this data?
Demand Forecasting
5 - 12
Time Series: Averaging Techniques
1. Naive Forecasts - a naive forecast for any period equals the previous
periods actual value. Although it appears simplistic, it is a legitimate
forecasting technique:
it has virtually no cost
forecasts are quick and easy to prepare
easy to understand
can be used for seasonal data (e.g. sales for this December equal
sales for preceding December)
2. Moving Average - a forecasting technique that use a number of the most
recent actual data values in generating a forecast. There are two types:
a. Simple moving average = SMA = S
i
A
i
/ n
where
i
= the age of the data
n = the number of periods in the moving average
A
i
= actual value with age
i
Note that each data value has the same importance (i.e. weight)
Demand Forecasting
5 - 13
b. Weighted moving average = WMA = S
i
A
i
W
i
where W
i
= the relative weight of each data point in the moving
average
Note that the sum of all weights , SW
i
,

must equal 1.
For both the SMA and the WMA, a key issue is how many data points will
be used to calculate the average. A large number of data points results in
a smooth average: a small number of data points means the the model
responds very quickly to the most recent changes.
If responsiveness in important, a simple moving average with relatively
few data points, or a weighted moving average with a heavy weight on
recent data, should be used.
A decision maker must weigh the risk of responding quickly to what might
be random fluctuations in the data against the risk of responding slowly to
real changes.
Demand Forecasting
5 - 14
3. Exponential Smoothing - This is a special case of a weighted moving
average in which the weights are determined by mathematical formula,
rather than assigned by the decision maker.
Each new forecast is based on a percentage of the previous periods
demand and a percentage of the previous periods forecast. That is:
F
t + 1
= aD
t
+ (1-a)F
t
where F
t+1
= forecast of the time series for period t + 1
D
t
= actual value of the time series for period t
F
t
= forecast value for the time series for period t
a = smoothing constant (0 1)
Demand Forecasting
5 - 15

Alpha () is a weighting factor with values between zero and one.
The sensitivity of forecast adjustments is determined by this
smoothing constant.
The closer is to zero, the slower the forecast will be to adjust to
forecast errors (i.e. the greater the smoothing). Conversely, the
closer the value of is to 1.00, the greater the sensitivity and the
less the smoothing.
Commonly used values of range from .05 to .50.
Weight
Attached To
.1 .2 .3 .4 .5
Values
Impact of a Values on the Weight Attached to Observations in a Time Series


D
t

D
t-1

D
t-2

D
t-3

D
t-4

D
t-5

D
t-6

D
t-7



.1000
.0900
.0810
.0729
.0656
.0590
.0531
.0478
.2000
.1600
.1280
.1024
.0819
.0655
.0524
.0419
.3000
.2100
.1470
.1029
.0720
.0504
.0353
.0247
.4000
.2400
.1440
.0864
.0518
.0311
.0187
.0112
.5000
.2500
.1250
.0625
.0313
.0156
.0078
.0039
Demand Forecasting
5 - 16
Simple Moving Average - Illustration
Compute a three-period simple moving average forecast given demand for gizmos for the last five periods:
Period
1
2
3
4
5
Age
5
4
3
2
1
Demand
42
40
43
40
41
Solution = Forecast for Period 6
MA
3
= (43 + 40 + 41) / 3 = 41.33
If actual demand in period 6 is 39, the forecast for period 7 will be: MA
3
= (40 + 41 + 39) / 3 = 40.00

Note that in a moving average, as each new actual value becomes available, the forecast is updated by
adding the newest value and dropping the oldest and then recomputing the average. Therefore, the
forecast moves by reflecting only the most recent values.
3-Period Moving Average
25
30
35
40
45
50
2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Period
Demand
MA3
Demand
Demand Forecasting
5 - 17
Exponential Smoothing Models
1. Simple Model - assumes the time series is flat with no trend or seasonality.
F
t + 1
= D
t
+ (1-)F
t
2. Exponential Smoothing for Trend - assumes the time series has a long term
linear trend. Trend may exhibit growth or decline.
A
t
= D
t
+ (1-)(A
t-1
+ T
t-1
)
T
t
= b(A
t
- A
t-1
) + (1 - b)T
t-1

F
t + 1
= A
t
+ T
t
3. Exponential Smoothing for Trend and Seasonal - assumes the time series
has both a long-term trend and seasonal variation. Seasonal variation
should occur at approximately the same time each year and be of the
same degree.
A
t
= (D
t
/ I
t-L
) + (1-)(A
t-1
+ T
t-1
)
T
t
= b(A
t
- A
t-1
) + (1 - b)T
t-1
I
t
= g(D
t
/A
t
) + (1-g)R
t-L

F
t + 1
= (A
t
+ T
t
)(I
t-L + K
)

Demand Forecasting
5 - 18
Simple Exponential Smoothing: An Illustration
1
2
3
4
5
6
7
8
9
10
11
12
13
170
210
190
230
180
160
200
180
220
200
180
190
200



170.0
170.0
174.0
175.6
181.0
180.9
178.8
181.0
180.9
184.8
186.1
185.7
186.1
187.5


0.0
40.0
16.0
54.4
-1.0
-20.9
21.2
-1.0
39.1
15.2
-6.1
4.3
13.9
0.0
1600.0
256.0
2959.4
1.1
438.3
447.6
0.9
1531.8
231.8
39.7
18.8
193.2
t
Actual
Demand
Forecast
a = .1
Error
(D
t
- F
t
)
Error
2

(D
t
- F
t
)
2
Forecast
a = .3


170.0
170.0
182.0
184.4
198.1
192.7
182.9
188.0
185.6
195.9
197.1
192.0
191.4
194.0


Error
(D
t
- F
t
)
0.0
40.0
8.0
45.6
-18.1
-32.7
17.1
-8.0
34.4
4.1
-17.1
-2.0
8.6
Error
2

(D
t
- F
t
)
2
0.0
1600.0
64.0
2079.4
326.9
1066.4
293.8
64.0
1183.3
16.6
293.9
4.0
73.9
Sum of the errors
= S(D
t
-F
t
) = 174.9

Sum of the absolute errors
= S|D
t
-F
t
| = 233.4
Sum of the errors
= S(D
t
-F
t
) = 79.9

Sum of the absolute errors
= S|D
t
-F
t
| = 235.7
Demand Forecasting
5 - 19
SIMPLE EXPONENTIAL SMOOTHING MODEL
ACTUAL vs. FORECAST
120
140
160
180
200
220
240
1 2 3 4 5 6 7 8 9 10 11 12 13
Original Demand
a = .1
a = .3
Demand Forecasting
5 - 20
D
t
F
t
|D
t
-F
t
| (D
t
-F
t
)^
2
(in '000s A
t
T
t
(forecast) D
t
-F
t
(absolute (squared
t of tons) (average) (trend) A
t
+T
t
(error) error) error)
0 205.00 11.00
1 216.00 216.00 11.00 216.00 0.00 0.00 0.00
2 229.00 227.40 11.04 227.00 2.00 2.00 4.00
3 255.00 241.75 11.37 238.44 16.56 16.56 274.23
4 219.00 246.30 10.69 253.12 -34.12 34.12 1164.39
5 239.00 253.39 10.33 256.99 -17.99 17.99 323.54
6 275.00 265.98 10.55 263.72 11.28 11.28 127.26
7 315.00 284.22 11.32 276.53 38.47 38.47 1479.97
8 297.00 295.84 11.35 295.55 1.45 1.45 2.11
9 286.00 302.95 10.93 307.19 -21.19 21.19 449.07
10 314.00 313.91 10.93 313.88 0.12 0.12 0.01





Sum of Forecast Errors - 3.42
Sum of Absolute Forecast Errors 143.18
Sum of Squared Forecast Errors 3824.59

A(t) + T(t) = F(t)
205 + 11 = 216
216 + 11 = 227
Exponential Smoothing With Trend: An Illustration
Assume A
0
= 205; T
0
= 11; = .2; b = .1
Demand Forecasting
5 - 21
TREND EXPONENTIAL SMOOTHING MODEL
ACTUAL vs FORECAST
150
200
250
300
350
1 2 3 4 5 6 7 8 9 10
Time Period
Demand
D(t)
F(t)
Demand Forecasting
5 - 22
D
t
I
t
F
t
|D
t
-F
t
| (D
t
-F
t
)^
2
(in A
t
T
t
(seasonal (forecast) D
t
-F
t
(absolute (squared
t units) (average) (trend) ratio) [A
t
+T
t
]*I
t-L+K
(error) error) error)
0
1 4800 0.90
2 4100 0.80
3 6000 1.10
4 6500 5500 0 1.20
5 5800 5689 47 0.96 4950 850 850 722500
6 5200 5889 85 0.84 4589 611 611 373457
7 6800 6016 96 1.12 6572 228 228 52104
8 7400 6123 99 1.20 7334 66 66 4367
9 6000 6227 100 0.96 5971 29 29 849
10 5600 6393 116 0.86 5324 276 276 75911
11 7500 6552 127 1.13 7259 241 241 58115
12 7800 6639 117 1.19 8044 -244 244 59764
13 6300 6715 107 0.95 6497 -197 197 38811
14 5900 6832 109 0.86 5858 42 42 1727
15 8000 6969 116 1.14 7843 157 157 24772
16 8400 7080 115 1.19 8428 -28 28 804
17 6835
18 6296
19 8457
20 8958
[A(t) + T(t)] x I(t-3) = F(t)
(5500 + 0) x 0.90 = 4950
(5689 + 47) x 0.80 = 4589
2030 2970 1413181
Exponential Smoothing With Trend and Seasonal: An Illustration
Assume A
0
= 5500; T
0
= 0; L = 4; I
0
= 1.20; I
-1
= 1.10; I
-2
= 0.80; I
-3
= 0.90; a = .20; b = .25; g = .50
Demand Forecasting
5 - 23
TREND AND SEASONAL EXPONENTIAL SMOOTHING MODEL
ACTUAL vs FORECAST
3000
4000
5000
6000
7000
8000
9000
10000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Time periods
Orders
D(t)
F(t)
Demand Forecasting
5 - 24
Trend Projection: An Alternative to Exponential Smoothing
Whazzit? A method of taking time series data and separating (decomposing) it into
one or more components of trend, seasonal, cyclical, and random variation. Once
the data has been decomposed, we can estimate the values of the individual
components and use these estimates to predict future values of the time series.
Steps:
1. Calculate an annual moving average.
2. Centre the moving average.
3. Divide the centered moving average into the demand values. This is the
seasonal-random component.
4. Average the seasonal-random component for the same time period in
successive years. This average is the seasonal factor for the time period.
5. Divide each actual demand value by its seasonal factor. This produces
deseasonalized demand.
6. Regress deseasonalized demand against time and calculate the trend value
and the constant term.
7. Develop a trend forecast.
8. Multiply the trend forecast by the seasonal factor. This is the actual forecast.
Demand Forecasting
5 - 25

Centered Seasonal
Time Moving Moving Random Seasonal Deseasonalized
Year Quarter Period Sales Average Average Component Factor Sales
Year 1 1 1 4800 0.932 5149
2 2 4100 5350 0.838 4894
3 3 6000 5600 5475 1.096 1.093 5488
4 4 6500 5875 5738 1.133 1.143 5685
Year 2 1 5 5800 6075 5975 0.971 0.932 6222
2 6 5200 6300 6188 0.840 0.838 6207
3 7 6800 6350 6325 1.075 1.093 6219
4 8 7400 6450 6400 1.156 1.143 6472
Year 3 1 9 6000 6625 6538 0.918 0.932 6436
2 10 5600 6725 6675 0.839 0.838 6684
3 11 7500 6800 6763 1.109 1.093 6860
4 12 7800 6875 6838 1.141 1.143 6822
Year 4 1 13 6300 7000 6938 0.908 0.932 6758
2 14 5900 7150 7075 0.834 0.838 7043
3 15 8000 1.093 7317
4 16 8400 1.143 7347
(Step 1 ) ( Step 2 ) ( Step 3 ) ( Step 4 ) ( Step 5 )
Trend Projection: An Illustration
Demand Forecasting
5 - 26

Regression Output: Trend Forecast: Quarterly Forecast:

Constant = 5099.5 T(17) = 5100 + 147(17) = 7601 F(17) = 7601 x .932 = 7084
Std Err of Est = 212.6531
R Squared = 0.920804 T(18) = 5100 + 147(18) = 7748 F(18) = 7748 x .838 = 6493
No. of Observations = 16
Degrees of Freedom = 14 T(19) = 5100 + 147(19) = 7895 F(19) = 7895 x 1.093 = 8629

X Coefficient(s) 147.1397 T(20) = 5100 + 147(20) = 8042 F(20) = 8042 x 1.143 = 9192
Std Err of Coef. 11.53273

( Step 6 ) ( Step 7 ) ( Step 8 )
Demand Forecasting
5 - 27
TREND PROJECTION MODEL
DESEASONALIZED DATA
3000
4000
5000
6000
7000
8000
9000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Time Periods
Quantity
Sales
Deseasonalized Sales
Demand Forecasting
5 - 28
TREND PROJECTION MODEL
ACTUAL vs FORECAST
3000
4000
5000
6000
7000
8000
9000
10000
1 3 5 7 9 11 13 15 17 19
Quarters
Quantity
Actual
Forecast
Demand Forecasting
5 - 29
Demand Forecasting- Additional Illustration # 1
National Mixer Inc. sells can openers. Monthly sales for a seven-month period were as follows:
Month Sales
Feb 20
Mar 18
Apr 15
May 20
Jun 18
Jul 22
Aug 20
a. Plot the monthly data on a sheet of graph paper.
b. Forecast September sales volume using each of the following:
(1) A linear trend equation.
(2) A five-month moving average.
(3) Exponential smoothing with a smoothing constant (a) equal to .20, and a March forecast of 19.
(4) The naive approach
c. Which method seems least appropriate? Why?
d. What does the use of the term sales rather than demand presume?
Demand Forecasting
5 - 30
Demand Forecasting- Additional Illustration # 2
a. Develop a linear trend equation for the following data on freight car loadings, and use it to predict
loadings for periods 11 through 14.
b. Use trend-adjusted exponential smoothing with a = .3 and b = .2 to smooth the data. Forecast periods
11 through 14.


Year Number(00)
1 220
2 245
3 280
4 275
5 300
6 310
Year Number(00)
7 350
8 360
9 400
10 380
11 420
12 450