Forecasting

&
Supply Chain

LECTURE 6&7

Dr. Surya Prakash

© 2007 Pearson Education

 Supply Chain Management
(3rd Edition)

Chapter 7
Demand Forecasting
in a Supply Chain

© 2007 Pearson Education 7-2

 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
Forecast error
Forecasting in practice

© 2007 Pearson Education 7-3

 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
© 2007 Pearson Education 7-4
 Characteristics of Forecasts

Forecasts are always incorrect. Should include

expected value and measure of error.
Long-term forecasts are less accurate than short-term
forecasts (i.e. forecast horizon is important).
Aggregate forecasts are more accurate than
disaggregate forecasts as they tend to have a smaller
standard deviation of error relative to the mean.

© 2007 Pearson Education 7-5

 Factors that are related to the
demand forecast.
Past demand
Lead time of product
Planned advertising or marketing efforts
State of the economy
Planned price discounts
Actions that competitors have taken

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 Forecasting Methods
Qualitative: primarily subjective; rely on judgment and opinion
Time Series: use historical demand only. They are based on the
assumption that past demand history is a good indicator of future
demand. These methods are most appropriate when the basic demand
pattern does not vary significantly from one year to the next.
– 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
© 2007 Pearson Education 7-7
 In this chapter we deal primarily with time-series
methods, which are most appropriate when future
demand is related to historical demand, growth
patterns, and any seasonal patterns. With any
forecasting method, there is always a random element
that cannot be explained by historical demand
patterns. Therefore, any observed demand can be
broken down into a systematic and a random
component:
Observed demand (O) = Systematic component (S) + Random component (R)

© 2007 Pearson Education 7-8

 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

© 2007 Pearson Education 7-9

 The systematic component measures the
expected value of demand and consists of what
we will call level, the current deseasonalized
demand; trend, the rate of growth or decline in
demand for the next period; and seasonality,
the predictable seasonal fluctuations in
demand.

© 2007 Pearson Education 7-10

 BASIC APPROACH TO DEMAND
FORECASTING
The following basic, six-step approach helps an
organization perform effective forecasting.

1. Understand the objective of forecasting.

2. Integrate demand planning and forecasting throughout the
supply chain.
3. Understand and identify customer segments.
4. Identify the major factors that influence the demand
forecast.
5. Determine the appropriate forecasting technique.
6. Establish performance and error measures for the forecast.

© 2007 Pearson Education 7-12

 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

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 Forecasting Methods
Static- (assumes estimates of L,S,T within
systematic component do not vary)

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

© 2007 Pearson Education 7-16

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

Ft+1 = [Lt + (l+t)T)]St+1 = forecast for period t+l in period t

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 Basic Formula for
Adaptive Forecasting
Ft+1 = [Lt + (l)T)]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
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 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
© 2007 Pearson Education 7-19
 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
© 2007 Pearson Education 7-20
 Moving Average

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 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 = aDt+1 + (1-a)Lt
Lt+1 = Sum(n=0 to t+1)[a(1-a)nDt+1-n ]
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 Simple Exponential Smoothing
Example

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 Holt’s Model
Trend-Corrected Exponential Smoothing
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

© 2007 Pearson Education 7-24

 Trend-Corrected Exponential
Smoothing (Holt’s Model)
After observing demand for period t, revise the estimates for level
and trend as follows:
Lt+1 = aDt+1 + (1-a)(Lt + Tt)
Tt+1 = b(Lt+1 - Lt) + (1-b)Tt
a = smoothing constant for level
b = smoothing constant for trend

Using linear regression,

L0 = (linear intercept)
T0 = (linear slope)

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 Example

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 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
© 2007 Pearson Education 7-27
 Enquiries..

Forecasting Method Applicability

Moving Average No ‘T’, No ‘S’

Simple Exponential Smoothing No ‘T’, No ‘S’

Holt’s Method ‘T’, but No ‘S’

Winter’s Method ‘T’, & ‘S’

© 2007 Pearson Education 7-28

 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 = a(Dt+1/St+1) + (1-a)(Lt+Tt)
Tt+1 = b(Lt+1 - Lt) + (1-b)Tt
St+p+1 = g(Dt+1/Lt+1) + (1-g)St+1
a = smoothing constant for level
b = smoothing constant for trend
g = 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
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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
s = 1.25MAD

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 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

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 Example Winter’s Model

Quarter Demand Dt
II, 1998 8000 p=4;
III, 1998 13000
IV, 1998 23000 Apply Lin. Reg.
I, 1999 34000 L0 = 18439
II, 1999 10000
T0 = 524
III, 1999 18000
IV, 1999 23000
I, 2000 38000 S 1 =0.47
II, 2000 12000 S 2 =0.68
III, 2000 13000 S 3 =1.17
IV, 2000 32000 S 4 =1.67
I, 2001 41000
© 2007 Pearson Education 7-32
 Example Cont…
Trend- and Seasonality-Corrected Exponential Smoothing

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 a = 0.1, b=0.2, g=0.1; revise estimates for level and trend
for period 1 and for seasonal factor for period 5
L1 = a(D1/S1)+(1-a)(L0+T0) = (0.1)(8000/0.47)+(0.9)(18439+524)=18769
T1 = b(L1-L0)+(1-b)T0 = (0.2)(18769-18439)+(0.8)(524) = 485
S5 = g(D1/L1)+(1-g)S1 = (0.1)(8000/18769)+(0.9)(0.47) = 0.47

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

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 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
Use Information Technology (IT)

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 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?

© 2007 Pearson Education 7-35