Production and Operations

Management
Chapter 2: Demand Forecasts
Nguyen Ngoc Duy, PhD.
Faculty of Economics
Nha Trang University
Email: [email protected]
Phone: 0931625879
 CONTENT

•Concepts of Forecasting
•Importance of demand forecasts
•Demand Patterns
•Measurement of Forecast Error
•Types of Forecasting technique

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 Concepts of Forecasting

• Forecasting is the art and science of predicting future

events.
• A forecast is a prediction of future events used for
planning purposes.
• Balancing supply and demand begins with making
accurate forecasts.
• Planning, in contrast, is the process of making
management decisions on how to deploy resources to
best respond to the demand forecasts
 Importance of demand forecasts
• Forecasts are critical inputs to business plans, annual plans, and
budgets.
• Finance needs forecasts to project cash flows and capital
requirements. Human resources will use forecasts to anticipate
hiring and training needs. Marketing is an important source for sales
forecast information because it is closest to external customers.
Operations and supply chain managers need forecasts to plan
output levels, purchases of services and materials, workforce and
output schedules, inventories, and long-term capacities.
• Managers at all levels need estimates of future demands, so that
they can plan activities consistent with the firm’s competitive
priorities.
Importance of demand forecasts

Using Operations to Create Value

Forecasting

Designing an integrated and

sustainable supply chain of
 Demand Patterns
• In most case, demand for products or services can be
broken down into 6 patterns:
• The four patterns of demand—horizontal, trend,
seasonal, and cyclical—combine in varying degrees to
define the underlying time pattern of demand for a
service or product
• The fifth pattern, random variation, results from chance
causes and thus cannot be predicted.
• The sixth pattern is autocorrelation.

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Demand Patterns: the first four
Demand Patterns

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Demand Patterns

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 Types of Forecasting technique

•Qualitative method (Judgmental)

•Quantitative method
• Time Series Analysis
• Causal Relationship (Regression method)
• Simulation

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 A Trend is Worth Noting

• Start by identifying the trend

• What is the trend in the sales of personal

computers?

• Are there any seasonal effects, cyclical factors or

other predicted events that might affect the sales of
personal computers?

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 Qualitative Methods
• Jury of executive opinion: A forecasting technique that uses the opinion of a
small group of high-level managers to form a group estimate of demand
• Under this method, the opinions of a group of high-level experts or
managers, often in combination with statistical models, are pooled to arrive
at a group estimate of demand.
• Delphi method: A forecasting technique using a group process that allows
experts to make forecasts
• There are three different types of participants in the Delphi method:
decision makers, staff personnel, and respondents. Decision makers usually
consist of a group of 5 to 10 experts who will be making the actual forecast.
Staff personnel assist decision makers by preparing, distributing, collecting,
and summarizing a series of questionnaires and survey results. The
respondents are a group of people, often located in different places, whose
judgments are valued. This group provides inputs to the decision makers
before the forecast is made.
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 Qualitative Methods
Delphi method

l. Choose the experts to participate. There should be a variety of

knowledgeable people in different areas.
2. Through a questionnaire (or E-mail), obtain forecasts (and any
premises or qualifications for the forecasts) from all participants.
3. Summarize the results and redistribute them to the participants
along with appropriate new questions.
4. Summarize again, refining forecasts and conditions, and again
develop new questions.
5. Repeat Step 4 if necessary. Distribute the final results to all
participants.

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 Qualitative Methods
• Sales force composite: A forecasting technique based on salespersons’
estimates of expected sales.
• In this approach, each salesperson estimates what sales will be in his or her
region. These forecasts are then reviewed to ensure that they are realistic.
Then they are combined at the district and national levels to reach an
overall forecast.
• Market survey: A forecasting method that solicits input from customers or
potential customers regarding future purchasing plans
• This method solicits input from customers or potential customers regarding
future purchasing plans. It can help not only in preparing a forecast but also
in improving product design and planning for new products. The consumer
market survey and sales force composite methods can, however, suffer from
overly optimistic forecasts that arise from customer input.

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 Measurement of Forecast Error

• For any forecasting technique, it is important to measure the accuracy of its

forecasts. Forecasts almost always contain errors. Random error results from
unpredictable factors that cause the forecast to deviate from the actual
demand. Forecasting analysts try to minimize forecast errors by selecting
appropriate forecasting models, but eliminating all forms of errors is impossible.
• Forecast error for a given period t is simply the difference found by subtracting
the forecast from actual demand, or
𝑬𝒕 = 𝑨𝒕 − 𝑭𝒕
where 𝐸𝑡 = forecast error for period t
𝐴𝑡 = actual demand for period t
𝐹𝑡 = forecast for period t
• This equation (notice the alphabetical order with Dt coming before Ft) is the
starting point for creating several measures of forecast error that cover longer
periods of time.
 Five basic measures of forecast error

Forecast errors (E): 𝐸𝑡 = 𝐴𝑡 − 𝐹𝑡

Cumulative/Running sum of forecast errors (RSFE):
Average forecast error (called the mean bias):

Mean squared error (MSE):

Standard deviation of the errors:

Mean absolute deviation (MAD):

(σ 𝐸𝑡 /𝐴𝑡 )(100%)
Mean absolute percent error (MAPE): 𝑀𝐴𝑃𝐸 =
𝑛
 Tracking signal (TS)
• One way to monitor forecasts to ensure that managers are performing well is to use a
tracking signal. A tracking signal (TS) is a measurement of how well a forecast is
predicting actual values. As forecasts are updated every week, month, or quarter, the
newly available demand data are compared to the forecast values.
• The tracking signal is computed as the cumulative error divided by the mean absolute
deviation (MAD):

OR
 Time Series Analysis

Choosing a model depends on:

1. Time horizon to forecast

2. Data availability
3. Accuracy required
4. Size of forecasting budget
5. Availability of qualified personnel

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 Time Series Analysis
Naïve Forecast

• A method often used in practice is the naïve forecast, whereby

the forecast for the next period (Ft + 1) equals the demand for
the current period (At).
• The naïve forecast method may be adapted to take into account
a demand trend. The increase (or decrease) in demand
observed between the last two periods is used to adjust the
current demand to arrive at a forecast.
• Suppose that last week the demand was 120 units and the week
before it was 108 units. Demand increased 12 units in 1 week,
so the forecast for next week would be 120 + 12 = 132 units.
Example:
 Time Series Analysis
Moving Average
• A moving-average forecast uses a number of historical actual
data values to generate a forecast.
• Moving averages are useful if we can assume that market demands
will stay fairly steady over time.

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

Ft =
n
where n is the number of periods in the moving average—for example, 2, 3 or
4… months, respectively, for a 2-, 3-, or 4-period moving average.

• Let’s develop 3-week and 6-week moving average forecasts for demand.
• Assume you only have 3 weeks and 6 weeks of actual demand data for
the respective forecasts

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 Example 1

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998 16

Solution from POM-QM software
 Time Series Analysis
Weighted Moving Average
When a detectable trend or pattern is present, weights can be used to place more
emphasis on recent values. This practice makes forecasting techniques more
responsive to changes because more recent periods may be more heavily weighted.

At −1 * kt −1 + At − 2 * kt − 2 + ... + At − n * kt − n A t −i * k t −i
Ft = = i =1

kt −1 + kt − 2 + ... + kt − n n

k
i =1
t −i

Or Ft = w 1 A t-1 + w 2 A t- 2 + w 3 A t-3 + ...+w n A t- n

n
where w
i=1
i =1
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Example 2
Solution from POM-QM software
 Time Series Analysis
Exponential Smoothing
• Exponential smoothing is a weighted-moving-average forecasting technique in
which data points are weighted by an exponential function.
• Exponential smoothing is another weighted-moving-average forecasting method.
It involves very little record keeping of past data and is fairly easy to use. The
basic exponential smoothing formula can be shown as follows:

where α is a weight, or smoothing constant, chosen by the forecaster, that has a value
greater than or equal to 0 and less than or equal to 1. The formula can also be written
mathematically as:
Ft = Ft-1 + (At-1 - Ft-1)

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 Example 3
During the past 8 quarters, the Port of Baltimore has unloaded large quantities of
grain from ships. The port’s operations manager wants to test the use of
exponential smoothing to see how well the technique works in predicting
tonnage unloaded. He guesses that the forecast of grain unloaded in the first
quarter was 175 tons. Two values of a are to be examined: α = 0.1 and α = 0.5.

SOLUTION

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 To evaluate the accuracy of each smoothing constant, we can
compute forecast errors in terms of absolute deviations and MADs:

How to find the value of alpha that maximizes the MAD?

Effect of  on Forecast

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 Time Series Analysis
Exponential Smoothing with trend

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 (Eq.1)

(Eq.2)

(Eq.3)

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 Time Series Analysis
Exponential Smoothing with trend

(2).
(3).

(1)]
Example 4
Solution for Example 4
 Time Series Analysis
Trend projections
• A time-series forecasting method that fits a trend line to a series of historical
data points and then projects the line into the future for forecasts.

• Several mathematical trend

equations can be developed (for
example, exponential and
quadratic), but in this section, we
will look at linear (straight-line)
trends only.
• If we decide to develop a linear
trend line by a precise statistical
method, we can apply the least-
squares method. This approach
results in a straight line that
minimizes the sum of the squares
of the vertical differences or
deviations from the line to each of
the actual observations.
Example 5
Solution from POM Software
Time Series Analysis
Seasonal forecasts
Example 6 and Solution
Solving Example 6 with a trend and seasonality
 Causal Relationship Forecasting
Simple linear regression analysis

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 Example 7 and Solution

If independent variable (X) is predicted equaling $6 billion next year, we can estimate sales
(Y) with the regression equation:

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 Causal Relationship Forecasting
Multiple regression analysis
Multiple regression is a practical extension of the simple regression
model we just explored. It allows us to build a model with several
independent variables instead of just one variable.

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 Judgmental Forecasting Applications
Small and Large Firms

Low High
Sales Sales
Technique < $100M > $500M
Manager’s opinion 40.7% 39.6%
Jury of executive opinion 40.7% 41.6%
Sales force composite 29.6% 35.4%
Number of Firms 27 48

Source: Nada Sanders and Karl Mandrodt (1994) “Practitioners Continue to Rely on Judgmental Forecasting
Methods Instead of Quantitative Methods,” Interfaces, vol. 24, no. 2, pp. 92-100.

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 Quantitative Forecasting Applications
Small and Large Firms
Low High
Sales Sales
Technique < $100M > $500M
Moving average 29.6% 29.2%
Straight line projection 14.8% 14.6%
Naive 18.5% 14.6%
Exponential smoothing 14.8% 20.8%
Regression 22.2% 27.1%
Simulation 3.7% 10.4%
Classical decomposition 3.7% 8.3%
Box-Jenkins 3.7% 6.3%
Number of Firms 27 48
Source: Nada Sanders and Karl Mandrodt (1994) “Practitioners Continue to Rely on Judgmental Forecasting
Methods Instead of Quantitative Methods,” Interfaces, vol. 24, no. 2, pp. 92-100.

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