DEMAND FORECASTING

Operations Management 1
 Learning Outcomes:
 Describe the importance of forecasting
 Explain various components of a time series
 Choose an appropriate forecasting model
 Perform regression analysis
 Identify cause-effect relationships
 Analyze and evaluate forecasting errors
 Use the DELPHI method
 Pool information for multiple forecasts
 Describe product life cycle stages
 Introduction
Forecasts of the demand for products and
services are business essentials.

Examples include:
o patients in a hospital
o students in a college
o customers in a grocery store
o cars to be manufactured etc.
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 Introduction (continued)
Demand forecasts set the agenda for how the entire company will:

o use its people

o commit its resources
o call on outside suppliers
o plan its work schedules

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 Introduction (continued)
 The Rivet and Nail Factory has to forecast sales of products to develop
departmental schedules for the next production period.

 The Mail Order Company has to forecast demand in order to have the
right number of trained agents and operators in place.

 Ford Motor Company has to forecast car sales so that dealer stocks are of
reasonable size for every model.

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 Introduction (continued)
Forecasts provide information to coordinate demands for products and
services with supplies of resources that are required to meet the demands.

 This is reactive planning.

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 Introduction (continued)
Modify forecasts to influence the future rather than just accepting forecasts
as inevitable truths.

Such an approach helps to better fit production capabilities (short- and

long-term) to marketing possibilities.

 This is proactive planning

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 Introduction (continued)
How well can one forecast the future?

o The answer depends on the stability of the pattern of the time series for
the events being studied.

o The underlying pattern may be hard to find, but not impossible.

o When a pattern is found, the question remains, how long will it persist?
When will it change? Forecasters are willing to accept the challenge.

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 Introduction (continued)
 Mathematical equations are used for forecasting.
 Equations do not make forecasts “the truth.”
 Good forecasting can be done without mathematics.
 Further, with or without mathematics, no forecast is ever guaranteed.

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 Time Series and Extrapolation
 A time series is a stream of data (e.g., demand).

 Data are recorded at different time periods – monthly, weekly, daily, etc.

 Forecasters predict (by extrapolation) the value(s) at a future time.

 The pattern of the series is considered to be time-dependent. External

causes are not brought into the picture.

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 Time Series and Extrapolation continued

The data in time series may consist of several different kinds of variations.

Important among them are:

o random variations
o increasing or decreasing trend
o seasonal variations

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Time Series (Random Variations)
o There are no specific assignable causes for
random variations.
o Values are a result of the economic environment
and the market place.

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 Time Series (Random Variations
and Increasing Trend)
There is a constant rate of change (increasing values) as time goes by.

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 Time Series (Random Variations and Decreasing
Trend)
There is a constant rate of change (decreasing values) as time goes by.

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 Time Series (Random Variations and Seasonal
Variations)
o Seasonal (cyclical) variations may also be present.
o Examples: demand for resort hotels & home heating oil.

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 Time Series (Random Variations, Seasonal Variations and Increasing
Trend)

All three components – random variations, an increasing (or decreasing)

trend, and seasonal variations (cycles) may be present simultaneously in a
time series.

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 Forecasting Methods for Time Series
The following techniques are discussed:

o Moving Average
o Weighted Moving Average
o Exponential Smoothing
o Seasonal Forecasting
o Trend Analysis

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 Moving Average
A n-month moving average is the sum of the
observed values during the past n months
divided by n.
Moving Average Method n =3

Month Sales Forecast Formula

1 100
2 80
3 90
4 110 90.00 =(100+80+90)/3
5 100 93.33 =(80+90+110)/3
6 110 100.00 =(90+110+100)/3
7 95 106.67 =(110+100+110)/3
8 115 101.67 =(100+110+95)/3
9 120 106.67 =(110+95+115)/3
10 90 110.00 =(95+115+120)/3
11 105 108.33 =(115+120+90)/3
12 110 105.00 =(120+90+105)/3
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 Weighted Moving Average
 The weighted moving average (WMA) makes forecasts more responsive
to the most recent actual occurrences (e.g., demand).

 The most recent n periods are used in forecasting.

 Each period is assigned a weight between 0 and 1.

 The total of all weights adds up to one (1).

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Weighted Moving Average (using
monthly demands)

Example:
Forecast (4) = 0.2*(Demand 1) + 0.3*(Demand 2) + 0.5*(Demand 3)

Weighted Moving Average Method n=3 Weights

0.2
0.3
Month Sales Forecast Calculation 0.5
1 100
2 80
3 90
4 110 89.00 = 0.2*100 + 0.3*80 + 0.5*90
5 100 98.00 = 0.2*80 + 0.3*90 + 0.5*110
6 110 101.00 = 0.2*90 + 0.3*110 + 0.5*100
7 95 107.00 = 0.2*110 + 0.3*100 + 0.5*110
8 115 100.50 = 0.2*100 + 0.3*110 + 0.5*95
9 120 108.00 = 0.2*110 + 0.3*95 + 0.5*115
10 90 113.50 = 0.2*95 + 0.3*115 + 0.5*120
11 105 104.00 = 0.2*115 + 0.3*120 + 0.5*90
12 110 103.50 = 0.2*120 + 0.3*90 + 0.5*105

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 Exponential Smoothing
 The Exponential Smoothing (ES) method forecasts the demand for a
given period t by combining the forecast of the previous period (t-1) and
the actual demand of the previous period (t-1).
 The actual demand for the previous period is given a weight of α and the
forecast of the prior period is given a weight of (1 - α).

 α is a smoothing constant whose value lies between 0 and 1 (0 ≤ α ≤ 1).

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 Exponential Smoothing (continued)
The equation for the forecast for period t is:
Forecast (t) = α*Actual Demand (t-1) + (1- α )*Forecast (t-1).

The equation can also be written as:

Forecast (t) = Forecast (t-1) + α*{Actual Demand (t-1)–Forecast (t-1)}

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 Exponential Smoothing (continued)
Example: F(3) = F(2) + α*{(A(2) – F(2)} = 100 + 0.2*(80 – 100) = 96.

Exponential Smoothing Method (sales are actual sales indicated by A in equation)

alpha = 0.2
Month Sales Forecast Comment and Calculation

Forecast for period 1 should be available before

1 100 100 starting the calculations. If it is not given then set
it equal to the sales of period 1.

2 80 100.00 =(100 + 0.2(100 -100))

3 90 96.00 =(100 + 0.2(80 -100))
4 110 94.80 =(96 + 0.2(90 -96))
5 100 97.84 =(94.8 + 0.2(110 -94.8))
6 110 98.27 =(97.84 + 0.2(100 -97.84))
7 95 100.62 =(98.27 + 0.2(110 -98.27))
8 115 99.50 =(100.62 + 0.2(95 -100.62))
9 120 102.60 =(99.5 + 0.2(115 -99.5))
10 90 106.08 =(102.6 + 0.2(120 -102.6))
11 105 102.86 =(106.08 + 0.2(90 -106.08))
12 110 103.29 =(102.86 + 0.2(105 -102.86))

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 Seasonal Forecast Step 1

Quarterly demand for last four years is given in the table below.
We use a 5-step process to forecast.
Step 1: Find average quarterly demand for each quarter.

Demand

Quarter Year 1 Year 2 Year 3 Year 4

Fall 2530 2690 2790 2860

Winter 2300 2420 2410 2600

Spring 1900 2000 2105 2175

Summer 1510 1775 1875 1945

Average 2060 2221 2295 2395

=(1510 + 1900 + 2300 =(1775 + 2000 + 2420 =(1875 + 2105 + 2410 =(1945 + 2175 + 2600 +
Formula
+ 2530)/4) + 2690)/4) + 2790)/4) 2860)/4)

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 Seasonal Forecast Step 2

Step 2: Compute Seasonal Index (SI) for each quarter

for each year.

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 Seasonal Forecast Step 3

Step 3: Calculate the average SI for each

quarter.

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 Seasonal Forecast Step 4

Step 4: Calculate the average quarterly demand for next year.

First, the yearly demand has to be estimated or calculated for next year using one of the forecasting
techniques.

Suppose the estimated demand is 2,800.

Therefore, the average quarterly demand = 2,800/4 = 700. The calculations are shown below.

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 Seasonal Forecast Step 5

Step 5: Forecast demand for the four quarters of next year.

Multiply the average demand by the SI for each quarter.

For example, forecast for Spring quarter = 638 = 700*0.912.

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 Time Series Analysis – Trend Line
 If the time series exhibits an increasing or decreasing trend then a trend analysis is
more appropriate.
 A trend line defines the relationship between demand forecast and the time period by
the following equation.
Y = a + bX, where, Y is the demand forecast and X is the time period.
 X is the independent variable and Y is the dependent variable since the demand
depends on the time period.

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 Time Series Analysis – Trend Line
(continued)

 In the equation, Y = a + bX, a is the intercept on the Y-axis. a gives the

value of demand (variable Y) when X = 0.
 The slope of the line is b which gives the change in the value of demand
(variable Y) for a unit change in the value of X.
 The “Intercept” and “Slope” functions in Excel are used to calculate a
and b respectively.

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 Time Series Analysis – Trend Line
(continued)

Example: Consider the demand data given in the table below.

o The Excel functions give b = 8.65 and a = 2.73.

o Use them in equation, Y = a + bX, to make a forecast.
o For example, for period 11 (X = 11),
Forecast = 2.73 + 11*8.65 = 97.87.
o Similarly, for period 12,
Forecast = 2.73 + 12*8.65 = 106.52.

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 Time Series Analysis – Trend Line
(continued)

The forecasts (values on straight line) and the actual

demand (values on zigzag line) have been plotted in
the following figure.

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 Time Series Analysis – Trend Line
(continued)

 For any given time period, the difference between the forecast (values on
straight line) and the actual demand (values on zigzag line) gives the
error in that period.

 The trend analysis method minimizes the sum of the squares of these
errors in calculating the values of a and b.

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 Regression Analysis
 Regression Analysis establishes a relationship between two sets of numbers that are
time series.

 For example, when a series of Y numbers (such as the monthly sales of cameras over
a period of years) is causally connected with the series of X numbers (the monthly
advertising budget), then it is beneficial to establish a relationship between X and Y in
order to forecast Y.

 In regression analysis X is the independent variable and Y is the dependent variable.

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 Regression Analysis (continued)
 The regression analysis gives the relationship between X and Y
by the following equation.
Y = a + bX,
where, a is the intercept on the Y-axis
(value of the variable Y when X = 0); and b is the slope of the line which
gives the change in the value of variable Y for a unit change in the value of
X.

 The “Intercept” function in Excel calculates a and the “Slope”

function in Excel is used to find the value of b.

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 Regression Analysis (continued)
Example: Use the data given in the following table for ten-pairs of X and Y.
o The Excel functions give b = 50.23 and a = 62.44.
o Use them in equation, Y = a + bX, to forecast.
o Suppose X = 15, then
Forecast = 62.44 + 50.23*15 = 815.84.

Observation 1 2 3 4 5 6 7 8 9 10
Number
Independent 10 12 11 9 10 12 10 13 14 12
Variable (x)
Dependent 400 600 700 500 800 700 500 700 800 600
Variable (y)

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 Regression Analysis continued

The forecasts (values on straight line) and the actual

demand data points have been plotted in the following
figure.

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 Regression Analysis (continued)
 For any given time period, the difference between the forecast
values and the actual demand gives the error in that period.

 The regression analysis minimizes the sum of the squares of

these errors in calculating the values of a and b.

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 Regression Analysis (continued)
 An assumption that is generally made in regression analysis is that the relationship
between the correlate pairs is linear.

 However, if nonlinear relations are hypothesized, there are strong, but more complex
methods for doing nonlinear regression analyses.

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 Correlation Coefficient
 An important prerequisite to use regression analysis is the
existence of a causal relationship between X and Y.

 A correlation coefficient (r) shows the extent of correlation of

X with Y, where r can take on values from “–1” to “+1”.

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 Correlation Coefficient (continued)
 When r = “–1”, X and Y are perfectly correlated going in opposite directions. As X
gets large, Y gets small, and vice versa.
 When r = 0, there is no correlation between X and Y.
 When r = +1, X and Y are perfectly correlated going in the same direction.

 The correlation coefficient can be found by using Excel’s built-in function “Correl”.

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 Correlation Coefficient (continued)
Scatter diagrams (shown below) are useful visual aids to intuit
whether there is a relationship between X and Y.
The r number is definitive.
r = -0.04 r = 0.97
Indicates an absence of any relationship. We should Indicates an almost perfect relationship. This time
not use regression analysis for this time series. series is a good candidate for regression analysis.

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 Coefficient of Determination
The coefficient of determination (r2), where r is the value of the coefficient of
correlation, is a measure of the variability that is accounted for by the regression line for
the dependent variable.

The coefficient of determination always falls between 0 and 1.

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 Coefficient of Determination (continued)
 For example, if r = 0.8, the coefficient of determination is r2 = 0.64 meaning that
64% of the variation in Y is due to variation in X.

 The remaining 36% variation in the value of Y is due to other variables.

 If the coefficient of determination is low, multiple regression analysis may be used to

account for all variables affecting the independent variable Y.

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 Error Analysis
The forecasting errors are computed as,
Error (t) = Demand (t) – Forecast (t).

Underestimate:
Demand is greater than the forecast. Error term is positive.

Overestimate:
Demand is smaller than the forecast. Error term is negative.

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 Error Analysis (continued)
The most commonly used method to measure errors is Mean Absolute Deviation
(MAD).

To calculate MAD, take the sum of the absolute measures of the errors and divide that
sum by the number of observations.

MAD treats all errors linearly.

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 Error Analysis (continued)
Example: Consider the demand and forecast given for 10
periods in the table below.

The sum of the absolute errors for 10 periods is 171. Therefore,

MAD = 171/10 = 17.10.

Absolute
Period Demand Forecast Error
Error
1 212 206.0 6.0 6.0
2 224 207.0 17.0 17.0
3 220 210.0 10.0 10.0
4 211 212.0 -1.0 1.0
5 198 205.0 -7.0 7.0
6 236 209.0 27.0 27.0
7 219 224.0 -5.0 5.0
8 296 238.0 58.0 58.0
9 280 249.0 31.0 31.0
10 252 261.0 -9.0 9.0
Total 127.0 171.0
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 Error Analysis (continued)
 To select a forecasting method, say exponential smoothing, calculate the values of
MAD choosing different values of α. The value of α that minimizes MAD will be
selected.

 Similarly, for moving average, find MAD for different values of n. The n that
minimizes MAD will be selected.

 A similar procedure can be used with the weighted moving average method to find
the best combination of weights.

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 Product Life Cycle Stages

 All products and services go through the following four stages:

o Introduction to the market
o Growth of volume and share
o Maturation, where maturity is the phase of relative equilibrium
o Decline occurs, because of deteriorating sales; decline leads to
restaging or withdrawal

 The production system’s capabilities need to be adjusted with

changes or transitions between stages.

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 Product Life Cycle Stages (continued)
Life cycle stages provide a classification for understanding the
nature of evolving demand trends that will occur over time.

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 Product Life Cycle Stages (continued)
 During the introductory phase, demand is led by the desire to
“fill the pipeline.” This means getting product into the stores
or warehouses—wherever it must be to supply the customers.

 When growth starts to occur, there is a trend line of increasing

sales. The trick is to estimate how fast demand will increase
over time and for how long a period growth will continue.

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 Product Life Cycle Stages (continued)
 When the new product or service stops growing, it is
considered mature. This means—its volume is stabilized at the
saturation level for that brand. The competitors have divided
the market, and only extraordinary events, such as a strike at a
competitor’s plant, are able to shift shares and volumes.

 Finally, the product begins to lose share, volume drops, and,

depending on the strategy, the product is either restaged or
terminated.

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 The Delphi Method

Delphi is a forecasting method that relies on expert estimation of future events.

The experts submit their opinions to a single individual (leader of the group) who maintains anonymity of
responses.

The leader combines the opinions into a report which is disseminated to all participants. We hope the
report is fair and balanced.

The participants are asked whether they wish to reevaluate and alter their previous opinions in the face of
the body of opinion of their colleagues.

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 The Delphi Method (continued)
Gradually, the group is supposed to move toward consensus. If it does not, at the least, a set of different
possibilities can be presented to management.

The Delphi method is meant to put all participants on an equal footing with respect to getting their ideas
heard.

There is no evidence that the Delphi method provides forecasts (and/or predictions) with smaller errors
than other techniques.

It is apparent that managers gain greater perspective about forces that should be considered when they are
contemplating possible outcomes. That is a positive benefit of Delphi.

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Thank You