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Demand Forecasting in a

Supply Chain
Presented by
Prof. M. K. Tiwari
At the end of session you will
Understand the role of forecasting
for both an enterprise and a Supply
Chain (SC)
Identify the components of a
demand forecasts.
Forecast demand in a SC given
historical demand data using time
series methodologies.
Analyze demand forecasts to
estimate forecast error.
Forecasting!......why?
Push system requires planning about:
Level of production
Pull system requires planning about:
Level of available capacity
Level of inventory
Both require future demand of customers.
Either Pull or push, both processes are
driven by customer demand.


Example of Dell Computer:
Mastering Pull and Push
Dell orders components anticipating
customers order (Push)
It determines capacity of assembly
plants on customer demand basis.
(Pull)
For both purposes it requires demand
forecasting.
Forecasting: Definition
and its role
Definition: In its simplest form It is
estimation of expected demand over a
specified future period.
If each SC stage makes own demand
forecast variation is unavoidable.
Collaborative forecasts tend to be more
accurate.
Role:
This accuracy enables SC to be more
responsible and efficient in serving their
customers.
Forecasting makes decisions
about:
1. Production: scheduling, inventory control,
aggregate planning, purchasing.

2. Marketing: sales-force allocation,
promotions, new product introduction.

3. Finance: plant/equipment investment,
budgetary planning.

4. Personal: workforce planning, hiring,
layoffs.
Characteristics of forecasts
1. Should include both expected and measure of
forecast error (demand uncertainty).

Consider, two car dealers
One expects sales between 100 and 1900
Other expects sales between 900 and 1100.


Even though for both average sales is 1000,
sourcing strategy will be different.
First dealer will have to arrange more resources
due to higher forecasting error.
High
Uncertaint
y
Low
Uncertainty
2. Long term forecasts are usually less
accurate than short term forecasts.

3. For same percentage error, aggregate
forecasts (e.g. GDP of a country) are
usually more accurate than
disaggregate forecasts (e.g. yearly
revenue of company or product wise
details).
Characteristics of forecasts
The classic example of summing up the
forecast error is bullwhip effect. Here
order variation is amplified as they
move up in SC from the end customers.
Mature products with stable demand
are usually easiest to forecast.
Forecasting is difficult when either the
supply of raw materials or the demand
for the finished products is highly
variable.


Characteristics of forecasts
Factors related to demand
forecast
Past demand
Lead time of products
Planned advertising or
marketing efforts
State of the economy
Planned price discounts
Actions competitors have
taken.
Classification of forecasting
methods
Qualitative:
Methods are subjective and rely on
human judgment.
Appropriate when there is little
historical data available or experts
have market intelligence.
Used to forecast demand several
years into the future in a new
industry.
Classification of forecasting
methods
Time series:
Uses historical demand to make
forecasts.
Based on assumption that past
demand history is a good indicator of
future demand.
Appropriate when the basic demand
pattern does not vary significantly
from one period to next.
Simple to use and can serve as a good
starting point.
Causal
Assumes that demand forecast is highly
correlated with certain factors in the
environment (e.g. state of economy,
interest rates etc.).

This method find the correlation
between demand and environment and
use estimates of environment factors to
forecast future demand.
Classification of forecasting
methods
Simulation
These methods imitate consumer choices that
give rise to demand to arrive at a forecast.

Using it a firm can combine time series and
causal method to answer:

1. What will be impact of price promotion?
2. What will be the impact of a competitor opening a
store nearby?
3. Airlines simulate customers buying behavior to
forecast demand for higher fare seats.
Classification of forecasting
methods
Appropriate method
Several studies have indicated that using
multiple forecasting method is more
effective than any individual method.

Deal with time series method when
future forecast is expected to follow
historical method.

Historical demand, growth pattern, any
seasonal pattern influence the forecast.
Components of demand
Observation demand can be broken
into two components.
Observed demand (0)=systematic (S)
+random (R)
Systematic component measures the
expected value of demand.
Random component is that part of
forecast that deviate from the
systematic part.

Company
can not
forecast
this value.

Basic approach
Step 1: Understand the objective of
forecasting

Step 2: Integrate demand planning
and forecasting through the SC

Step 3: Understand and identify
customers segments
Basic approach
Step 4: Identify the major factors
that influence the demand forecast

Step 5: Determine the appropriate
forecasting technique

Step 6: Establish performance and
error measure for the forecast.

Step 1: Understand the
objective of forecasting
Clearly identify the decisions such as:
How much of a particular product to make?
How much to inventory?
How much to order?
It is important that all parties must come
up with a common forecast demand.
Failure to make such decisions jointly
may results either too much or too little
product in various stages of supply chain.
Step 2: Integrated demand
planning and forecasting
through SC
A company should link its forecast to all
planning activities throughout SC.

Link should exist at both the information
system and human resource system.

As a variety of functions are affected by the
outcomes of the planning process, it is
important that all of them are integrated into
the forecasting process.
Step 3: Understand and
identify customers segments
Customers may be grouped by similarities
in service requirements, demand volumes,
order frequency, demand volatility,
seasonality.

Companies may use different forecasting
methods for different segments.

Clear understanding facilitates an
accurate and simplified approach for
forecasting.
Step 4: Identify major factors that
influence the demand forecasts
A proper analysis of major factors is
central to developing an appropriate
forecasting technique.
The main factors are demand, supply,
and product-related phenomena.
On the demand side, a company must
ascertain whether demand is growing,
declining or has a seasonal pattern.
Must be based on demand not sales
data.
Step 5: Supply side Vs Product
side
On the supply side, a company must
consider available supply sources to
decide on accuracy of forecast desired.
If alternative supply sources with short lead
time is available, a highly accurate forecast
may not be specially important.
On the product side, firm must know the
number of variants of a product being
sold.
If demand for a product influences or is
influenced by demand of another product,
two forecasts are made jointly.
Step 6: Determine appropriate
forecasting technique
A company should first understand the
dimensions that will be relevant to
forecasts.

These dimensions include geographical
area, product groups, and customers
groups.

A firm should be wise enough to have
different forecasts and techniques
for each dimension.
Step 7: Establish performance and
error measure of forecast
These measures should evaluate accuracy and
timeliness of forecast.
Measure should correlate with the objective of
the business decisions based on the forecasts.
Example:
A mail order company uses forecast to place orders to
suppliers.
Orders are send to the suppliers with two months lead
time
Orders are to provide company with a quantity
minimizing both extra product left over at the end of
sale season and any lost sale due to unavailability.
At the end of season the company
must compare actual demand to
forecasted demand to estimate the
accuracy of forecast.

The observed accuracy should be
compared with the desired and
resulting gap should be used to
identify corrective action that
company needs to take.
Step 7: Establish performance and
error measure of forecast
Time series forecast
methods
Goal of forecasting is to predict
systematic component demand and
estimate the random component.

In general, systematic component
data contains 3 factors:
level factor (L)
trend factor (T) , and
seasonal factor (S).
Forms of seasonal component
Multiplicative:
systematic component=level * trend *
seasonal factor

Additive:
systematic component=level + trend +
seasonal factor

Mixed:
systematic component=(level + trend)*
seasonal factor

Static methods
For static methods, the level, trend, and
seasonality within systematic component
is estimated on the basis of historical
data and then same values are used for
future forecasts.
Mathematical model

The forecast in period t for demand
in period t+l
F
t+1
=[L+(t+l)T]S
t+1
where,
L=estimate of level at t=0
T=estimate of trend
S
t
=estimate of seasonal factor for period t
D
t
= actual demand observed for period t
F
t
=forecast for demand for period t


Example problem to estimate L, T, and S.
Tahoe , a producer of salt noticed that his
retailers always overestimated the demand. This
lead to his excess inventory holding costs of rock
salt used in the production of salt. To reduce his
inventory costs. Tahoe decided to produce a
collaborative demand forecast.

The demand is measured on quarterly basis and
demand pattern repeats every year (i.e. p =4). p is
the periodicity defined as the number of periods
after which seasonal cycle repeats itself.
Quarterly demand for Tahoe salt
Year Quarter Period Demand D
t
2000 2 1 8,000
2000 3 2 13,000
2000 4 3 23,000
2001 1 4 34,000
2001 2 5 10,000
2001 3 6 18,000
2001 4 7 23,000
2002 1 8 38,000
2002 2 9 12,000
2002 3 10 13,000
2002 4 11 32,000
2003 1 12 41,000
Estimation of three
parameters
Two steps
1. Deseasonalize demand and run
linear regression to estimate level
and trend.

1. Estimate seasonal factors.

Estimating level at period 0
and trend

First, deseasonalize the demand data.

Deseasonalized demand represents the
demand that would have been observed
in the absence of a seasonal
fluctuations.

Method
To ensure that each season is given equal
weight when deseasonalizing the demand,
take average of p consecutive periods.
Average of demand from period l+1 to l +
p provides deseasonalized demand for
period l+(1 + p)/2.
This method provides deseasonalized
demand
for existing period, if p is odd,
at a point between period l+(p)/2 and l +1+ (
p)/2 , if p is even,
Method
By taking the average of deseasonalized demand
provided by periods l+1 to (l + p) and l+2 to
(l+ p+1) we obtain deseasonalized demand for
period l+1+(p/2) .
i t 1 (p/ 2)
t t p/ 2 t p/ 2 i
i t 1 (p/ 2)
t p/ 2
i
i t p/ 2
D D D 2D / 2p if p is even
D / p, for p odd
= +
+
= +
+
(

=
(

(
= + +
(

Contd...
For example, in the case of Tahoe salt
where p=4, for t=3 the decentralized
demand is given by


4
3 1 5 i
i 2
D D D 2D / 8
=
(
= + +
(

Deseasolized demand for Tahoe


Demand
Period Demand D
t
Deseasonalized
demand
1 8,000
2 13,000
3 23,000 19,750
4 34,000 20,625
5 10,000 21,250
6 18,000 21,750
7 23,000 22,500
8 38,000 22,125
9 12,000 22,625
10 13,000 24,125
11 32,000
12 41,000
Once the demand is deseasonalized it is
either growing or declining at a steady
rate. It can be expressed as follows:




Where,
L= level or deseasonalized demand at period t.
T=rate of growth of deseasonalized demand or trend

t
D L Tt = +
L and T estimation
For previous formula, need to estimate the
values of L and T.

Use linear regression with deseasonalized
demand( using excel sheet).

For the example of salt, L=18439, T=524
t
D 18, 439 524t = +
Deseasonalized demand and
seasonal factor for Tahoe Salt
Period Demand D
t
Deseasonali
zed demand
Seasonal
Factor
1 8,000 18,963 0.42
2 13,000 19,487 0.67
3 23,000 20,011 1.15
4 34,000 20,535 1.66
5 10,000 21,059 0.47
6 18,000 21,583 0.83
7 23,000 22,107 1.04
8 38,000 22,631 1.68
9 12,000 23,155 0.52
10 13,000 23,679 0.55
11 32,000 24,203 1.32
12 41,000 24,727 1.66
Estimating seasonal factors
The seasonal factor for period t is the ratio of actual
demand to deseasonalized demand and is given as follows:


For a given periodicity, p, we can obtain the
seasonal factor for a given period by averaging
seasonal factors corresponding to similar periods.

Example ,if periodicity p=4, the periods 1,5,and 9
will have similar seasonal factors. The seasonal
factor for these periods is obtained as the average
of the 3 seasonal factors.

t t t
S D / D =
_
t
S
Estimating seasonal factors
Given r seasonal cycles in data, for all periods of
the form we obtain the seasonal
factor as:



For the Tahoe salt example, a total of 12 periods and
periodicity of 4 implies r=3 therefore we get

_ _ _
1 1 5 9
( ) / 3 (0.42 0.47 0.52) / 3 0.47 S S S S = + + = + + =
r 1
i jp i
j 0
S S / r

+
=
| |
=
|
\ .

,1 pt i i p + s s
Adaptive forecasting
In this, the estimates of level, trend,
and seasonality are updated after each
demand observation.
In most general setting, systematic
component of demand data contains a
level, a trend, and a seasonal factor.
Can be easily modified for other cases
also.
We have historical data for n periods
and demand is periodic with periodicity p
Mathematical model
In adaptive methods the forecast for period t+1is
given as follows:


where
L
t
=estimate of level at the end of period t
T
t
=estimate of trend at the end of period t
S
t
=estimate of seasonal factor at the end of period t
D
t
= Actual demand observed at the end of period t
F
t
=forecast for demand at the end of period t
E
t
=forecast for demand at the end of period t

( )
t l t t t l
F L lT S
+ +
= +
Steps in adaptive
forecasting framework
1. Initialize:
1. Compute initial estimates of level (L
0
),
trend (T
0
), seasonal factor (S
1
,, S
P
)
from given data.

2. Forecast:
1. Given the estimates in period t,
forecast demand for t+1.
2. First forecast if for period 1 and is
made with the estimates of level,
trend, and seasonal factor at period 0.
Steps
3. Estimate error

Record the actual demand D
t+1
for
period t+1 and compute the error E
t+1

in the forecast for period t+1 as the
difference between the forecast
and actual demand. The error for
period t+1 is stated as follows:

E
t+1
= F
t+1
- D
t+1
Steps
4. Modifying estimates
o Modify estimates of level (L
t+1
), trend (T
t+1
),
and seasonal factor (S
t+p+1
) for a given error
E
t+1
.
o Desirable modifications can be such that
If the demand is lower than forecast,
estimates are revised downward.
If demand is higher than forecast, estimates
are revised upward.

Revised estimates in period t+1 are then
used to make forecast for period t+2.

Steps 2, 3, 4 are repeated until all
historical data upto period n have been
covered.
Moving Average
Used when demand has no observable
trend or seasonality.
i.e. Systematic components of
demand=level
Estimate level in period t is given as
the average demand over most
recent N periods.


1 1
( ... ) /
t t t t N
L D D D N
+
= + + +
Moving average
The current forecast of all future periods is
same and is based on current estimate of level.
The forecast is stated as follows:




To compute new moving average, simply add the
latest observation and drop the oldest one.
Revised moving average serves as the next
forecast.

1 t t
F L
+
=
t n t
F L
+
=
and
1 1 2 2 1
( ... ) / ,
t t t t N t t
L D D D N F L
+ + + + +
= + + + =
Simple exponential smoothing
Appropriate when demand has no
observable trend or seasonality.
i.e. Systematic component=level
Initial estimate of level, L
0
, is taken to
be the average of all historical data.


The current forecast for all the future
periods is equal to the current estimate
of level is as follows
n
0 i
i 1
1
L D
n
=
=

1 t t
F L
+
=
t n t
F L
+
=
and
Simple exponential smoothing
After observing demand D
t+1
for period t+1,
estimate the level as


is the smoothing constant for the level,0< <1
Revised value of level is a weighted average of
observed value of level D
t+1
and old estimates of
level (L
t
) in period t.


Higher value of corresponds to a forecast that
is more responsive to recent observation and vice-
versa.
t 1
n
t 1 t 1 n
i 0
1
L ( )(1 ) D
n
+
+ +
=
= o o

1 1
(1 )
t t t
L D L o o
+ +
= +
o o
o
Trend corrected exponential
smoothing (Holts method)
Appropriate when demand is assumed to have a
level and a trend in systematic component but
no seasonality.
i.e. Systematic component of demand=level + trend
Initial estimation of level and trend by
running a linear regression between demand
D
t
and time period t
D
t
=at+b
where b mesures the estimate of the
demand at period t=0 and is our estimate of
initial level L
0
and
slope a measure the rate of change in
demand per period and is our intial estimate
of trend T
0.
Holts model
Running a linear regression
between demand and time periods
is appropriate since demand has a
trend but no seasonality.

Forecast for future periods is
F
t+1
=L
t
+T
t
and F
t+n
=L
t
+nT
t

Holts Method
After observing the demand for
period t, we estimate the level and
trend as follows

L
t+1
=D
t+1
+(1-)(L
t
+T
t
)

T
t+1
=(L
t+1
-L
t
)+(1- )T
t

is the smoothing constant for the
level 0<<1

is the smoothing constant for the
trend 0< <1

Trend and seasonality exponential
smoothing (winters model)
Appropriate when systematic
component of demand assumed to be
have a level, a trend, seasonal factor.
Systematic component of
demand=(level + trend) X seasonal
factor
Initiate with the estimation of level and
trend, and seasonal factor.
Forecast for future periods
F
t+1
=(L
t
+T
t
)S
t
and F
t+1
= (L
t
+lT
t
)S
t+1

Winters model
L
t+1
=(D
t+1
/S
t+1
)S
t
+(1-) (L
t
+T
t
)

T
t+1
= (L
t+1
- L
t
)S
t
+(1-)T
t


S
t+p+1
= (D
t+1
/L
t+1
)S
t
+(1- )S
t+1

is the smoothing constant for the level 0<<1
is the smoothing constant for the trend 0<<1
is the smoothing constant for the level 0< <1

Forecast error
Every demand has a random component. A good
forecast method should capture the systematic
component of the demand but not the random
component. The random component manifests
itself in the form of forecast error.
Reasons for the error analysis of forecast.
Use error analysis to determine Whether the current
forecasting method is accurately predicting the systematic
component of demand. E.g. If a forecasting method continues
to give positive error appropriate measures can be taken by
the manager.
Estimate forecast error because any contingency plan must
account for such an error

Measures of forecast error
Observed error are within historical error estimates,
firms can continue to use their current forecasting
method.

In the other case, finding may indicate forecasting
method is no more appropriate.

Forecast error E
t
for t
th
time period is given as the
difference between the forecast for period t and actual
demand.




1 1 1 t t t
E F D
+ + +
=
Mean Squared Error
(MSE)

One measure of forecast error is the mean
squared error (MSE) and is given by :




n
2
n t
i 1
1
MSE E
n
=
=

Absolute deviation
Absolute deviation is the absolute value of
error in period t

Mean absolute deviation (MAD) to be average
of absolute deviation over all periods


MAD can be used to estimate the SD of
random component assuming it to be normally
distributed.
t t
A E =
n
n t
t 1
1
MAD A
n
=
=

Mean percentage of
error
Is the average absolute error as a
percentage of demand


We can use the sum of forecast errors
to evaluate the bias

The bias will fluctuate around 0 if the
error is truly random and not biased one
way or the other.
n
t
t 1 t
n
E
100
D
MAPE
n
=
=

n
n t
t 1
bias E
=
=

Tracking signal
The tracking signal is the ratio of the
bias and the MAD and is given as
follows:
t
t
t
bias
TS
MAD
=
Tracking signal
If the TS at any period is outside the range
+6, this signal that the forecast is biased and
is either under-forecasting (TS below -6) or
over forecasting (TS below -6) .

In such a case, a firm will choose a new fore
casting method.
Specialty Packaging Corporation: A Case Study
Company Profile
Manufacturer of disposable containers
Major customers are from the food industry
Main raw material is Polystyrene resin
Manages inventory through a make-to-stock
policy
Specialty Packaging Corporation: A Case Study
Manufacturing Process
Polystyrene is stored in the form of resin pallets
Extruder generates rolled sheets, which may be
stored or further processed
Thermo-setting press trims the rolls into
containers
Resin
Storage
Roll
Storage
Extruder
Thermo-
Setting
Press
Fig. Manufacturing Process at SPC
Specialty Packaging Corporation: A Case Study
Market Scenario
Steady growth in demand, which will stabilize
after 2005
Unable to meet the peak demand, extrusion
becomes a bottleneck
Lost sales occur frequently
Plastic
Clear Black
Grocery
Store
Bakery Restaurants
Grocery
Store
Catering
Fig. Customer Base
Peak demand in summer
Peak demand in fall
Specialty Packaging Corporation: A Case Study
Goal
Synergizing marketing and customer feedbacks to
improve supply chain performance by adequate demand
matching
Objective
Forecasting quarterly demand during 2003-2005 for
both types of containers
Results
Method of forecasting
Likely forecast errors