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Demand Forecasting
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OBJECTIVES

Demand Forecasting
Qualitative Forecasting Methods

Quantitative Forecasting Methods


Moving Average Method
Exponential Smoothing Method
Simple Linear Regression Method
Measuring Forecast Accuracy
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Demand Forecasting

Demand forecasting is predicting future


demands based on past data and/or
judgment
Demand forecasts may be used for various
purposes
Capacity decisions, production planning, pricing
decisions, whether to enter a new market,
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Patterns of Demand

Horizontal Trend

Year 1

Year 2 | | | | | |
1 2 3 4 5 6 years
Seasonal Cyclical
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Forecasting as a Process

Typically, the forecasting process involves the


following steps:
1. Update history file
2. Prepare initial forecasts
Using forecasting methods
3. Consensus meetings and collaboration
Meetings among marketing, sales, operations,
and finance
Collaboration with key customers and suppliers
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Forecasting as a Process (Contd)

4. Revise forecasts
Based on the inputs from the consensus
meetings and collaborative sources
5. Review by operating committee
6. Finalize and communicate
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Steps for Building and Using


a Forecasting Model

1. Decide what to forecast


e.g.) Weekly demands for individual products, quarterly
or yearly demands for product groups
2. Collect and evaluate data
Identify any pattern of data
3. Select and test a forecasting model
A forecasting method and its parameter values
4. Generate the forecast
5. Monitor forecast accuracy
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Key Decisions in Forecasting

Deciding what to forecast


Individual products or product groups?
Weekly, monthly, or quarterly demands?
Units or dollars?
Choosing a forecasting software package
e.g.) SAS, Forecast Master, Forecast Pro
Choosing a forecasting method
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Choosing a Forecasting Method

The choice of a forecasting method may


depend on:
Time horizon to forecast
Amount and pattern of data
Degree of forecast accuracy required
Size of forecasting budget
Availability of qualified personnel
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Types of Forecasting Method

Qualitative forecasting methods


Judgmental and subjective
Quantitative forecasting methods
Use quantitative techniques
Time series methods
Forecasting based on past demand history only
Causal methods
Forecasting based on historical relationship between
demand and other factors (e.g., advertising amount)
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Qualitative Forecasting Methods

Executive Opinion Salesforce Estimates

Historical analogy Qualitative Market Research

Methods

Panel Consensus Delphi Method


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Qualitative Forecasting Methods (Contd)

Executive opinion
Forecasts determined by executive opinion
Salesforce estimates
Forecasts collected from salesforces
Historical analogy
Predicting demands for a new product by using
demand history of similar products
Market research
Using surveys or interviews to determine
demand forecasts
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Qualitative Forecasting Methods (Contd)

Panel consensus
Forecasts developed by a group of people from
a variety of positions and departments through
open meetings
Delphi method
Similar to panel consensus, but through
anonymous procedures
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Delphi Method

1. Choose a group of experts representing a variety of


positions and departments
2. Obtain forecasts (and any reasons for the forecasts)
from the participants through a questionnaire
3. Provide an anonymous summary of the results to the
participants
4. Obtain revised forecasts (and any reasons) from the
participants
The participants revise their forecasts considering the
summarized results
5. Repeat Step 3 and 4 as necessary and distribute the
final results to the participants
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Quantitative Forecasting Methods

Time series methods


Forecasting based on past demand history only
Moving average method
Exponential smoothing method
Causal methods
Forecasting based on historical relationship
between demand and other factors
Linear regression method
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Simple Moving Average Method

The forecast is determined by averaging


the actual demands in the past n periods

D t + D t-1 + D t-2 +...+D t-n+1


Ft+1 =
n

Ft+1 = forecast for period t+1


Dt-i = actual demand in period t-i
n = number of periods (or data points)
in the average
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Example of Simple Moving Average


Method

Given the following demand history for a


product in the past six weeks, what are the
3-week and 6-week moving average
forecasts for week 7?
Week Demand
1 650
2 678
3 720
4 785
5 859
6 920
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Example of Simple Moving Average


Method (Contd)
3-week moving average forecast for week 7
D6 + D5 + D4 920 + 859 + 785
F7 = 855
3 3

6-week moving average forecast for week 7


D6 + D5 + D 4 + D3 + D 2 + D1
F7 =
6
920 + 859 + 785 + 720 + 678 + 650
769
6
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Comparison of Forecasts and Actual


Demands

950
900
850
800
750 Demand
700
650 3-Week
600 6-Week
550
500
1 2 3 4 5 6 7 8 9 10 11 12
Note how the 3-
Week
Week is smoother
than the Demand,
and the 6-Week is
even smoother.
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Choosing Parameter Value, n

Need to choose the value of parameter n


n = number of periods (or data points) in the
average
Effects of parameter n
A large value of n results in more stable
forecasts
A small value of n results in forecasts more
responsive to changes in demand
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Weighted Moving Average Method

The forecast is determined by the weighted


average of the actual demands

Ft+1 = w1D t + w 2 D t-1 +w 3D t-2 +...+w n D t-(n-1)

wi = weight given to actual


n
demand in i periods ago
e.g.) w1 = weight given to the w
i=1
i =1
most recent actual demand
Weights must add to one
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Example of Weighted Moving Average
Method

Given the following demand history and


weights, what is the weighted moving
average forecast of week 5?

Week Demand
Weights
1 820
w1 = .7
2 775
3 680
w2 = .2
4 655 w3 = .1
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Example of Weighted Moving Average


Method (Contd)

Week Demand Forecast Weights


1 820 w1 = .7
2 775 w2 = .2
3 680 w3 = .1
4 655
5 672

F5 = w1 D4 + w2 D3 + w3 D2
= (0.7)(655) + (0.2)(680) + (0.1)(775) = 672
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Exponential Smoothing Method


The forecast is updated based on its forecast
error
Ft+1 = Ft Dt Ft

Or, equivalently, it is determined by the weighted


average of actual demand and forecast demand
Ft+1 = Dt 1 Ft

Ft+1 = forecast for period t+1


Dt = actual demand in period t
= smoothing parameter
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Example of Exponential Smoothing


Method

Given the following actual demand and


forecast data in the past three weeks,
what is the exponential smoothing forecast
for week 4, using 0.1 and 0.6?

Week Demand Forecast


1 650 657
2 678 656
3 720 658
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Example of Exponential Smoothing


Method (Contd)

Using 0.1

F4 = F3 D3 F3 658 0.1 720 658 664

Using 0.6

F4 = 658 0.6 720 658 695


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Comparison of Forecasts and Actual


Demands

850
800
750 Demand
700 0.1
650
600 0.6
550
500
1 2 3 4 5 6 7 8 9 10
Week Note how the
forecasts become
smoother as the
value of alpha
decreases.
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Choosing Parameter Value,

Need to choose the value of parameter


= smoothing parameter
Effects of parameter
A small value of results in more stable
forecasts
A large value of results in forecasts more
responsive to changes in demand
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Other Time-Series Forecasting


Methods

Trend-adjusted exponential smoothing


method
When demand has a trend pattern
Multiplicative seasonal method
When demand has a seasonal pattern
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Simple Linear Regression Method


The simple linear (xi ,yi )
y
regression model
seeks to find a linear b
relationship between a
two variables
x
y = a + bx
y = dependent variable (demand)
y = predicted value of dependent variable
x = independent variable (e.g., advertising amount)
a = y-intercept of the line
b = slope of the line.
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Simple Linear Regression Formulas


for Calculating a and b
n
(xi ,yi ) y = a + bx
x y
i=1
i i n(y)(x) y
b= n

i
x 2

i=1
n(x) 2

a = y bx x
n n
i=1 yi
i=1 xi y = n = number of data points
x = n
n

These formulas minimize the sum of the squares


of forecast error, ni=1 yi y i 2 , where y i = a + bxi
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Example: Simple Linear Regression


Method

Month Sales Advertising


1 164 2.5
2 116 1.3
3 165 1.4
4 101 1.0
5 179 2.0
* Advertising: thousands of dollars

Question: Given the data above, what is the simple


linear regression model that can be used to predict
sales?
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x x^2 y x*y
2.5 6.25 164 410
1.3 1.69 116 150.8
1.4 1.96 165 231
1.0 1 101 101
2.0 4 179 358
1.64 14.9 145 1250.8
Average Sum Average Sum

b=
x y n(y)(x)
i i
=
1250.8 5(145)(1.64) 61.8
= = 42.6
x n(x)
2
i
2
14.9 5(1.64) 2
1.45
a = y bx = 145 (42.6)(1.64) = 75.1
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Example: Results of Simple Linear
Regression Method

The resulting regression model is:

y = 75.1 + 42.6x

If we plan to invest $3,000 in advertising,


then the forecast demand is:

y = 75.1 + 42.6 * 3.0


= 203
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Forecast Error

Forecast error = actual demand forecast

E t = D t Ft

Et = forecast error in period t


Dt = actual demand in period t
Ft = forecast for period t

Examples:
Ft = 200, Dt = 180 Et = 180 200 = 20
Ft = 200, Dt = 210 Et = 210 200 = 10
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Measures of Forecast Accuracy


n

Mean absolute deviation (MAD) E t=1


t

= Average of the absolute errors MAD = n

Et
2
Mean squared error (MSE)
t=1
=Average of the squared errors MSE =
n

n
Cumulative sum of forecast CFE = E t
errors (CFE) t=1
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Example of MAD, MSE and CFE

Given the following information, what are the


values of MAD, MSE and CFE?

Month Sales Forecast


1 200 225
2 240 220
3 300 285
4 270 290
5 230 250
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Example of MAD, MSE and CFE (Contd)


Month Sales Forecast Error Abs Error Sqrd Error
1 200 225 -25 25 625
2 240 220 20 20 400
3 300 285 15 15 225
4 270 290 -20 20 400
5 230 250 -20 20 400
Total: -30 100 2050
n

Et
100 CFE =
n

E 30
MAD = t=1
20 t=1
t

n 5
n

Et
2

2050
MSE = t=1
410
n 5
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MAD vs. Standard Deviation

If forecast errors are normally distributed


with mean 0 and standard deviation ,
then the value of MAD is approximately
equal to 0.8

1 MAD 0.8
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MAD vs. Standard Deviation (Contd)

Equivalent Percentage of Area


Number of MAD Number of within # of MAD
1 MAD 0.8 57.048
2 MAD 1.6 88.946
3 MAD 2.4 98.334
4 MAD 3.2 99.856

Normal distribution
with mean 0 and
standard deviation
57.048%

0.8 0 0.8
MAD MAD
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MAD vs. Standard Deviation (Contd)

Equivalent Percentage of Area


Number of MAD Number of within # of MAD
1 MAD 0.8 57.048
2 MAD 1.6 88.946
3 MAD 2.4 98.334
4 MAD 3.2 99.856

For example, if MAD=10,


The forecast error will be between -10 and 10 with
a probability of 57.048%
The forecast error will be between -20 and 20 with
a probability of 88.946%
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MAD vs. Standard Deviation (Contd)

In particular, notice that the forecast error will be


between -3MAD and 3MAD with a probability of
98.334%
forecast error
Equivalently, will be between -3 and
MAD
3 with a probability of 98.334%

98.334%

-3MAD 0 3MAD
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Tracking Signal

Tracking signal is defined as

CFE
Tracking signal =
MAD

The tracking signal value will be within -3 and 3


with a very high probability

Tracking signal can be used to monitor


forecast accuracy over time
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Monitoring Forecast Accuracy


using Tracking Signal
Out of control
+4.0
Upper control limit
+3.0
Tracking Signal

+2.0
+1.0
0
1.0
2.0
Lower control limit
3.0
| | | | |
0 5 10 15 20 25
Observation Number
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Example of Tracking Signal

What is the tracking signal value at the end of


Month 3?

Month Sales Forecast


1 230 200
2 240 220
3 219 235
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Example of Tracking Signal (Contd)

Month Sales Forecast Error Abs Error


1 230 200 30 30
2 240 220 20 20
3 219 235 -16 16
Total: 34 66

Et
66 CFE =
n

E 34
MAD = t=1
22 t=1
t

n 3

CFE 34
Tracking signal = 1.55
MAD 22

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