Chapter 7

Demand Forecasting

Introduction

Demand estimates for products and services are the starting point for all the other planning in operations management. Management teams develop sales forecasts based in part on demand estimates. The sales forecasts become inputs to both business strategy and production resource forecasts.

Forecasting is an Integral Part of Business Planning

Inputs: Market, Economic, Other

Forecast Method(s)

Demand Estimates

Sales Forecast

Management Team

Business Strategy

Production Resource Forecasts

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Some Reasons Why Forecasting is Essential

New Facility Planning It can take 5 years to design and build a new factory or design and implement a new production process. Production Planning Demand for products vary from month to month and it can take several months to change the capacities of production processes. Workforce Scheduling Demand for services (and the necessary staffing) can vary from hour to hour and employees weekly work schedules must be developed in advance.
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Forecasting Methods

Qualitative Approaches Quantitative Approaches

Methods of demand forecasting

Qualitative Approaches

Usually based on judgments about causal factors that underlie the demand of particular products or services Do not require a demand history for the product or service, therefore are useful for new products/services Approaches vary in sophistication from scientifically conducted surveys to intuitive hunches about future events The approach/method that is appropriate depends on a products life cycle stage
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Qualitative Methods

Educated guess intuitive hunches Executive committee consensus Delphi method Survey of sales force Survey of customers Historical analogy Market research scientifically conducted surveys

Quantitative Forecasting Approaches

Based on the assumption that the forces that generated the past demand will generate the future demand, i.e., history will tend to repeat itself Analysis of the past demand pattern provides a good basis for forecasting future demand Majority of quantitative approaches fall in the category of time series analysis Time spans usually greater than one year Necessary to support strategic decisions about planning products, processes, and facilities
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Quantitative Forecasting Approaches

Linear Regression Simple Moving Average Weighted Moving Average Exponential Smoothing (exponentially weighted moving average) Time Series analysis

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Simple Linear Regression

Linear regression analysis establishes a relationship between a dependent variable and one or more independent variables. In simple linear regression analysis there is only one independent variable. If the data is a time series, the independent variable is the time period. The dependent variable is whatever we wish to forecast.
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Simple Linear Regression

Regression Equation This model is of the form: Y = a + bX Y = dependent variable X = independent variable a = y-axis intercept b = slope of regression line

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Simple Linear Regression

Constants a and b The constants a and b are computed using the following equations:
a= x2 y- x xy n x2 -( x)2 n xy- x y n x2 -( x)2

b=

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Simple Linear Regression

Once the a and b values are computed, a future value of X can be entered into the regression equation and a corresponding value of Y (the forecast) can be calculated.

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Example: College Enrollment

Simple Linear Regression At a small regional college enrollments have grown steadily over the past six years, as evidenced below. Use time series regression to forecast the student enrollments for the next three years. Year 1 2 3

Students Enrolled (1000s) 2.5 2.8 2.9

Year 4 5 6

Students Enrolled (1000s) 3.2 3.3 3.4

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Example: College Enrollment

Simple Linear Regression x y x2 1 2.5 1 2 2.8 4 3 2.9 9 4 3.2 16 5 3.3 25 6 3.4 36 Sx=21 Sy=18.1 Sx2=91 xy 2.5 5.6 8.7 12.8 16.5 20.4 Sxy=66.5
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Example: College Enrollment

Simple Linear Regression

91(18.1) 21(66.5) a 2.387 2 6(91) (21)
6(66.5) 21(18.1) b 0.180 105

Y = 2.387 + 0.180X

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Example: College Enrollment

Simple Linear Regression Y7 = 2.387 + 0.180(7) = 3.65 or 3,650 students Y8 = 2.387 + 0.180(8) = 3.83 or 3,830 students Y9 = 2.387 + 0.180(9) = 4.01 or 4,010 students Note: Enrollment is expected to increase by 180 students per year.

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Simple Linear Regression

Simple linear regression can also be used when the independent variable X represents a variable other than time. In this case, linear regression is representative of a class of forecasting models called causal forecasting models.

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Linear Regression (Causal forecasting)

Illustration: Fit a linear regression line to the following data and estimate the demand at price = Rs. 30

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Linear Regression

Coefficients a and b calculation

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Linear Regression

Coefficients a and b calculation

Equation of Regression line,

S = 44.82 0.641P
S(when P = 30) = 44.82 0.641*30 = 25.29 (000 units)
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Multiple Regression Analysis

Multiple regression analysis is used when there are two or more independent variables. An example of a multiple regression equation is: Y = 50.0 + 0.05X1 + 0.10X2 0.03X3 where: Y = firms annual sales ($millions) X1 = industry sales ($millions) X2 = regional per capita income ($thousands) X3 = regional per capita debt ($thousands)
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Time Series Analysis

A time series is a set of numbers where the order or sequence of the numbers is important, e.g., historical demand Analysis of the time series identifies patterns Once the patterns are identified, they can be used to develop a forecast

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Components of Time Series

Trends are noted by an upward or downward sloping line Seasonality is a data pattern that repeats itself over the period of one year or less Cycle is a data pattern that repeats itself... may take years Irregular variations are jumps in the level of the series due to extraordinary events Random fluctuation from random variation or unexplained causes
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Seasonal Patterns
Length of Time Before Pattern Is Repeated Year Year Year Month Week Number of Seasons in Pattern 4 12 52 28-31 7
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Length of Season Quarter Month Week Day Day

Seasonalized Time Series Regression Analysis

Select a representative historical data set. Develop a seasonal index for each season. Use the seasonal indexes to deseasonalize the data. Perform linear regression analysis on the deseasonalized data. Use the regression equation to compute the forecasts. Use the seasonal indexes to reapply the seasonal patterns to the forecasts.

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Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis An analyst at CPC wants to develop next years quarterly forecasts of sales revenue for CPCs line of Epsilon Computers. She believes that the most recent 8 quarters of sales (shown on the next slide) are representative of next years sales.

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Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis Representative Historical Data Set

Year Qtr. ($mil.) 1 1 1 1 1 2 3 4 7.4 6.5 4.9 16.1

Year Qtr. ($mil.) 2 2 2 2 1 2 3 4 8.3 7.4 5.4 18.0

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Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis Compute the Seasonal Indexes

Year 1 2 Totals Qtr. Avg. Seas.Ind.

Quarterly Sales Q1 Q2 Q3 Q4 Total 7.4 6.5 4.9 16.1 34.9 8.3 7.4 5.4 18.0 39.1 15.7 13.9 10.3 34.1 74.0 7.85 6.95 5.15 17.05 9.25 .849 .751 .557 1.843 4.000
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Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis Deseasonalize the Data

Year 1 2

Q1 8.72 9.78

Quarterly Sales Q2 Q3 8.66 8.80 9.85 9.69

Q4 8.74 9.77

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Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis Perform Regression on Deseasonalized Data

Yr. 1 1 1 1 2 2 2 2

Qtr. 1 2 3 4 1 2 3 4 Totals

x 1 2 3 4 5 6 7 8 36

y 8.72 8.66 8.80 8.74 9.78 9.85 9.69 9.77 74.01

x2 1 4 9 16 25 36 49 64 204

xy 8.72 17.32 26.40 34.96 48.90 59.10 67.83 78.16 341.39

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Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis Perform Regression on Deseasonalized Data

204(74.01) 36(341.39) a 8.357 2 8(204) (36)

8(341.39) 36(74.01) b 0.199 2 8(204) (36)

Y = 8.357 + 0.199X

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Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis Compute the Deseasonalized Forecasts

Y9 Y10 Y11 Y12

= 8.357 + 0.199(9) = 10.148 = 8.357 + 0.199(10) = 10.347 = 8.357 + 0.199(11) = 10.546 = 8.357 + 0.199(12) = 10.745

Note: Average sales are expected to increase by .199 million (about $200,000) per quarter.
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Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis Seasonalize the Forecasts

Seas. Yr. Qtr. Index

Deseas. Forecast

Seas. Forecast

3 3 3 3

1 2 3 4

.849 .751 .557 1.843

10.148 10.347 10.546 10.745

8.62 7.77 5.87 19.80

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Forecasting Horizons

long-term: more than 2 years medium-term: 3 months to 2 years short-term: 0 to 3 months

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Short-Range Forecasts

Time spans ranging from a few days to a few weeks Cycles, seasonality, and trend may have little effect Random fluctuation is main data component

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Short-Range Forecasting Methods

Simple Moving Average Weighted Moving Average Exponential Smoothing

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Simple Moving Average

An averaging period (AP) is given or selected The forecast for the next period is the arithmetic average of the AP most recent actual demands It is called a simple average because each period used to compute the average is equally weighted It is called moving because as new demand data becomes available, the oldest data is not used By increasing the AP, the forecast is less responsive to fluctuations in demand (low impulse response and high noise dampening) By decreasing the AP, the forecast is more responsive to fluctuations in demand (high impulse response and low noise dampening) 39

Moving Averages
Wallace Garden Supply
Forecasting
Storage Shed Sales

Period January February March April May June July August September October November December

Actual Value 10 12 16 13 17 19 15 20 22 19 21 19

Three-Month Moving Averages

10 12 16 13 17 19 15 20 22

+ + + + + + + + +

12 16 13 17 19 15 20 22 19

+ + + + + + + + +

16 13 17 19 15 20 22 19 21

/ / / / / / / / /

3 3 3 3 3 3 3 3 3

= = = = = = = = =

12.67 13.67 15.33 16.33 17.00 18.00 19.00 20.33 20.67

Moving Average Method

Illustration: Calculate 3 yearly moving average for the following data on the firms market share:

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Moving Average Method

Calculation of 3 yearly Moving Average

Root Mean Square Error, RMSE:

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Weighted Moving Average

This is a variation on the simple moving average where the weights used to compute the average are not equal. This allows more recent demand data to have a greater effect on the moving average, therefore the forecast. The weights must add to 1.0 and generally decrease in value with the age of the data. The distribution of the weights determine the impulse response of the forecast.
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Weighted Moving Average

Wallace Garden Supply
Forecasting
Storage Shed Sales

Period January February March April May June July August September October November December Next period

Actual Value Weights 10 0.222 12 0.593 16 0.185 13 17 19 15 20 22 19 21 19 20.185 1.000

Three-Month Weighted Moving Averages

2.2 2.7 3.5 2.9 3.8 4.2 3.3 4.4 4.9

+ + + + + + + + +

7.1 9.5 7.7 10 11 8.9 12 13 11

+ + + + + + + + +

3 2.4 3.2 3.5 2.8 3.7 4.1 3.5 3.9

/ / / / / / / / /

1 1 1 1 1 1 1 1 1

= = = = = = = = =

12.298 14.556 14.407 16.484 17.814 16.815 19.262 21.000 20.036

Sum of weights =

Exponential Smoothing

The weights used to compute the forecast (moving average) are exponentially distributed. The forecast is the sum of the old forecast and a portion (w) of the forecast error (A t-1 - Ft-1). Ft = wA1 + (1 w) Ft-1

The smoothing constant, w, must be between 0.0 and 1.0. A large w provides a high impulse response forecast. A small w provides a low impulse response forecast.
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Exponential Smoothing

Illustration: The demand for shoes of Reebok Company have been recorded quarterly for 3 years. Find the 3 month moving averages and the exponentially smoothened time series using smoothing constant w = 0.1

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Exponential Smoothing

Original and Smoothened values of Demand

Root Mean Square Error, RMSE:

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Criteria for Selecting a Forecasting Method

Cost Accuracy Data available Time span Nature of products and services Impulse response and noise dampening

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Criteria for Selecting a Forecasting Method

Cost and Accuracy There is a trade-off between cost and accuracy; generally, more forecast accuracy can be obtained at a cost. High-accuracy approaches have disadvantages: Use more data Data are ordinarily more difficult to obtain The models are more costly to design, implement, and operate Take longer to use

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Criteria for Selecting a Forecasting Method

Cost and Accuracy Low/Moderate-Cost Approaches statistical models, historical analogies, executive-committee consensus High-Cost Approaches complex econometric models, Delphi, and market research

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Criteria for Selecting a Forecasting Method

Data Available Is the necessary data available or can it be economically obtained? If the need is to forecast sales of a new product, then a customer survey may not be practical; instead, historical analogy or market research may have to be used.

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Criteria for Selecting a Forecasting Method

Time Span What operations resource is being forecast and for what purpose? Short-term staffing needs might best be forecast with moving average or exponential smoothing models. Long-term factory capacity needs might best be predicted with regression or executive-committee consensus methods.

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Criteria for Selecting a Forecasting Method

Nature of Products and Services Is the product/service high cost or high volume? Where is the product/service in its life cycle? Does the product/service have seasonal demand fluctuations?

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Criteria for Selecting a Forecasting Method

Impulse Response and Noise Dampening An appropriate balance must be achieved between: How responsive we want the forecasting model to be to changes in the actual demand data Our desire to suppress undesirable chance variation or noise in the demand data

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Reasons for Ineffective Forecasting

Not involving a broad cross section of people Not recognizing that forecasting is integral to business planning Not recognizing that forecasts will always be wrong Not forecasting the right things Not selecting an appropriate forecasting method Not tracking the accuracy of the forecasting models

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Computer Software for Forecasting

Examples of computer software with forecasting capabilities Forecast Pro Primarily for Autobox forecasting SmartForecasts for Windows SAS Have SPSS Forecasting SAP modules POM Software Library

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