Demand

Forecasting
- Prashant Jain
What is Forecasting?
• Process of predicting a future event and it is a mere
guess.
• The estimation of the future demand for products
and services are commonly referred as a sales
forecast
• Underlying basis of all business decisions:
• Production

• Inventory

• Personnel

• Facilities
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Types of Forecasts

• Economic forecasts
– Address the future business conditions (e.g.,
inflation rate, money supply, etc.)
• Technological forecasts
– Predict the rate of technological progress
– Predict acceptance of new products
• Demand forecasts
– Predict sales of existing products

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What is Demand ?
• Demand in economics means effective demand, that
is one which meets with all its three crucial
characteristics;
• desire to have a good,
• willingness to pay for that good &
• ability to pay for that good.
• In absence of any of these three characteristics,
there is no demand

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What is Demand Forecasting ?
• Demand forecast forms the basis of all Supply chain
• All push processes in the supply chain are performed in
anticipation of customer demand, whereas all pull
processes are performed in response to customer
demand.
• For push processes, a manager must plan the level of
activity , be it production, transportation, or any other
planned activity.
• for pull processes, A manager must plan the level of
available capacity & inventory but not the actual
amount to be executed.
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What is Demand Forecasting ? (contd…)
• So for both Push and Pull processes the first step a
manager must take is to forecast what customer
demand will be………
• Demand forecasting means estimation of the
demand for the good in the forecast period.
• It is a process of estimating a future event by casting
forward past data.
• The past data are systematically combined in a
predetermined way to obtain the estimate of future
demand.
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Factors Involved in Demand Forecasting
• How far ahead the long-term forecast goes.
• Should the forecast be general or specific?
• Problems & methods of forecasting are usually
different for new products from those for products
already well established in the market.
• It is important to classify the products as
producer goods, consumer durable, or consumer
goods & services.
• Finally, in every forecast, special factors peculiar to the
product & the market must be taken into account.
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Importance of Demand Forecasting
• The basic operations process, moving from the
suppliers' raw materials to finished goods in the
customers' hands, takes time.
• Most firms cannot simply wait for demand to emerge
and then react to it.
• Instead, they must anticipate and plan for future
demand so that they can react immediately to
customer orders as they occur.
• Most manufacturers "make to stock" rather than
"make to order" – they plan ahead and then deploy
inventories of finished goods into field locations
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Why demand forecasting?

• Planning and scheduling production

• Acquiring inputs
• Making provision for finances
• Formulating pricing strategy
• Planning advertisement

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Elements of a Good Forecast

Timely

Reliable Accurate

Written

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Steps

• Specifying the objective

• Determining the time perspective
• Making choice of method
• Collection of data
• Estimation and interpretation of results

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Steps in the
Forecasting
“The forecast”
Process

Step 6 Monitor the forecast

Step 5 Prepare the forecast
Step 4 Gather and analyze data
Step 3 Select a forecasting technique
Step 2 Establish a time horizon
Step 1 Determine purpose of forecast
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 Forecasting Horizons
• Long Term
– 5+ years into the future
– R&D, plant location, product planning
– Principally judgment-based
• Medium Term
– 1 season to 2 years
– Aggregate planning, capacity planning, sales forecasts
– Mixture of quantitative methods and judgment
• Short Term
– 1 day to 1 year, less than 1 season
– Demand forecasting, staffing levels, purchasing, inventory
levels
– Quantitative methods Prashant Jain 13
Purpose of Long Term forecasting
• Planning of a new unit or expansion of an existing unit.
A multi-product firm must ascertain not only the total
demand situation, but also the demand for different
items separately.
• Planning long-term financial requirements.
As planning or raising funds requires considerable time,
long –term sales forecasting are quite essential to assess
long-term financial requirements.
• Planning man-power requirements.
Training & personnel development are long-term
propositions, taking considerable time to complete.
Prashant Jain 14
Short Term Forecasting: Needs and Uses
• Scheduling existing resources
– How many employees do we need and when?
– How much product should we make in anticipation of
demand?

• Acquiring additional resources

– When are we going to run out of capacity?
– How many more people will we need?
– How large will our back-orders be?

• Determining what resources are needed

– What kind of machines will we require?
– Which services are growing in demand? declining?
– What kind of people should we be hiring?
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General approaches to Demand forecasting
Judgmental Approaches
The forecasting issue is addressed by assuming that
someone else knows and can tell you the right answer.
Experimental Approaches
When an item is "new" and when there is no other
information upon which to base a forecast, a demand
experiment is conducted on a small group of customers.

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General approaches to Demand forecasting (contd…)

Relational/Causal Approaches:
There is a reason why people buy our product. If we can
understand what that reason (or set of reasons) is, we
can use that understanding to develop a demand
forecast.
Time Series Approaches:
A time series is a collection of observations of well-
defined data items obtained through repeated
measurements over time.
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 Forecasting Approaches (contd…)
Qualitative Methods Quantitative Methods
 Used when situation is  Used when situation is
vague & little data exist stable & historical data
• New products exist
• New technology • Existing products
 Involves intuition, • Current technology
experience  Involves mathematical
• e.g., forecasting sales techniques
on Internet • e.g., forecasting
sales of color
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televisions 18
Classification of Demand Forecasting Techniques
QUALTITATIVE TECHNIQUES QUANTITATIVE TECHNIQUES

1. EXPERT OPINION 1. TIME SERIES ANALYSIS.

Delphi method. 2. BAROMETRIC ANALYSIS.
2. SURVEY a) Leading indicators
3. MARKET EXPERIMENT b) Coincident
indicators
a) Test marketing
c) Lagging indicators.
b) Controlled
Experiments.

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 Qualitative Quantitative

Judgment
Numbers

Qualitative Methods Quantitative Methods

• Used when situation is • Used in stable situations
vague & little data exist when historical data exist
– New products – Existing products
– New technology – Current technology
• Intuition, experience • Math / stats techniques
• e.g., Internet sales • e.g., color televisions
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Expert Opinion
• Also known as “Expert Consensus Method”, is being
widely used for demand forecasting.
• This method utilizes the findings of market research
and the opinions of management executives,
consultants, and trade association officials, trade
journal editors and sector analysts.
• When done by an expert, qualitative techniques
provide reasonably good forecasts for a short term
because of the expert’s familiarity with the issues and
the problems involved.
• Delphi Method: This is primarily used to forecast the
demand for new products.
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The Delphi Method
• The Delphi Method is a group decision process about
the likelihood that certain events will occur.
• Today it is also used for environmental, marketing
and sales forecasting.
• The Delphi Method uses a panel of experts.
• Expert responses to a series of questionnaires are
anonymous.
• Each round of questionnaires results in a median
answer.
• The process guides the group towards a consensus.
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The Delphi Method (contd...)
• The Delphi technique was invented by Olaf Helmer
and Norman Dalkey of the Rand Corporation in 1953
for the purpose of addressing a specific military
problem.
• The object of the Delphi method is to obtain a
reliable response to a problem from a group of
experts.
• In a Delphi study, the participants do not interact
with one another,
• Delphi technique is used today in business,
education, and the social sciences
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Delphi Method Detail
• The Delphi method is an exercise in group
communication among a panel of geographically
dispersed experts (Adler and Ziglio, 1996).
• It allows experts to deal systematically with a
complex problem or task.
• A series of questionnaires are sent either by mail or
email to a pre-selected group of experts.
• According to Fowles (1978) anonymity, controlled
feedback, and statistical response characterize
Delphi.
• Interaction in Delphi is anonymous, comments,
forecasts, etc are presented to the group in such a
way as to suppress any identification.
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Delphi Method Process...
Fowles (1978) describes ten steps for the Delphi method:
1. Formation of a Delphi team to undertake a Delphi on a
subject.
2. Selection of expert panel(s).000
3. Development of the first round questionnaire
4. Testing the questionnaire for proper wording.
5. Transmission to the panelists.
6. Analysis of 1st responses
7. Preparation of 2nd round.
8. Transmission of 2nd round questionnaires to the panelists
9. Analysis of the 2nd round responses (7 to 9 may be repeated
to get consensus)
10. Preparation and presentation of report.
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Qualitative Forecasting Models (cont)
• Sales force composite
– Each salesperson estimates sales in his region.
– Forecasts are reviewed to ensure realistic.
– Combined at higher levels to reach an overall
forecast.
• Consumer market survey
– Solicits input from customers and potential
customers regarding future purchases.
– Used for forecasts and product design & planning

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 Survey
• A firm can determine the demand for its products
through a market survey. It may launch a new
product, if the survey indicates that there is a
demand for that particular product in the market.

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 Survey: Example
• Coke in India expanded its product range beyond
carbonated drinks, after the company conducted a
nationwide survey.
• It was found that about 80% of the youth preferred to
drink tea or coffee rather than carbonated drinks at
regular intervals.
• The remaining 20% preferred to have milk products
while only 2% preferred to drink carbonated drinks.
• The company is now trying to bring tea and coffee
brands to India by installing vending machines.
• It is also planning to introduce a coconut flavored
drink in kerala and a black currant in Tamilnadu named
portello. Prashant Jain 28
 Market Experiment

• Market Experiment can help to overcome the survey

problems as they generate data before introducing a
product or implementing a policy.
• Market Experiments are of two types:
1) Test marketing
2) Controlled experiments

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Test Marketing
• A test area is selected, which should be representative
of the whole market in which the new product is to be
launched.
• A test area may include several cities and towns, or a
particular region of a country or even a sample of
consumers.
• More than one test area can be selected if the firm
wants to assess the effects on demand due to various
alternative marketing mix.
• Product is launched in various test areas. Then the
demand for the product can be compared at different
levels of price and advertising expenditure.
• In this way, consumer’s response to change in price or
advertising can be judged.
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Drawbacks of The Market Experiment
1. The main drawback of the test experiments is
that they are very costly and much time
consuming.
2. If in a test market prices are raised, consumer
may switch to the competitor’s products.
3. It may be difficult to regain lost customers even if
the price is reduced to the previous level.
Moreover, it is often difficult to select an area,
which accurately represents the potential
market.

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Controlled experiments

• Controlled experiments are conducted to test the

demand for a new product launched or to test the
demands for various brands of a product.
• Experiments are conducted with some selected
consumers .

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Drawbacks of The Controlled Experiments

1. The researchers may be biased in the process of

selection of a sample of consumers on which
experiments is to be performed.

1. The selected consumers may not respond

accurately If they come to know that they are a
part of an experiment being conducted and their
behavior is being recorded.

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 Time Series Analysis
• The time series analysis is one of the most common
quantitative method used to predict the future
demand for a product.

• In this the past sales and demand are taken into

considerations.

• Time series has four components:

1. Trend
2. Seasonal variations
3. Cyclical variations
4. Random fluctuations
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Time Series Components

Trend Cycle

Seasonal Random

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 Components of Time Series
Trend
Past data is used to predict the future sales of firm trend is a
long term increase or decrease in the variable.
Seasonal Variations
It is taken into account the Variations in demand during
different seasons. Ex.- The sale of cotton dresses increases in
summer. The sale of Woolen clothes increases in winter.
Cyclical Variations
This variations in demand due to the fluctuations in the
business cycle. Ex. – Boom, recession and depression.
Random Fluctuations
It may happen due to natural calamities which cannot be
predicted accurately. Ex. - flood, earthquake, union strike etc.
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Patterns of Demand

Horizontal Trend

Seasonal Cyclical

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Types of Forecasting Models
• Types of Forecasts
– Qualitative: based on experience, judgment,
knowledge
– Quantitative: based on data, statistics
• Methods of Forecasting
– Naive Methods: eye-balling the numbers
– Formal Methods: systematically reduce
forecasting errors
• time series models (e.g. exponential smoothing);
• causal models (e.g. regression).
– Focus here is on Time Series Models
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Forecasting Performance
How good is the forecast?
• Mean Forecast Error (MFE or Bias): Measures
average deviation of forecast from actual.

• Mean Absolute Deviation (MAD): Measures average

absolute deviation of forecast from actual.
• Mean Absolute Percentage Error (MAPE): Measures
absolute error as a percentage of the forecast.

• Standard Squared Error (MSE): Measures variance

of forecast error

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Forecasting Performance Measures
1 n Mean Forecast Error
MFE   (D  F )
n t 1 t t Also called Bias

1 n
MAD   D F Mean Absolute deviation
n t 1 t t

100 n Dt  Ft Mean Absolute Percentage Error

MAPE  
n t 1 D
t

1 n 2
MSE   (D  F ) Mean Square Error
n t 1 t t
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Naive Forecasts

Uh, give me a minute....

We sold 250 wheels last
week.... Now, next week
we should sell....

The forecast for any period

equals the previous period’s
actual value.

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Naive Forecasts

• Simple to use
• Virtually no cost
• Quick and easy to prepare
• Data analysis is nonexistent
• Easily understandable
• Cannot provide high accuracy
• Can be a standard for accuracy

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 Naive Forecast
Wallace Garden Supply
Forecasting
Storage Shed Sales

Actual Naïve Absolute Percent Squared

Period Value Forecast Error Error Error Error
January 10 N/A
February 12 10 2 2 16.67% 4.0
March 16 12 4 4 25.00% 16.0
April 13 16 -3 3 23.08% 9.0
May 17 13 4 4 23.53% 16.0
June 19 17 2 2 10.53% 4.0
July 15 19 -4 4 26.67% 16.0
August 20 15 5 5 25.00% 25.0
September 22 20 2 2 9.09% 4.0
October 19 22 -3 3 15.79% 9.0
November 21 19 2 2 9.52% 4.0
December 19 21 -2 2 10.53% 4.0
0.818 3 17.76% 10.091
BIAS MAD MAPE MSE

Standard Error (Square Root of MSE) = 3.176619

Prashant Jain 43
Naive Forecast Graph

Wallace Garden - Naive Forecast

25

20

15
Sheds

Actual Value
Naïve Forecast
10

0
February March April May June July August September October November December
Period

Prashant Jain 44
Assumptions of Time Series Models
– There is information about the past;
– This information can be quantified in the form of data;
– The pattern of the past will continue into the future.

Forecasting Examples
Demand for tellers in a bank
Traffic on major communication switch
Demand for cars in the next quarter
Demand for frozen foods in local grocery warehouse

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Trend projection method
Linear regression
• Regression means dependence and involves
estimating the value of a dependent variable ‘y’ from
an independent variable ‘x’
• It is used to fit a trend line (i.e. to find out long term
trend in demand – stable , increasing or decreasing )
• A trend line is drawn either by
• observation (graphical method) or
• using a statistical method ( least square
method).

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Graphical method:
Year wise sales of cars
Year Sales ( in 000 )
96-97 28
97-98 38
98-99 46
99-00 40
00-01 56
01-02 49
02-03 58
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 car sales

70
60
50
sales (000)

40
Series1
30
20
10
0
96 -97 97-98 98 -99 99-20002000-012001-022002-03

years
Prashant Jain 48
Least Square Method
Used to
1. To wipe out fluctuations in actual data
2. To project demand in the future
For this a new trend line is derived
The equation for such a trend line is given in a
general form
Y=a+bX
Where y = estimated value of variable
a = intercept / constant
b = estimate of the trend factor
X = unit of time
Prashant Jain 49
Linear Trend Equation

Ft

Ft = a + bt

0 1 2 3 4 5 t

Ft = Forecast for period t

t = Specified number of time periods
a = Value of Ft at t = 0
b = Slope of the line
Prashant Jain 50
Formulae's for determining the values of b & a

N * ∑ XY – (∑ X ) * (∑ Y )
• b = -----------------------------
N * ∑X2 – (∑ X )2

∑Y ∑X
• a = -------- - b * (--------)
N N

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 Year wise sales of cars

Sales=Y
Year X XY X2 Y2
(*1000)
96-97 28 1 28 1
97-98 38 2 76 4
98-99 46 3 138 9
99-00 40 4 160 16
00-01 56 5 280 25
N= 5 ∑Y =208 ∑X = 15 ∑XY=682 X2==55 ∑Y2 =

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 N * ∑ XY – (∑ X ) * (∑ Y )
• b = --------------------------------
N * ∑X2 – (∑ X )2

5 * ∑ 682 – (15 ) * (208 )

• b = ---------------------------------
5 * ∑ 55 – (15 )2

3410 – 3 120 290

• b = ------------------- = ------ = 5.8
275 – 225 50
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 ∑Y ∑X
• a = -------- - b * (-------)
N N

208 15
• a = ------- - 5.8 * (-----)
5 5

• a = 41.6 – 5.8 * (3)

• a = 41.6 – 17.4

• a = 24.2

Prashant Jain 54
X Year Sales a + b *x Trend value
1 96-97 28 24.2 + 5.8 * 1 30.0
2 97-98 38 2 35.8
3 98-99 46 3 41.6
4 99-00 40 4 47.4
5 00-01 56 5 53.2
6 01-02 6 59.0
7 02-03 7 64.8
8 03-04 8 70.0
9 04-05 9 76.4
Prashant Jain 55
 new trend line

100
80
trend value

60
trend value
40
20
0
7

5
9
-9

-0

-0

-0
-9

00

02

04
96

98

20

20

20

year

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Coefficient of Correlation

[N * ∑ XY – (∑ X ) * (∑ Y )]
r = ----------------------------------------------------------
[√ N * ∑X2 – (∑ X )2] [√ N * ∑Y2 – (∑ Y )2]

Value of r is between 0 and 1. Closer is the value to 1,

better is the correlation.

Prashant Jain 57
Linear Trend Data & Error Analysis

Midwestern Manufacturing Company

Forecasting Linear trend analysis

Input Data Forecast Error Analysis

Actual value Period number Absolute Squared Absolute
Period (or) Y (or) X Forecast Error error error % error
Year 1 74 1 67.250 6.750 6.750 45.563 9.12%
Year 2 79 2 77.786 1.214 1.214 1.474 1.54%
Year 3 80 3 88.321 -8.321 8.321 69.246 10.40%
Year 4 90 4 98.857 -8.857 8.857 78.449 9.84%
Year 5 105 5 109.393 -4.393 4.393 19.297 4.18%
Year 6 142 6 119.929 22.071 22.071 487.148 15.54%
Year 7 122 7 130.464 -8.464 8.464 71.644 6.94%
Average 8.582 110.403 8.22%
Intercept 56.714 MAD MSE MAPE
Slope 10.536

Next period 141.000 8

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Least Squares Graph

Trend Analysis

160

140

y = 10.536x + 56.714
120

100
Value

80

60

40

20

0
1 2 3 4 5 6 7
Time

Actual values Linear (Actual values)

Prashant Jain 59
Multiple Regression
• When there are many independent variables involved
which influence a dependent variable then issues
become complicated.
• Then not only linear regression equations are required
but also multiple regression analysis is involved where
the interdependency of the various independent
variables are taken into account.
• These involve complex statistics beyond the scope of
this course.
• For their practical use, advanced techniques and tools
are available throgh MS Excel tools, SPSS (Statistical
Package for the Social Sciences) and other software
packages Prashant Jain 60
Simple Moving Average
• This is the simplest model of extrapolative
forecasting
• Since demand varies over time, only a certain
amount of historical data is relevant to the future,
implying that we can ignore all observations older
than some specified age
• A moving average uses this approach by taking
average demand over a fixed number of previous
periods (say 3 as in the example)

MA 
 Demand in previous n periods
_________________________
n
Prashant Jain 61
Simple Moving Average: Example
If product demand is 150, 130 and 125 over the last 3
months then forecast for 4th month is
(150+130+125)/3= 135.
If actual demand in 4th month is 135 as forecast* then
forecast for 5th month is (130+125+135)/3= 130; and this
process is repeated for subsequent periods
* If actual demand is different from the forecast, their
differences are forecasting errors which have been
already discussed.
In this example, all past periods were given equal
weightage; which can then be differentially weighted to
give more importance toPrashant
most Jain recent periods 62
Simple Moving Averages
• Used when demand has no observable trend or
seasonality
• The forecast demand for the period t+1 is equal to Mt,
the simple moving average at the end of period t
• If its an n-period moving average, then
• Ft+1 = Mt = (Dt + Dt-1 + … + Dt-n+1) / n
• Current forecast for all future periods is same and is
equal to the current estimate of demand
• After observing the actual demand for period t+1,
revise the estimates as follows:
Ft+2 = Mt+1 = (Dt+1 + Dt + … + Dt-n+2) / n
Prashant Jain 63
 Simple Moving Averages
Month Actual Sales Forecast
Chosen 3 months
moving average
Jan 24500
Feb 27000
Mar 19950
Apr 26000 23817
May 21200 24317
June 18900 22383
July 17500 22033
Aug 19000 19200
Sep 18525 Prashant Jain
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Moving Averages Forecast
Wallace Garden Supply
Forecasting
Storage Shed Sales

Actual
Period Value Three-Month Moving Averages
January 10
February 12
March 16
April 13 10 + 12 + 16 / 3 = 12.67
May 17 12 + 16 + 13 / 3 = 13.67
June 19 16 + 13 + 17 / 3 = 15.33
July 15 13 + 17 + 19 / 3 = 16.33
August 20 17 + 19 + 15 / 3 = 17.00
September 22 19 + 15 + 20 / 3 = 18.00
October 19 15 + 20 + 22 / 3 = 19.00
November 21 20 + 22 + 19 / 3 = 20.33
December 19 22 + 19 + 21 / 3 = 20.67
Prashant Jain 65
 Moving Averages Forecast: Error Calculation

Wallace Garden Supply

Forecasting 3 period moving average
Actual Value - Forecast

Input Data Forecast Error Analysis

Absolute Squared Absolute
Period Actual Value Forecast Error error error % error
Month 1 10
Month 2 12
Month 3 16
Month 4 13 12.667 0.333 0.333 0.111 2.56%
Month 5 17 13.667 3.333 3.333 11.111 19.61%
Month 6 19 15.333 3.667 3.667 13.444 19.30%
Month 7 15 16.333 -1.333 1.333 1.778 8.89%
Month 8 20 17.000 3.000 3.000 9.000 15.00%
Month 9 22 18.000 4.000 4.000 16.000 18.18%
Month 10 19 19.000 0.000 0.000 0.000 0.00%
Month 11 21 20.333 0.667 0.667 0.444 3.17%
Month 12 19 20.667 -1.667 1.667 2.778 8.77%
Average 12.000 2.000 6.074 10.61%
Next period 19.667 BIAS MAD MSE MAPE

Prashant Jain 66
Moving Averages Graph
Three Period Moving Average

25

20

15
Value

Actual Value
Forecast

10

0
1 2 3 4 5 6 7 8 9 10 11 12
Time

Prashant Jain 67
 Issues with moving average forecasts:
– All n past observations treated equally
– Observations older than n are not included at all
– Requires that n past observations be retained
– Problem when 1000's of items are being forecast

weight

1/n

n ... 3 2 1
today
Prashant Jain 68
Simple Moving Average n

 D i
Mn = i=1

Actual
MA5
47
45
43
41
39
37
35 MA3
1 2 3 4 5 6 7 8 9 10 11 12

Prashant Jain 69
Weighted Moving Averages
• This is to overcome the lacuna of all past periods being
given same importance
• Here, different past periods are given different
weightage
• In same earlier example, let us take past periods
weightage as 0.60, 0.30 and 0.10( totaling 1 or 100%)
• then forecast for 4th month is
( 125x0.60+ 130x0.30+ 150x0.10)= 75+39+15= 129
and further forecast for 5th month as
(129x0.60+125x0.30+130x0.10)= 127.9; and so on……..
• Idea is to give more importance to most recent
observations Prashant Jain 70
Weighted Moving Averages (contd…)
• But problems relate to the logic of deciding the
number of past periods and the given differential
weightage.
• Generally, if the demand is stable, then larger n
values are chosen; if not, then a smaller n and using
weightage factors is better.

Prashant Jain 71
Weighted Moving Averages
Month Actual Sales Forecast
Chosen 3 months
moving average
Weightage- immediate
past as 0.45, then 0.30
and then 0.25
Jan 24500
Feb 27000
Mar 25500
Apr 26000 25700
May 21200 26100
June 18900 23715
July 17500 21365
Aug 19000 18845
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Weighted Moving Average
Wallace Garden Supply
Forecasting
Storage Shed Sales

Actual
Period Value Weights Three-Month Weighted Moving Averages
January 10 0.222
February 12 0.593
March 16 0.185
April 13 2.2 + 7.1 + 3 / 1 = 12.298
May 17 2.7 + 9.5 + 2.4 / 1 = 14.556
June 19 3.5 + 7.7 + 3.2 / 1 = 14.407
July 15 2.9 + 10 + 3.5 / 1 = 16.484
August 20 3.8 + 11 + 2.8 / 1 = 17.814
September 22 4.2 + 8.9 + 3.7 / 1 = 16.815
October 19 3.3 + 12 + 4.1 / 1 = 19.262
November 21 4.4 + 13 + 3.5 / 1 = 21.000
December 19 4.9 + 11 + 3.9 / 1 = 20.036

Next period 20.185

Sum of weights = 1.000

Prashant Jain 73
Weighted Moving Average: Error Calculation

Wallace Garden Supply

Forecasting 3 period weighted moving average

Input Data Forecast Error Analysis

Absolute Squared Absolute
Period Actual value Weights Forecast Error error error % error
Month 1 10 0.222
Month 2 12 0.593
Month 3 16 0.185
Month 4 13 12.298 0.702 0.702 0.492 5.40%
Month 5 17 14.556 2.444 2.444 5.971 14.37%
Month 6 19 14.407 4.593 4.593 21.093 24.17%
Month 7 15 16.484 -1.484 1.484 2.202 9.89%
Month 8 20 17.814 2.186 2.186 4.776 10.93%
Month 9 22 16.815 5.185 5.185 26.889 23.57%
Month 10 19 19.262 -0.262 0.262 0.069 1.38%
Month 11 21 21.000 0.000 0.000 0.000 0.00%
Month 12 19 20.036 -1.036 1.036 1.074 5.45%
Average 1.988 6.952 6.952 10.57%
Next period 20.185 BIAS MAD MSE MAPE

Sum of weights = 1.000

Prashant Jain 74
Moving Averages- closing remarks
• All moving average methods focus on short term
forecasting and provide such capability without
consideration of any time series patterns.
• But when medium term( say 1 year) or long term( 5
years or more) forecasting needed, then time series
data patterns need looking into.
• These data patterns relate to trend, cyclical, seasonal
and random forms( as introduced earlier).
• Once these patterns are extracted from a given time
series data , they can be used for forecasting.

Prashant Jain 75
 Exponential Smoothing
• The most recent observations might have the highest
predictive value.
• Therefore, we should give more weight to the more recent
time periods when forecasting.
• This weighted averaging method is based on previous
forecast plus a percentage of the forecast error
• (D-F) is the error term,  is the % feedback

Ft = Ft-1 + (Dt-1 - Ft-1)

Ft = forecast for this period
Ft-1 = forecast for the previous period
Dt-1= Actual demand for the previous period
  Smoothing constant (0 to 1)
Prashant Jain 76
 Exponential Smoothing - I
• Include all past observations
• Weight recent observations much more
heavily than very old observations:

weight
Decreasing weight given
to older observations

today
Prashant Jain 77
 Exponential Smoothing - I
• Include all past observations
• Weight recent observations much more
heavily than very old observations:
0  1
weight
Decreasing weight given 
to older observations

today
Prashant Jain 78
 Exponential Smoothing - I
• Include all past observations
• Weight recent observations much more
heavily than very old observations:
0  1
weight
Decreasing weight given 
to older observations
 (1  )

today
Prashant Jain 79
 Exponential Smoothing - I
• Include all past observations
• Weight recent observations much more
heavily than very old observations:
0  1
weight
Decreasing weight given 
to older observations  (1   )
 (1   ) 2

today
Prashant Jain 80
 Exponential Smoothing: Concept
• Include all past observations
• Weight recent observations much more
heavily than very old observations:
0  1
weight
Decreasing weight given 
to older observations
 (1   )
 (1   ) 2

 (1   ) 3

today 
Prashant Jain 81
Exponential Smoothing: Math

Ft = α Dt-1 + α (1- α ) Dt-2 + α (1- α )2 Dt-3 + ……..

Ft = α Dt-1 + (1- α ) [α Dt-2 + α (1- α ) Dt-3 + ……..]

Ft = α Dt-1 + (1- α ) Ft-1

Ft = Ft-1 + α (Dt-1 - Ft-1)

Prashant Jain 82
Exponential Smoothing:
Most frequently used time series method because
of ease of use and minimal amount of data needed
• Need just three pieces of data to start:
– Last period’s forecast
– Last periods actual value
– Select value of smoothing coefficient, ,
between 0 and 1.0
• If no last period forecast is available, average the
last few periods or use naive method
• Higher  values (e.g. 0.7 or 0.8) may place too
much weight on last period’s random variation
Prashant Jain 83
Exponential Smoothing (contd…)
Ft = Ft-1 + α (Dt-1 - Ft-1)
Thus,
Next period’s forecast = Current period’s forecast
+ α (Current period’s actual demand - Current period’s
forecast)
– Only 2 values (Dt-1 and Ft-1 ) are required, compared with n
for moving average
– Parameter  is determined empirically
– Rule of thumb:  < 0.5
– Typically,  = 0.2 or  = 0.3 work well
– Forecast for k periods into future is: Ft+k = Ft
Prashant Jain 84
Exponential Smoothing:
What should be the Value of  ?
• The value of smoothing constant  must be between 0
and 1
•  can not be equal to 0 or 1.
• If stable predictions with smoothed random variation is
desired then a small value of  is desired.
• If a rapid response to a real change in the pattern of
observations is desired, a large value of  is appropriate.
• To estimate , Forecasts are computed for  equal to .1,
.2, .3, …, .9 and the sum of squared forecast error is
computed for each.
• The value of  with the smallest RMSE is chosen for use
in producing the future forecasts.
Prashant Jain 85
 Effect of  value on the Forecast

• Small values of  means that the forecasted value

will be stable (show low variability)
– Low  increases the lag of the forecast to the
actual data if a trend is present
• Large values of  mean that the forecast will more
closely track the actual time series

Prashant Jain 86
Exponential Given Data Answer
Smoothing: Months Sales Forecast Forecast
Example given to find
Jan 23.3 25
• Forecast for Feb:
Feb 72.3 24.745
= Djan + (1- )Fjan
= 0.15*23.3 + (0.85)*25 March 30.3 31.88
= 24.745 April 15.5 31.64
• Forecast for Mar: May 29.22
= Dfeb + (1- )Ffeb Take  = 0.15, Find
= 0.15*72.3 + (0.85)*24.745 Forecasts for Feb,
March, April and May
= 31.88
• For April = Dmar + (1- )Fmar = .15*30.3 + .85*31.88 = 31.64
• For May = Dapr + (1- )Fapr = .15*15.5 + .85*31.64 = 29.22
Prashant Jain 87
Comparison of MA and ES

• Similarities
– Both methods are appropriate for stationary
series
– Both methods depend on a single parameter
– Both methods lag behind a trend
– One can achieve the same distribution of
forecast error by setting:
 = 2/ ( N + 1) or N = (2 - )/ 

Prashant Jain 88
Comparison of MA and ES
• Differences
– ES carries all past history (forever!)
– MA eliminates “bad” data after N periods
– MA requires all N past data points to compute
new forecast estimate while ES only requires last
forecast and last observation of ‘demand’ to
continue

Prashant Jain 89
Exponential Smoothing Data
Wallace Garden Supply
Forecasting
Storage Shed Sales

Exponential Smoothing
Actual
Period Value Ft α At Ft Ft+1
January 10 10 0.1
February 12 10 + 0.1 *( 10 - 10 ) = 10.000
March 16 10 + 0.1 *( 12 - 10 ) = 10.200
April 13 10 + 0.1 *( 16 - 10 ) = 10.780
May 17 11 + 0.1 *( 13 - 11 ) = 11.002
June 19 11 + 0.1 *( 17 - 11 ) = 11.602
July 15 12 + 0.1 *( 19 - 12 ) = 12.342
August 20 12 + 0.1 *( 15 - 12 ) = 12.607
September 22 13 + 0.1 *( 20 - 13 ) = 13.347
October 19 13 + 0.1 *( 22 - 13 ) = 14.212
November 21 14 + 0.1 *( 19 - 14 ) = 14.691
December 19 15 + 0.1 *( 21 - 15 ) = 15.322
Prashant Jain 90
Exponential Smoothing: Error Calculation
Wallace Garden Supply
Forecasting Exponential smoothing

Input Data Forecast Error Analysis

Absolute Squared Absolute
Period Actual value Forecast Error error error % error
Month 1 10 10.000
Month 2 12 10.000 2.000 2.000 4.000 16.67%
Month 3 16 10.838 5.162 5.162 26.649 32.26%
Month 4 13 13.000 0.000 0.000 0.000 0.00%
Month 5 17 13.000 4.000 4.000 16.000 23.53%
Month 6 19 14.675 4.325 4.325 18.702 22.76%
Month 7 15 16.487 -1.487 1.487 2.211 9.91%
Month 8 20 15.864 4.136 4.136 17.106 20.68%
Month 9 22 17.596 4.404 4.404 19.391 20.02%
Month 10 19 19.441 -0.441 0.441 0.194 2.32%
Month 11 21 19.256 1.744 1.744 3.041 8.30%
Month 12 19 19.987 -0.987 0.987 0.973 5.19%
Average 2.608 9.842 14.70%
Alpha 0.419 MAD MSE MAPE

Next period 19.573

Prashant Jain 91
Exponential Smoothing

Exponential Smoothing

25

20

15
Sheds

Actual value
Forecast

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Prashant Jain 92
Complicating Factors
• Simple Exponential Smoothing works well with data
that is ‘moving sideways’ i. e. stationary
• Must be adapted for data series which exhibit a
definite trend
• Must be further adapted for data series which
exhibit seasonal patterns

Prashant Jain 93
 Seasonality Analysis
Ratio = demand / average demand
Eichler Supplies
Average Seasonal
Year Month Demand Demand Ratio Index
1 January 80 94 0.851 0.957 Seasonal Index – ratio of the
February 75 94 0.798 0.851 average value of the item in a
March 80 94 0.851 0.904
April 90 94 0.957 1.064 season to the overall average
May 115 94 1.223 1.309
June 110 94 1.170 1.223
annual value.
July 100 94 1.064 1.117
August 90 94 0.957 1.064
September 85 94 0.904 0.957
Example: average of year 1 January
October 75 94 0.798 0.851 ratio to year 2 January ratio.
November 75 94 0.798 0.851
December 80 94 0.851 0.851 (0.851 + 1.064)/2 = 0.957
2 January 100 94 1.064
February 85 94 0.904
March 90 94 0.957 If Year 3 average monthly demand
April 110 94 1.170 is expected to be 100 units.
May 131 94 1.394
June 120 94 1.277 Forecast demand Year 3 January:
July 110 94 1.170 100 X 0.957 = 96 units
August 110 94 1.170
September 95 94 1.011 Forecast demand Year 3 May:
October 85 94 0.904 100 X 1.309 = 131 units
November 85 94 0.904
December 80 94 0.851
Prashant Jain 94
Which Method to Use for
Short-Term Demand Forecasting?
Short Term: (Up to three months)
– Purpose:
• Production scheduling
• Inventory planning
– Method:
• Time Series Forecasting is the most
commonly used forecasting technique.
• It is inexpensive and easy to do.
• Some judgment models can be used.
• Sales-force estimates, executive opinion
Prashant Jain 95
Which Method to Use for
Medium-Term Demand Forecasting?
Medium Term (3 months–2 years)
– Purpose:
capacity planning
– Method:
• Causal Models are the best to use.
• Regression is common.
• Qualitative (Judgment) models are also
helpful.
• Executive opinion, Market Research, Sales
force estimates
Prashant Jain 96
Which Method to Use for
Long-Term Demand Forecasting?
Long Term (Beyond 2 years)
– Purpose:
– Location decisions
– Capacity decisions
– Layout and Process decisions
– Method:
• Causal & Qualitative (judgment) Models are
typically used.
• Most forecasting for strategic decisions is long-
term forecasting.
Prashant Jain 97
 Demand Forecasting Applications
Time Horizon

Application Short Term Medium Term Long Term

(0–3 months) (3 months–2 yrs) (over 2 years)
• Individual products • Total sales • Total sales
Forecast or services • Groups of products or
Focus services

• Inventory Mgt. • Staff planning • Facility location

• Final assembly • Production planning • Capacity planning
Decision scheduling • Aggregate Prod. • Process
• Workforce scheduling management
Area scheduling • Purchasing
• Master Prod. • Distribution
scheduling

Forecasting • Time series • Causal • Causal

Technique • Causal • Judgment • Judgment
• Judgment
Finding The Right Technique
1. Test a number of different forecasting
techniques on past data.
2. Using historic data, forecast the demand for the
most recent demand period for which you have
data.
3. See which forecasting technique gives the most
accurate forecast.
4. Use that technique for the next period.
5. Repeat the process using new data once you
know what the new demand is.
This process is called FOCUS FORECASTING.
Prashant Jain 99
Forecasting as a Process
The forecast process itself, typically done on a monthly basis,
consists of structured steps. They often are facilitated by
someone who might be called a demand manager, forecast
analyst, or demand/supply planner.
It is not simply a matter of running a computer model!

Prashant Jain 100

Recent Trends
• More firms are giving importance to demand
forecasting than a decade ago.
• Better kind of data & improved forecasting techniques
have been developed.
• There is a greater emphasis on sophisticated
techniques such as using computers.
• New products forecasting is still in infancy.
• Forecasts are usually broken down in monthly
forecasts.
• However, in spite of application of newer & modern
techniques, demand forecasts are still not too accurate.
Prashant Jain 101
Some Principles for the Forecasting Process

• Forecasting is being done in virtually every company.

The challenge is to do it better than the competition.
– Better forecasts result in better customer service and
lower costs, as well as better relationships with
suppliers and customers.
• The forecast can, and must, make sense based on the
big picture, economic outlook, market share, and so
on.

Prashant Jain 102

Some Principles for the Forecasting Process
(contd…)
• The best way to improve forecast accuracy is to focus
on reducing forecast error.
– Bias is the worst kind of forecast error; strive for zero
bias.
• Whenever possible, forecast aggregate levels. Forecast
in detail only where necessary.
• Far more can be gained by people collaborating,
communicating well, and using judgment, than by
using the most advanced forecasting technique or
model.
Prashant Jain 103
 Barometric Analysis
• DEFINITION:- “The prediction of turning points in
one economic time series through the use of
observations on another time series is called the
Barometer of the Indicator”.

It can be divided into three groups

1. Leading indicators.
2. Coincident indicators.
3. Lagging indicators.

Prashant Jain 104

 Leading indicators

• It compares the existing data available.

• This Index includes things such as
• average weekly hours worked
• claims for unemployment insurance
• manufacturers new orders
• stock prices
• orders for plant and equipment
• index of consumer expectations
• and real M2 money supply.
Prashant Jain 105
Composite of Coincident Indicators
• It is useful in understanding the business cycle.
• Is primarily intended to identify changes in the
direction of the economy.
• Components of the index of coincident Indicators are
 employees on nonagricultural payrolls
 industrial production
 Personal income minus transfer payments
 manufacturing and trade sales.

Prashant Jain 106

Lagging Indicators
• The lagging indicator composite includes
• Changes in labour costs per unit
• Ratio of inventory to sales
• Figures on installment credit and loans etc.
• In Practical attempts to forecast the future, these
indices are among the most important tools available
to most organizations, including the government.
• These indicators provide signals of changes in economic
activities like
• National income or national product
• The level of employment
• The rate of inflation.
Prashant Jain 107
Conclusion

• Accurate demand forecasting requires

– Product knowledge

– Knowledge about the customer

– Knowledge about the environment

Prashant Jain 108

So Which Model Do You Choose?

• If you only require the forecast with the smallest

average deviation, choose the model with the
smallest MAD or MAPE
• However, if you have a low tolerance for large
deviations choose the model with the smallest MSE

Prashant Jain 109

Prashant Jain 110
I see that you will
get an A this semester.

Prashant Jain 111