Demand Forecasting

Demand Management

Independent Demand
(finished goods and spare parts)

Dependent Demand
(components)

B(4)

C(2)

D(2)

E(1)

D(3)

F(2)

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

3

Forecasting Methods
 

Qualitative Approaches Quantitative Approaches

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
5

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

Qualitative Forecasting Applications

Small and Large Firms

Technique
Managers Opinion Executives Opinion Sales Force Composite Number of Firms

Low Sales
(less than $100M)

High Sales
(more than $500M)

40.7% 40.7% 29.6% 27

39.6% 41.6% 35.4% 48

Source: Nada Sanders and Karl Mandrodt (1994) Practitioners Continue to Rely on Judgmental Forecasting Methods Instead of Quantitative Methods, Interfaces, vol. 24, no. 2, pp. 92-100. Note: More than one response was permitted.

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

Quantitative Forecasting Applications

Small and Large Firms

Technique
Moving Average Simple Linear Regression Naive Single Exponential Smoothing Multiple Regression Simulation Classical Decomposition BoxBox-Jenkins Number of Firms

Low Sales
(less than $100M) 29.6% 14.8% 18.5% 14.8% 22.2% 3.7% 3.7% 3.7% 27

High Sales
(more than $500M) 29.2 14.6 14.6 20.8 27.1 10.4 8.3 6.3 48

Source: Nada Sanders and Karl Mandrodt (1994) Practitioners Continue to Rely on Judgmental Forecasting Methods Instead of Quantitative Methods, Interfaces, vol. 24, no. 2, pp. 92-100. Note: More than one response was permitted.

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

10

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 28-31 287
12

Length of Season Quarter Month Week Day Day

Quantitative Forecasting Approaches

   

Linear Regression Simple Moving Average Weighted Moving Average Exponential Smoothing (exponentially weighted moving average) Exponential Smoothing with Trend (double exponential smoothing)

13

LongLong-Range Forecasts
 

Time spans usually greater than one year Necessary to support strategic decisions about planning products, processes, and facilities

14

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.
15

Simple Linear Regression



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

16

Simple Linear Regression



Constants a and b The constants a and b are computed using the following equations:
a=

x y- x xy n x -( x)
2 2 2

b=

n xy- x y

n x2 -( x)2

17

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.

18

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 7x=21 7y=18.1 7x2=91 xy 2.5 5.6 8.7 12.8 16.5 20.4 7xy=66.5
20

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

21

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.

22

Example: Railroad Products Co.



Simple Linear Regression Causal Model The manager of RPC wants to project the firms sales for the next 3 years. He knows that RPCs longlongrange sales are tied very closely to national freight car loadings. On the next slide are 7 years of relevant historical data. Develop a simple linear regression model between RPC sales and national freight car loadings. Forecast RPC sales for the next 3 years, given that the rail industry estimates car loadings of 250, 270, and 300 million.
23

Example: Railroad Products Co.



Simple Linear Regression Causal Model Year 1 2 3 4 5 6 7 RPC Sales ($millions) 9.5 11.0 12.0 12.5 14.0 16.0 18.0 Car Loadings (millions) 120 135 130 150 170 190 220
24

Example: Railroad Products Co.



Simple Linear Regression Causal Model x 120 135 130 150 170 190 220 1,115 y 9.5 11.0 12.0 12.5 14.0 16.0 18.0 93.0 x2 14,400 18,225 16,900 22,500 28,900 36,100 48,400 185,425 xy 1,140 1,485 1,560 1,875 2,380 3,040 3,960 15,440
25

Example: Railroad Products Co.



Simple Linear Regression Causal Model

185, 425(93  1,115(15, 440 a! ! 0.528 2 7(185, 425  (1,115 7(15, 440  1,115(93 ! 0.0801 b! 2 7(185, 425  (1,115

Y = 0.528 + 0.0801X

26

Example: Railroad Products Co.



Simple Linear Regression Causal Model Y8 = 0.528 + 0.0801(250) = $20.55 million Y9 = 0.528 + 0.0801(270) = $22.16 million Y10 = 0.528 + 0.0801(300) = $24.56 million Note: RPC sales are expected to increase by $80,100 for each additional million national freight car loadings.

27

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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Coefficient of Correlation (r) (r



 

 

The coefficient of correlation, r, explains the relative importance of the relationship between x and y. The sign of r shows the direction of the relationship. The absolute value of r shows the strength of the relationship. The sign of r is always the same as the sign of b. r can take on any value between 1 and +1.

29

Coefficient of Correlation (r) (r



Meanings of several values of r: -1 a perfect negative relationship (as x goes up, y goes down by one unit, and vice versa) +1 a perfect positive relationship (as x goes up, y goes up by one unit, and vice versa) 0 no relationship exists between x and y +0.3 a weak positive relationship -0.8 a strong negative relationship

30

Coefficient of Correlation (r) (r



r is computed by:
r! n xy  x y n x 2  ( x )2 n y 2  ( y ) 2

31

Coefficient of Determination (r2) (r



The coefficient of determination, r2, is the square of the coefficient of correlation. The modification of r to r2 allows us to shift from subjective measures of relationship to a more specific measure. r2 is determined by the ratio of explained variation to total variation:
r2 !

(Y  y )2 ( y  y )2
32

Example: Railroad Products Co.



Coefficient of Correlation x 120 135 130 150 170 190 220 y 9.5 11.0 12.0 12.5 14.0 16.0 18.0 x2 14,400 18,225 16,900 22,500 28,900 36,100 48,400 xy 1,140 1,485 1,560 1,875 2,380 3,040 3,960 y2 90.25 121.00 144.00 156.25 196.00 256.00 324.00
33

1,115 93.0 185,425 15,440 1,287.50

Example: Railroad Products Co.



Coefficient of Correlation

r! 7(

7( 25)  (

)
2

) )
2

5) 7( 287.5)  (

r = .9829

34

ShortShort-Range Forecasting Methods

   

(Simple) Moving Average Weighted Moving Average Exponential Smoothing Exponential Smoothing with Trend

35

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 . . . more

36

Simple Moving Average



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)

37

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. . . . more

38

Weighted Moving Average



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.

39

Example: Central Call Center



Moving Average CCC wishes to forecast the number of incoming calls it receives in a day from the customers of one of its clients, BMI. CCC schedules the appropriate number of telephone operators based on projected call volumes. CCC believes that the most recent 12 days of call volumes (shown on the next slide) are representative of the near future call volumes.

40

Example: Central Call Center



Moving Average Representative Historical Data



Day 1 2 3 4 5 6

Calls 159 217 186 161 173 157

Day 7 8 9 10 11 12

Calls 203 195 188 168 198 159

41

Example: Central Call Center



Moving Average Use the moving average method with an AP = 3 days to develop a forecast of the call volume in Day 13. F13 = (168 + 198 + 159)/3 = 175.0 calls

42

Example: Central Call Center



Weighted Moving Average Use the weighted moving average method with an AP = 3 days and weights of .1 (for oldest datum), .3, and .6 to develop a forecast of the call volume in Day 13. F13 = .1(168) + .3(198) + .6(159) = 171.6 calls Note: The WMA forecast is lower than the MA forecast because Day 13s relatively low call volume carries almost twice as much weight in the WMA (.60) as it does in the MA (.33).
43

Example: Central Call Center



Exponential Smoothing If a smoothing constant value of .25 is used and the exponential smoothing forecast for Day 11 was 180.76 calls, what is the exponential smoothing forecast for Day 13? F12 = 180.76 + .25(198 180.76) = 185.07 F13 = 185.07 + .25(159 185.07) = 178.55

44

Example: Central Call Center



Forecast Accuracy - MAD Which forecasting method (the AP = 3 moving average or the E = .25 exponential smoothing) is preferred, based on the MAD over the most recent 9 days? (Assume that the exponential smoothing forecast for Day 3 is the same as the actual call volume.)

45

Example: Central Call Center

Day Calls 4 161 5 173 6 157 7 203 8 195 9 188 10 168 11 198 12 159 MAD AP = 3 Forec. |Error| 187.3 26.3 188.0 15.0 173.3 16.3 163.7 39.3 177.7 17.3 185.0 3.0 195.3 27.3 183.7 14.3 184.7 25.7 20.5 E = .25 Forec. |Error| 186.0 25.0 179.8 6.8 178.1 21.1 172.8 30.2 180.4 14.6 184.0 4.0 185.0 17.0 180.8 17.2 185.1 26.1 18.0
46

Exponential Smoothing with Trend



As we move toward medium-range forecasts, trend mediumbecomes more important. Incorporating a trend component into exponentially smoothed forecasts is called double exponential smoothing. smoothing. The estimate for the average and the estimate for the trend are both smoothed.

47

Exponential Smoothing with Trend



Model Form FTt = St-1 + Tt-1 where: FTt = forecast with trend in period t St-1 = smoothed forecast (average) in period t-1 tTt-1 = smoothed trend estimate in period t-1 t-

48

Exponential Smoothing with Trend



Smoothing the Average St = FTt + E(At FTt) E(A

Smoothing the Trend F(FT Tt = Tt-1 + F(FTt FTt-1 - Tt-1) where: E = smoothing constant for the average F = smoothing constant for the trend

49

Criteria for Selecting a Forecasting Method

     

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

50

Criteria for Selecting a Forecasting Method



Cost and Accuracy There is a trade-off between cost and accuracy; tradegenerally, more forecast accuracy can be obtained at a cost. HighHigh-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
 
   

51

Criteria for Selecting a Forecasting Method



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

52

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.
 

53

Criteria for Selecting a Forecasting Method



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

54

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?
  

55

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

 

56

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

57

Monitoring and Controlling a Forecasting Model



Tracking Signal (TS) The TS measures the cumulative forecast error over n periods in terms of MAD


(Actual demand
TS =
i! 1


- Forecast demandi )

MAD If the forecasting model is performing well, the TS should be around zero The TS indicates the direction of the forecasting error; if the TS is positive -- increase the forecasts, if the TS is negative -- decrease the forecasts.
58

Monitoring and Controlling a Forecasting Model



Tracking Signal The value of the TS can be used to automatically trigger new parameter values of a model, thereby correcting model performance. If the limits are set too narrow, the parameter values will be changed too often. If the limits are set too wide, the parameter values will not be changed often enough and accuracy will suffer.
  

59

Tracking Signal: What do you notice?

40 35 Sales 30 25 20 0 1 2 3 4 5 6 7 8 9 10 11

Period

60

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
      

61

Forecasting in Small Businesses and Start-Up Ventures Start

Forecasting for these businesses can be difficult for the following reasons: Not enough personnel with the time to forecast Personnel lack the necessary skills to develop good forecasts Such businesses are not data-rich environments dataForecasting for new products/services is always difficult, even for the experienced forecaster
   

62

Sources of Forecasting Data and Help



 

Government agencies at the local, regional, state, and federal levels Industry associations Consulting companies

63

Some Specific Forecasting Data

        

Consumer Confidence Index Consumer Price Index (CPI) Gross Domestic Product (GDP) Housing Starts Index of Leading Economic Indicators Personal Income and Consumption Producer Price Index (PPI) Purchasing Managers Index Retail Sales
64

WrapWrap-Up: World-Class Practice World

 

Predisposed to have effective methods of forecasting because they have exceptional long-range business longplanning Formal forecasting effort Develop methods to monitor the performance of their forecasting models Do not overlook the short run.... excellent short range forecasts as well

65

End of Chapter 3

66