Demand Forecasting

Demand Forecasting
Forecast: It is a statement / an estimate about the future. It helps managers by reducing some of the uncertainties & enables them to develop meaningful plans. It helps managers to determine in the present what course of action they will take in future Forecasting : It is an art & science of predicting /estimating future events. It is not a mere guess or prediction about the future without any rational basis. It may involve taking historical data & projecting them in to the future. It may include a managers good judgment or a intuitive prediction in the absence of historical data

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Any business organization can not afford to avoid forecasting & just wait to see what happens & then take its chances. Effective planning in both short & long run depends on forecast of demand for the companys products. Uses of forecasts: Helps in planning the productive system involving i) Long range & ii) Short & intermediate plans. i) Long range plans relate to a) what products & services to offer, b) what facilities & equipments to have, c) where to locate them, ii) Short & intermediate plans involves a) Planning inventories & workforce levels, b) Planning purchasing, c) Production, scheduling & budgeting

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Forecasts are also used to predict Profits, revenue, costs. prices productivity changes, availability of energy, raw materials interest rates, movements of key economic indicators e.g. GNP, inflation etc, prices of stocks & bonds. Forecasting is necessary in Production & operations management for the followings: i) New facilities planning: ii) Production Planning: iii) Workforce Scheduling: iv) Financial Planning:

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Types of forecasts: 1 Technological forecasts 2 Economic forecasts 3 Demand forecasts: Features common to all forecasts: - These generally assume that same underlying reasons that existed in the past will continue to exist in the future -These are rarely perfect. Actual demand, differs from forecasted demand. Allowances should be made for inaccuracies. - Forecasts for group of items tend to be more accurate than forecasts for individual items. - Forecast accuracies decreases as the time period for the forecast (forecasting time horizon) increases.

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Elements / requirements of a good forecast: A forecast should be - Timely i.e. the forecasting horizon must have the time necessary to implement possible changes in production capacity, financial needs etc. - Accurate & the degree of accuracy should known - Reliable i.e. consistent in accuracy - Expressed in meaningful units e.g. Rs, units of products machines & skills needed. - Written form to permit an objective basis for evaluating the forecast once the actual results are known. - The technique should be simple to understand & use (comfortable for users)

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Objectives of demand forecasting i) Short range objectivesii) medium or long range i) Short range objectivesa) Formulation of production strategy & policy: to bridge the gap between demand & supply & to ensure b) Formulation of pricing policy- Demand forecasting enables management to formulate suitable mechanism for fixing the prices for products to be sold. c) Planning & control of sales- Demand forecasting facilitate territory design & determination of quotas to be assigned to sales people.

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ii) Medium or Long-range objectives: a) Long-range planning for production capacity: The installed capacity of the plant is usually based on long-term demand forecasts. b) Labour requirements (Employment levels)These are based on reliable medium/long term demand forecasts so as to optimise the cost of production over the long-term planning horizon. c) Restructuring the capital structureLong-term forecasts facilitate planning for long-term finance requirements at reasonable financial costa & other terms & conditions for obtaining finance from financial institutions as well as planning for internal financial resources to meet long-term financial needs.

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Classification of demand forecasting methods: i) Qualitative - These consist mainly of subjective inputs, often of non-numerical description & ii) Quantitative These involve either projection of historical data or the development of association models which attempt to use casual variables to arrive at the forecast. Overview of qualitative methods: 1) Jury of executive opinion- In this the opinions of a small group of high-level executives (managers) are taken, based on which a group estimate of demand is obtained as the forecast. Advantage- i) uses experience & knowledge of two or more managers to arrive at a single forecast .ii) Can be used for technological forecasting iii) Can be used for forecasting for new products. iv) Can be used to modify an existing forecast to account for unusual circumstances.

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Jury of executive opinion- contd Disadvantages- i) It can be costly because it takes valuable executive time. ii) some times gets out of control or gets delayed. iii) difficult to get consensus opinion of several experts. 2) Salesforce composite method - Also known as Pooled salesforce estimate method. In this each sales person estimates what sales will be in his / her territory. These estimates are then reviewed to ensure that they are realistic. Then they are combined at the district or national level to arrive at the overall forecast.

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2) Salesforce composite method-contd: Advantages- i) The sales force is the group closest to the customers. They are most likely to know which product or services, customers will be buying in the near future & in what quantities. ii) Sales territories are divided in to districts or regions & forecasts for district or regions will be useful in inventory management, distribution & sales staffing. Disadvantages- i) Individual bias of sales people may affect the sales forecast (Some are optimistic & some pessimistic) ii) Sales people may be unable to distinguish between what customers would like to do & what they actually will do. iii) some sales people may be overly influenced by their recent experience. iv) If the firm uses sales persons estimate as a performance measure , sales people may deliberately under estimate their forecast so that their performance will look good when they exceed their quotas which are fixed based on their estimates

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3) Market Research method: A sample of consumers survey is the systematic approach to determine their interest in a product or service. This method may be used to forecast demand for short, medium or long term. Advantage: i) Consumers opinion regarding their future purchasing plans are better than executive opinion because it is the consumers who determine demand. Also this is first hand & direct information obtained by consumer survey. Disadvantages: i) As opinions are obtained from a sample of customers, it may lead to forecast error if the sample size is inadequate. ii) Survey require considerable knowledge & skills to handle correctly. iii) Survey can be expensive & time consuming. iv) Response rate of mailed questionnaire may be poor. v) The survey results may not reflect the opinion of the market.

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4) Delphi Method: It is also a judgemental method. - In this method opinions are solicited from a number of other managers & staff personnel. -The decision makers consist of 5-10 experts who will be making actual forecast. -The staff personnel assist decision makers by preparing, distributing, collecting & summarising a series of questionnaires & survey results. -The managers whose judgements are valid are the respondents. This group provides inputs to the decision makers before forecast is made. Responses of each respondent are kept anonymous which tends to encourage honest responses. - Each new questionnaire is developed using the information extracted from the previous one, thus enlarging the scope of information on which participants base their judgements. The goal is to achieve consensus forecast.

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Delphi Method: contd Advantages: i) This method can be used to develop long-range forecasts of product demand & sales projections for new products ii) A panel of experts may be used as participants (respondents) Disadvantages: i) The process can take a long time ii) Responses may be less meaningful because respondents are not accountable due to anonymity. iii) High accuracy may not be possible. iv) Poorly designed questionnaire will result in ambiguous or false conclusions

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Overview of quantitative methods: 5-methods, under 2-catagorie They all use historical data. 1- a) Nave approach (lacking experience or judgement) b) Moving averages method c) Exponential smoothing method These are time series models 2- a) Trend projection ] These are b) Linear regression analysis ] Causal models Time series models: -Predict on assumption that the future is a projection of past. -They look at what has happened over a period of time & use a series of past data to make a forecast for the future. Causal (or association) models: eg linear regression incorporate the variables or factors that might influence the quantity being forecast. The demand or sales forecast is a dependent variable & other factors that affect demand are independent variables ( causal variables) In linear regression the dependent variable (Demand) is related to one or more independent variables by a linear equation

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Time series forecasting methods: -A Time series is a time-ordered sequence of observations taken at regular intervals over a period of time (hourly, daily, weekly, monthly, quarterly or annually) -Data may be measurement of demand, earnings, profits, outputs, productivity, consumer price index etc. Decomposition of time-series: -Analysis of time-series data requires the analyst to identify the underlying behaviour of the series. This can be done by plotting the data with time on X-axis, & data on Y-axis & visually examining the plot. One or more patterns might appear. They are- trends, seasonal variations, cycles & random or irregular variations ( errors)

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Trend- refers to gradual, long term, upward or downward movement in data over time. Changes in income, population, age, distribution or cultural views may account for such movements. Seasonality- refers to short term, fairly regular variations related to factors such as weather, holidays, vacation etc. Seasonal variations can be daily, weekly or monthly. Cycles- are wave like variations of more than one year duration or which occur every several years. They are usually tied with business cycle related to a variety of economic , political, or agricultural conditions. Random Variations are residual variations which are blips in the data caused by chance & unusual situations, which cannot be predicted (eg war, earthquake, flood etc)

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Techniques of averagingHistorical data contain a certain amount of random variation, or noise which tends to observe systematic movement in data. It is desirable to completely remove any randomness from the data& leave only real variation such as change in demand. Averaging technique smooth fluctuations in a time series so that the forecast can be based on average, to exhibit less variability than the usual data. Averaging techniques generate forecasts to reflect recent values of a time series. 3-Techniques of averaging are- a) Nave approach b) moving averages (simple & weighted) & c) Exponential smoothing. i) Nave approach: It is the simplest way to forecast & it assumes that demand in the next period is equal to actual demand in the most recent period i.e the current period. example- if actual sales of a product in March 2011 is 300 units, the forecast demand in April 2011 will also be 300 units.

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ii) Moving averages method- It uses a no. of most recent historical actual data values to generate a forecast The moving average for n number of periods in the moving average is calculated as: Moving average= [ demand in previous periods] n n may be 3,4,5,or 6 for 3,4,5,or 6 period moving average Simple moving average method: - Used to estimate the average of a demand time series & remove the effects of random fluctuations. -Most useful when demand has no pronounced trend or seasonal fluctuations. -** In this we use n period moving average. The average demand of the n most recent time periods is calculated & used as forecast for the next time period

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Month Actual (period) Demand 1 2 3 4 5 6 d1 d2 d3 d4 d5 d6 Forecast based on simple moving average Arithmetic mean values

[d1+d2+d3] 3 Forecast for 4th month [d2+d3+d4] 3 Forecast for 5th month [d3+d4+d5] 3 Forecast for 6th month

Weighted moving average Decreasing values of weights Forecast for 4th month : such that w = 1 [w1d1+w2d2+w3d3] {w1+w2+w3} w3 w2 w1 Forecast for 5th month : [w2d2+w3d3+w4d4] {w2+w3+w4} w4 w3 w2 Forecast for 6th month : [w3d3+w4d4+w5d6] {w3+w4+w5} w5 w4 w3

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iii) Exponential smoothing method: -It is a sophisticated weighted moving average method -Relatively easy to understand & use. -Requires only three items of data: a) this periods forecast, b) actual demand of this period & c) , a greek alphabet called alpha, which is referred to as smoothing constant & having a value between 0 &1. The formula used isNext Periods forecast = This Periods forecast + { This periods actual demand - This Periods forecast } Or Ft = F t -1 + [ A t -1 F t -1 ] Ft = Forecast for period (t) Ft -1 = Forecast for period (t -1) ,= smoothing constant ] value between 0 &1] A t -1= Actual demand for period (t -1) Commonly used value of ranges between 0.05 to 0.5

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Factors to be considered in selection of a forecasting method are: i) Cost & accuracy, ii) Data available, iii) Time span, iv) Nature of products & services v) Impulse response & noise dampening. i) Cost & accuracy- A trade-off may result between cost & accuracy. High forecast accuracy can be obtained- at a high cost- will require more data which are difficult to obtain & models are difficult to design, implement & operate. Delphi, market research, jury of executive opinion, statistical models based on historical data are of low or moderate cost. ii) Data available: Relevant data availability is important in the choice of forecasting method. Example