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1

Chapter 15
Demand Management & Forecasting
• Demand Management

• Qualitative Forecasting Methods

• Simple & Weighted Moving Average


Forecasts

• Exponential Smoothing

• Simple Linear Regression


2

Demand Management
Independent Demand:
Finished Goods

A Dependent Demand:
Raw Materials,
Component parts,
B(4) C(2) Sub-assemblies, etc.

D(2) E(1) D(3) F(2)


3

Independent Demand: What a firm can


do to manage it.
• Can take an active role to influence demand

• Can take a passive role and simply respond


to demand
4

What Is Forecasting?

• Process of predicting a Sales will be


future event $200 Million!
• Underlying basis of
all business decisions
– Production
– Inventory
– Personnel
– Facilities

5

Types of Forecasts
by Time Horizon
• Short-range forecast

– Job scheduling, worker assignments
• Medium-range forecast

– Sales & production planning, budgeting
• Long-range forecast

– New product planning, facility location
6

Types of Forecasts
by Item Forecast
• Economic forecasts
– Address business cycle
– e.g., inflation rate, money supply etc.
• Technological forecasts
– Predict technological change
– Predict new product sales
• Demand forecasts
– Predict existing product sales
7

Types of Forecasts
• Qualitative (Judgmental)

• Quantitative
– Time Series Analysis
– Causal Relationships
– Simulation
8

Components of Demand
• Average demand for a period of time
• Trend
• Seasonal element
• Cyclical elements
• Random variation
• Autocorrelation
9

Finding Components of Demand


Seasonal variation

x Linear
x x
x x
x x x Trend
Sales

x
x x x
x
x
xx
x xx x x
x
x
x x x x x x
x x x x x x
x x x
x xxxxx
x
x x

1 2 3 4
Year
10

Cyclical Component

• Repeating up & down movements


• Usually 2-10 years duration

Cycle
Response

B
Mo., Qtr., Yr.
11

Random Component
• Erratic, unsystematic, unpredictable
‘residual’ fluctuations
• © 1984-1994 T/Maker Co.


12

Qualitative Methods

Executive Judgment Grass Roots

Qualitative Market Research


Historical analogy
Methods

Delphi Method Panel Consensus


13

Delphi Method
l. Choose the experts to participate. There should be
a variety of knowledgeable people in different
areas.
2. Through a questionnaire (or E-mail), obtain
forecasts (and any premises or qualifications for
the forecasts) from all participants.
3. Summarize the results and redistribute them to
the participants along with appropriate new
questions.
4. Summarize again, refining forecasts and
conditions, and again develop new questions.
5. Repeat Step 4 if necessary. Distribute the final
results to all participants.
14

Quantitative Forecasting Methods

Quantitative
Forecasting

Time Series Causal


Models Models

Moving Exponential Trend Linear


Average Smoothing Projection Regression
15

Time Series Analysis


• Time series forecasting models try to predict
the future based on past data.
• You can pick models based on:
1. Time horizon to forecast
2. Data availability
3. Accuracy required
4. Size of forecasting budget
5. Availability of qualified personnel
16

Simple Moving Average Formula


• The simple moving average model assumes
an average is a good estimator of future
behavior.
• The formula for the simple moving average is:
A t-1 + A t-2 + A t-3 +...+A t- n
Ft =
n
Ft = Forecast for the coming period
N = Number of periods to be averaged
A t-1 = Actual occurrence in the past period for
up to “n” periods
17

Forecasting Example # 1
Weekly Video Rentals
Week Video Rentals
W e e kly V id e o Re n ta ls
1 654
2 658
3 665 720
4 672 710
5 673 700
6 671 690
7 693
Videos Rented

680
8 694 670
9 701 660
10 703 650
11 702 640
12 710 630
620
1 2 3 4 5 6 7 8 9 10 11
We ek
18

Forecasting Video Rentals With Moving


Averages
Video
Week Rentals A t-1 + A t-2 + A t-3 +...+A t- n
1 654 Ft =
2
3
658
665
n
4 672 • Question: What are the
5 673
6 671 2-week and 4-week
7 693
8 694 moving average
9
10
701
703
forecasts for video
11 702 rentals?
12 710
• Which forecast would
you prefer?
19
Calculating the moving averages gives us:
Week Demand 2-Week 4-Week
1 654
2 658
3 665 656
4 672 661.5
5 673 668.5 662.25
6 671 672.5 667.00
7 693 672 670.25
8 694 682 677.25
9 701 693.5 682.75
10 703 697.5 689.75
11 702 702 697.75
12 710 702.5 700.00

©The McGraw-Hill Companies, Inc.


20

Which Forecast Would You Prefer?


2 Period Moving Average
( Weekly Video Rentals)

720

710

Video Rentals
700

690 Forecast
680 Actual

670

660

650
3 4 5 6 7 8 9 10 11 12 13
Week

4 Period Moving Average


(Weekly Video Rentals)

720

710
Video Rentals

700
690 Forecast
680 Actual

670
660

650
5 6 7 8 9 10 11 12 13
Week
21

Forecasting Example # 2
Quarterly Sales Data (Acme Tool Company)
Qua rte rly Sa le s Da ta
Quarter Sales
(Acm e Tool Com pa ny)
1 550
2 400
3 350 900
4 600 800
5 750 700
6 500 600
Quarterly Sales

7 400 500
8 650 400
9 850 300
10 600 200
11 450
100
12 700
0
3 4 5 6 7 8 9 10 11 12

Quar te r
22

Forecasting Quarterly Sales With Moving


Averages
Quarter Demand
1 550 A t-1 + A t-2 + A t-3 +...+A t- n
2 400 Ft =
3 350 n
4 600
5 750 • Question: What are the
6
7
500
400
2-week and 4-week
8 650 moving average
9 850
10 600
forecasts for Quarterly
11 450 Sales
12 700
• Which forecast would
you prefer?
23
Calculating the moving averages gives us:
Quarter Demand 2-Week 4-Week
1 550
2 400
3 350 475
4 600 375
5 750 475 475
6 500 675 525
7 400 625 550
8 650 450 562.5
9 850 525 575
10 600 750 600
11 450 725 625
12 700 525 637.5
24
Which Forecast Would You Prefer?
2 Period Moving Average
(Acme Tool Company)

900
800
700

Quarterly Sales
600
500 Forecast
400 Actual
300
200
100
0
3 4 5 6 7 8 9 10 11 12 13
Quarter

4 Period Moving Average


(Acme Tool Company)

900
800
700
Quarterly Sales

600
500 Forecast
400 Actual
300
200
100
0
5 6 7 8 9 10 11 12 13
Quarter
25

Weighted Moving Average Formula


While the moving average formula implies an equal
weight being placed on each value that is being
averaged, the weighted moving average permits an
unequal weighting on prior time periods.

The formula for the weighted average is:


Ft = w 1A t-1 + w 2 A t-2 + w 3A t-3 +. ..+w n A t-n
wt = weight given to time period “t” n

occurrence. (Weights must add to one.) ∑w


i=1
i =1
26

Weighted Moving Average Problem


(1) Data
Question: Given the weekly demand and weights, what is
the forecast for the 4th period or Week 4?

Week Demand Weights:


1 650
2 678 t-1 .5
3 720 t-2 .3
4 t-3 .2
27

Weighted Moving Average Problem (1)


Solution

Week Demand Forecast


1 650
2 678
3 720
4 693.4
28

Weighted Moving Average Problem (2)


Data
Question: Given the weekly demand information and
weights, what is the weighted moving average
forecast of the 5th period or week?

Week Demand Weights:


1 820 t-1 .7
2 775 t-2 .2
3 680
t-3 .1
4 655
29

Weighted Moving Average Problem (2)


Solution

W eek Demand Forecast


1 820
2 775
3 680
4 655
5 672
30

Exponential Smoothing Model


Ft = α At-1 +(1- α )Ft-1
Or,
Ft = Ft-1 + α (At-1 - Ft-1 )
Equivalently

Where,
α = smoothing constant
Ft = Forecast for period t
At = Actual value in period t
Note:
31

Exponential Smoothing Expansion

• Ft = α At - 1 + α (1-α )At - 2 + α (1- α )2·At - 3


+ α (1- α )3At - 4 + ... + α (1- α )t-1·A0
– Ft = Forecast value
– At = Actual value
 α = Smoothing constant
32
Forecasting Weekly Video Rentals With
Exponential Smoothing

Video
Week Rentals
1 654
• Question: Given the
2
3
658
665 weekly video rental data,
4
5
672
673
what are the exponential
6
7
671
693
smoothing forecasts for
8
9
694
701
periods 2-13 using
10 703 α =0.10 and α =0.60?
11 702
12 710 • Assume F1=A1
33
Calculating the Exponential smoothing forecasts gives us:
Forecasts
Video
Week Rentals α = .1 α = .6
1 654 654.00 654.00
2 658 654.00 654.00
3 665 654.40 656.40
4 672 655.46 661.56
5 673 657.11 667.82
6 671 658.70 670.93
7 693 659.93 670.97
8 694 663.24 684.19
9 701 666.32 690.08
10 703 669.78 696.63
11 702 673.11 700.45
12 710 675.99 701.38
13 679.40 706.55
34

Which Forecast Would You Prefer?


Exponential Smoothing (Weekly Video Rentals)
α = .1

720
710
700
690

Video Rentals
680
Forecast
670
Actual
660
650
640
630
620
2 3 4 5 6 7 8 9 10 11 12 13
Week

Exponential Smoothing (Weekly Video Rentals)


α = .6

720
710
700
690
Video Rentals

680
Forecast
670
Actual
660
650
640
630
620
2 3 4 5 6 7 8 9 10 11 12 13
Week
35

Forecasting Quarterly Sales for the Acme Tool


Company With Exponential Smoothing

Quarter Sales
1 550
• Question: Given the
2 400
3
4
350
600
quarterly sales data,
5 750 what are the exponential
6 500
7 400 smoothing forecasts for
8
9
650
850
periods 2-13 using
10 600 α =0.10 and α =0.60?
11 450
12 700 • Assume F1=A1
36
Calculating the Exponential smoothing forecasts gives us:
Forecasts
Quarterly
Week Sales α = .1 α = .6
1 550.00 550.00 550.00
2 400.00 550.00 550.00
3 350.00 535.00 460.00
4 600.00 516.50 394.00
5 750.00 524.85 517.60
6 500.00 547.37 657.04
7 400.00 542.63 562.82
8 650.00 528.37 465.13
9 850.00 540.53 576.05
10 600.00 571.48 740.42
11 450.00 574.33 656.17
12 700.00 561.90 532.47
13 575.71 632.99
37

Which Forecast Would You Prefer?


Exponential Smoothing (Acme Tool Company)
α = .1

900
800

Quarterly Sales
700
600 Actual
500 Forecasted
400
300
200
2 3 4 5 6 7 8 9 10 11 12 13
Quarter

Exponential Smoothing (Acme Tool Company)


α = .6

900
800
Quarterly Sales

700
600 Actual
500 Forecasted
400
300
200
2 3 4 5 6 7 8 9 10 11 12 13
Quarter
38

Forecast Effects of
Smoothing Constant α
Ft = α At -1 + α (1- α )At -2 + α (1- α )2At -3 + ...

Weights
α = Prior Period 2 periods ago 3 periods ago
α α (1 - α ) α (1 - α )2

α = 0.10

α = 0.90
39
The MAD Statistic to Determine
Forecasting Error
n

∑ A t - Ft
t=1
1 MAD ≈ 0.8 standard deviation
1 standard deviation ≈ 1.25 MAD
MAD =
n
• The ideal MAD is zero.

• The larger the MAD, the less the desirable the resulting model.


40

Weekly Video Rentals


2 Period 4 Period
Moving Moving
Average Absolute Average Absolute
Week At Forecast Deviation Forecast Deviation
1 654
2 658
3 665 656 9
4 672 661.5 10.5
5 673 668.5 4.5 662.25 10.75
6 671 672.5 1.5 667 4
7 693 672 21 670.25 22.75
8 694 682 12 677.25 16.75
9 701 693.5 7.5 682.75 18.25
10 703 697.5 5.5 689.75 13.25
11 702 702 0 697.75 4.25
12 710 702.5 7.5 700 10
Total 79 Total 100
MAD 7.9 MAD 12.5
41

Quarterly Sales (Acme Tool Company)


2 Period 4 Period
Moving Moving
Average Absolute Average Absolute
Quarter At Forecast Deviation Forecast Deviation
1 550
2 400
3 350 475 125
4 600 375 225
5 750 475 275 475 275
6 500 675 175 525 25
7 400 625 225 550 150
8 650 450 200 562.5 87.5
9 850 525 325 575 275
10 600 750 150 600 0
11 450 725 275 625 175
12 700 525 175 637.5 62.5
Total 2150 Total 1050
MAD 215 MAD 131.25
42
A Comparison of Exponential Smoothing Forecasts (Video Rentals)
Video Absolute Absolute
Week Rentals α = .1 Deviation α = .6 Deviation
1 654 654.00 654.00
2 658 654.00 4.00 654.00 4.00
3 665 654.40 10.60 656.40 8.60
4 672 655.46 16.54 661.56 10.44
5 673 657.11 15.89 667.82 5.18
6 671 658.70 12.30 670.93 0.07
7 693 659.93 33.07 670.97 22.03
8 694 663.24 30.76 684.19 9.81
9 701 666.32 34.68 690.08 10.92
10 703 669.78 33.22 696.63 6.37
11 702 673.11 28.89 700.45 1.55
12 710 675.99 34.01 701.38 8.62
MAD 23.09 MAD 7.96
43
A Comparison of Exponential Smoothing Forecasts (Acme Tool)

Quarterly Absolute Absolute


Week Sales α = .1 Deviation α = .6 Deviation
1 550.00 550.00 550.00
2 400.00 550.00 150.00 550.00 150.00
3 350.00 535.00 185.00 460.00 110.00
4 600.00 516.50 83.50 394.00 206.00
5 750.00 524.85 225.15 517.60 232.40
6 500.00 547.37 47.37 657.04 157.04
7 400.00 542.63 142.63 562.82 162.82
8 650.00 528.37 121.63 465.13 184.87
9 850.00 540.53 309.47 576.05 273.95
10 600.00 571.48 28.52 740.42 140.42
11 450.00 574.33 124.33 656.17 206.17
12 700.00 561.90 138.10 532.47 167.53
MAD 141.43 MAD 181.02
44

Tracking Signal Formula


• The TS is a measure that indicates whether the
forecast average is keeping pace with any
genuine upward or downward changes in
demand.
• Depending on the number of MAD’s selected, the
TS can be used like a quality control chart
indicating when the model is generating too much
error in its forecasts.
• The TS formula is:
RSFE Running su m of forec ast errors
TS = =
MAD Mean absol ute deviat ion
45

Calculating Tracking Signals for the Exponential Smoothing


Forecasts From the Acme Tool Company Example
Q u a r te r ly S a l e s D a ta - A c m e T o o l C o m p a n y
α = 0.1

R u n n in g
S um of
A c t u a l F o re c a s tF o re c a s t F o re c a s t A b s o lu t e S u m o f T ra c k in g
(A t ) (F t ) E rro r E rro rs D e via tio n A b s . D e v.M A D S ig n a l
1 5 5 0 . 0 0 5 5 0 .0 0
2 4 0 0 . 0 0 5 5 0 .0 0 -1 5 0 .0 0 -1 5 0 .0 0 1 5 0 . 0 0 1 5 0 . 0 0 1 5 0 . 0 0 -1 .0 0
3 3 5 0 . 0 0 5 3 5 .0 0 -1 8 5 .0 0 -3 3 5 .0 0 1 8 5 . 0 0 3 3 5 . 0 0 1 6 7 . 5 0 -2 .0 0
4 6 0 0 . 0 0 5 1 6 .5 0 8 3 .5 0 -2 5 1 .5 0 8 3 .5 0 4 1 8 . 5 0 1 3 9 . 5 0 -1 .8 0
5 7 5 0 . 0 0 5 2 4 .8 5 225.15 -2 6 . 3 5 2 2 5 . 1 5 6 4 3 . 6 5 1 6 0 . 9 1 -0 .1 6
6 5 0 0 . 0 0 5 4 7 .3 7 -4 7 .3 7 -7 3 . 7 2 4 7 .3 7 6 9 1 . 0 2 1 3 8 . 2 0 -0 .5 3
7 4 0 0 . 0 0 5 4 2 .6 3 -1 4 2 .6 3 -2 1 6 .3 4 1 4 2 . 6 3 8 3 3 . 6 4 1 3 8 . 9 4 -1 .5 6
8 6 5 0 . 0 0 5 2 8 .3 7 121.63 -9 4 . 7 1 1 2 1 . 6 3 9 5 5 . 2 8 1 3 6 . 4 7 -0 .6 9
9 8 5 0 . 0 0 5 4 0 .5 3 309.47 21 4.76 309.47 1264.75 158.09 1.36
1 0 6 0 0 . 0 0 5 7 1 .4 8 2 8 .5 2 243.29 2 8 .5 2 1 2 9 3 . 2 7 1 4 3 . 7 0 1.69
1 1 4 5 0 . 0 0 5 7 4 .3 3 -1 2 4 .3 3 11 8.96 124.33 1417.60 141.76 0.84
1 2 7 0 0 . 0 0 5 6 1 .9 0 138.10 25 7.06 138.10 1555.71 141.43 1.82
46
Tracking Signal Charts
Tracking Signal (Weekly Video Rentals)
α = 0.1
12

10

Tracking Signal
8

6 Tracking Signal

0
2 3 4 5 6 7 8 9 10 11 12
Forecast Period

Tracking Signal (Acme Tool Company)


α = 0.1

2.5
2
1.5
1
Tracking Signal

0.5
0 Tracking Signal
-0.5 2 3 4 5 6 7 8 9 10 11 12
-1
-1.5
-2
-2.5
Forecas t Period
47

Linear Trend Projection

• Used for forecasting linear trend line


• Assumes relationship between response
variable Y & time X is a linear function

• Estimated by least squares method


– Minimizes sum of squared errors
48

Linear Regression Model

Y Yi = a + b X i + Error

Error
Regression line

Yi = a + b X i
X
Observed value
49

Correlation

• Answers ‘how strong is the linear


relationship between 2 variables?’
• Coefficient of correlation used
– Sample correlation coefficient denoted r
– Values range from -1 to +1
– Measures degree of association
• Used mainly for understanding
50

Coefficient of Correlation Values

Perfect Perfect
Negative No Positive
Correlation Correlation Correlation

-1.0 -.5 0 +.5 +1.0

Increasing degree of Increasing degree of


negative correlation positive correlation
51

Web-Based Forecasting: CPFR


Defined
• Collaborative Planning, Forecasting, and
Replenishment (CPFR) a Web-based tool used to
coordinate demand forecasting, production and
purchase planning, and inventory replenishment
between supply chain trading partners.
• Used to integrate the multi-tier or n-Tier supply chain,
including manufacturers, distributors and retailers.
• CPFR’s objective is to exchange selected internal
information to provide for a reliable, longer term
future views of demand in the supply chain.
• CPFR uses a cyclic and iterative approach to derive
consensus forecasts.
52

Web-Based Forecasting:
Steps in CPFR
• 1. Creation of a front-end partnership
agreement
• 2. Joint business planning
• 3. Development of demand forecasts
• 4. Sharing forecasts
• 5. Inventory replenishment