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# Understanding Quantitative Demand

Forecasting

## Slide 2: Course Overview

Have you ever heard of an occupation that rewards an employee for being wrong?
Surprisingly, you can, as a demand forecaster, be wrong and still remain in the
companys good graces.

Why are errors in this occupation tolerated when they would likely lead to dismissal in
other job roles? The answer lies in the fact that all organizations have a need to
understand and quantify future customer demands for its products and services. This
knowledge will facilitate decisions that can significantly increase the competiveness and
profitability of the organization. For example, an organization projecting 25% annual
growth will need to invest in manufacturing capacity upgrades and additions in the
future. Failure to do so on a timely basis would likely result in lost sales, expediting
costs, and low employee morale.

Forecasts are often wrong. Luckily, the decisions required to operate a successful
enterprise rarely require 100% accuracy. As long as the demand forecast is reasonably
accurate, the organization can still make the correct decision. Continuing with the
previous illustration, if forecasted growth was 25% while actual annual growth was 28%,
the company will still need to expand in the future. While the timing of their capacity
expansion may be slightly incorrect, the plan to add capacity is still valid. In other words,

This course will provide you with quantitative demand forecasting techniques that are
appropriate for a large number of the mature products sold today. In addition, forecast
performance measures will be discussed that evaluate the degree to which a demand

## Slide 3: Course Objectives

After completing this course, you should be able to:
Develop demand forecasts using averaging methods.
Develop demand forecasts using single exponential smoothing.
Calculate a variety of forecast error measures.
Calculate and detect forecast bias.
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Slide 4: Lesson 1: Demand Forecasting Concepts

## Slide 5: Lesson Introduction

At any given time, successful organizations will have various products at different
stages of the product life cycle. This lesson will demonstrate the quantitative forecasting
techniques required to predict future demands for mature products.

## After completing this lesson, you should be able to:

List the steps required to perform simple averaging forecasts.
Update a forecast created with a simple average.
Discuss weaknesses of a simple average forecast.
Develop an initial forecast using a moving average technique.
Update a forecast using a moving average method.
Calculate an initial demand forecast utilizing a weighted moving average method.
Perform ongoing updates to a weighted moving average forecast.

## Slide 6: Calculating a Simple Average

Introduction
The simple averaging forecasting method follows a five-step process:

## Step 1: Gather Data

Simple averaging begins with the gathering of historical demand data. This step must
be completed with care and should include a data cleansing activity to eliminate
abnormalities in the demand data. For example, if the past demand was heavily
influenced by an unusual and rare weather-related event, the demand forecaster may
replace it with an estimate that represents the normal demand for that time period.

## Step 2: Sum Data

Add all of the demand data to obtain the total demand for this product.

## Step 3: Calculate the Average of All Data

Use the arithmetic mean to average the data. Obtain the mean by dividing the total
demand by the total number of periods.

Step 4: Round
Round the average to the number of decimal places that makes sense for the item
being forecast. As a guideline, if a product is manufactured and sold in units of one,
then round to the nearest whole number.

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Step 5: Publish Forecast
This step should include estimating the forecast error that can be expected. This is
calculated by comparing the smallest and largest historical demands to the forecast and
selecting the largest difference.

A graph of sample data illustrates the outcome of the five-step process. In this case 8
periods of historical data are added, with a result of 600, and divided by 8 to create the
forecast of 75. The largest forecast error is 15. This was derived from the smallest
demand data, 60, subtracted from the forecast of 75. The published forecast becomes
75 +/- 15.

## Slide 7: Simple Average: Ongoing Usage

As extra historical demand is realized, the procedure can be repeated to include the
latest data. In this example period, 9 data has been added to the previous
demonstration, resulting in a new total of 680 and an updated average of 75.5. This was
rounded up to 76. Similarly, the new error is set at 16, and the published forecast is now
76 +/- 16.

## Slide 8: Weaknesses of Simple Average

By definition, simple averaging uses inception-to-date historical data. For products with
a long product life cycle, this aspect of the averaging technique can be very
cumbersome. As a result, most organizations utilize an approach that limits the
historical data to a manageable and meaningful quantity. This is usually one to three
years in duration. In this case a moving average forecast is being utilized.

Simple averaging also treats all historical data equally. This is not appropriate when the
current marketplace conditions have changed dramatically. For example, consider a
product with three years of demand data. In the first year, distribution was limited to 100
retail outlets, and the unit selling price was \$5.00. Today, the distribution network has
expanded to 300 retail locations, and the price has been reduced to \$3.99. Clearly, the
inclusion of introductory product demand will distort the demand forecast moving
forward. This can be corrected by reducing the amount of historical data included in the
moving average calculations or by adopting a weighted moving average.

Last, the simple averaging technique is only suitable when the base component of
demand is present. If trends, seasonality, or cyclical patterns exist, more complex tools
are required. These can include regression, seasonal decomposition, and econometric
modeling.

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Slide 9: Calculating a Moving Average
Introduction
The procedure to perform a moving average forecast is very similar to that of a simple
averaging technique and uses a five-step process.

Step 1: Initialization
In this technique, a fixed window of the most recent historical data is utilized in the
averaging process. Most applications utilize a window size of three to six periods.
Smaller window sizes tend to be more reactive to any random elements in the demand
pattern. They would also detect any demand pattern shifts faster than larger window
sizes.

## Step 2: Prepare and Gather Demand Data

After setting the window size, the procedure for the first period starts by gathering
historical demand data to fill the window. This data should be cleansed for
abnormalities.

## Step 3: Compute the Average

Calculate the average value inside the window by summing demand and dividing by the
number of periods in the window.

## Step 4: Publish the Forecast

After rounding, the forecast error is computed by comparing the smallest and largest
values inside the window to the new forecast. As before, the largest absolute difference
is adopted as the error value. Last, the new forecast is published for all periods in the
future.

## Step 5: Adjust the Window

As new historical data becomes available, the window slides down the table of
demands, allowing the oldest data to be dropped from future calculations. At the same
time, the most recent historical data is included in the window for analysis. Steps 3 and
4 are then repeated.

## Slide 10: Moving Average Example

This example utilizes a three-month moving average technique. The initial forecast
generation is shown first. It is calculated from the first three periods of data: 112, 123,
and 124. As time passes, period four historical data becomes available. Note how the
moving window drops down to include the newest demand history, 108, which in turn
causes the oldest data, 112, to be dropped from further analysis. A new updated
forecast is published going forward. This process will repeat itself as new data is
realized each period.

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Slide 11: Calculating a Weighted Moving Average
The weighted moving average is an extension of the moving average technique. In
addition to introducing the moving window of historical data, this technique multiplies
each data point by a weighting factor. This weighting factor ranges from 0 to 1. The
actual number used represents the percentage of the historical data that is utilized to
generate the new forecast. Typically, larger numbers are reserved for the most recent
past and the weights are reduced with time. Care must be taken to ensure that the sum
of the weights equals 1. In this course, the weights will always be given.

The procedure used in this methodology closely parallels the moving average technique.
It begins by setting the window size and weights. Following this step, historical demand
data is gathered to fill the window. Data cleansing is performed as required. Each of the
data points is then multiplied by an appropriate weight. The weighted numbers are
added to generate a future forecast that can be rounded as desired. Forecast error is
computed as before to complete the process.

Subsequent periods follow the same procedure after the window has been shifted to
drop off the oldest historical data.

## Slide 12: Weighted Moving Average Example

This example utilizes the same data that was analyzed on a three-month moving
average basis. Weights of 0.6, 0.3, and 0.1 will be utilized. The initial forecast is
calculated by adding the weighted historical demand values. Specifically, the forecast
equals 10% of 112 plus 30% of 123 plus 60% of 124. The initial forecast of 122.5 has
been rounded up to 123. The forecast error has been set at plus or minus 11 based
upon the smallest historical data, or 112 in comparison to this forecast.

## An updated forecast is generated when another period of actual demand is realized.

Note how the window slides down to drop off the oldest demand data. In addition, the
weights slide down. The new updated forecast is the addition of 10% of 123 plus 30% of
124 plus 60% of 108.

The last table summarizes the forecasts generated by the moving average and
weighted moving average examples. Notice how the weighted average technique tends
to be more reactive to the most recent demands as evidenced by the close proximity of
the forecast to the latest demand value. This sensitivity is increased by selecting greater
values for the most recent weight, 0.6 in this example, relative to the other weights
utilized.

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## Slide 14: Lesson Summary

At any given time, successful organizations will have various products at different
stages of the product life cycle. This lesson provided the quantitative demand
forecasting techniques required to predict future demands for mature products.

In this lesson, you listed the steps required to perform a simple averaging forecast. In
addition, you updated a simple average forecast and discussed weaknesses associated
with this technique. You also developed an initial forecast using either moving average
or weighted moving average methods. Finally, you reviewed how to update forecasts
using the same methods as new historical data becomes available.

## Slide 16: Lesson Introduction

Demand forecasters are always searching for improved forecasting methods. In
particular, a quicker and more efficient method of developing a moving average forecast
exists called single exponential smoothing.

## After completing this lesson, you should be able to:

Discuss the exponential smoothing formula and how it relates to the moving
average technique.
Develop and update a demand forecast utilizing exponential smoothing.
Discuss the impact of different smoothing constants on forecasting results.

## Slide 17: Exponential Smoothing

Many decades ago, the cost of computer storage was extremely high. As a result, an
organization with thousands of items utilizing a six-month moving average forecasting
method would have experienced a large computing charge for its demand forecasting
process. Demand forecasters were given the challenge of creating a methodology that
would generate the same result at a fraction of the computing costs. This ultimately led
to the creation of a technique called single exponential smoothing.

## Slide 18: Single Exponential Smoothing

Single exponential smoothing is a very popular demand forecasting technique
supported by a large number of software packages. Its popularity is linked to its ability to
predict stable demand patterns with minimal historical data.
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This course will utilize the terms single exponential smoothing and exponential
smoothing interchangeably. While other similar forecasting techniques such as double
and triple exponential smoothing exist, our discussion will be limited to single
exponential smoothing.

Exponential smoothing demand forecasts are calculated based upon the formula

NF = OF + (A - OF)

In this equation NF is the new or updated forecast, OF is the current or old forecast, A is
the actual demand this period, and is a smoothing constant that ranges between 0
and 1. The new forecast is equal to the old forecast plus the product of the difference
between actual demand and the old forecast and the smoothing constant. In effect, the
exponential smoothing formula updates the current forecast with a percentage of the
forecast error. The exact percentage is determined by the smoothing constant.

## Exponential smoothing is related to the equivalent moving average forecast by the

equation

= 2/(n + 1)

In this equation, is the smoothing constant, and n represents the number of periods
included in the moving average forecasting method. The smoothing constant equals two
divided by the sum of the number of periods plus 1. For example, a smoothing constant
of 50% would give results similar to a three-month moving average.

## Slide 19: Smoothing Constants

As mentioned earlier, the smoothing constant can range from 0 to 1. It is very rare to
utilize either extreme. A value of 0 would result in a forecast that never changes, while a
value of 1 would be equivalent to setting the new forecast to the actual demand. Instead,
demand planners often make a qualitative judgment and assign an alpha value that is
appropriate to their situation. Some demand forecasting software can also provide
recommendations for this parameter.

Two general guidelines that can be utilized when selecting a smoothing constant are:
1. If you have a flexible supply chain, use a higher alpha value.
2. If your supply chain is less flexible, use a lower alpha value.

To illustrate these guidelines, some of the previous demonstration data has been
recalculated for a relatively high smoothing constant of 80%. In addition, the forecast
has been updated for an additional two periods. Examination of the results reveals the
most important principle of smoothing constants: higher smoothing constant values

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make the forecasting process more sensitive to random variations in the demand
pattern. This extra forecast sensitivity is generally desirable when:
The supply chain is very flexible. A factory with short lead times, excess capacity,
small setup times, and cross-trained employees could benefit from higher
smoothing constant values.
The product is very profitable or important. An organization may find it
advantageous to aggressively chase demand when the product has a high
margin or is sold to important customers.
The marketplace is volatile and may be subject to a sudden increase in overall
demand.

## Slide 20: Single Exponential Smoothing Example

In this example a relatively small smoothing constant of 0.2 is utilized. Beginning with
nine periods of historical data, the initial starting forecast is set at the average of the
data. As with other averaging techniques, an error range is calculated by comparing the
forecast to the maximum demand and the minimum demand contained in the historical
data. The largest absolute difference is chosen as the error approximation. In this
example, the initial forecast becomes 105 +/- 7.

## As new historical data is realized, the exponential smoothing formula is utilized to

update the forecasted demand moving forward. The figure summarizes this calculation
for an actual demand of 115. The new updated forecast becomes 107 +/- 8.

This simple calculation is repeated each time new data becomes available. The
calculations are shown for the next period actual of 100. In this case the resulting
forecast is reduced to 106 +/-9. This forecast was rounded from 105.6. Last, a table
summarizing the previous results compared to a nine-month moving average illustrates
the similarity between the two methods as predicted by the formula alpha equals 2
divided by n plus 1.

## Slide 22: Lesson Summary

Single exponential smoothing represents a quicker and more efficient method for the
development of demand forecasts for mature products. Therefore every forecaster
should be aware of this technique and be able to utilize it as appropriate.

In this lesson, you explored the exponential smoothing formula and how it relates to the
moving average technique. In addition, you developed and updated a demand forecast

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utilizing exponential smoothing. Last, you examined the impact of different smoothing
constants on forecasting results.

## Slide 24: Lesson Introduction

Forecast error measurements can be utilized to signal the need for an enhanced
forecasting methodology or to guide statistical safety stock calculations. This lesson will
provide a variety of forecast error measurements that can be utilized for this purpose.
These measures are applicable to all industries.

## After completing this lesson, you should be able to

Discuss the relationship of the normal curve distribution as it relates to forecast
errors.
Calculate mean absolute deviation.
Calculate the absolute percent error.
Develop the mean absolute percent error.

## Slide 25: The Normal Distribution

If the forecaster were to analyze a set of unbiased forecast errors by creating a
histogram of those errors, the result will often approximate a normal distribution.

## The key properties of a normal curve include:

It is symmetrical about the mean or average (that is, no bias).
A majority of the data points cluster around the mean.
The tails of the normal curve run asymptotic to the x-axis (that is, they never
cross the horizontal axis).

Mathematicians have studied normal curves for decades. As a result, a complete set of
terminology and measurement systems have been developed for normal curves. The
spread of the normal curve, in this example 50150, is referred to as the dispersion.
The size of this dispersion can be measured in a variety of ways including by standard
deviation. This measure is often referred to as the Greek letter sigma. A simpler
measure of dispersion is mean absolute deviation. This measure can be utilized to
approximate the standard deviation by using the formula

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To reiterate, this formula provides an approximation of standard deviation, not an exact
equivalent.

## Slide 26: Calculating Mean Absolute Deviation

1. Compute the forecast error or deviation by period. The industry standard for this
calculation is actual demand minus forecasted demand. For example, period one
deviation is the difference between 110 and 100, or 10 units.
2. Calculate the absolute value of this error by turning negative deviations positive.
Positive deviations remain unchanged. This is illustrated nicely in period two.
Note how the negative deviation of -10 becomes +10 upon completion of this
step.
3. Sum the absolute deviations. In this example the result is 65.
4. Divide the result by the number of observations. For this example the result is 65
divided by 5, or 13.

Using the formula, the standard deviation can be approximated by multiplying by 1.25.
This results in a value of 16.25, which compares favorably as an approximation of the
actual standard deviation of 17.53.

## Slide 27: Calculating Absolute Percent Error

The steps required to calculate absolute percent error (APE) also follow the measures
name. Specifically:
1. Compute the forecast error or deviation by period. As with the MAD calculation,
the industry standard of actual minus forecast is used.
2. Calculate the percent error by dividing the forecast error by actual demand. In
period one this is achieved by dividing 10 by 110, which is 9.1%. This calculation
can be problematic when the actual demand is 0. When this occurs, most
organizations report the specific APE as infinity but substitutes a value of 100%.
Doing this facilitates subsequent MAPE and accuracy calculations.
3. Calculate the absolute value of this percentage by turning negative values
positive. Positive percentages remain unchanged. Using period three for
illustration purposes, note how the percent error of -5.3% becomes +5.3% upon
completion of this step.

## Slide 28: Calculating Mean Absolute Percent Error

Mean absolute percent error (MAPE) is a logical extension of the APE calculation. This
calculation starts by calculating the APEs for all periods. The arithmetic mean, often

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referred to simply as the mean, is then calculated from this data to create the MAPE. In
this example, the MAPE is 11.2%.

MAPE is the most common measure of forecast error used in industry. For positive
thinkers, it can be transformed into a forecast accuracy measure by subtracting it from
100%. The previous example would therefore represent 11.2% error, or 88.8% accuracy.

## Slide 30: Lesson Summary

Forecast error measurements can be utilized to signal the need for an enhanced
forecasting methodology or to guide statistical safety stock calculations. This lesson
provided participants a variety of forecast error measurements, applicable in all
industries, that can be utilized for this purpose.

In this lesson, you calculated mean absolute deviation (MAD) and absolute percent
errors (APE). In addition, you examined the relationship of the normal curve distribution
as it relates to forecast errors and developing the mean absolute percent error (MAPE)
for any product forecast.

## Slide 32: Lesson Introduction

Supply chain performance can be severely compromised if forecast bias is allowed to
exist. As a result, every demand forecaster must understand the concept of bias, be
able to calculate bias measures, and interpret those measures to determine when bias
exists.

## After completing this lesson, you should be able to:

Discuss the concept of bias.
Calculate and detect forecast bias utilizing tracking signals.
Discuss the implications of forecast bias on supply chain performance.

## Slide 33: What Is Bias?

As every demand pattern includes a random component, forecasters should expect that
forecast error will always exist. However, demand forecasts can be wrong in another
way. If the forecast error over time has a tendency to always be positive or a tendency
to always be negative, it is referred to as a biased forecast.
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The cumulative sum of the error is one way to detect bias. In an unbiased state, the
positive and negative errors should balance out to approximately zero. Values
significantly less than zero or significantly greater than zero are an indication of forecast
bias.

## Slide 34: Tracking Signals

A very popular measure used to detect forecast bias is called a tracking signal. The
formula for this measure is

Where TS is the tracking signal, errors is actual demand minus forecasted demand, and
MAD is the mean absolute deviation.

## Slide 35: Detecting Bias

The following guideline can be used to detect forecast bias:
If tracking signal is greater than 3 or is less than -3, bias exists.
Initially it may be confusing that two different sets of values can indicate forecast bias.
However, recall that consistent overselling or consistent underselling of the forecast are
both called forecast bias. Large negative tracking signals are an indication of consistent
underselling, while large positive values are indicative of overselling.

Conversely, any tracking signal values between -3 and 3 have little to no bias
associated with them.

Tracking signals are calculated for two sets of data to illustrate these guidelines. The
first table is characterized by a tracking signal of 0.37 and is clearly unbiased.

The second table of data is heavily biased and has a tracking signal of 7.0.

## Slide 36: Business Impacts of Bias

When forecast bias exists, company schedulers, planners, and management are
continually working with invalid demand and supply plans. As these plans are executed,
corrective action is required to overcome the bias condition. These corrective actions
can have serious financial impacts on the organization. Specifically, a large positive
tracking signal occurs when actual demand consistently exceeds the forecasted
demand. As a result, all supply plans are understated, safety stock inventory is totally
consumed, and expediting occurs throughout the supply chain. This could include rush
orders from suppliers, factory overtime, and premium freight charges. Inevitably, low

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inventory levels typically also generate customer backorders. This results in lost sales,
customer fines, and the potential loss of future sales.

Large negative tracking signals are also associated with poor performance. In this case
lower than expected customer demand creates excessive inventory levels. Inventory
carrying costs naturally rise. Examples include extra storage charges and higher than
expected inventory write-offs. This could be especially troublesome for food and
pharmaceutical products with expiry dating concerns.

Supply chain professionals must continually monitor the forecast process for forecast
bias. When detected, the root cause of the bias must be addressed and eliminated.

## Slide 38: Lesson Summary

Supply chain performance is severely compromised when forecast bias is allowed to
exist. Consistent overselling of the demand forecast typically results in backorders or
excessive expediting costs. Conversely, poor inventory turns accompany sales results
that are chronically below forecast. Every demand forecaster should be capable of
calculating forecast bias measures and initiating the appropriate corrective action when
bias is detected.

In this lesson, you explored the concept of bias and its implications on supply chain
performance. In particular, you calculated and detected forecast bias utilizing tracking
signals.

## Slide 39: Course Summary

This course provided quantitative demand forecasting techniques that are appropriate
for a large number of mature products sold today. In addition, the course discussed and
demonstrated forecast performance measures. This provides a quantitative basis for
evaluating the degree to which a demand forecast is value adding.

Specifically, you developed demand forecasts using averaging methods and single
exponential smoothing. These averaging methods include simple, moving, and
weighted moving techniques. You measured forecast performance along two major
dimensions. You also calculated mean absolute deviation, absolute percent error, and
mean absolute percent error as a measure of forecast error. Similarly, you detected
forecast bias by calculating and interpreting a tracking signal.

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