Forecasting

Forecasting product demand is crucial to any supplier,

manufacturer, or retailer.
Forecasts of future demand will determine the quantities
that should be purchased, produced, and shipped.
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.
In other words, most manufacturers "make to stock" rather
than "make to order" they plan ahead and then deploy
inventories of finished goods into field locations. Thus, once
a customer order materializes, it can be fulfilled immediately
since most customers are not willing to wait the time it
would take to actually process their order throughout the
supply chain and make the product based on their order. An
order cycle could take weeks or months to go back through
part suppliers and sub-assemblers, through manufacture of
the product, and through to the eventual shipment of the
order to the customer.

 In general practice, accurate demand

forecasts lead to efficient operations
and high levels of customer service,
while inaccurate forecasts will inevitably
lead to inefficient, high cost operations
and/or poor levels of customer service.
In many supply chains, the most
important action we can take to
improve the efficiency and
effectiveness of the logistics process is
to improve the quality of the demand
forecasts.

Forecasting as a planning tool

Managerial decision making is often complicated due to an

element of uncertainty in the variables affecting the
decision making process.
For example, when the decision to build a new production
facility is made, the demand for its products is not known
with certainty.
Similarly, when a hospital chooses to add one more
specialty healthcare wing, it needs to make some
assumptions about the demand for the facility.
Since these decisions often involve considerable cash flow
and time in creating new facilities, accurate estimates of the
future events for which the decisions have been made are
crucial.
Forecasts are estimates of the timings and magnitude of the
occurrence of future events.
Forecasting involves 2 important aspects-the magnitude
(how much demand) and the timing of occurrence of events.

 Consider a fast food joint that operates close to a commercial centre.

As large number of visitors visits commercial centre, one could
expect a good demand for food and beverages. Let us suppose that
the owner of the fast food joint estimates the daily demand for
beverages to be 3000 cups. But this information is not sufficient. The
timing of the demand is very crucial. For example if 40% of the
estimated demand happens in just 2 blocks of two hours each in the
morning and the evening, then the nature of planning and even
operational practices during these peak hours could be very different.
Manufacturing and service systems experience peak demand certain
times and average or even low demand during other times. Hence
estimation of timing is important.
The timing is important for long term planning as well. Example if a
company wants to add one more product line microwave ovens to its
product portfolio. The decision to add microwave ovens to the
product line requires a good understanding of the nature of demand
for the range of microwave ovens proposed to be manufactured.
Depending on both the timing and the magnitude of demand, the
manufacturer will schedule the building of new plants, planning of the
product launch, and the creation of the necessary infrastructure for
the marketing and distribution of microwave ovens.

 Even government needs forecast of population growth

over the next 10-20 years in order to make long term
plans for creating infrastructure for transportation and
the development of cities and towns.
Forecasting is the process of projecting the values of one
or more variables into the future.
Poor forecasting can result in poor inventory and staffing
decisions, resulting in part shortages, inadequate
customer service and many customer complaints.
Accurate forecasts are needed throughout the value
chain, and are used by all functional areas of the
organization, including accounting, finance, marketing,
operations and distribution.
The planning horizon is the length of time on which a
forecast is based. This spans from short range forecasts
with a planning horizon of under 3 months to long range
forecasts of 1 to 10 years.

Why do we Forecast?
Dynamic and complex environments: Forecasting is not
required if an organization has complete control over market
forces and knows exactly what the sale of its products is going to
be in the future. But such conditions does not exist.
Short term fluctuations in production: A good forecasting
system will be able to predict the occurrence of short term
fluctuations in demand.
Better materials management: Since the impending events in
an organization are predicted through a forecasting system,
organizations can benefit from better materials management and
ensure better resources availability. Example- from the above
example of fast food joint, if the owner could predict the
occurrence of peak hours in his joint, he would have planned and
ensured better material and greater availability of resources.

 Rationalized manpower decisions: A forecasting system

provides useful information on the nature of the resources
required and their timing and magnitude. Therefore,
organizations can minimize hiring and lay-off decisions
through forecasting. Moreover, better planning of overtime
and idle time can also be done based on this information.
Basis for planning and scheduling: The uses of
forecasting clearly point to the fact that the planning and
scheduling of activities can be done on a rational basis.
Strategic decisions: Earlier example of microwave oven
suggests that forecasting plays an important role in long
term strategic decision making. This includes planning for
product line decisions, new products, augmenting capacity,
building new factories, and expanding the current level of
activities.

Forecasting Time Horizon

Three categories are short-term, medium-term and long term horizons.
Short term Forecasting
Forecasting acts as an input for the tactical decisions that an organization makes.
For example, based on the sales in the last quarter, an organization could
develop better estimates of the demand in the next quarter and use that
information for adjusting various quarterly plans.
Medium- term Forecasting
An organization uses forecasting as a starting point to the annual business planning exercise.
This constitutes the medium term forecasting.
Planning horizon is usually 12-18 months.
Since the forecasting is done for a slightly longer time, cyclical and seasonal patterns will
make a significant impact and need to be incorporated in the analysis.
The decisions taken using the forecasting information vary from purely tactical decisions
such as annual production planning to somewhat strategic ones such as augmentation
of capacity in specific areas of business.
Long term Forecasting
Long term forecasts involve purely strategic decisions for a time period of about 5-10 years,
so the forecasting processes need to cater to these requirements.

Models for Forecasting

The various models for forecasting can
be classified into 3 categories:1) Extrapolative methods
2) Causal methods
3) Subjective judgments using
qualitative data

1) Extrapolative methods
Make use of past data and prepare future estimates by some
method
of extrapolating the past data.
For example, the demand for soft drinks in a city or a
locality could be estimated as 110 per cent of the
average sales during the last
three months.
Similarly the sales of new garments during the festive season
could be estimated to be a percentage of the festive season
sales during the previous year.
In both the above examples we are using the past data
and extrapolating it into the future on some basis.

2) Causal models
Analyse data from the viewpoint of a cause effect
relationship.
For example, in the process of estimating the demand for
new houses, the model will identify the factors that could
influence the demand for new houses and establish the
relationship between these factors and the demand.
For example, the factors may include real estate prices,
housing finance options, disposable income of families,
the cost of construction and benefits derived from the tax
laws.
Once the relationship between these variables and the
demand is established, it is possible to use it for
estimating the demand for new houses.

 Subjective judgments using qualitative

data
An organization such as the Indian Space Research Organization
(ISRO) would use this method to forecast the technology trends in
space launch vehicles and the expertise that needs to be
developed in the organization over the next 10 years.

A) Extrapolative Methods using Time Series

A time series is simply a collection of data at fixed time intervals
over several years.
Since extrapolative methods are estimates of future requirement
on the basis of past data, the most important requirement for
extrapolative methods is the existence of past data.
Hence, this method is unsuitable for brand new products and new
markets.
For example, if Tata Motors wants to estimate the demand for the
Nano for the next two quarters, it is not possible to use this
method.
Established product lines will have several data points of the past
that could be put to use.
They are useful for short term forecasts in an organization.
This includes predicting weekly/monthly demand for several fast
moving items and forecast of capacity requirements in
manufacturing and service organizations.
Extrapolative models with some level of sophistication will also be
useful for medium term forecasts.

i) Moving Averages
The simplest model for extrapolative
forecasting is the method of simple
moving averages.
The model has a single parameter, that
is, the number of periods to be
considered for computing the moving
average.
For example, an organization may use a
three period moving average to
estimate the demand of one of its fast
moving products.

3-Period and 6-Period Moving Average

(1300+1356+1442)/3

(1300+1356+1442+1576+1716+1832)/6

Weighted Moving Averages

When there is a detectable trend or pattern, weights can be used to
place more emphasis on recent values. This makes the techniques
more responsive to changes since more recent periods may be
more heavily weighted. Deciding which weights to use requires
some experience and a bit of luck. Choice of weights is somewhat
arbitrary since there is not set formula to determine them.
Advantage of moving average: Easy to use and to compute.
Disadvantage: values in the average are weighted equally. For
example, in a ten- period moving average
each the same weight of 1/10., the oldest has an equal value to the
most recent.
Mathematically,
Weighted Moving average = (weight for period n) x (Demand in
period n) / weights

Time in the past

Weightage

4 years ago

0.05

3 years ago

0.25

2 years ago

0.3

Last year

0.4

Month

Actual sales

January

10

February

12

March

13

April

16

May
June

19
23

July

26

August

30

September

28

October

18

November

16

December

14

Three month weighted moving

average

(1 x 10 + 2 x 12 + 3 x 13) / 6 =
12.16
(1 x 12 + 2 x 13 + 3 x 16) / 6 =
14.33
(1 x 13 + 2 x 16 + 3 x 19) / 6 = 17
(1 x 16 + 2 x 19 + 3 x 23) / 6 =
20.5
(1 x 19 + 2 x 23 + 3 x 26) / 6 =
23.83
(1 x 23 + 2 x 26 + 3 x 30) / 6 =
27.5
(1 x 26 + 2 x 30 + 3 x 28) / 6 =
28.33
(1 x 30 + 2 x 28 + 3 x 18) / 6 =
23.33
(1 x 28 + 2 x 18 + 3 x 16) / 6 =
18.67
(1 x 18 + 2 x 16 + 3 x 14)/6= 15.33

 Both simple and weighted moving averages are effective in

smoothing out sudden fluctuations in the demand pattern in order
to provide stable estimates. Moving averages do, however, have
three problems.
The other issue in using the moving average method is the logic
behind the choice of n. How should one decide on n? In general it
can be seen that when the demand is stable, larger values of n
are appropriate. On the other hand, if the demand is not stable
and has frequent tendencies to have significant shifts, then
smaller values of n and the use of the weighted moving average
model are likely to provide better results.
Increasing the size of n (the number of periods averaged) does
smooth out fluctuations better, but it makes the method less
sensitive to real changes in the data.
Second, moving averages cannot pick up trends very well. Since
they are averages, they will always stay within past levels and
will not predict a change to either a higher or lower level.
Finally, moving averages require extensive records of past data.
Weighted moving average is more accurate, but fixing the
weights is difficult. Gives more reflective of the most recent
occurrences.

ii) The Exponential Smoothening Method

Form of weighted moving average

Weights decline exponentially
Most recent data weighted most
Requires smoothing constant ()
Constant ranges from 0 to 1
Subjectively chosen
Involves little record keeping of past data

Ft = Ft-1 + a(At-1 - Ft-1)

= aAt-1 + (1 - a) Ft-1
Ft = Forecast value

At = Actual value
a = Smoothing constant
Ft = aAt - 1 + a(1-a)At - 2 + a(1- a)2At - 3+ a(1- a)3At - 4 + ... + a(1- a)t-1A0
We see in this equation that the previous demand points are
successively smoothened with a factor of (1-a).

Example:Youre organizing a meeting. You want to

forecast attendance for year 2000 using
exponential smoothing (a=.10). The
1995 (made in 1994) forecast was 175.
Actual data:
1995 180
1996
168
1997 159
1998
175
1999
190
Ft = Ft-1 + (At-1 - Ft-1)

Time

Actual

1995

180

175 (Given)

1996

168

175.00 + .10(180 - 175.00) = 175.50

1997

159

175.50 + .10(168 - 175.50) = 174.75

1998

175

174.75 + .10(159 - 174.75)= 173.18

1999

190

173.18 + .10(175 - 173.18) = 173.36

2000

Forecast, Ft
(a=.10)

173.36 + .10(190 - 173.36) = 175.02

By choosing a higher value of a , the model weights recent demand

points more.
Relation between the smoothing constant and response to error:
Exponential smoothing is one of the most widely used techniques in
forecasting.
The quickness of the forecast adjustment to error is determined by the
smoothing constant .
The closer the value of to zero, the slower the forecast will respond to
error- more smoothing

iii) Linear Regression

The simplest method to estimate the trend in a time
series is to treat the time periods as independent
variables and the actual demand as a dependent
variable. Using the standard method of least
squares, it is possible to estimate the trend
component.
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. (e.g. sales)

b = Delta Y / Delta X = Slope

Example: b= ..0 means that for

every one unit increase in X , ..0

Delta
Y
Delta
X

unit will increase in Y

Y=a+bX
Y = dependent variable (example: Company Sales)
X = independent variable (example: time periods, sales of other related company) a = Y-axis intercept
b = Slope of regression line = delta Y/ delta X
Constants a and b:
The constants a and b are computed using the
following equations:
b

XY n XY
X nX
2

a Y bX
Once the a and b values are computed, a future value of X (time, or sales of other elated
product)
can be entered into the regression equation and a corresponding value of Y (the forecast) can be
calculated.

Example

A manufacturer of critical components for two wheelers in the automotive sector is interested in forecasting
the trend of demand during the next year as a key input to its annual planning exercise. Information on the
past sales is available for the last three years. Extract the trend component of the time series data and use
it for predicting the future demand of the components.

Actual demand in the last three years (in thousands of units)

Period

Actual demand

Year 1: Q1

360

Year 1: Q2

438

Year 1: Q3

359

Year 1: Q4

406

Year 2: Q1

393

Year 2: Q2

465

Year 2: Q3

387

Year 2: Q4

464

Year 3: Q1

505

Year 3: Q2

618

Year 3: Q3

443

Year 3: Q4

540

Solution
The model for forecasting using linear trend is denoted by
Y=a+ bX
From the above table, we compute the following:

X = 78/12=6.50

Y =5379/12=448.25
Computations for trend extraction using the method of least squares

Period

X*Y

X*X

Year 1: Q1

360

360

Year 1: Q2

438

876

Year 1: Q3

359

1,078

Year 1: Q4

406

1,625

16

Year 2: Q1

393

1,965

25

Year 2: Q2

465

2,790

36

Year 2: Q3

387

2,709

49

Year 2: Q4

464

3,712

64

Year 3: Q1

505

4,545

81

Year 3: Q2

10

618

6,180

100

Year 3: Q3

11

443

4,873

121

Year 3: Q4

12

540

6,480

144

Sum

78

5,379

37,193

650

Therefore using the values from the table, we can compute b as:
b=[37193-(12*6.50*448.25)]/[650-(12*6.50*6.50)]=2229.5/143 =15.59
Similarly a=448.25-15.59*6.50=346.91
The linear trend for the time series is given by
Y=346.91 + 15.59X
The trend components of forecasts for the four quarters in Year 4 are obtained by substituting the values of 13 to 16 for X respectively.
Forecast for Q1 of Year 4= 346.91+15.59*13=550
Forecast for Q2 of Year 4= 346.91+15.59*14=565
Forecast for Q3 of Year 4= 346.91+15.59*15=581
Forecast for Q4 of Year 4= 346.91+15.59*16=596