DEMAND FORECASTING

What is Forecasting?

• Process of predicting a
future event on the basis of Sales will
past as well as present be $200
knowledge and experience Million!

• Underlying basis of
all business decisions
– Production
– Inventory
– Personnel
– Facilities
• To reduce risk and uncertainty

• To take business decisions

• For planning
Steps involved in Demand Forecasting

• Setting the objective

• Selection and classification of goods
• Selection of method
• Interpreting the results
 Purpose of Demand Forecasting
• Purpose of Short- term Forecasting
– Scheduling of production
– Inventory management
– Price strategy
– Sales strategy
– Financial requirements
• Purpose of Long- term Forecasting
– Planning a new Project
– Financial requirements
– Manpower
 Nature of Product

• Capital Goods (Producer goods)- goods which

help in further production of goods
– Replacement Demand
– New Demand
• Information required
– Growth possibilities of industry demanding such goods
– Life expectancy
– The norm of consumption
• Durable consumer goods - consumer goods
which can be used repeatedly
– Replacement demand
– New demand
• Information required
– Life expectancy tables
– Purchasing power
– Number of households/firms
– Existence and growth of cooperating facilities
• Non durable consumer goods - goods
which can be used once

• Information required
– Disposable income of consumer
– Price of the product
– Price of related products
– Demography
 Selection of Method
• Time horizon
• Stability
• Data Availability
• Cost
• Accuracy
• Ease of Application
 Qualitative Forecasts & Sources of Data

Expert Opinion Consumer Survey Composite Market

method method Opinion Method Experiments

Complete Sample
enumeration survey
 Delphi Method
• Iterative group
process Decision Makers
• 3 types of people (Sales?)
Staff (Sales will be 50!)
– Decision makers
– Staff (What
will sales
– Experts be?
• Proposes to reduce survey)

‘group-think’ Experts
(Sales will be 45, 50, 55)
 Demerits

• Expensive

• Time consuming

• Biased opinion
 Consumer Market Survey
• Ask customers How many hours will
about purchasing you use the Internet
plans next week?

• What consumers
say, and what they
actually do are
often different
• Sometimes
difficult to answer
 Merits & Demerits

• Direct method of assessing information from primary

sources
• Simple method

• Insufficient Information
• Lack of time
• Biased information
• Utility limited to very short period
• There may be sampling error, if sample is not properly
chosen
 Sales Force Composite

• Each salesperson projects

their sales Sales

• Combined at district &

national levels
• Sales rep’s know
customers’ wants
• Tends to be overly
optimistic
 Jury of Executive Opinion
• Involves small group of high-level managers
– Group estimates demand by working together
• Combines managerial experience with statistical
models
• Relatively quick
• ‘Group-think’
disadvantage
 Merits & Demerits

• Simple
• Based on first-hand knowledge of salesman

• Biased opinion
• Restricted to short-term forecasting
 Market Experiments

Can help in determining the demand function

Expensive
Time consuming
Risky
Difficult to satisfy the condition of homogeneity
 Quantitative Forecasting Methods
Quantitative
Forecasting

Time Series Associative

Models Models

Trend Exponential Moving Linear

Projection Smoothing Average Regression
 Time Series Analysis
• Time -Series data - values of a variable arranged
chronologically by days, weeks, months, quarters or
years
– Past Values plotted on y- axis
– Time plotted on x- axis
• Time Series analysis- attempts to forecast future
values of the time series by examining past
observations of the data
• Assumption - past pattern will continue unchanged
in the future
Time Series Sales Data
Reasons for fluctuation in Time-series Data

• Secular Trend - long run increase or decrease in

data series
• Cyclical fluctuations - changes that recur over
years
• Seasonal variation - regularly recurring fluctuation
• Irregular or random influences - variations
resulting from unique events
 Secular Trend
• Persistent, overall upward or downward
pattern
• Due to population, technology etc
• Several years duration

Response

Mo., Qtr., Yr.

 Cyclical Component
• Repeating up & down movements
• Due to interactions of factors influencing
economy
• Usually 2-10 years duration

Cycle
Response

Mo., Qtr., Yr.

 Seasonal Component
• Regular pattern of up & down fluctuations
• Due to weather, customs etc
• Occurs within 1 year

Summer
Response

Mo., Qtr.
 Random Component
• Erratic, unsystematic, ‘residual’ fluctuations
• Due to random variation or unforeseen
events
– Union strike
– Cyclone
• Short duration &
nonrepeating
 Trend Projection – Graphic Curve Fitting
Random Influences
Values of Dependent Variable

Cyclical Fluctuation

Secular Trend

Time
 Trend Projection – Graphic Curve Fitting
Values of Dependent Variable

Actual
observation

Time
 Trend Projection – Graphic Curve Fitting

Deviation
Values of Dependent Variable

Deviation Deviation

Actual
Deviation
Deviation observation

Deviation Point on
Deviation
the line

Time
 Trend Projection – Graphic Curve Fitting

Deviation
Values of Dependent Variable

Deviation Deviation

Actual
Deviation
Deviation observation

Deviation Point on
Deviation
the line
Yˆ = a + bx
Time
Trend Projection – Graphic Curve Fitting

Assumptions

• Relationship is assumed to be linear

• Relationship is assumed to hold only within or slightly

outside data range

• Deviations around least squares line are assumed to be

random
 Trend Projection
• Projecting the past trend by fitting a straight line
to the data
• Constant Rate of Change

St = So + bt
• Where:
– St value of time series to be forecasted for period t
– So estimated value of time series in the base period
– b is the absolute amount of growth per period
– t time period for which series is to be forecasted
Time Series Sales Data
Time Series Sales Data

St = So + bt

Σ S = nSo + b Σ t
Σ S*t = SoΣ t + b
Σ t2
So = [(∑S )(∑t ) −(∑t )(∑S * t )] / d
2

[
b = n ∑S * t −(∑t )(∑S ) / d ]

Where: d = n ∑ ∑
t 2
− ( t ) 2
 Time Series Sales Data
Period
Year Quarter (t) Sales (S) S*t t^2
1996 I 1 300 300 1
1996 II 2 305 610 4
1996 III 3 315 945 9
1996 IV 4 340 1360 16
1997 I 5 346 1730 25
1997 II 6 352 2112 36
1997 III 7 364 2548 49
1997 IV 8 390 3120 64
1998 I 9 397 3573 81
1998 II 10 404 4040 100
1998 III 11 418 4598 121
1998 IV 12 445 5340 144
n = 12 78 4376 30276 650

St = So + bt St = 281.39 + 12.81t

Σ S = nSo + b Σ t
Σ S*t = SoΣ t + b Σ t2
Sales per Quarter
500

450

400

350

300

250

200
0 2 4 6 8 10 12 14
1996 1997 1998 Quarter
 Seasonal Variation

Ratio to Trend Method

Actual
Ratio =
Trend Forecast

Seasonal Average of Ratios for

=
Adjustment Each Seasonal Period

Adjusted Trend Seasonal

Forecast = Forecast Adjustment
Seasonal Adjustment using Ratio-Trend method

F o re c a ste d IV A c tua l IV A d juste d

Y e a r q ua rte r sa le s q ua rte r sa le s R a tio q ua rte r sa le s

1996 332.64 340 1.022 3 39.2 9

1997 383.88 390 1.016 3 91.5 6
1998 435.13 445 1.023 4 43.8 3
S e a s o n a l A d ju s t m e n1t . 0 2
(A v e ra g e )
 Limitations of Trend Analysis

• Limited to short term predictions

• Fluctuation in economic growth are not

considered

• Assumes that historical relationships will not

change
 Smoothing Techniques

• Predicting values of a time series on the

basis of some average of its past values
• Used when time series exhibit irregular or
random variation

– Moving Averages

– Exponential Smoothing
Moving Average
Moving Average
Moving Average
 Moving Average
Qua rte r Actua l M a rke t 3 Qua rte r M oving A - F (A - F)^ 2 5 Qua rte r M oving A - F (A - F)^ 2
S ha re (A) Ave ra ge (F) Ave ra ge (F)
1 20
2 22
3 23
4 24 21.67 2.33 5.44
5 18 23.00 -5.00 25.00
6 23 21.67 1.33 1.78 21.40 1.60 2.56
7 19 21.67 -2.67 7.11 22.00 -3.00 9.00
8 17 20.00 -3.00 9.00 21.40 -4.40 19.36
9 22 19.67 2.33 5.44 20.20 1.80 3.24
10 23 19.33 3.67 13.44 19.80 3.20 10.24
11 18 20.67 -2.67 7.11 20.80 -2.80 7.84
12 23 21.00 2.00 4.00 19.80 3.20 10.24
78.33 62.48

13 21.33 20.60(Forec as t)
To decide on the better moving average forecast calculate the
root-mean-square error(RMSE) of each forecast and use the
moving average which results in the smallest RMSE

RMSE = ∑ ( A −F )
t t
2

n
 Moving Average
Qua rte r Actua l M a rke t 3 Qua rte r M oving A - F (A - F)^ 2 5 Qua rte r M oving A - F (A - F)^ 2
S ha re (A) Ave ra ge (F) Ave ra ge (F)
1 20
2 22
3 23
4 24 21.67 2.33 5.44
5 18 23.00 -5.00 25.00
6 23 21.67 1.33 1.78 21.40 1.60 2.56
7 19 21.67 -2.67 7.11 22.00 -3.00 9.00
8 17 20.00 -3.00 9.00 21.40 -4.40 19.36
9 22 19.67 2.33 5.44 20.20 1.80 3.24
10 23 19.33 3.67 13.44 19.80 3.20 10.24
11 18 20.67 -2.67 7.11 20.80 -2.80 7.84
12 23 21.00 2.00 4.00 19.80 3.20 10.24
78.33 62.48

13 21.33 20.60(Forec as t)

RM S E 2.95 2.99
 Criticism

• Gives equal weightage to all observations in

computing the average.
 Exponential Smoothing

• Forecast for next period (ie, t + 1) is a weighted

average of the actual and forecasted values of the
time series in period t

Ft +1 = wAt + (1 − w) Ft

0 ≤ w ≤1
Exponential Forecasting
Exponential Forecasting
 Exponential Forecasting
Q ua rte r Actua l M a rke t Fore ca st w ith A-F (A - F)^ 2 Fore ca st w ith A-F (A - F)^ 2
S ha re (A) w = 0.3 w = 0.5
1 20 21.0 -1.0 1.0 21.0 -1.0 1.0
2 22 20.7 1.3 1.7 20.5 1.5 2.3
3 23 21.1 1.9 3.6 21.3 1.8 3.1
4 24 21.7 2.3 5.5 22.1 1.9 3.5
5 18 22.4 -4.4 19.0 23.1 -5.1 25.6
6 23 21.1 1.9 3.8 20.5 2.5 6.1
7 19 21.6 -2.6 7.0 21.8 -2.8 7.6
8 17 20.8 -3.8 14.8 20.4 -3.4 11.4
9 22 19.7 2.3 5.3 18.7 3.3 10.9
10 23 20.4 2.6 6.8 20.3 2.7 7.0
11 18 21.2 -3.2 10.0 21.7 -3.7 13.5
12 23 20.2 2.8 7.7 19.8 3.2 10.0
252 86.3 102.1

13 21.1 21.4

RM S E = 2.68 2.92
 Evaluation of Smoothing Techniques

• Gives greater weight to recent data

• It is easy to update the forecasts
• No need to re-estimate the equations
• When time trend is positive, forecasts are
likely to be too low
• When time time trend is negative, forecasts
are likely to be too high
 Barometric Forecasting
• A time series that is correlated with another time
series is called an indicator

• Coincident indicators two series change at the

same time

• Leading indicators one series consistently occurs

prior to changes in another series
 Economic Indicators
Value
Leading indicator A

B
Indicator level

Coincident indicator
C

Business Cycle Time

 Determinants of a good indicator

• Must be accurate
• Provide adequate lead time
• Lead time should be constant
• Logical explanation why it is a leading
indicator
• Cost and time necessary for data collection
 Construction of an Index
• Indices represent a single time series made up
of a number of individual leading indicators.
– Purpose is to smooth out the random fluctuations in
each individual series.
• Composite index- weighted average of individual indicators
in each group. Good indicators are given more weightage.
– Index is interpreted in terms of percentage change from period to
period.

• Diffusion Index- gives the percentage of the leading

indicators that increase from one time period to the next.
 Example

Month Leading Leading Leading

Indicator I Indicator I Indicator I
1 400 30 100
2 425 29 110
3 460 33 135

The 1 month represents the base period

All series to be given equal weight
Construct a composite & diffusion index
 Composite Index:

[ 25/400 + (-1)/30 + 10/100] / 3 = 4.31

[ 60/400 + 3/30 +35/100] / 3 = 20

Month Diffusion Index Composite Index

1 - 100.00
2 66.7 104.31
3 100.00 120.00
 Evaluation

– Forecast turning points in the business cycles

– Prediction record not perfect
– Variability in lead time
– Difficult to identify accurate indicators
– Provides only qualitative forecast of turning point