Session 1.

Demand Forecasting

Prof. Suresh K Jakhar

Indian Institute of Management Lucknow
 Nobody can accurately predict the future
every time.
 Forecasting:

 When historical sales data are available, some proven

statistical forecasting methods have been developed for
using these data to forecast future demand.

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 Such methods assumes that historical trends will
continue.

 Managers needs to make any adjustments to reflect

current changes (if any) in the marketplace.

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 Nevertheless, the future success of any business
depends heavily on how savvy its management is in
spotting trends and developing appropriate
strategies.
 The ability to forecast well makes the difference

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 Forecasting Stories

• Sharing forecasting information along

the supply chain is not very common.
• The result is forecast error as much as
60 percent of actual demand.
• US economy alone can save $200
billion in inventory investment with a
coordinated forecasting.
• Wal-Mart has initiated such a process
with Warner-Lambert, a manufacturer of
Listerine.
• Hewlett-Packard uses forecasting
method for new product development &
shares with partners.
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 Forecasting Success Stories

• Taco Bell developed a forecasting

method that gives customer demand
for every 15-minute interval.
• The forecast is used to determine the
number of employees required. Taco
Bell achieved labor savings of more
than $40 million from 1993 to 1996.
• Compaq Computers, experimented
with a powerful simulation based
forecasting tool for assisting with the
process of new product introduction.

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• This program recommends the optimal timing and
pricing of new product introduction by
incorporating forecast of component availability and
price changes, fluctuating demand for given feature
or price, and the impact of rival models.
• Using this tool, the company delayed announcement
of several new Pentium based models in late 1994.
• This strategy “went against everything the company
believed”. Compaq’s basic strategy had always been
to be a technology leader.

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• But the forecasting tool
suggested that the corporate
customers were not quite
ready to switch to Pantium
based machines at the end of
1994.
• This strategy proved to be
very profitable for Compaq,
which subsequently posted
record earning.

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 Forecasting Success Stories

• Forecasting is necessary to determine the number of

reservations an airline should accept for a particular
flight - overbooking, traffic management, discount
allocation, etc.

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 Decisions Based on Forecasts

 Production
◦ Aggregate planning,
inventory control,
scheduling
 Marketing
◦ New product
introduction, sales-force
allocation, promotions
 Finance
◦ Plant/equipment
investment, budgetary
planning
 Personnel
◦ Workforce planning,
hiring, layoff
 The basis for all
planning decisions in
a supply chain
 Used for both push
and pull processes
 All of these decisions
are interrelated

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 Decisions Based on Forecasts
 The decisions should not be segregated by functional
area, as they influence each other and are best made
jointly.
 For example, Coca-cola considers the demand
forecast over the coming quarter and decides on the
timing of various promotions.
 The promotion information is then used to update the
demand forecast. Based on this forecast, Coca-Cola
will decide on a production plan for the quarter.

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 Decisions Based on Forecasts
 This plan may require additional investment, hiring,
or perhaps subcontracting of production. Coke will
make these decisions based on the production plan
and existing capacity, and it must make them all in
advance of actual production.

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 Decisions Based on Forecasts

 7-Eleven Japan has a

replenishment process that enables
it to respond to an order within
hours.
 If a store manager places an order
by 10 am, the order is delivered by
7 pm the same day.
 The store manager thus has to
forecast what will sell that night
less than 12 hours before the actual
sale.
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 Characteristics of Forecasts

1. Forecasts are always inaccurate and should thus

include both the expected value of the forecast and a
measure of forecast error
2. Long-term forecasts are usually less accurate than
short-term forecasts
3. Aggregate forecasts are usually more accurate than
disaggregate forecasts
4. In general, the farther up in the supply chain a
company is, the greater is the distortion of
information it receives
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 Components
 Companies must identify the factors that influence
future demand and then ascertain the relationship
between these factors and future demand
◦ Past demand
◦ Lead time of product replenishment
◦ Planned advertising or marketing efforts
◦ Planned price discounts
◦ State of the economy
◦ Actions that competitors have taken

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 Methods

1. Qualitative/Judgmental
◦ Primarily subjective
◦ Rely on judgment
2. Time Series
◦ Use historical demand only
◦ Best with stable demand
3. Causal
◦ Relationship between demand and some other factor
4. Simulation
◦ Imitate consumer choices that give rise to demand

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 Judgmental forecasting methods

Judgmental forecasting methods are, by their very

nature, subjective, and they may involve such
qualities as intuition, expert opinion, and
experience. They generally lead to forecasts that are
based upon qualitative criteria.
 Manager’s opinion
 Jury of executive opinion
 Sales force composite
 Consumer market survey
 Delphi method

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 Judgmental, Some Thoughts

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 Components of Demand
• Average demand
• Trend
– Gradual shift in average demand
• Seasonal pattern
– Periodic oscillation in demand which repeats
• Cycle
– Similar to seasonal patterns, length and magnitude of the
cycle may vary
• Random movements
• Auto-correlation

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 Components of an Observation

Observed demand (O) = systematic component (S)

+ random component (R)

• Systematic component – expected value of demand

− Level (current deseasonalized demand)
− Trend (growth or decline in demand)
− Seasonality (predictable seasonal fluctuation)
• Random component – part of forecast that deviates from
systematic part
• Forecast error – difference between forecast and actual
demand

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 (a) Average: Data cluster about a horizontal line.
Quantity

Time

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 (b) Linear trend: Data consistently increase or decrease.

Quantity

Time

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(c) Seasonal influence: Data consistently show peaks and
valleys.

Year 1
Quantity

Year 2

| | | | | | | | | | | |
J F M A M J J A S O N D
Months

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 Components of Demand

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 (d) Cyclical movements: Gradual changes over extended periods of
time.

Quantity

| | | | | |
1 2 3 4 5 6
Years

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 Seasonal Vs Cyclical

 A seasonal pattern exists when a series is influenced

by seasonal factors (e.g., the quarter of the year, the
month, or day of the week).
 Seasonality is always of a fixed and known period.
Hence, seasonal time series are sometimes
called periodic time series.
 A cyclic pattern exists when data exhibit rises and
falls that are not of fixed period. The duration of
these fluctuations is usually of at least 2 years.
 Think of business cycles which usually last several
years, but where the length of the current cycle is
unknown beforehand.
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 Time-Series Forecasting
o The goal of any forecasting method is to predict
the systematic component and estimate the
random component.
o In its most general form, the systematic
component of demand data contains a level, a
trend and a seasonal factor.
o The specific form of the systematic component
applicable to a given forecast depends on the
nature of demand.

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 Time-Series Forecasting

 Three ways to calculate the systematic

component
◦ Multiplicative
S = level x trend x seasonal factor
◦ Additive
S = level + trend + seasonal factor
◦ Mixed
S = (level + trend) x seasonal factor

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 Time-Series Forecasting Methods

 Static Methods: A static method assumes that

estimates of level, trend, and seasonality within
the systematic component do not very as new
demand is observed.
 Adaptive Forecasting: The estimates of level,
trend, and seasonality are updated after each
demand observation.

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Static Methods

Systematic Component = (level + trend)× seasonal factor

Ft+l = [L + (t + l)T ]St+l

where

L = estimate of level at t = 0
T = estimate of trend
St = estimate of seasonal factor for Period t
Dt = actual demand observed in Period t
Ft = forecast of demand for Period t

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 Tahoe Salt (rock salt to melt snow)
Year Quarter Period, t Demand, Dt
1 2 1 8,000
1 3 2 13,000
1 4 3 23,000
2 1 4 34,000
2 2 5 10,000
2 3 6 18,000
2 4 7 23,000
3 1 8 38,000
3 2 9 12,000
3 3 10 13,000
3 4 11 32,000
4 1 12 41,000
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 Tahoe Salt

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Estimation of Level, Trend, and Seasonality

 We now describe the following two steps

required to estimate the each of three
parameters:
1) Deseasonalize the demand and run linear
regression to estimate level and trend.
2) Estimate seasonal factors.

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