Demand Forecasting:

Time Series Models

Professor Stephen R. Lawrence

College of Business and Administration
University of Colorado
Boulder, CO 80309-0419
 Forecasting Horizons
 Long Term
 5+ years into the future
 R&D, plant location, product planning
 Principally judgement-based
 Medium Term
 1 season to 2 years
 Aggregate planning, capacity planning, sales forecasts
 Mixture of quantitative methods and judgement
 Short Term
 1 day to 1 year, less than 1 season
 Demand forecasting, staffing levels, purchasing, inventory levels
 Quantitative methods
 Short Term Forecasting:
Needs and Uses
 Scheduling existing resources
 How many employees do we need and when?
 How much product should we make in anticipation of demand?
 Acquiring additional resources
 When are we going to run out of capacity?
 How many more people will we need?
 How large will our back-orders be?
 Determining what resources are needed
 What kind of machines will we require?
 Which services are growing in demand? declining?
 What kind of people should we be hiring?
 Types of Forecasting Models
 Types of Forecasts
 Qualitative --- based on experience, judgement, knowledge;
 Quantitative --- based on data, statistics;
 Methods of Forecasting
 Naive Methods --- eye-balling the numbers;
 Formal Methods --- systematically reduce forecasting errors;
– time series models (e.g. exponential smoothing);
– causal models (e.g. regression).
 Focus here on Time Series Models
 Assumptions of Time Series Models
 There is information about the past;
 This information can be quantified in the form of data;
 The pattern of the past will continue into the future.
 Forecasting Examples
 Examples from student projects:
 Demand for tellers in a bank;
 Traffic on major communication switch;
 Demand for liquor in bar;
 Demand for frozen foods in local grocery warehouse.

 Example from Industry: American Hospital Supply Corp.

 70,000 items;
 25 stocking locations;
 Store 3 years of data (63 million data points);
 Update forecasts monthly;
 21 million forecast updates per year.
 Simple Moving Average
 Forecast Ft is average of n previous observations or
actuals Dt :
1
Ft 1  ( Dt  Dt 1    Dt 1 n )
n
1 t
Ft 1   Di
n i t 1n
 Note that the n past observations are equally weighted.
 Issues with moving average forecasts:
 All n past observations treated equally;
 Observations older than n are not included at all;
 Requires that n past observations be retained;
 Problem when 1000's of items are being forecast.
 Simple Moving Average
 Include n most recent observations
 Weight equally
 Ignore older observations

weight

1/n

n ... 3 2 1
today
 Moving Average

Internet Unicycle Sales

n=3
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 Example:

Moving Average
Forecasting
 Exponential Smoothing I
 Include all past observations
 Weight recent observations much more heavily
than very old observations:

weight
Decreasing weight given
to older observations

today
 Exponential Smoothing I
 Include all past observations
 Weight recent observations much more heavily
than very old observations:

0  1
weight
Decreasing weight given 
to older observations

today
 Exponential Smoothing I
 Include all past observations
 Weight recent observations much more heavily
than very old observations:

0  1
weight
Decreasing weight given 
to older observations
 (1  )

today
 Exponential Smoothing I
 Include all past observations
 Weight recent observations much more heavily
than very old observations:

0  1
weight
Decreasing weight given 
to older observations
 (1   )
 (1   ) 2

today
 Exponential Smoothing: Concept
 Include all past observations
 Weight recent observations much more heavily
than very old observations:

0  1
weight
Decreasing weight given 
to older observations
 (1   )
 (1   ) 2

 (1   ) 3

today 
 Exponential Smoothing: Math
Ft  Dt   (1   ) Dt 1   (1   ) 2 Dt  2  
Ft  Dt  (1   )Dt 1   (1  a ) Dt  2  
 Exponential Smoothing: Math
Ft  Dt   (1   ) Dt 1   (1   ) 2 Dt  2  
Ft  Dt  (1   )Dt 1   (1  a ) Dt  2  

Ft  aDt  (1  a ) Ft 1
 Exponential Smoothing: Math
Ft  aDt  a (1  a ) Dt 1  a (1  a ) Dt  2   2

Ft  aDt  (1  a ) Ft 1
 Thus, new forecast is weighted sum of old forecast and actual
demand
 Notes:
 Only 2 values (Dt and Ft-1 ) are required, compared with n for moving
average
 Parameter a determined empirically (whatever works best)
 Rule of thumb:  < 0.5
 Typically,  = 0.2 or  = 0.3 work well
 Forecast for k periods into future is:

Ft  k  Ft
 Exponential Smoothing

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 Example:

Exponential Smoothing
 Complicating Factors

 Simple Exponential Smoothing works well

with data that is “moving sideways”
(stationary)
 Must be adapted for data series which
exhibit a definite trend
 Must be further adapted for data series
which exhibit seasonal patterns
 Holt’s Method:
Double Exponential Smoothing
 What happens when there is a definite trend?
A trendy clothing boutique has had the following sales
over the past 6 months:
1 2 3 4 5 6
510 512 528 530 542 552

560
550 Actual
540
Demand 530 Forecast
520
510
500
490
480
1 2 3 4 5 6 7 8 9 10

Month
 Holt’s Method:
Double Exponential Smoothing
 Ideas behind smoothing with trend:
 ``De-trend'' time-series by separating base from trend effects
 Smooth base in usual manner using 
 Smooth trend forecasts in usual manner using 
 Smooth the base forecast Bt
Bt  Dt  (1   )( Bt 1  Tt 1 )
 Smooth the trend forecast Tt
Tt   ( Bt  Bt 1 )  (1   )Tt 1
 Forecast k periods into future Ft+k with base and trend

Ft  k  Bt  kTt
 ES with Trend

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 Example:

Exponential Smoothing
with Trend
 Winter’s Method:
Exponential Smoothing
w/ Trend and Seasonality
 Ideas behind smoothing with trend and seasonality:
 “De-trend’: and “de-seasonalize”time-series by separating base from
trend and seasonality effects
 Smooth base in usual manner using 
 Smooth trend forecasts in usual manner using 
 Smooth seasonality forecasts using 

 Assume m seasons in a cycle

 12 months in a year
 4 quarters in a month
 3 months in a quarter
 et cetera
 Winter’s Method:
Exponential Smoothing
w/ Trend and Seasonality
 Smooth the base forecast Bt
Dt
Bt    (1   )( Bt 1  Tt 1 )
St  m
 Smooth the trend forecast Tt

Tt   ( Bt  Bt 1 )  (1   )Tt 1
 Smooth the seasonality forecast St
Dt
St    (1   ) St m
Bt
 Winter’s Method:
Exponential Smoothing
w/ Trend and Seasonality
 Forecast Ft with trend and seasonality

Ft  k  ( Bt 1  kTt 1 ) St  k m
 Smooth the trend forecast Tt

Tt   ( Bt  Bt 1 )  (1   )Tt 1
 Smooth the seasonality forecast St

Dt
St    (1   ) St m
Bt
 ES with Trend and Seasonality

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 Example:

Exponential Smoothing
with
Trend and Seasonality
 Forecasting Performance
How good is the forecast?
 Mean Forecast Error (MFE or Bias): Measures
average deviation of forecast from actuals.

 Mean Absolute Deviation (MAD): Measures

average absolute deviation of forecast from
actuals.

 Mean Absolute Percentage Error (MAPE):

Measures absolute error as a percentage of the
forecast.

 Standard Squared Error (MSE): Measures

variance of forecast error
Forecasting Performance Measures

1 n
MFE   ( Dt  Ft )
n t 1
1 n
MAD   Dt  Ft
n t 1
100 n
Dt  Ft
MAPE  
n t 1 Dt
1 n
MSE   ( Dt  Ft ) 2

n t 1
 Mean Forecast Error (MFE or Bias)

1 n
MFE   ( Dt  Ft )
n t 1
 Want MFE to be as close to zero as possible -- minimum
bias
 A large positive (negative) MFE means that the forecast is
undershooting (overshooting) the actual observations
 Note that zero MFE does not imply that forecasts are
perfect (no error) -- only that mean is “on target”
 Also called forecast BIAS
 Mean Absolute Deviation (MAD)

1 n
MAD   Dt  Ft
n t 1

 Measures absolute error

 Positive and negative errors thus do not cancel out (as with
MFE)
 Want MAD to be as small as possible
 No way to know if MAD error is large or small in relation to
the actual data
 Mean Absolute Percentage Error
(MAPE)

100 n Dt  Ft
MAPE  
n t 1 Dt

 Same as MAD, except ...

 Measures deviation as a percentage of actual data
 Mean Squared Error (MSE)

1 n
MSE   ( Dt  Ft ) 2
n t 1

 Measures squared forecast error -- error variance

 Recognizes that large errors are disproportionately more
“expensive” than small errors
 But is not as easily interpreted as MAD, MAPE -- not as
intuitive
Fortunately, there is software...