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 :

Ft 1
Ft 1

1
( Dt Dt 1 Dt 1n )
n
1 t

Di

n i t 1n

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

...

today

Moving Average
Internet Unicycle Sales

n=
3

450
400
350

Units

300
250
200
150
100
50
0
Apr-01

Sep-02

Jan-04

May-05

Oct-06

Feb-08

Month

Jul-09

Nov-10

Apr-12

Aug-13

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

(1 )

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

(1 )

weight

Decreasing weight given

to older observations

(1 ) 2

today

Exponential Smoothing: Concept

Include all past observations

Weight recent observations much more heavily
than very old observations:

0 1

weight

(1 )

Decreasing weight given

to older observations

(1 ) 2
(1 )
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 ) 2 Dt 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
Internet Unicycle Sales (1000's)
450
400
350

= 0.2

Units

300
250
200
150
100
50
0
Jan-03

May-04

Sep-05

Feb-07

Jun-08

Month

Nov-09

Mar-11

Aug-12

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

Holts Method:

Double Exponential Smoothing

What happens when there is a definite trend?

A trendy clothing boutique has had the following sale

over the past 6 months:
1
2
3
4
5
6
510
512
528
530
542
552

560
550
540
530
Demand
520
510
500
490
480

Actual
Forecast

Month

10

Holts 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
Internet Unicycle Sales (1000's)
450
400

= 0.2, = 0.4

350

Units

300
250
200
150
100
50
0
Jan-03

May-04

Sep-05

Feb-07

Jun-08

Month

Nov-09

Mar-11

Aug-12

Example:

Exponential Smoothing
with Trend

Winters Method:

Exponential Smoothing
w/ Trend and Seasonality

Ideas behind smoothing with trend and seasonality:

De-trend: and de-seasonalizetime-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

Winters 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

Winters 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

Internet Unicycle Sales (1000's)
500
450
400

= 0.2, = 0.4, = 0.6

350

Units

300
250
200
150
100
50
0
Jan-03

May-04

Sep-05

Feb-07

Jun-08

Month

Nov-09

Mar-11

Aug-12

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

n

1
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
2
MSE ( Dt Ft )
n t 1

Mean Forecast Error (MFE or Bias)

n

1
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)

n

1
2
MSE ( Dt Ft )
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...