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
y 5+ years into the future y R&D, plant location, product planning y Principally judgement-based

Medium Term
y 1 season to 2 years y Aggregate planning, capacity planning, sales forecasts y Mixture of quantitative methods and judgement

Short Term
y 1 day to 1 year, less than 1 season y Demand forecasting, staffing levels, purchasing, inventory levels y Quantitative methods

Short Term Forecasting: Needs and Uses
Scheduling existing resources
y How many employees do we need and when? y How much product should we make in anticipation of demand?

Acquiring additional resources
y When are we going to run out of capacity? y How many more people will we need? y How large will our back-orders be?

Determining what resources are needed
y What kind of machines will we require? y Which services are growing in demand? declining? y What kind of people should we be hiring?

Types of Forecasting Models Types of Forecasts y Qualitative --. .based on experience. judgement.g. causal models (e. y Quantitative --.based on data. y Focus here on Time Series Models Assumptions of Time Series Models y There is information about the past. exponential smoothing). regression). y The pattern of the past will continue into the future.eye-balling the numbers.g. time series models (e.systematically reduce forecasting errors. knowledge. Methods of Forecasting y Naive Methods --. statistics. y Formal Methods --. y This information can be quantified in the form of data.

000 items. Example from Industry: American Hospital Supply Corp. Demand for liquor in bar. y y y y y 70. 25 stocking locations. Store 3 years of data (63 million data points). Update forecasts monthly. Demand for frozen foods in local grocery warehouse. . Traffic on major communication switch.Forecasting Examples Examples from student projects: y y y y Demand for tellers in a bank. 21 million forecast updates per year.

Observations older than n are not included at all. Issues with moving average forecasts: y y y y All n past observations treated equally. Problem when 1000's of items are being forecast. Requires that n past observations be retained.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 ! D §n i n i !t 1 Note that the n past observations are equally weighted.

3 2 1 today ..Simple Moving Average Include n most recent observations Weight equally Ignore older observations weight 1/n n ..

Moving Average Internet Unicycle Sales 450 400 350 300 250 200 150 100 50 0 Apr-01 Sep-02 Jan-04 May-05 Oct-06 Feb-08 Jul-09 Nov-10 Apr-12 Aug-13 n=3 Units Month .

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: weight Decreasing weight given to older observations 0 E 1 E today .

Exponential Smoothing I Include all past observations Weight recent observations much more heavily than very old observations: 0 E 1 weight Decreasing weight given to older observations E E (1 E ) today .

Exponential Smoothing I Include all past observations Weight recent observations much more heavily than very old observations: weight 0 E 1 Decreasing weight given to older observations E E (1  E ) E (1  E ) 2 today .

Exponential Smoothing: Concept Include all past observations Weight recent observations much more heavily than very old observations: weight 0 E 1 Decreasing weight given to older observations E E (1  E ) E (1  E ) 2 E (1  E ) today 3 / .

Exponential Smoothing: Math Ft ! EDt  E (1  E ) Dt 1  E (1  E ) Dt 2  . E 2 A . Ft ! EDt  (1  E )? Dt 1  E (1  a ) Dt 2  .

E 2 A Ft ! aDt  (1  a ) Ft 1 .Exponential Smoothing: Math Ft ! EDt  E (1  E ) Dt 1  E (1  E ) Dt 2  . Ft ! EDt  (1  E )? Dt 1  E (1  a ) Dt 2  .

Exponential Smoothing: Math Ft ! aDt  a (1  a ) Dt 1  a (1  a ) 2 Dt 2  .3 work well Forecast for k periods into future is: Ft  k ! Ft . compared with n for moving average y Parameter a determined empirically (whatever works best) y Rule of thumb: E < 0. Ft ! aDt  (1  a ) Ft 1 Thus.2 or E = 0. E = 0.5 y Typically. new forecast is weighted sum of old forecast and actual demand Notes: y Only 2 values (Dt and Ft-1 ) are required.

Exponential Smoothing Internet Unicycle Sales (1000's) 450 400 350 300 Units 250 200 150 100 50 0 Jan-03 May-04 Sep-05 Feb-07 Jun-08 Nov-09 Mar-11 Aug-12 E= 0.2 Month .

Example: Exponential Smoothing .

Complicating Factors Simple Exponential Smoothing works well with data that is ³moving 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 6 510 512 528 530 542 552 560 550 540 Demand530 520 510 500 490 480 1 2 3 Actual Forecast 4 5 6 7 8 9 10 Month .

Holt¶s Method: Double Exponential Smoothing Ideas behind smoothing with trend: y ``De-trend'' time-series by separating base from trend effects y Smooth base in usual manner using E y Smooth trend forecasts in usual manner using F Smooth the base forecast Bt Bt ! EDt  (1  E )( Bt 1  Tt 1 ) Smooth the trend forecast Tt Tt ! F ( Bt  Bt 1 )  (1  F )Tt 1 Forecast k periods into future Ft+k with base and trend Ft  k ! Bt  kTt .

2.4 Month .ES with Trend Internet Unicycle Sales (1000's) 450 400 350 300 Units 250 200 150 100 50 0 Jan-03 May-04 Sep-05 Feb-07 Jun-08 Nov-09 Mar-11 Aug-12 E= 0. F= 0.

Example: Exponential Smoothing with Trend .

Winter¶s Method: Exponential Smoothing w/ Trend and Seasonality Ideas behind smoothing with trend and seasonality: y ³De-trend¶: and ³de-seasonalize´time-series by separating base from trend and seasonality effects y Smooth base in usual manner using E y Smooth trend forecasts in usual manner using F y Smooth seasonality forecasts using K Assume m seasons in a cycle y y y y 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 ! E  (1  E )( Bt 1  Tt 1 ) St m Smooth the trend forecast Tt Tt ! F ( Bt  Bt 1 )  (1  F )Tt 1 Smooth the seasonality forecast St Dt St ! K  (1  K ) 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 ! F ( Bt  Bt 1 )  (1  F )Tt 1 Smooth the seasonality forecast St Dt St ! K  (1  K ) St m Bt .

ES with Trend and Seasonality Internet Unicycle Sales (1000's) 500 450 400 350 300 Units 250 200 150 100 50 0 Jan-03 May-04 Sep-05 Feb-07 Jun-08 Nov-09 Mar-11 Aug-12 E= 0. F= 0.2.4. K= 0.6 Month .

Example: Exponential Smoothing with Trend and Seasonality .

Standard Squared Error (MSE): Measures variance of forecast error .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.

Forecasting Performance Measures 1 n MFE ! § ( Dt  Ft ) n t !1 1 MAD ! § Dt  Ft n t !1 100 Dt  Ft MAPE ! § D n t !1 t n n 1 n 2 MSE ! § ( Dt  Ft ) 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 ³on 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 .

. except .. Measures deviation as a percentage of actual data n .Mean Absolute Percentage Error (MAPE) Dt  Ft 100 MAPE ! § D n t !1 t Same as MAD.

MAPE -.not as intuitive .error variance Recognizes that large errors are disproportionately more ³expensive´ than small errors But is not as easily interpreted as MAD.Mean Squared Error (MSE) 1 n 2 MSE ! § ( Dt  Ft ) n t !1 Measures squared forecast error -.

. there is software.Fortunately...

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