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Methods

Topic 10

Course : Supply Chain: Logistics

Selecting a Forecasting Method

• It should be based on the following considerations:

– Forecasting horizon (validity of extrapolating past

data)

– Availability and quality of data

– Lead Times (time pressures)

– Cost of forecasting (understanding the value of

forecasting accuracy)

– Forecasting flexibility (amenability of the model to

revision; quite often, a trade-off between filtering

out noise and the ability of the model to respond to

abrupt and/or drastic changes)

Data Pattern

• A time series is likely to contain some or all of the following

components:

– Trend

– Seasonal

– Cyclical

– Irregular

Data Pattern

• Trend in a time series is the long-term change in the

level of the data i.e. observations grow or decline

over an extended period of time.

– Positive trend

• When the series move upward over an extended period of time

– Negative trend

• When the series move downward over an extended period of time

– Stationary

• When there is neither positive or negative trend.

Data Pattern

• Seasonal pattern in time series is a regular variation in the

level of data that repeats itself at the same time every year.

– Examples:

• Retail sales for many products tend to peak in

November and December.

• Housing starts are stronger in spring and summer than

fall and winter.

Data Pattern

• Cyclical patterns in a time series is presented by

wavelike upward and downward movements of the

data around the long-term trend.

• They are of longer duration and are less regular than

seasonal fluctuations.

• The causes of cyclical fluctuations are usually less

apparent than seasonal variations.

Data Pattern

• Irregular pattern in a time series data are the fluctuations that

are not part of the other three components

• These are the most difficult to capture in a forecasting model

Example:GDP, in 1996 Dollars

Example:Quarterly data on private housing starts

Example:U.S. billings of the Leo Burnet

advertising agency

Data Patterns and Model Selection

• The pattern that exist in the data is an important

consideration in determining which forecasting

techniques are appropriate.

• To forecast stationary data; use the available history to

estimate its mean value, this is the forecast for future

period.

• The estimate can be updated as new information becomes

available.

• The updating techniques are useful when initial estimates

are unreliable or the stability of the average is in question.

Data Patterns and Model Selection

• Forecasting techniques used for stationary time series data are:

– Naive methods

– Simple averaging methods,

– Moving averages

– Simple exponential smoothing

– autoregressive moving average(ARMA)

Data Patterns and Model Selection

• Methods used for time series data with trend are:

– Moving averages

– Holt’s linear exponential smoothing

– Simple regression

– Growth curve

– Exponential models

– Time series decomposition

– Autoregressive integrated moving average(ARIMA)

Data Patterns and Model Selection

• For time series data with seasonal component the goal is

to estimate seasonal indexes from historical data.

• These indexes are used to include seasonality in forecast

or remove such effect from the observed value.

• Forecasting methods to be considered for these type of

data are:

– Winter’s exponential smoothing

– Time series multiple regression

– Autoregressive integrated moving average(ARIMA)

Data Patterns and Model Selection

• Cyclical time series data show wavelike fluctuation around the

trend that tend to repeat.

• Difficult to model because their patterns are not stable.

• Because of the irregular behavior of cycles, analyzing these

type data requires finding coincidental or leading economic

indicators.

Data Patterns and Model Selection

• Forecasting methods to be considered for these type of data

are:

– Classical decomposition methods

– Econometric models

– Multiple regression

– Autoregressive integrated moving average (ARIMA)

Example:GDP, in 1996 Dollars

• For GDP, which has a trend and a cycle but no seasonality, the

following might be appropriate:

– Holt’s exponential smoothing

– Linear regression trend

– Causal regression

– Time series decomposition

Example:Quarterly data on private housing starts

• Private housing starts have a trend, seasonality, and a cycle.

The likely forecasting models are:

– Winter’s exponential smoothing

– Linear regression trend with seasonal adjustment

– Causal regression

– Time series decomposition

Example:U.S. billings of the Leo Burnet

advertising agency

• For U.S. billings of Leo Burnett advertising, There is a non-

linear trend, with no seasonality and no cycle, therefore the

models appropriate for this data set are:

– Non-linear regression trend

– Causal regression

Autocorrelation

• Correlation coefficient is a summary statistic that measures the

extent of linear relationship between two variables. As such

they can be used to identify explanatory relationships.

• Autocorrelation is comparable measure that serves the same

purpose for a single variable measured over time.

Autocorrelation

• In evaluating time series data, it is useful to look at the

correlation between successive observations over time.

• This measure of correlation is called autocorrelation and may

be calculated as follows:

– r

k

= autocorrelation coefficient for a k period lag.

– mean of the time series.

– y

t

= Value of the time series at period t.

– y

t-k

= Value of time series k periods before period t.

¿

¿

=

+ =

÷

÷

÷ ÷

=

n

t

t

n

k t

k t t

k

y y

y y y y

r

1

2

1

) (

) )( (

y

Autocorrelation

• Autocorrelation coefficient for different time lags can be used

to answer the following questions about a time series data.

– Are the data random?

• In this case the autocorrelations between y

t

and y

t-k

for

any lag are close to zero. The successive values of a

time series are not related to each other.

Correlograms: An Alternative Method of

Data Exploration

– Is there a trend?

• If the series has a trend, y

t

and y

t-k

are highly correlated

• The autocorrelation coefficients are significantly

different from zero for the first few lags and then

gradually drops toward zero.

• The autocorrelation coefficient for the lag 1 is often

very large (close to 1).

• A series that contains a trend is said to be non-

stationary.

Correlograms: An Alternative Method of

Data Exploration

– Is there seasonal pattern?

• If a series has a seasonal pattern, there will be a

significant autocorrelation coefficient at the seasonal

time lag or multiples of the seasonal lag.

• The seasonal lag is 4 for quarterly data and 12 for

monthly data.

Correlograms: An Alternative Method of

Data Exploration

– Is it stationary?

• A stationary time series is one whose basic statistical

properties, such as the mean and variance, remain

constant over time.

• Autocorrelation coefficients for a stationary series

decline to zero fairly rapidly, generally after the second

or third time lag.

Correlograms: An Alternative Method of

Data Exploration

• To determine whether the autocorrelation at lag k is

significantly different from zero, the following hypothesis and

rule of thumb may be used.

• H

0

: µ

k

= 0, H

a

: µ

k

= 0

• For any k, reject H

0

if

• Where n is the number of observations.

• This rule of thumb is for o = 5%

n

r

k

2

>

Correlograms: An Alternative Method of

Data Exploration

• The hypothesis test developed to determine whether a

particular autocorrelation coefficient is significantly different

from zero is:

• Hypotheses

• H

0

: µ

k

= 0, H

a

: µ

k

= 0

• Test Statistic:

k n

r

t

k

÷

÷

=

1

0

Correlograms: An Alternative Method of

Data Exploration

• Reject H

0

if

2 ; 2 ;

or

o o k n k n

t t t t

÷ ÷

÷ < >

Correlograms: An Alternative Method of

Data Exploration

• The plot of the autocorrelation Function (ACF) versus time lag

is called Correlogram.

• The horizontal scale is the time lag

• The vertical axis is the autocorrelation coefficient.

• Patterns in a Correlogram are used to analyze key features of

data.

Example:Mobil Home Shipment

• Correlograms for the mobile home shipment

• Note that this is quarterly data

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1 2 3 4 5 6 7 8 9 10 11 12

ACF

Upper Limit

Lower Limit

Example:Japanese exchange Rate

• As the world’s economy becomes increasingly

interdependent, various exchange rates between

currencies have become important in making business

decisions. For many U.S. businesses, The Japanese

exchange rate (in yen per U.S. dollar) is an important

decision variable. A time series plot of the Japanese-

yen U.S.-dollar exchange rate is shown below. On the

basis of this plot, would you say the data is

stationary? Is there any seasonal component to this

time series plot?

Example:Japanese exchange Rate

Japanese Exchange Rate

0

20

40

60

80

100

120

140

160

180

0 5 10 15 20 25 30

Months

E

x

c

h

a

n

g

e

R

a

t

e

(

y

e

n

p

e

r

U

.

S

.

d

o

l

l

a

r

)

EXRJ

Example:Japanese exchange Rate

• Here is the autocorrelation

structure for EXRJ.

• With a sample size of 12,

the critical value is

• This is the approximate

95% critical value for

rejecting the null

hypothesis of zero

autocorrelation at lag K.

Obs ACF

1 .8157

2 .5383

3 .2733

4 .0340

5 -.1214

6 -.1924

7 -.2157

8 -.1978

9 -.1215

10 -.1217

11 -.1823

12 -.2593

408 . 0

24

2 2

= =

n

Example:Japanese exchange Rate

• The Correlograms for EXRJ is given below

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1 2 3 4 5 6 7 8 9 10 11 12

ACF

Upper Limit

Lower Limit

Example:Japanese exchange Rate

• Since the autocorrelation coefficients fall to below the critical

value after just two periods, we can conclude that there is no

trend in the data.

Example:Japanese exchange Rate

• To check for seasonality at o = .05

• The hypotheses are:

– H

0

; µ

12

= 0 H

a

:µ

12

= 0

• Test statistic is:

• Reject H

0

if

899 . 0

12 24 / 1

2595 .

1

0

÷ =

÷

÷

=

÷

÷

=

k n

r

t

k

2 ; 2 ;

or

o o k n k n

t t t t

÷ ÷

÷ < >

179 . 2

025 . 0 ; 12 2 ;

= =

÷

t t

k n o

Example:Japanese exchange Rate

• Since

• We do not reject H

0

, therefore seasonality does not appear to

be an attribute of the data.

179 . 2 899 . 0

025 . 0 ; 12

÷ = ÷ > ÷ = t t

ACF of Forecast Error

• The autocorrelation function of the forecast errors is very

useful in determining if there is any remaining pattern in the

errors (residuals) after a forecasting model has been applied.

• This is not a measure of accuracy, but rather can be used to

indicate if the forecasting method could be improved.

Applying a Quantitative Forecasting

Method

Determine Method

•Time Series

•Causal Model

Collect data:

<Ind.Vars; Obs. Dem.>

Fit an analytical model

to the data:

F(t+1) = f(X1, X2,…)

Use the model for

forecasting future

demand

Monitor error:

e(t+1) = D(t+1)-F(t+1)

Model

Valid?

Update Model

Parameters

Yes No

- Determine

functional form

- Estimate parameters

- Validate

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