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especially if it's about the future.

Nils Bohr

Objectives

Give the fundamental rules of forecasting

average, weighted moving average, and

exponential smoothing

What is forecasting?

future demand based on

past demand information.

Forecasting Horizons

Long Term

5+ years into the future

R&D, plant location, product planning

Principally judgment-based

Medium Term

1 season to 2 years

Aggregate planning, capacity planning, sales forecasts

Mixture of quantitative methods and judgment

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?

Why is forecasting important?

Forecasting can be used for

Strategic planning (long range planning)

Finance and accounting (budgets and cost controls)

Marketing (future sales, new products)

Production and operations

Forecasting for Strategic Business Planning

Capital expansion projects.

Proposals to develop a new product line.

Merger or acquisition opportunities.

Forecasts are usually stated in very general terms.

Useful techniques: Management judgment, economic

growth models, regression.

Forecasting for Sales and Operations

Planning

Provide the basis for plans that are usually stated in

terms of planned sales and output of product

families in dollars or some other aggregate

measure.

Useful techniques: Aggregation of detailed forecast,

customer plans, regression

A common mean for producing aggregate forecast for

SOP s to sum the forecast for the individual products

in each product line.

Forecasting for Master Production

Scheduling and Control

frequent and detailed.

Useful techniques: Projection techniques (moving

averages, exponential smoothing)

What is forecasting all about?

future by looking back at

the past

Predicted

demand

looking

Time back six

Jan Feb Mar Apr May Jun Jul Aug months

Actual demand (past sales)

Predicted demand

Whats Forecasting All About?

From the March 10, 2006 WSJ:

Journal, processed data about this year's films nominated for best picture

through his statistical model and predicted with 97.4% certainty that

"Brokeback Mountain" would win. Oops. Last year, the professor tuned

his model until it correctly predicted 18 of the previous 20 best-picture

awards; then it predicted that "The Aviator" would win; "Million Dollar

Baby" won instead.

powers.

Some general characteristics of forecasts

wrong

Second law of forecasting: Detailed forecasts are

worse than aggregate forecasts.

Forecasts are more accurate for groups or families of items

Third law of forecasting: The further into the

future, the less reliable the forecast will be.

Forecasts are more accurate for shorter time periods

Forecasts are no substitute for calculated demand.

Key issues in forecasting

the forecast (past data)

2. History is not a perfect predictor of the future (i.e.: there

is no such thing as a perfect forecast)

that the past predicts the future! When forecasting, think

carefully whether or not the past is strongly related to

what you expect to see in the future

Example: Mercedes E-class vs. M-class Sales

Month E-class Sales M-class Sales

Jan 23,345 -

Feb 22,034 -

Mar 21,453 -

Apr 24,897 -

May 23,561 -

Jun 22,684 -

Jul ? ?

based on the data in the the table?

two markets have in common

What should we consider when looking at

past demand data?

Trends

Seasonality

Cyclical elements

Autocorrelation

Random variation

Some Important Questions

Which systems will use the forecast?

How important is the past in estimating the future?

techniques, and level of detail for the forecast.

Forecasting Steps

1. What needs to be forecast?

Level of detail, units of analysis & time horizon required

2. What data is available to evaluate?

Identify needed data & whether its available

3. Select and test the forecasting model

Cost, ease of use & accuracy

4. Generate the forecast

5. Monitor forecast accuracy over time

Types of Forecasting Models

Qualitative (technological) methods:

Forecasts generated subjectively by the forecaster

Forecasts generated through mathematical

modeling

Qualitative Methods

Type Characteristics Strengths Weaknesses

Executive A group of managers Good for strategic or One person's opinion

opinion meet & come up with new-product can dominate the

a forecast forecasting forecast

research interviews to identify customer preferences develop a good

customer preferences questionnaire

method consensus among a forecasting long-term develop

group of experts product demand,

technological

changes, and

Statistical Forecasting

Time Series Models:

Assumes the future will follow same patterns as the past

Causal Models:

Explores cause-and-effect relationships

Uses leading indicators to predict the future

E.g. housing starts and appliance sales

Simulation:

Models that can incorporate some randomness and non-

linear effects

Composition of Time Series Data

Historic pattern may include:

Level (long-term average)

Trend

Seasonality

Cycle

Time Series Patterns

Methods of Forecasting the Level

Nave Forecasting

Simple Mean

Moving Average

Weighted Moving Average

Exponential Smoothing

Time Series Problem

Determine forecast for

periods 11

Nave forecast

Period Orders

Simple average 1 122

3- and 5-period moving 2 91

average 3 100

3-period weighted moving 4 77

average with weights 0.5, 5 115

0.3, and 0.2 6 58

Exponential smoothing 7 75

with alpha=0.2 and 0.5 8 128

9 111

10 88

11

Time Chart of Orders Data

140

120

100

80

60

40

20

0

1 2 3 4 5 6 7 8 9 10

Nave Forecasting

actual:

Ft 1 At

Simple Average (Mean)

Next periods forecast = average of all

historical data

At At 1 At 2 .............

Ft 1

n

Time Series: Moving average

The moving average model uses the last t periods in order to

predict demand in period t+1.

There can be two types of moving average models: simple

moving average and weighted moving average

The moving average model assumption is that the most accurate

prediction of future demand is a simple (linear) combination of

past demand.

Time series: simple moving

average

In the simple moving average models the forecast value is:

At + At-1 + + At-n

Ft+1 =

n

Ft+1 is the forecast for next period

n is the forecasting horizon (how far back we look),

A is the actual sales figure from each period.

Moving Average

Next periods forecast = simple average

of the last N periods

At At 1 ......... At N 1

Ft 1

N

Example: forecasting sales at Kroger

Kroger sells (among other stuff) bottled spring water

Month Bottles

Jan 1,325

Feb 1,353 What will the

Mar 1,305 sales be for

Apr 1,275 July?

May 1,210

Jun 1,195

Jul ?

What if we use a 3-month simple moving average?

FJul = = 1,227

3

FJul = = 1,268

5

1400

1350

1300

5-month

1250

MA forecast

1200

3-month

1150 MA forecast

1100

1050

1000

0 1 2 3 4 5 6 7 8

What do we observe?

3-month average more responsive

The Effect of the Parameter N

responsive

A larger N makes the forecast more

stable

Time series: weighted moving

average

We may want to give more importance to some of the data

Ft+1 = wt At + wt-1 At-1 + + wt-n At-n

wt + wt-1 + + wt-n = 1

Ft+1 is the forecast for next period

n is the forecasting horizon (how far back we look),

A is the actual sales figure from each period.

w is the importance (weight) we give to each period

Why do we need the WMA models?

Because of the ability to give more importance to what

happened recently, without losing the impact of the past.

Prediction when using 6-month SMA

Prediction when using 6-months WMA

For a 6-month

SMA, attributing

equal weights to all

past data we miss

Time the downward trend

Jan Feb Mar Apr May Jun Jul Aug

Example: Kroger sales of bottled

water

Month Bottles

Jan 1,325

Feb 1,353

Mar 1,305

What will be the sales

Apr 1,275 for July?

May 1,210

Jun 1,195

Jul ?

6-month simple moving average

FJul = = 1,277

6

downward trend that actually exists is not observed

What if we use a weighted moving

average?

Make the weights for the last three months more than the

first three months

SMA 40% / 60% 30% / 70% 20% / 80%

July

1,277 1,267 1,257 1,247

Forecast

we pick up the declining trend in our forecast.

How do we choose weights?

1. Depending on the importance that we feel past data has

2. Depending on known seasonality (weights of past data

can also be zero).

because of the ability to

vary the weights!

Time Series: Exponential Smoothing

(ES)

Main idea: The prediction of the future depends mostly on the

most recent observation, and on the error for the latest

forecast.

Smoothing

Denotes the importance

constant

of the past error

alpha

Why use exponential smoothing?

2. Extremely accurate

3. Easy to understand

4. Little calculation complexity

5. There are simple accuracy tests

Exponential smoothing: the method

Assume that we are currently in period t. We calculated the

forecast for the last period (Ft-1) and we know the actual

demand last period (At-1)

Ft Ft 1 ( At 1 Ft 1 )

Ft At 1 (1 ) Ft 1

0 1

The smoothing constant expresses how much our forecast

will react to observed differences

If is low: there is little reaction to differences.

If is high: there is a lot of reaction to differences.

Example: bottled water at Kroger

Month Actual Forecasted = 0.2

Jan 1,325 1,370

Jun ? 1,309

Example: bottled water at Kroger

Jun ? 1,225

Impact of the smoothing constant

1380

1360

1340

1320 Actual

1300

a = 0.2

1280

1260 a = 0.8

1240

1220

1200

0 1 2 3 4 5 6 7

Time Series Problem Solution

Nave Simple Moving Moving Moving Smoothing Smoothing

Period Orders (A) Forecast Average Average (N=3) Average(N=5) Average (N=3) ( = 0.2) ( = 0.5)

1 122 122 122

2 91 122 122 122 122

3 100 91 107 116 107

4 77 100 104 104 102 113 104

5 115 77 98 89 87 106 91

6 58 115 101 97 101 101 108 103

7 75 58 94 83 88 79 98 81

8 128 75 91 83 85 78 93 78

9 111 128 96 87 91 98 100 103

10 88 111 97 105 97 109 102 107

11 88 97 109 92 103 99 98

Trend..

What do you think will happen to a

moving average or exponential smoothing

model when there is a trend in the data?

Impact of trend

Sales

Actual

Regular exponential

Data smoothing will always

Forecast lag behind the trend.

Can we include trend

analysis in exponential

smoothing?

Month

Exponential smoothing with trend

FIT: Forecast including trend

: Trend smoothing constant

FITt Ft Tt (chosen by the user)

(F is the forecast without trend and T is the trend component)

Example: bottled water at Kroger

At Ft Tt FITt = 0.8

= 0.5

Jan 1325 1380 -10 1370

Feb 1353 1334 -28 1306

Mar 1305 1344 -9 1334

Apr 1275 1311 -21 1290

May 1210 1278 -27 1251

Jun 1218 -43 1175

Exponential Smoothing with Trend

1400

1350

Actual

1300

a = 0.2

1250 a = 0.8

a = 0.8, d = 0.5

1200

1150

0 1 2 3 4 5 6 7

Forecasting For Seasonal Series

Seasonality corresponds to a pattern in the data

that repeats at regular intervals. (See figure next

slide)

For instance, ice cream, air conditioners have peaks

associated with summer. Toys and gift items

experiences spikes in demand right before

Christmas.

Multiplicative seasonal factors: c1 , c2 , . . . , cN where

i = 1 is first season of cycle, i = 2 is second season

of the cycle, etc.

S ci = N

ci = 1.25 implies a demand 25% higher than the

baseline

ci = 0.75 implies 25% lower than the baseline

A Seasonal Demand Series

Quick and Dirty Method of Estimating

Seasonal Factors

Compute the sample mean of the entire data

set (should be at least several cycles of data)

Divide each observation by the sample mean

(This gives a factor for each observation)

Average the factors for like seasons

The resulting n numbers will exactly

add to N and correspond to the N

seasonal factors.

Deseasonalizing a Series

To remove seasonality from a series, simply

divide each observation in the series by the

appropriate seasonal factor. The resulting series

will have no seasonality and may then be

predicted using an appropriate method.

Once a forecast is made on the deseasonalized

series, one then multiplies that forecast by the

appropriate seasonal factor to obtain a forecast

for the original series.

Lets do one:

Season Cycle Demand Season Cycle Demand

Q1 2001 205 Q1 2002 225

Q2 2001 225 Q2 2002 248

Q3 2001 185 Q3 2002 203

Q4 2001 285 Q4 2002 310

Expected Demand Q203 = (225+248)/2 = 236.5

Expected Demand Q303 = (185+203)/2 = 194

Expected Demand Q403 = (285+310)/2 = 298

Overall average demand: SDi/8 = 235.75

Lets do one:

Seasonal Demand Factors:

Q1: 215/235.75 = 0.912

Q2: 236.5/235.75 = 1.003

Q3: 194/235.75 = 0.823

Q4: 297.5/235.75 = 1.262

Sum: 4.000

The seasonal factors must sum to the number

of seasons in the cycle

if they do not factors must be Normalized: {(number

of seasons in cycle)/Scj}*cji where i represents each

season in the cycle

Deseasonalize the Demand

For each period: Di/cj

Factor Demand (y)

Q1 01 205 215 .912 224.78

Q2 01 225 236.5 1.003 224.29

Q3 01 185 194 .823 224.81

Q4 01 285 298 1.262 225.84

Q1 02 225 215 .912 246.72

Q2 02 248 236.5 1.003 247.21

Q3 02 203 194 .823 246.64

Q4 02 310 298 1.262 245.66

But what about new data?

Same problem prevails as before updating is

expensive

As new data becomes available, we must start

over to get seasonal factors, trend and intercept

estimates

Isnt there a method to smooth this

seasonalized technique?

Yes, its called Winters Method or triple

exponential smoothing

The Winters Method for Seasonality

Suggested by Winters (1960)

The basic idea is to estimate a multiplicative

seasonality factor c(t), t=1,2,, where c(t)

represents the ratio of demand during period t to

the average demand during the season. Therefore,

if there are N periods in the season (for example,

N=12 if periods are months and the season is a

year), then the sum of the c(t) factors over the

season will always be equal to N. The seasonally

adjusted forecast is computed by multiplying the

forecast from the exponential smoothing with

linear trend model by the appropiate seasonality

factor.

Linear regression in forecasting

Linear regression is based on

1. Fitting a straight line to data

2. Explaining the change in one variable through changes

in other variables.

independent variables affect the dependent variable

Example: do people drink more when

its cold?

Alcohol Sales

fits the data?

Average Monthly

Temperature

The best line is the one that minimizes

the error

The predicted line is

Y a bX

i yi - Yi

y is the observed value

Y is the predicted value

Least Squares Method of Linear

Regression

errors

Min i

2

What does that mean?

Alcohol Sales

So LSM tries to

minimize the distance

between the line and

the points!

Average Monthly

Temperature

Least Squares Method of Linear

Regression

Then the line is defined by

Y a bX

a y bx

b

xy nx y

x nx 2 2

How can we compare across

forecasting models?

We need a metric that provides estimation of accuracy

Forecast Error 1. biased

2. random

value (also known as residual)

Measuring Accuracy: MFE

MFE = Mean Forecast Error (Bias)

It is the average error in the observations

A F t t

M FE i 1

n

1. A more positive or negative MFE implies worse

performance; the forecast is biased.

More critical: Wecan compesate for forecaste errors through

inventory, expediting, faster delivery means, and other kind

of responses.

Measuring Accuracy: MAD

MAD = Mean Absolute Deviation

It is the average absolute error in the observations

A F t t

M AD i1

n

1. Higher MAD implies worse performance.

2. MAD also measures deviation (error) from the

expected result (the forecast).

2. If errors are normally distributed, then =1.25MAD

Key Point

measuring the either the mean absolute

deviation or the standard deviation of the

forecast error

Measuring Accuracy: Tracking signal

The tracking signal is a measure of how often our estimations

have been above or below the actual value. It is used to

decide when to re-evaluate using a model.

n

RSFE (At Ft )

RSFE

TS

i1 MAD

Positive tracking signal: most of the time actual values are

above our forecasted values

Negative tracking signal: most of the time actual values are

below our forecasted values

Example: bottled water at Kroger

Month Actual Forecast Month Actual Forecast

( = 0.2) ( = 0.8)

( = 0.5)

Bottled water at Kroger: compare

MAD and TS

MAD TS

Exponential

70 - 6.0

Smoothing

Forecast

33 - 2.0

Including Trend

Exponential smoothing cannot capture

Which Forecasting Method Should You

Use

Gather the historical data of what you want to

forecast

Divide data into initiation set and evaluation set

Use the first set to develop the models

Use the second set to evaluate

Compare the MADs and MFEs of each model

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