Chapter Two

Forecasting
Planning
Forecast

Customer

Production Finished
Inputs Process Goods
Forecasting
 Marketing: forecasts sales for new and
existing products.

 Production: uses sales forecasts to plan

production and operations; sometimes
involved in generating sales forecasts.
Characteristics of Forecasts
 They are usually wrong
 A good forecast is usually more than a
single number
 Aggregate forecast are more accurate
 The longer the forecasting horizon, the
less accurate the forecasts will be
 Forecasts should not be used to the
exclusion of known information
Forecasting Horizon
 Short term
 (inventory management, production plans..)
 Intermediate term
 (sales patterns for product families..)
 Long term
 (long term planning of capacity needs)
Forecasting Techniques
Forecasting
Technique

Judgmental Time Series

Models Causal Methods
Methods

Delphi Moving Regression

Method Average Analysis

Exponential
Smoothing

Seasonality
Models
Types of forecasting Methods

 Subjective methods
 Sales force composites
 Customer survey
 Jury of executive opinion
 The Delphi method

 Objective methods
 Causal methods
Time series methods
Qualitative Methods
 Don’t have data
 Don’t have time to develop a forecast
 Often used in practice
 “Close enough”
 Depend on expert opinions
 Market surveys
 More appropriate for long term forecasts
Delphi Technique
 A method to obtain a consensus forecast
by using opinions from a group of
“experts”
 expert opinion
 consulting salespersons
 consulting consumers
 Causal Methods
 Causal methods use data from sources other than the
series being predicted.

 If Y is the phenomenon to be forecast and X1 , X2 , . .., Xn

are the n variables we believe to be related to Y, then a
causal model is one in which the forecast for Y is some
function of these variables:

Y = f (X1 , X2 , . .., Xn )

 Econometric models are causal models in which the

relationship between Y and (X1 , X2 , . .., Xn ) is linear.
That is
Y = ao + a1 X1 + a2 X2 + … an Xn
for some constants a1 , a2 , . . . , an
Forecasting Steps for
Quantitative Methods
 Collect data
 Reduce/clean data
 Build and evaluate model(s)
 Forecast (model extrapolation)
 Track the forecast
Identify the correct pattern
• Collect data. Look for possible cause/effect
relationships
• Determine which form can be used to
generate the pattern
• Determine specific values of the parameters
 Sales in thousands of cases

200
400
600
800
1000
1200
1400
1600

0
Ja
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Ap
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Ju
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Ja
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Ju
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Period
ct
Ja
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Building Models
 Plot data over time. (remove outliers & get right
scale).
 Using part of the data, estimate model parameters.
 Forecast the rest of the data with the model.
 Evaluate accuracy of the model.
 Use judgment to modify.
 Keep track of model accuracy over time (redo, if
needed).
Forecasting Stationary
Series
Time series Analysis
Patterns that arise most often

 Trend
 Seasonality
 Cycles
 Randomness
Fig. 2-2
Time Series Patterns
 Notation

Dt : Observed value of the demand during period t

{Dt , t ≥ 1} : time series we would like to predict

Ft : forecast made for period t in period t-1

forecast made at the end of t-1 after having
observed Dt −1 , Dt − 2 , …
Time Series Forecast
∞
Ft = ∑ an Dt − n
n =0

For some set of weights

a0 , a1 ,....
Evaluating forecasts
 Forecast error in period t

et = Ft − Dt

 For multiple-step-ahead

et = Ft −τ − Dt
Evaluating Forecasts
 Mean Absolute Deviation
n

∑| e | i
MAD = i =1
n
 Mean Square Error
n

∑e 2
i
MSE = i =1
n
Fig. 2-3
Forecast Errors Over Time
 TIME SERIES METHODS
Stationary Series
 A stationary time series is represented by a
constant plus a random fluctuation:
Dt = µ+ εt
where µ is an unknown constant corresponding to
the mean of the series and εt is a random error
with mean 0 and variance σ2 .
 The methods described for stationary series are:
 MovingAverages
 Exponential Smoothing
Methods of Forecasting
Stationary Series
 Moving Averages
t −1

∑D i
Dt −1 + Dt − 2 + ... + Dt − N
Ft = i =t − N
=
N N
 Exponential Smoothing

Ft = αDt −1 + (1 − α ) Ft −1
Moving Average

Dt −1 + Dt − 2 + ... + Dt − N
Ft =
N
 Month Deliveries
Jan 120
Feb 90
Mar 100
Apr 75
May 110
Jun 50
Jul 75
Aug 130
Sep 110
Oct 90
140

120

100

80

60

40

20

0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct

Mo n t h
Month Deliveries MA(3) MA(6)
Jan 120
Feb 90
Mar 100
Apr 75 103
May 110 88
Jun 50 95
Jul 75 78 91
Aug 130 78 83
Sep 110 85 90
Oct 90 105 92
110 94
140

120

100

80

60

40

20

0
1 2 3 4 5 6 7 8 9 10 11
Month Deliveries MA(3) MA(6)
1 2
2 4
3 6
4 8 4
5 10 6
6 12 8
7 14 10 7
8 16 12 9
9 18 14 11
10 20 16 13
11 22 18 15
12 24 20 17
22 19
Fig. 2-4

Moving-Average Forecasts
Lag Behind a Trend
 EXPONENTIAL SMOOTHING
 Current forecast is a weighted average of the
last forecast and the current value of demand

New forecast = α (current observation of demand)

+ (1- α ) (last forecast)
Exponential Smoothing
Ft = αDt −1 + (1 − α ) Ft −1
Ft = Ft −1 − α ( Ft −1 − Dt −1 )
Ft = Ft −1 − αet −1

Ft = Ft-1 – (fraction of the observed forecast error in t-1)

If we forecast high in period t-1  error is positive  adjustment
to decrease current forecast
If we forecast low in period t-1  error is negative  adjustment
to increase current forecast
Ft = α Dt −1 + (1 − α ) Ft −1
Ft −1 = α Dt − 2 + (1 − α ) Ft − 2

Ft = α Dt −1 + α (1 − α ) Dt − 2 + (1 − α ) 2 Ft − 2
∞
Ft = ∑ α (1 − α ) Dt −i −1
i

i =o
Example

Quarter Failures Forecast

1 200 200
2 250 200
3 175 205
4 186 202
5 225 201
6 285 203
7 305 211
8 190 220
350

300

250

200

150

100

50

0
1 2 3 4 5 6 7 8
Fig. 2-5

Weights in Exponential
Smoothing
Fig. 2-6

Exponential Smoothing for

Different Values of Alpha
Smaller values of α produce more stable forecasts,
whereas larger values of α will produce forecasts
which react more quickly to changes in the demand
pattern.
Comparison
1 N ( N + 1) N + 1
(1 + 2 + 3 + ... + N ) = =
N N 2
∞
1
∑ iα (1 − α )
i −1
=
i =1 α

1 N +1
=
α 2
Similarities & Differences
 Stationary series  ES weighted average
 Single parameter of all past data
 Lag behind a trend  MA only last N periods
 When α=2/(N+1)

Same distribution of  MA : save past N data

forecast error  ES : only last forecast
Multiple-Step-Ahead Forecasts
Same as one-step-ahead-forecast
Trend Based Methods
 Regression Analysis

Ft = a + bt
 Double Exponential
Smoothing

Ft ,t +τ = St + τGt
Double Exponential Smoothing
Intercept at time t

St = αDt + (1 − α )( St −1 + Gt −1 )
and slope at time t

Gt = β ( St − St −1 ) + (1 − β )Gt −1

Ft ,t +τ = St + τGt