Prof.

Rath Session 2 – Forecasting (1) 1

 BUSI 403 - SESSION 2

Forecasting (1)

"A good forecaster is not smarter than everyone else, he merely has his
ignorance better organized. "
- Anonymous

Prof. Rath Session 2 – Forecasting (1) 2

 Class Business
▪ Seating chart
▪ Homework assignment
– Due Tue 1/28, 11:59 PM
– Problem Data in Excel sheet on course website (Canvas)
– SUBMISSION ONLY VIA CANVAS
– LATE SUBMISSIONS OR SUBMISSIONS VIA EMAIL WILL NOT
BE ACCEPTED

▪ Excel Refresher Video Available on Canvas Home

▪ Office Hour for Homework 1 Jan 26th 12:30 PM

▪ Remember project-group sign-up due Feb 2nd

– Link to Google Spreadsheet on canvas

Prof. Rath Session 2 – Forecasting (1) 3

 Agenda
▪ Forecasting - background
– What is a forecast? Why should we forecast?
▪ Forecasting methods
– Qualitative versus quantitative
– Time series quantitative methods
▪ Measuring how good a forecast is

Prof. Rath Session 2 – Forecasting (1) 4

 Why Forecast

Prof. Rath Session 2 – Forecasting (1) 5

 Why Forecast

• What needs to be forecast?

• What decisions are made on
the basis of the forecasts?

Prof. Rath Session 2 – Forecasting (1) 6

 Poor Forecasting Costs Money
▪ Cisco […] reported more than $3.4 billion in one-time
charges, including a $2.2 billion write-down for excess
inventory. The inventory charge, primarily reflecting a
huge store of components Cisco accumulated in response
to a parts shortage last year. WSJ 5/9/2001

▪ In June 2008, due to an industry-wide capacity constraint

for compact and hybrid cars, GM estimated vehicle
shortages cost the auto industry 40,000 sales. WSJ 7/2/2008

▪ In 2006, Xbox 360 faced a manufacturing shortage and

couldn’t take advantage of a delayed Sony Playstation 3 LA
Times 01/29/2006

Prof. Rath Session 2 – Forecasting (1) 7

 Definition
▪ Operations Management is about the management of
processes that transforms inputs to outputs
▪ This transformation process is almost never instantaneous, so
the demand for some point in time needs to be predicted so
the matching level of inputs can be lined up
▪ Demand forecasting is prediction of probable demand for a
product or a service on the basis of the past events and
prevailing trends in the present

Prof. Rath Session 2 – Forecasting (1) 8

Qualitative versus Quantitative Forecasting

Qualitative Quantitative

• Subjective, based on • Objective, based on

Characteristic people’s opinions numeric data and
equations

• Can incorporate • Consistent

Strength expertise that is hard • Can consider large
to codify amounts of data

• Opinions can • Must have data

Weakness dominate/and or bias
the forecast

Prof. Rath Session 2 – Forecasting (1) 9

 Time Series Forecasts

▪ Time Series Forecast: Forecast based

on the time series (previously
observed values) of the variable to be
forecast
▪ Assumption: Past history is best
predictor of the future

Prof. Rath Session 2 – Forecasting (1) 10

 Forecasting Demand
Demand

250

200

150

100

50

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Week

What Would Be Your Forecast of Demand in Week 11 ?

Prof. Rath Session 2 – Forecasting (1) 11

 Previous Example Was Unrealistic
Demand is Almost Never Constant

2. Fluctuates And Has

1. Fluctuates About A 3. Fluctuates And Has
Increasing (or Decreasing)
Constant Mean “Seasonal” Pattern
Trend
Demand Demand Demand

250 250 250

200 200 200

150 150 150

100 100 100

50 50 50

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

Prof. Rath Session 2 – Forecasting (1) 12

 Notations
▪ Demand observed in period t
– At
– A3 = 150, means, the observed demand in period
3 was 150
▪ Forecast (made in period t) of demand for
period t+1, i.e. forecast of next period’s
demand
– Ft+1
– F4 = 200, means, the forecast for period 4 was
200. This forecast was made in period 3
Prof. Rath Session 2 – Forecasting (1) 13
 Previous Example Was Unrealistic
Demand is Almost Never Constant

2. Fluctuates And Has

1. Fluctuates About A 3. Fluctuates And Has
Increasing (or Decreasing)
Constant Mean “Seasonal” Pattern
Trend
Demand Demand Demand

250 250 250

200 200 200

150 150 150

100 100 100

50 50 50

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

Prof. Rath Session 2 – Forecasting (1) 14

 Today We Will Focus on Type 1: Basic Time Series
Fluctuates About A
Constant Mean

Demand

250

200

150

100

50

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

Prof. Rath Session 2 – Forecasting (1) 15

 Today We Will Focus on Type 1: Basic Time Series

Fluctuates About A
Constant Mean
Demand = Mean + Random Fluctuation
Demand

250
Notes:
200 (1) Fluctuation Can be Positive or Negative
(2) Average Fluctuation = 0
150

100
Forecast = Current Estimate of the Mean
50

1 2 3 4 5 6 7 8 9 10 11 The Challenge is to Estimate the Mean

level of Demand
Week

Prof. Rath Session 2 – Forecasting (1) 16

 Example
Forecasting Demand for Polio Vaccines

▪ You have just joined a pediatric hospital as head

of operations. You need to order polio vaccines
monthly starting with February. You know that
January demand was 130.
Month t Demand for Vaccine
January 1 130
February 2
March 3
April 4
May 5
June 6
July 7

Prof. Rath Session 2 – Forecasting (1) 17

 Methods of Forecasting
▪ Naïve method
▪ Simple Average
▪ Moving Average
▪ Exponential smoothing

Prof. Rath Session 2 – Forecasting (1) 18

 Method 1: The Naïve Method, Ft+1=At
Simplest Approach to Forecasting

Period Demand Forecast

Forecast of Demand in
Period 2 1 130 -
(This forecast made
after seeing Demand
in Period 1) 2 155 130

3 145 155
Forecast of Demand
in Period 5 4 160 145
(This forecast made
after seeing Demand
in Period 4) 5 151 160
6 143 151
7 143

Prof. Rath Session 2 – Forecasting (1) 19

 Method 2: The Simple Average,
Ft+1=(At+ At-1+ At-2+…A1)/t

Period Demand Forecast

Forecast of
Demand in 1 130 -
Period 2
(This forecast
made after 2 155 130.00 130/1 =130

seeing Demand
in Period 1)
3 145 142.50 (130+155)/2 =142.50

Forecast of 4 160 143.33 (130+155+145)/3 = 143.33

Demand in
Period 5
(This forecast 5 151 147.50 (130+155+145+160)/4 =
147.5
made after
seeing Demand
in Period 4) 6 143 148.20 (130+155+145+160+151)/5 =
148.2

7 147.33 (130+155+145+160+151+143
) / 6 = 147.33

Prof. Rath Session 2 – Forecasting (1) 20

 The Moving Average Forecast
“Old history is not relevant”
▪ The Simple Average forecast uses ALL THE
HISTORY of demands to generate the forecast for
the next period

▪ The (Simple) Moving Average forecast (order n) uses

ONLY THE ‘n’ MOST RECENT period demands to
generate the forecast for the next period

▪ ‘n’ depends on the company, usually determined by a

trial and error based method. Taco Bell uses 6
weeks moving average forecast to forecast sales*
* J. Hueter and W. Swart "An Integrated Labor-Management System for Taco Bell," Interfaces, 28, no. 1 (January-February 1998): 75-91.
Prof. Rath Session 2 – Forecasting (1) 21
 Method 3: The Moving Average Forecast
Ft+1=(At+At-1+ At-2 +At-3+…+At-n+1)/n

Period Demand Forecast Using

n=3
Forecast of
Demand in 1 130 -
Period 2
(This forecast
made after 2 155 - Not enough history

seeing Demand
in Period 1)
3 145 - Not enough history

Forecast of 4 160 143.33 (145+155+130)/3 = 143.33

Demand in
Period 5
(This forecast 5 151 153.33 (160+145+155)/3 = 153.33

made after
seeing Demand
in Period 4) 6 143 152.00 (151+160+145)/3 = 152.00

7 151.33 (143+151+160) /3 = 151.33

Prof. Rath Session 2 – Forecasting (1) 22

 The Weighted Moving Average Forecast “Recent
history is more relevant”
▪ The (simple) Moving Average forecast (order n)
treats each of the n most recent demands EQUALLY
in generating the forecast for the next period

▪ The Weighted Moving Average forecast (order n)

weights each of the n most recent demands
(possibly) DIFFERENTLY in generating the forecast
for the next period

Prof. Rath Session 2 – Forecasting (1) 23

 Method 4: Weighted Moving Average Forecast
Ft+1 = wt At+wt-1 At-1+… +wt-n+1At-n+1
The weights (𝒘𝒕 , 𝒘𝒕−𝟏 , … , 𝒘𝒕−𝒏+𝟏 ) have to be positive and should sum to 1

n=3:
Period Demand Forecast wt=0.5, wt-1=0.3,
Forecast of wt-2=0.2
Demand in 1 130 -
Period 2
(This forecast
made after 2 155 - Not enough history

seeing Demand
in Period 1)
3 145 - Not enough history

Forecast of 4 160 145.00 0.5(145) +0.3(155)+ 0.2(130)

= 145.00
Demand in
Period 5
(This forecast 5 151 154.50 0.5(160) +0.3(145)+ 0.2(155)
= 154.50
made after
seeing Demand
in Period 4) 6 143 152.50 0.5(151) +0.3(160)+ 0.2(145)
= 152.50

7 148.80 0.5(143) +0.3(151)+ 0.2(160) =

148.80

Prof. Rath Session 2 – Forecasting (1) 24

 Exponential Smoothing Forecast “Never forget, with
weights”
▪ The (Simple) Moving Average forecast (order n) uses
only the ‘n’ most recent period demands to generate
the forecast for the next period. Old history is
completely forgotten.

▪ We might want a method where old history is not

forgotten but more recent demand is given more
weight. This is achieved through Exponential
Smoothing

Prof. Rath Session 2 – Forecasting (1) 25

 Method 5: Exponential Smoothing Forecast
Weights for exponential smoothing
0.6

0.5

0.4
Weights

0.3

0.2

0.1

0
t t-1 t-2 t-3 t-4 t-5 t-6 t-7 t-8 t-9
Time Period

Prof. Rath Session 2 – Forecasting (1) 26

 Method 5: Exponential Smoothing Forecast
Weights for exponential smoothing
0.6
𝒘𝒕−𝒊 = 𝜶 𝟏 − 𝜶 𝒊 , 𝟎≤𝜶≤𝟏
Example table for weights for exponential smoothing for
0.5 𝜶 = 𝟎. 𝟓

𝒊 𝒕−𝒊 𝒊
𝒘𝒕−𝒊 = 𝟎. 𝟓 𝟏 − 𝟎. 𝟓
0.4 0 t 0.5
1 t-1 0.25
Weights

0.3 2 t–2 0.125

3 t–3 0.0625
0.2 4 t–4 0.03125
5 t–5 0.015625
0.1 6 t–6 0.007813
7 t–7 0.003906
0 8 t–8 0.001953
t t-1 t-2 t-3 t-4 t-5 t-6 t-7 t-8 t-9
Time Period 9 t-9 0.000977
Prof. Rath Session 2 – Forecasting (1) 27
 Method 5: Exponential Smoothing Forecast
The weights for exponential smoothing are given by,
𝑤𝑡−𝑖 = 𝛼 1 − 𝛼 𝑖
The forecast from a exponential smoothing forecast will be given by,
𝐹𝑡+1 = 𝑤𝑡 𝐴𝑡 + 𝑤𝑡−1 𝐴𝑡−1 + ⋯ + 𝑤1 𝐴1 Like weighted average

This is same as writing,

𝑡

𝐹𝑡+1 = ෍ 𝑤𝑡−𝑖 𝐴𝑡−𝑖

𝑖=0
Because, 𝑤𝑡−𝑖 = 𝛼 1 − 𝛼 𝑖 , so,
𝑡

𝐹𝑡+1 = ෍ 𝛼 1 − 𝛼 𝑖 𝐴𝑡−𝑖
𝑖=0
This is the same as, We will use this –
𝐹𝑡+1 = 𝛼𝐴𝑡 + 1 − 𝛼 𝐹𝑡 more concise
representation and
easier to do in Excel

Prof. Rath Session 2 – Forecasting (1) 28

 Method 5: Exponential Smoothing Forecast
Ft+1=αAt + (1- α)Ft

Period Demand Forecast α=.2

Forecast of
Demand in 1 130 -
Period 2
(This forecast
made after 2 F2=αA1 + (1- α)F1
seeing Demand
in Period 1)
F2=(0.2)130 + (1- 0.2)F1
Problem!
Didn’t have a forecast for period 1 so how can we start the
exponential smoothing method
Options
(1) Use Naïve Forecast for Period 2 and then do exponential smoothing for periods 3,4,5,6,……
(2) Choose an initial forecast for period 1 (in some manner) and then do exponential smoothing
for periods 2,3,4,5,6,……

Prof. Rath Session 2 – Forecasting (1) 29

 Exponential Smoothing Forecast:
Using Naïve Method for Period 2

Period Demand Forecast

α=.2
Forecast of
Demand in 1 130 -
Period 2
(This forecast
made after 2 155 130 Using Naive

seeing Demand
in Period 1)
3 145 135.00 0.2(155)+(1-0.2)(130)=135.00

Forecast of 4 160 137.00 0.2(145)+(1-0.2)(135)=137.00

Demand in
Period 5
(This forecast 5 151 141.60 0.2(160)+(1-0.2)(137)=141.60

made after
seeing Demand
in Period 4) 6 143 143.48 0.2(151) +
(1-0.2)(141.60) =143.48

7 143.38 0.2(143) +
(1-0.2)(143.48) = 143.38

Prof. Rath Session 2 – Forecasting (1) 30

 Exponential Smoothing Forecast:
Forecast for Period 1 Is Given

Period Demand Forecast

α=.2
Forecast of
Demand in 1 130 140
Period 2
(This forecast
made after 2 155 138 0.2(130)+(1-0.2)(140)=138.00

seeing Demand
in Period 1)
3 145 141.40 0.2(155)+(1-0.2)(138)=141.40

Forecast of 4 160 141.12 0.2(145) +

(1-0.2)(141.40) = 141.12
Demand in
Period 5
(This forecast 5 151 145.70 0.2(160) +
(1-0.2)(141.12) = 145.70
made after
seeing Demand
in Period 4) 6 143 146.76 0.2(151) +
(1-0.2)(145.70) =146.76

Prof. Rath Session 2 – Forecasting (1) 31

 Exponential Smoothing Forecast:
Forecast for Period 1 Is Given

Period Demand Forecast

α=.2
Forecast of
Demand in 1 130 140
Period 2
(This forecast
made after 2 155 138 0.2(130)+(1-0.2)(140)=138.00

seeing Demand
in Period 1)
3 145 141.40 0.2(155)+(1-0.2)(138)=141.40

Forecast of 4 160 141.12 0.2(145) +

(1-0.2)(141.40) = 141.12
Demand in
Period 5
(This forecast 5 151 145.70 0.2(160) +
(1-0.2)(141.12) = 145.70
made after
seeing Demand
in Period 4) 6 143 146.76 0.2(151) +
(1-0.2)(145.70) =146.76

7 146.00 0.2(143) +
(1-0.2)(146.76) = 146.00

Prof. Rath Session 2 – Forecasting (1) 32

 Summary of Basic Time Series Methods

Technique Decision Implicit assumption

• Simple Average • None • All periods are equally
informative.

• Simple Moving • Length (n) • Only last n periods are

Average important (equally).

• Weighted Moving • Length (n) • Not all recent periods equally

Average and weights important.

• Exponential • Smoothing • Importance of data declines

Smoothing constant, smoothly (in an exponential
alpha (α) fashion)

Prof. Rath Session 2 – Forecasting (1) 33

 What If Mean Demand Level Shifts at Some Point in Time
?

Change in Mean Demand Forecast reaction?

180 • How will the following
160 forecasts react
140 • Moving Average
120 • n=2
100 • n=7
80
• Exponential smoothing
60
• α =0.2
40
• α =0.9
20

0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Demand

Prof. Rath Session 2 – Forecasting (1) 34

 Forecast Parameter Influences Responsiveness to
Shift in Mean

Moving Average Exponential Smoothing

180 180

160 160

140 140

120 120

100 100

80 80

60 60

40 40

20 20

0 0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Demand MA 2 MA 7 Demand alpha 0.9 alpha 0.2

Prof. Rath Session 2 – Forecasting (1) 35

 Why Not Use An Extremely Responsive Forecast?

No Change in Mean Demand Forecast reaction?

160 • How will the following
140
forecasts react
120
• Moving Average
• n=2
100
• n=7
80
• Exponential smoothing
60
• α=0.9
40
• α=0.2
20

0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Demand

Prof. Rath Session 2 – Forecasting (1) 36

 Forecast Parameter Influences Stability to Random
Fluctuations

Moving Average Exponential Smoothing

160 160

140 140

120 120

100 100

80 80

60 60

40 40

20 20

0 0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Demand MA 2 MA 7 Demand alpha 0.9 alpha 0.2

Prof. Rath Session 2 – Forecasting (1) 37

 Responsiveness vs. Stability: Trade-off

Responsiveness: Ability of forecast to respond quickly to a

true change in mean level demand

small n large α

Moving Average Exponential Smoothing

large n small α

Stability: Ability of forecast to ignore random variations

Prof. Rath Session 2 – Forecasting (1) 38

Prof. Rath Session 2 – Forecasting (1) 39
 Measuring Forecast Errors

▪ All measures start with per period forecast error

▪ 𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡 𝐸𝑟𝑟𝑜𝑟𝑡 = 𝐷𝑒𝑚𝑎𝑛𝑑𝑡 − 𝐹𝑜𝑟𝑐𝑎𝑠𝑡𝑡

▪ 𝑒𝑡 = 𝐴𝑡 − 𝐹𝑡

▪ Four measures of forecast errors

– Mean Forecast Error
– Mean Absolute Deviation
– Mean Absolute Percentage Error
– Mean Squared Error

Prof. Rath Session 2 – Forecasting (1) 40

 Measuring Forecast Errors:
Mean Forecast Error (MFE)

Period Demand (𝑨𝒕 ) Forecast (𝑭𝒕 ) Error (𝒆𝒕 )

1 130 - -

2 155 130.00 25.00 25= 155-130

3 145 155.00 -10.00 -10 = 145-155

4 160 145.00 15.00

5 151 160.00 -9.00

6 143 151.00 -8.00
Mean Forecast (25+(-10)+15+(-9)+(-

Error = 2.60 8))/5=

2.60

Prof. Rath Session 2 – Forecasting (1) 41

 Measuring Forecast Errors:
Mean Absolute Deviation (MAD)

Absolute
Period Demand (𝑨𝒕 ) Forecast (𝑭𝒕 ) Error (𝒆𝒕 )
Error
1 130 - - -

2 155 130.00 25.00 25.00

3 145 155.00 -10.00 10.00

4 160 145.00 15.00 15.00

5 151 160.00 -9.00 9.00

6 143 151.00 -8.00 8.00
MAD = 13.40

Prof. Rath Session 2 – Forecasting (1) 42

 Measuring Forecast Errors:
Mean Absolute Percentage Error (MAPE)

Abs %
Period Demand (𝑨𝒕 ) Forecast (𝑭𝒕 ) Error (𝒆𝒕 ) % Error
Error
1 130 - - - -

2 155 130.00 25.00 =25/155=16.13% 16.13%

3 145 155.00 -10.00 =-10/145=-6.90% 6.9%

4 160 145.00 15.00 =15/160=9.38% 9.38%

5 151 160.00 -9.00 =-9/151=-5.96% 5.96%

6 143 151.00 -8.00 =-8/143=-5.59% 5.59%
MAPE 8.79%

Prof. Rath Session 2 – Forecasting (1) 43

 Measuring Forecast Errors:
Mean Squared Error (MSE)
Squared
Period Demand (𝑨𝒕 ) Forecast (𝑭𝒕 ) Error (𝒆𝒕 )
Error
1 130 - - -
𝟐𝟓𝟐
2 155 130.00 25.00 625.00 = 𝟔𝟐𝟓

−𝟏𝟎 𝟐
3 145 155.00 -10.00 100.00 = 𝟏𝟎𝟎

4 160 145.00 15.00 225.00

5 151 160.00 -9.00 81.00

6 143 151.00 -8.00 64.00

(625+100
MSE = 219.00 +225+81+
64)/5=219

Prof. Rath Session 2 – Forecasting (1) 44

 MAD vs. MSE
▪ MSE penalizes large errors while MAD treats all
errors equally.

▪ If a manager prefers a forecasting method that

generates small frequent forecasting errors over
than one that generates large infrequent errors
(obviously, everyone likes small and infrequent
errors and no one likes large and frequent errors),
which approach should he use to measure
forecasting errors? MAD or MSE?

Prof. Rath Session 2 – Forecasting (1) 45

 Summary
▪ Poor forecasting costs money!!!
▪ Time Series Methods for demand fluctuating about a mean
- Naïve
- Simple Average
- Simple Moving Average
- Weighted Moving Average
- (Simple) Exponential Smoothing
▪ Responsiveness vs. Stability trade-off
▪ Measures of Forecast Errors
- MFE
- MAD
- MSE
- MAPE

Prof. Rath Session 2 – Forecasting (1) 46

 For Next Session...
▪ Forecasting (cont’d)
Chapter 9 pp. 188-192

Prof. Rath Session 2 – Forecasting (1) 47

 Appendix: Exponential Smoothing Forecast (you will
not be tested on this)
Why is
𝐹𝑡+1 = 𝛼𝐴𝑡 + 1 − 𝛼 𝐹𝑡
The same as
𝑡

𝐹𝑡+1 = ෍ 𝑤𝑡−𝑖 𝐴𝑡−𝑖

𝑖=0

𝐹𝑡+1 = 𝛼𝐴𝑡 + 1 − 𝛼 𝐹𝑡 (1)

𝐹𝑡 = 𝛼𝐴𝑡−1 + 1 − 𝛼 𝐹𝑡−1 (2)

Substitute 𝐹𝑡 in (1)
𝐹𝑡+1 = 𝛼𝐴𝑡 + 𝛼 1 − 𝛼 𝐴𝑡−1 + 1 − 𝛼 2 𝐹𝑡−1 (3)
And so on…

Prof. Rath Session 2 – Forecasting (1) 48