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Why Forecast?

Assess long-term capacity needs


Develop budgets, hiring plans, etc.
Plan production or order materials
Get agreement within firm and
across supply chain partners

Types of Forecasts
Demand
Firm-level
Market-level

Supply
Materials
Labor supply

Price
Cost of supplies and services
Cost of money interest rates, currency
rates
Market price for firms product or service

Forecast Laws

Almost always wrong by some


amount

More accurate for shorter time


periods

More accurate for groups or families


No substitute for calculated values.

Forecasting Approaches
Qualitative Methods

Quantitative Methods

Used when situation is


vague and little data
exists

Used when situation is


stable and historical
data exists

New products
New technology

Involves intuition,
experience
************************
*****
E.g., forecasting sales
to a new market

Existing products
Current technology

Heavy use of
mathematical
techniques
**************************
*****
E.g., forecasting sales of
a mature product

Qualitative Forecasting
Executive opinions
Sales force composite
Consumer surveys
Outside opinions
Delphi method
Life cycle analogy*

Demand Forecasting
Uses historical data
Basic time series models
Linear regression
For time series or causal
modeling

Measuring forecast accuracy

Time Series Models


Period
1
2
3
4
5
6
7
8

Demand
12
15
11
9
10
8
14
12

What assumptions
must we make to
use this data to
forecast?

Time Series Components of


Demand . . .
Demand

. . . randomness

Time

Time Series with . . .


Demand

. . . randomness and trend

Time

Time series with . . .


Demand

. . . randomness, trend, and seasonality

May

May

May

May

Idea Behind Time Series


Models
Distinguish between random
fluctuations and true changes
in underlying demand
patterns.

Averaging Methods
generates a forecast for a particular
time period by averaging the
observed data values(that is the
actual values of the dependent
variable) for the most recent n time
periods.
Two versions of this method are:
simple moving averages and
weighted moving averages.

Simple Moving Average


Model
Moving Average Model A time
series forecasting model that derives
a forecast by taking an average of
recent demand value.
Smoothes out random fluctuations
n
of
Dt 1i

data
Ft 1 i 1
n
Best for short term forecasts
in the
absence of seasonal or cyclical
variations

Simple Moving Average


Models
Period
1
2
3
4
5
6
7
8

Demand
12
15
11
9
10
8
14
12

Ft 1

Dt 1i

i 1

3-period moving average


forecast for Period 8:
=
=

(14 + 8 + 10) / 3
10.67

Weighted Moving Averages


Weighted Moving Average Model A
form of the moving average model
that allows the actual weights
applied to past observations to differ.
Weights are used to vary the effect of
past data, based on the fact that
more recent data is more important,
the weights should go up and always

Weighted Moving Averages


n

Wt 1i Dt 1i

Ft 1 i 1

Wt 1i

i 1

Forecast for Period 8


=
[(0.5 14) + (0.3 8) + (0.2 10)] / (0.5 + 0.3 + 0.2)
=
11.4
What are the advantages?
What do the weights add up to?
Could we use different weights?
Compare with a simple 3-period moving average.

Table of Forecasts and


Demand Values . . .
Period

Actual
Demand

Two-Period
Moving
Average
Forecast

Three-Period Weighted
Moving Average
Forecast Weights = 0.5,
0.3, 0.2

12

15

11

13.5

13

12.4

10

10

10.8

9.5

9.9

14

8.8

12

11

11.4

13

11.8

. . . and Resulting Graph

Note how the forecasts smooth out demand variations

Exponential Smoothing
Sophisticated weight averaging model
In fact, exponential smoothing is a short
name for an exponentially weighted
moving average that require only three
pieces of data:
Ft = Forecast for the current period t
Dt = Actual demand for the current period t
= Weight between 0 and 1 (smoothing constant)

Simple Exponential
Smoothing
Formula

Ft+1
+ (1

= Ft + (Dt Ft) = Dt

Ft

Where did the current forecast come from?


What happens as gets closer to 0 or 1?
Where does the very first forecast come from?

Exponential Smoothing
Forecast with = 0.3
Period

Actual
Demand

Exponential
Smoothing
Forecast

12

11.00

15

11.30

11

12.41

11.99

10

11.09

10.76

14

9.93

12

11.15

11.41

F2 = 0.312 + 0.711
= 3.6 + 7.7
= 11.3

F3 = 0.315 + 0.711.3
= 12.41

Resulting Graph

Trends

What do you think will happen to a


moving average or exponential
smoothing model when there is a
trend in the data?

Same Exponential Smoothing


Model as Before:
Period

Actual
Demand

Exponential
Smoothing
Forecast

11

11.00

12

11.00

13

11.30

14

11.81

15

12.47

16

13.23

17

14.06

18

14.94

15.86

Since the model


is based on
historical demand,
it always lags
the obvious
upward trend

Adjusting Exponential Smoothing


for Trend
Add trend factor and adjust using exponential
smoothing
Needs only two more numbers:
Tt = Trend factor for the current period t
= Weight between 0 and 1
Then: Tt+1 = (Ft+1 Ft) + (1 ) Tt
And the Ft+1 adjusted for trend is = Ft+1 + Tt+1

Measuring Forecast
Accuracy
How do we know:
If a forecast model is best?
If a forecast model is still working?
What types of errors a particular
forecasting model is prone to make?
Need measures of forecast accuracy

Measures of Forecast
Accuracy
Error = Actual demand Forecast
or

Et = Dt Ft

Mean Forecast Error (MFE)


For n time periods where we have
actual demand and forecast values:

MFE

Ei

i 1

Mean Absolute Deviation


(MAD)
For n time periods where we have
actual demand and forecast values:

MAD

Ei

i 1

What does this tell us that MFE doesnt?

Example
Period Demand Forecast
3
4
5
6
7
8

11
9
10
8
14
12

13.5
13
10
9.5
9
11

Error
-2.5
-4.0
0
-1.5
5.0
1.0

Absolute
Error
2.5
4.0
0.0
1.5
5.0
1.0

What is the MFE? The MAD? Interpret!

MFE and MAD:


A Dartboard Analogy

Low MFE and MAD:


The forecast errors
are small and unbiased

An Analogy (continued)
Low MFE, but high
MAD:
On average, the
darts hit the
bulls eye (so much
for averages!)

An Analogy (concluded)

High MFE and MAD:


The forecasts
are inaccurate and
biased