Forecasting Horizons

Long Term
y 5+ years into the future y R&D, plant location, product planning y Principally judgement-based

Medium Term
y 1 season to 2 years y Aggregate planning, capacity planning, sales forecasts y Mixture of quantitative methods and judgement

Short Term
y 1 day to 1 year, less than 1 season y Demand forecasting, staffing levels, purchasing, inventory levels y Quantitative methods

Short Term Forecasting: Needs and Uses

Scheduling existing resources
y How many employees do we need and when? y How much product should we make in anticipation of demand?

Acquiring additional resources

y When are we going to run out of capacity? y How many more people will we need? y How large will our back-orders be?

Determining what resources are needed

y What kind of machines will we require? y Which services are growing in demand? declining? y What kind of people should we be hiring?

Types of Forecasting Models

Types of Forecasts
y Qualitative --- based on experience, judgement, knowledge; y Quantitative --- based on data, statistics;

Methods of Forecasting
y Naive Methods --- eye-balling the numbers; y Formal Methods --- systematically reduce forecasting errors; time series models (e.g. exponential smoothing); causal models (e.g. regression). y Focus here on Time Series Models

Assumptions of Time Series Models

y There is information about the past; y This information can be quantified in the form of data; y The pattern of the past will continue into the future.

Forecasting Examples
Examples from student projects:
y y y y

Demand for tellers in a bank; Traffic on major communication switch; Demand for liquor in bar; Demand for frozen foods in local grocery warehouse.

Example from Industry: American Hospital Supply Corp.

y y y y y

70,000 items; 25 stocking locations; Store 3 years of data (63 million data points); Update forecasts monthly; 21 million forecast updates per year.

Simple Moving Average

Forecast Ft is average of n previous observations or actuals Dt :

Ft 1 Ft 1

1 ! ( Dt  Dt 1  .  Dt 1n ) n 1 t D ! n i n i !t 1

Note that the n past observations are equally weighted. Issues with moving average forecasts:
y y y y

All n past observations treated equally; Observations older than n are not included at all; Requires that n past observations be retained; Problem when 1000's of items are being forecast.

Simple Moving Average

Include n most recent observations Weight equally Ignore older observations
weight
1/n

...

today

Moving Average
Internet Unicycle Sales
450 400 350 300 250 200 150 100 50 0
Apr-01 Sep-02 Jan-04 May-05 Oct-06 Feb-08 Jul-09 Nov-10 Apr-12 Aug-13

n=3

Units

Month

Example:

Moving Average Forecasting

Exponential Smoothing I
Include all past observations Weight recent observations much more heavily than very old observations:
weight Decreasing weight given to older observations

today

Exponential Smoothing I
Include all past observations Weight recent observations much more heavily than very old observations:

0 E 1
weight Decreasing weight given to older observations

today

Exponential Smoothing I
Include all past observations Weight recent observations much more heavily than very old observations:

0 E 1
weight Decreasing weight given to older observations

E E(1  E)

today

Exponential Smoothing I
Include all past observations Weight recent observations much more heavily than very old observations:

0 E 1
weight

Decreasing weight given to older observations

E E(1  E) E(1  E) 2

today

Exponential Smoothing: Concept

Include all past observations Weight recent observations much more heavily than very old observations:

0 E 1
weight

Decreasing weight given to older observations

E E(1  E) E(1  E) 2 E(1  E)

today
3

Exponential Smoothing: Math

Ft ! EDt  E (1  E ) Dt 1  E (1  E ) Dt 2  . Ft ! EDt  (1  E )? Dt 1  E (1  a ) Dt 2  . E
2

Exponential Smoothing: Math

Ft ! EDt  E (1  E ) Dt 1  E (1  E ) Dt 2  . Ft ! EDt  (1  E )? Dt 1  E (1  a ) Dt 2  . E
2

Ft ! aDt  (1  a ) Ft 1

Exponential Smoothing: Math

Ft ! aDt  a (1  a ) Dt 1  a (1  a ) 2 Dt 2  . Ft ! aDt  (1  a ) Ft 1
Thus, new forecast is weighted sum of old forecast and actual demand Notes:
y Only 2 values (Dt and Ft-1 ) are required, compared with n for moving average y Parameter a determined empirically (whatever works best) y Rule of thumb: E < 0.5 y Typically, E = 0.2 or E = 0.3 work well

Forecast for k periods into future is:

Ft  k ! Ft

Exponential Smoothing
I
450 400 350 300 Units 250 200 150 100 50 0
Jan-03 May-04 Sep-05 Feb-07 Jun-08 Nov-09 Mar-11 Aug-12

(1000' )

E= 0.2

Month

Example:

Exponential Smoothing

Complicating Factors
Simple Exponential Smoothing works well with data that is moving sideways (stationary) Must be adapted for data series which exhibit a definite trend Must be further adapted for data series which exhibit seasonal patterns

Holts Method:

Double Exponential Smoothing

What happens when there is a definite trend?
A trendy clothing boutique has had the following sales over the past 6 months: 1 2 3 4 5 6 510 512 528 530 542 552

560 550 540 Demand530 520 510 500 490 480 1 2 3

Actual Forecast

10

Month

Holts Method:

Double Exponential Smoothing

Ideas behind smoothing with trend:
y ``De-trend'' time-series by separating base from trend effects y Smooth base in usual manner using E y Smooth trend forecasts in usual manner using F

Smooth the base forecast Bt

Bt ! EDt  (1  E )( Bt 1  Tt 1 )
Smooth the trend forecast Tt

Tt ! F ( Bt  Bt 1 )  (1  F )Tt 1
Forecast k periods into future Ft+k with base and trend

Ft  k ! Bt  kTt

ES with Trend
Inte net Unicycle ales (
450 400 350 300 Units 250 200 150 100 50 0
Jan-03 ay-04 Sep-05 Feb-07 Jun-08 No -09 ar-11 Aug-12

's)

E= 0.2, F= 0.4

Month

Example:

Exponential Smoothing with Trend

Winters Method:

Exponential Smoothing w/ Trend and Seasonality

Ideas behind smoothing with trend and seasonality:
y De-trend: and de-seasonalizetime-series by separating base from trend and seasonality effects y Smooth base in usual manner using E y Smooth trend forecasts in usual manner using F y Smooth seasonality forecasts using K

Assume m seasons in a cycle

y y y y

12 months in a year 4 quarters in a month 3 months in a quarter et cetera

Winters Method:

Exponential Smoothing w/ Trend and Seasonality

Smooth the base forecast Bt

Dt Bt ! E  (1  E )( Bt 1  Tt 1 ) St m
Smooth the trend forecast Tt

Tt ! F (

t 1

)  (1  F )Tt 1

Smooth the seasonality forecast St

Dt St ! K  (1  K ) St m Bt

Winters Method:

Exponential Smoothing w/ Trend and Seasonality

Forecast Ft with trend and seasonality

Ft  k ! ( Bt 1  kTt 1 ) St  k m
Smooth the trend forecast Tt

Tt ! F (Bt  Bt 1)  (1  F )Tt 1

Smooth the seasonality forecast St

Dt St ! K  (1  K ) St m Bt

ES with Trend and Seasonality

Inte net Unicycle ales (
500 450 400 350 300 Units 250 200 150 100 50 0
Jan-03 ay-04 Sep-05 Feb-07 Jun-08 No -09 ar-11 Aug-12

's)

E= 0.2, F= 0.4, K= 0.6

Month

Example:

Exponential Smoothing with Trend and Seasonality

Forecasting Performance
How good is the forecast? Mean Forecast Error (MFE or Bias): Measures average deviation of forecast from actuals. Mean Absolute Deviation (MAD): Measures average absolute deviation of forecast from actuals. Mean Absolute Percentage Error (MAPE): Measures absolute error as a percentage of the forecast. Standard Squared Error (MSE): Measures variance of forecast error

Forecasting Performance Measures

1 n MFE ! ( Dt  Ft ) n t !1
1 MAD ! Dt  Ft n t!1
100 Dt  Ft MAPE ! D n t !1 t
n n

1 MSE ! n

(D
t !1

 Ft )

Mean Forecast Error (MFE or Bias)

1 n MFE ! ( Dt  Ft ) n t !1
Want MFE to be as close to zero as possible -minimum bias A large positive (negative) MFE means that the forecast is undershooting (overshooting) the actual observations Note that zero MFE does not imply that forecasts are perfect (no error) -- only that mean is on target Also called forecast BIAS

Mean Absolute Deviation (MAD)

1 n MAD ! n t !1

Measures absolute error Positive and negative errors thus do not cancel out (as with MFE) Want MAD to be as small as possible No way to know if MAD error is large or small in relation to the actual data

Mean Absolute Percentage Error (MAPE)

100 Dt  Ft MAPE ! D n t !1 t
Same as MAD, except ... Measures deviation as a percentage of actual data
n

Mean Squared Error (MSE)

n

MS

(D n
t!

 Ft )

Measures squared forecast error -- error variance Recognizes that large errors are disproportionately more expensive than small errors But is not as easily interpreted as MAD, MAPE -- not as intuitive

Fortunately, there is software...