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Lecture 2: Forecasting

Learning Objectives
What you will learn in this lecture:

I see that you will get an A this semester.

Demand Management Qualitative Forecasting Methods Quantitative Forecasting Methods Forecasting Error Estimation

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Demand Management
Independent Demand: Finished Goods
A

Independent Demand: What a firm can do to manage it?

Can take an active role to influence demand

B(4)

C(2)

Dependent Demand: Raw Materials, C Component t parts, t Sub-assemblies, etc.

Can take a passive role and simply respond to

demand

D(2)

E(1)

D(3)

F(2)

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Forecast
A statement about the future Used to help managers
Plan the system Plan the use of the system

Uses of Forecasts
Accounting Finance Human Resources Marketing Operations Product/service design Cost/profit estimates Cash flow and funding Hiring/recruiting/training Pricing, promotion, strategy Schedules, workloads, inventory planning Modification of current features, design new products and services

It affects decisions and activities throughout an

organization

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Some Useful Facts about Forecasting

Assumes causal system past ==> future Forecasts rarely perfect because of randomness Forecasts more accurate for groups vs. vs
individuals Forecast accuracy decreases as time horizon increases

Elements of a Good Forecast

Timely

Reliable

Accurate

Written

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Steps in the Forecasting Process

Types of Forecasts
Qualitative (Judgmental)

The forecast

Quantitative
Step 6 Monitor the forecast Step 5 Prepare the forecast Step 4 Gather and analyze data Step 3 Select a forecasting technique Step 2 Establish a time horizon Step 1 Determine purpose of forecast

Time Series Analysis Causal Relationships/Associative

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Qualitative Methods

Delphi Method
l. Choose the experts to participate representing a
variety of knowledgeable people in different areas 2. Through a questionnaire (or E-mail), obtain forecasts (and any premises or qualifications for the forecasts) from all participants 3. Summarize the results and redistribute them to the participants along with appropriate new questions 4. Summarize again, refining forecasts and conditions, and again develop new questions 5. Repeat Step 4 as necessary and distribute the final results to all participants

Executive Judgment

Grass Roots

Historical analogy

Qualitative Methods

Market Research

Delphi Method

Panel Consensus

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Quantitative Forecasting Methods

Time Series Analysis
Simple Moving Average Weighted Moving Average Exponential Smoothing Technique Simple Linear Regression

Time Series Analysis

Time series forecasting models try to predict the
future based on past data

You can pick models based on:

1. Time horizon to forecast 2. Data availability 3. Accuracy required 4. Size of forecasting budget 5. Availability of qualified personnel

Causal Analysis/Associative Techniques

Simple Linear Regression Multiple Linear Regression

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Components of Demand
Analysis of time series data requires the
analyst to identify the underlying behavior of the series

Finding Components of Demand

Seasonal variation

Can be accomplished by plotting the data

Sales s
and visually examining the plot

x x x x x xx x x xx x x x x x x x x x x x x xx x x x x x x x x x x x

Linear
x x x

Trend

Different patterns might appear

o Average demand for a period of time o Trend o Seasonal element o Cyclical element o Random variation

x x x x x 1

x x

Year
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Simple Moving Average (SMA)

The simple moving average model assumes an average is
a good estimator of future behavior

Simple Moving Average Problem

Ft =
Week 1 2 3 4 5 6 7 8 9 10 11 12 Demand 650 678 720 785 859 920 850 758 892 920 789 844

The formula for the simple moving average is:

A t-1 + A t-2 + A t-3 +...+A t- n n

Ft =

A t-1 + A t-2 + A t-3 +...+A t- n n

Question: What are the 3g week and 6-week moving average forecasts for demand? Assume you only have 3 weeks and 6 weeks of actual demand data for the respective forecasts
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Ft =Forecastforthecomingperiod N=Numberofperiodstobeaveraged At1 =Actualoccurrenceinthepastperiodfor uptonperiods

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Simple Moving Average Problem

Week 1 2 3 4 5 6 7 8 9 10 11 12 Demand 3-Week 6-Week F4=(650+678+720)/3 650 =682.67 678 F7=(650+678+720 720 +785+859+920)/6 785 682.67 =768.67 859 727.67 920 788 00 788.00 850 854.67 768.67 758 876.33 802.00 892 842.67 815.33 920 833.33 844.00 789 856.67 866.50 844 867.00 854.83
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Simple Moving Average Problem

Plotting the moving averages and comparing them shows how the lines smooth out to reveal the overall upward trend in this example

Note how the 3Week is smoother than the Demand, and 6-Week is even smoother

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Weighted Moving Average (WMA)

While the moving average formula implies an equal weight being placed on each value that is being averaged, the weighted moving average permits an unequal weighting on prior time periods The formula for the moving average is:

Weighted Moving Average Problem Data

Question: Given the weekly demand and weights, what is the forecast for the 4th period or Week 4?

Ft = w 1 A t-1 + w 2 A t-2 + w 3 A t-3 + ...+ w n A t- n

wt = weight given to time period t occurrence (weights must add to one)
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Week 1 2 3 4

Demand 650 678 720

Weights: t1 .5 t2 .3 t3 .2

w
i=1

=1

Note that the weights place more emphasis on the most recent data, that is time period t-1

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Weighted Moving Average Problem Solution

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).

Week 1 2 3 4

Demand 650 678 720

Forecast

693.4

WMA is better than SMA because of the ability to vary the weights!

F4 =0.5(720)+0.3(678)+0.2(650)=693.4

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Exponential Smoothing Model Ft = Ft-1 + (At-1 - Ft-1)

Forecasting error

Exponential Smoothing Problem

Week 1 2 3 4 5 6 7 8 9 10 Demand 820 775 680 655 750 802 798 689 775

Where : Ft Forcast value for the coming t time period Ft - 1 Forecast value in 1 past time period At - 1 Actual occurance in the past 1 time period Alpha smoothing constant

Premise: The most recent observations might have the highest predictive value Therefore, we should give more weight to the more recent time periods when forecasting

Question: Given the weekly demand data, what are the exponential smoothing forecasts for periods 2-10 using =0.10 and =0.60? Assume F1=D1

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Exponential Smoothing Problem

Answer: The respective alphas columns denote the forecast values. Note that you can only forecast one time period into the future.

Exponential Smoothing Problem

Note how that the smaller alpha results in a smoother line in this example

Week 1 2 3 4 5 6 7 8 9 10
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Demand 820 775 680 655 750 802 798 689 775

0.1 820.00 820.00 815.50 801.95 787.26 783.53 785.38 786.64 776.88 776.69

0.6 820.00 820.00 793.00 725.20 683.08 723.23 770.50 787.00 728.20 756.30
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Why use exponential smoothing?

1. Uses less storage space for data 2. Extremely accurate 3. Easy to understand 4. Little calculation complexity

Alpha in Exponential Smoothing

Selection of is a matter of judgment or trial and error
(forecast errors guide the decision)

The goal is to select a smoothing constant that benefits

of smoothing random variations responding to real changes with benefits of

Commonly used values for : 0.050 05 0.5 05 represents a percentage of forecast error The closer the value of is to zero, the slower the forecast will be to adjust the forecast errors the greater
the smoothing

The closer the value of is to 1, the greater the responsiveness the less the smoothing
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Techniques for Trend

Simple Linear Regression Model

Y

What do you think will happen to a moving average or exponential smoothing model when there is a trend in the data?

The simple linear regression model seeks to fit a line through various data over time

012345x (Time)

Yt =a +bx
i yi - Yi
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Is the linear regression model

Where: is the error y is the observed value Y is the predicted value

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Simple Linear Regression

Formulas for Calculating a and b:

Simple Linear Regression Problem

Question: Given the data below, what is the simple linear regression model that can be used to predict sales in future weeks?

a = y - bx
x y - n ( y )( x ) x
2

b =

- n(x )2

Assumptions Variations around the line are random Deviations around the line should be normally distributed Predictions are being made only within the range of observed values Limitations Can be applied only to linear relationships with one independent variable Needs considerable amount of data Equal weightage on each data

Week 1 2 3 4 5
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Sales 150 157 162 166 177

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Simple Linear Regression Problem

Week 1 2 3 4 5 3 Average Week*Week 1 4 9 16 25 55 Sum Sales Week*Sales 150 150 157 314 162 486 166 664 177 885 162.4 2499 Average Sum

Simple Linear Regression Problem

Theresultingregressionmodel is:

Yt =143.5+6.3x

Nowifweplottheregressiongeneratedforecastsagainsttheactualsalesweobtain thefollowingchart: 180 175 170 165 160 155 150 145 140 135 1 2 3 Period 4 5

Sales

Sales Forecast

b=

xy - n(y)(x) = 2499 - 5(162.4)(3) 63 = 6.3 55 5(9 ) 10 x - n(x )

2 2

a = y - bx = 162.4 - (6.3)(3) = 143.5

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Causal Relationship Forecasting

The technique relies on identification of related variables
that can be used to predict values of the variable of interest predictor variables.

Example: Causal Relationship Forecasting

Number of housing starts
Year 1989 1990 1991 1992 1993 1994 1995 1996 1997 Permits 18 15 12 10 20 28 35 30 20 Sales
(In Sq. Yds)

x = Number of housing
start permits

Forecasting independent variable must be a leading

indicator

13,000 12 000 12,000 11,000 10,000 14,000 16,000 19,000 17,000 13,000

y = Sales of carpeting p g

Example: An extended period of rain increases sales of

umbrellas and raincoats a causal relationship

First step in this type of forecasting is to find the

occurrences that are really the causes

The primary method of analysis is known as regression

analysis.
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Multiple linear regression

Example: Multiple linear regression

Factors in heating cost for a sample of 13 homes
Home Heating cost $250 360 165 43 92 200 355 290 230 120 73 205 400 Mean outside temp (F) 35 29 36 60 65 30 10 7 21 55 54 48 20 Attic insulation (inches) 3 4 7 6 5 5 6 10 9 2 12 5 5 Age of furnace (years) 6 10 3 9 6 5 7 10 11 5 4 1 15

Y a b1 x1 b2 x2 b3 x3 ...
'

a intercept, the value of y when all the x' s are zero b j amount by which y changes when the particular x j increases by one unit with all other values held the same
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Forecast Accuracy
It is a significant factor if the task is to decide among
available forecasting alternatives

Formulas: Forecast Accuracy

MAD = MSE=
Actual
t

Forecast t n

Three commonly used measures are:

Mean Absolute Deviation (MAD) Mean Squared Error (MSE) Mean Absolute Percent Error (MAPE)

Actual

Forecastt

n 1

MAPE=

Actualt Forecast t 100 Actualt n

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Forecast Accuracy

Forecast Accuracy Example Problem

Compute MAD, MSE, and MAPE for the following data:

MAD weights all errors evenly MSE weights errors according to their squared values MAPE weights according to relative error
Period 1 2 3 4 5 6 7 8 Actual 217 213 216 210 213 219 216 212 Forecast 215 216 215 214 211 214 217 216

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Which forecasting method should you use?

Gather the historical data of what you want to
forecast

Assignment-2

Factors in heating cost for a sample of 25 homes (13

Data points are given, fabricate 12 more). Fit a multiple regression equation for heating cost. Explain the equation.

Divide data into initiation set and evaluation set Use U the th first fi t set t to t develop d l the th models d l Use the second set to evaluate Compare the MADs, MSEs, and MAPEs of each
model

Problems: P bl 2 3, 2, 3 5, 5 7, 7 26

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