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Lecture 8: Forecasting

Outline

I. Perspectives

II. Forecasting techniques

III. Time series

IV. Summary
I. Perspectives

- Forecasts required for operation decisions

* Process
* Capacity
* Inventory

- Forecasting versus planning

* Initial Forecast: What will happen in future?

* Plan : What you wish to happen in future?


: Incorporate the effects of planned
actions to produce the “final” forecast.

- Why Forecast?

Decisions and actions during the Speculation Horizon are based on


anticipated orders.

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- Facts of forecasts

* Forecasts are almost always wrong

* Forecast should include three numbers

* Forecasts are more accurate for product families

* Forecasts are less accurate further out

* Stop looking for a magical way to better forecasts, but to


plan and work more effectively with imperfect forecasts

- Five ways to better forecasts and plans

* Reduce lead time

* Force a match between plan and reality

* Simplify your product line

* Standardize your component and process requirement

* Forecast more accurately

- Three ways to cope with forecast errors

1. Safety stock
2. Safety lead time
3. Excess capacity

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II. Forecasting techniques:

* Qualitative – Experts’ opinions, Market surveys

* Quantitative – Time series, Regression

III. Time Series

Demand pattern is decomposed into components:

* Level or Trend
* Seasonal effects
* Cycle
* Random effects

Forecasts are then made by projecting the components into the future.

Months

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1. Simple N-period Moving Averages

- Good for demand with level and random components

- Average demand at time t is estimated from actual demands over the


most recent N periods

At = (Dt+Dt-1+....+Dt-N+1)/N

- Since demand is level, the best forecast for t+1 is

Ft+1= At

Exercise 1: Forecast using a 3-period moving averages:

Period Dt At Ft Dt-Ft

1 10
2 18
3 29
4 15
5 10
6

Above, we forecast only one period ahead

If current time t=4, A4=20.7

F5=
F6=

When t=5, actual demand D5 is known, so new A5=

F6=

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2. Weighted N-period Moving Averages

- Good for demand with level and random components

- Use weights wi to control responsiveness to demand changes

At = (w1Dt+w2Dt-1+. . .+wNDt-N+1)

with the condition that

(w1 + w2 + . . + wN)=1

- Since demand is level, the best forecast for t+1 is

Ft+1= At

- Example:

w1=0.5, w2=0.3, w3=0.2

Heavier weights to recent past demands


Forecast more responsive to recent demand changes

w1=0.2, w2=0.3, w3=0.5


Lighter weights to recent past demands
Less responsive, but more stable

w1=1/3, w2=1/3, w3=1/3


Equivalent to 3-period simple moving averages model

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Exercise 2:

In Victoria Street, the number of daily calls from students has been
recorded as follows:

October Calls

1 92
2 127
3 103
4 165
5 132
6 111
7 174
8 94

a. Prepare a 3-period moving average forecast. What is the forecast error


on each day?

b. Prepare a 3-period weighted moving average forecast with w1=0.2,


w2=0.3, and w3=0.5. What is the forecast error on each day?

c. Which of the two forecasts is better?

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How do you choose the right forecast model?

a. Mean Bias (Mean Forecast Error)

N
MFE = ∑(Dt-Ft )/N
t=1

MFE measures the mean forecast error per period

MFE = +ve implies underestimate


= -ve implies overforecast

Problem with MFE:

b. Mean Absolute Deviation (MAD)

N
MAD = ∑|Dt-Ft |/N
t=1

MAD measures average absolute size of forecast errors

Problem with MAD:

* A forecast model with lower MFE and MAD is obviously better

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How do you monitor the chosen model over time?

a. Tracking Signal Tt

Tt = Cumulative sum of forecast errors


MAD

t
Tt = ∑ (Di-Fi)/MADt
i=1

** Use to track, i.e. monitor, closeness of forecast to demand

We often conclude that model is not well when Tt falls


outside + 3 even though there is a chance of 2% that Tt can
fall outside +3 when model is working well

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3. Simple Exponential Smoothing

- Good for demand with level and random components

- New exponentially smoothed average demand At is estimated from the


previous average demand At-1 and the most recent demand Dt

- Dt is known at the end of period t, so compute At at the end of period t

At= ∝Dt+(1-∝)At-1

- Forecast for period t+1

Ft+1= At

- Use a larger ∝ implies Ft+1 biases to Dt

- Use a smaller ∝ implies Ft+1 biases to At-1

- Generally 0.1<∝<0.3 is used.

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Exercise 3: Forecast using simple exponential smoothing and ∝=0.3:

Period Dt At Ft Dt-Ft

0 - A0=15(Assume)

1 10

2 18

3 29

4 15

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4. Enhanced Exponential Smoothing with Trend

- Good for demand pattern with a trend

- New average At computed from Dt, At-1 and Tt-1:

At= ∝Dt+(1-∝)(At-1+Tt-1)

Tt= ß(At-At-1)+(1-ß)Tt-1

∝= average smoothing constant


ß= trend smoothing constant

** Tt is one "unit of trend"

Procedure:

Initial estimates of A0 and T0 required

Step 1: With current Dt known, update At

Step 2: With At, update Tt

Step 3: Using the most current At and Tt, forecast the future demands for
time t+1, t+2, ...., and t+k

Ft+1=At+Tt

Ft+2=At+2.Tt
:
:
:
Ft+k=At+k.Tt

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Exercise 4:

A0= 70, T0=15, ∝= 0.1 and ß= 0.1

t Dt At Tt Ft

1 85

2 105

3 112

4 132

5 145

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5. Enhanced Exponential Smoothing with Trend and Seasonal effects

- Good for demand pattern with a trend and seasonal effects

- To calculate At, Dt must be adjusted to remove the seasonal effect by


dividing Dt by its seasonal index Rt-L

At= ∝(Dt/Rt-L)+(1-∝)(At-1+Tt-1)

Tt= ß(At-At-1)+(1-ß)Tt-1

Rt= φ (Dt/At)+(1- φ)Rt-L

where

∝ = average smoothing constant


ß = trend smoothing constant
φ = season smoothing constant
L = number of seasons in one seasonal cycle

Example:

If DMon is often lower than other days, RMon is less than 1


If DSun is often higher than other days, RSun is larger than 1
L= 7 days

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Procedure:

Initial estimates of A0, T0, R0, R-1,... R-L+1 are assumed

Step 1: With current Dt known, update At

Step 2: With At, update Tt

Step 3: With At, update Rt

* Periods t and t-L have the same season

Step 3: Using the most current At and Tt and the appropriate seasonal
indices, forecast the future demand for time t+k as

Ft+k = (At + k.Tt) Rt+k-L

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Exercise 5: Given the following, develop a forecast

Season t Dt At Tt Rt Ft

A -1 - - - 0.8 -
B 0 - 70 10 1.2 -
A 1 66
B 2 106
A 3
B 4

∝= 0.2 At= ∝(Dt/Rt-L)+(1-∝)(At-1+Tt-1)


ß = 0.2 Tt= ß(At-At-1)+(1-ß)Tt-1
φ = 0.2 Rt= φ(Dt/At)+(1- φ)Rt-L
L=2

Ft+k= (At+k.Tt)Rt+k-L

At t=1, D1=66,

A1 =
=
=

T1 =
=
=

R1 =
=
=

F2 =
=
=

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At t=2, D2=106,

A2 =
=
=

T2 =
=
=

R2 =
=
=

F3 =
=
=

F4 =

F5 =

F6 =

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IV. Summary

Steps in forecasting

1. Given the past demand data, plot data and decide on which models to
try fitting

2. Fit different models

3. Finally, select the model with lowest MFE and lowest MAD

4. When using the selected model, monitor its performance by its MAD
and Tt

5. If the MAD or Tt is out of control, change model and/or reset model by


discarding obsolete data

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Exercise 6:

Management feels that there is a seasonal pattern in the data below for the
Donut-Hole, with the first 2 days of a week representing one season; the
third and fourth days representing a second season; and the fifth, sixth, and
seventh days a third season. Thus, three seasonal indices have been
suggested: RA = 0.9 (for Mon & Tues), RB = 1.3 (for Wed & Thurs), and RC
= 0.8 (for Fri, Sat & Sun).

Day Demand Day Demand

1 80 8 85
2 95 9 99
3 120 10 110
4 110 11 90
5 75 12 80
6 60 13 65
7 50 14 50

Using exponential smoothing with trend and seasons, forecast demands using A0 =
85, T0 = 1 and α = 0.1, β = 0.2, φ = 0.3.

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