Forecasting Chapter Overview Purpose fo present and illustrate the most important methods for forecasting demand in the context of operations planning, Key Points 1. Characteristics of forecasts. © They are almost always going to be w forecasting individual into the future are less acc hnique should not be used to the exclusio that measure either individual or group methods include: ‘Jury of executive opinion ‘© The Delphi method 3. Objective forecasting methods (time series methods and regression). Using objective forecasting methods, one makes forecasts based on past history. Time seri forecasting uses only the past history of the series to be forecasted, while regression models often incorporate the past history of other series. In time series forecasting, the goal is to find predictable and repeatable patterns in past data. Based on the identified patter, different methods are appropriate, Time series methods have the advantage of easily being incorporated into a computer program for automatic forecasting and updating, Repeatable patterns that we consider include incr r decreasing linear trend, curvilinear trend (including exponential grovet seasonal When using regression, one construct n (the dependent variable) base52 Chapter Two Foecane ‘4, Evaluation of forecasting methods. The forecast error in any period, eis the difference between the forecast for period t, and the actual value of the series realized for period t(e- = F — 3. Three common measures of forecast error are MAD {average of the absolute errors over periods), MSE (the average of the Sum of the squared errors over n periods), and MAPE (the average of the percentage errors over n periods). 5, Methods for forecasting stationary time series. We consider two forecasting methods when the underiying pattern of the series is stationary over time: roving averages end exponential smoothing. A moving average = sm the Srthmetic average of the N most recent observations. Exponential smoothing orecasts rely on a weighted average of the most recent observation and the previous forecast The weight applied to the most recent observation sa. where Oca <1, and the weight applied to the last forecasts 1 ~ a. Both methods gre commonly used in practice, but the exponential smoothing method's favored in inventory control applications—especiall in large systems—becauseit requires much less data storage than does moving averages. 6. Methods for forecasting series with trend. When there is an upward or Hownward linear trend in the data, two common forecasting methods are linear regression and double exponential smoothing via Holt’s method. near regression is used to fita straight line to past data based on the method of east Squares, and Holl's method uses separate exponential smoothing equations 10 forecast the intercept and the slope of the series each period, 7, Methods for forecasting seasonal series. A seasonal time series is one that has 2 requir repeating pattern over the same time fame. Typically the time frame would be a yeer, and the penods would be weeks or months. The simplest Spproach for forecasting seasonal series is based on multiplicative seasona) Feros. A multiplicative seasonal factor is a number that indicates the relative \alue of the series in any period compared to the average value over 2 yea" ‘Suppose a season consists of 12 months. A seasonal factor of 1.25 for 2 gvven jronth means that the demand in that month is 25 percent higher than the mean monthly demand. Winter's method is a more complex method based ‘on triple exponential smoothing. Three distinct smoothing equations are Cced to forecast the intercept, the slope, and the seasonal factors each period 8. Other considerations. Economic forecasting and time series analysis are very ich grees of research. When one has along history of data, far more sophisticated orethods are available. The so-called Box-Jenkins methods ely on evaluation and txamination of the autocorrelation function to determine a suitable model. Fitering theory, originally developed in the context of problems in communications, Con often be adapted to forecast economic time series. Two of the better known fiters are Wiener and Kalman fiers. In recent years, there has been a surge of interest in neural nets, a computer search-based method. None of these techniaues ite amenable to automatic forecestng, and they al require a knowledgeable and sophisticated user. Monte Carlo simulation is another useful tool fr forecasting in ompex environments. The chapter concludes vith 2 discussion ot severa forecasting issues that arse in the context of inventory control ‘As was so cloquently stated by Charles F. Kettering, “My concern is with the fare ‘nce [plan to spend the rest of my life there.” But the future can never be Kncten. £0 since be forecasts. We forecast traffic pattems and plan rovies accordingly. WeChapter Two for <3 forecast which foods will be best in a particular restaurant, and order accordingly. We choose universities to attend based on forecasting our experiences there and the doors that a degree from that university will open. We make hundreds of forecasts every day, some carefully thought out, some made almost unconsciously. Forecasting plays 1 central role in all of our lives. Tn the same way, forecasting plays a central role in the operations function of a frm. Al business planning is based on forecasts. Sales of existing and new products, re- quirements and availabilities of raw materials, changing skills of workers, inicrest fates, capacity requirements, and international politicy are only a few of the factors likely to affect the Future success ofa firm. ‘The two functional areas ofthe firm that make the most use of forecasting methods tare marketing and production. Marketing typically forecasts sales for both new und ‘existing product lines. Sales forecasts are usc by the production department for op- ‘erations planning. In some caxes the forecasts prepared by marketing may not meet the needs of production. Tor example, in order to determine suitable spare parts in ventory levels, one must know maintenance schedules and forecast machine break- downs. Also, marketing may be providing forceasts on product groups or families. but proxtuction may require forecasts for individual stockkeeping units (SKUs) for its planning, We have seen firms benefit from asting and pay the price for poor fore- casting. During the 1960s, consumer tastes in automobiles slowly shifted from larg. heavy gas guzzlers to smaller, more fuel efficient automobiles. Detroit, slow 10 Fe spond to this change, suffered when the OPEC oil embargo hit in the late 1970s and tastes shifled more dramatically to smaller cars. Compaq Computer became a market leader in the early 1980s by properly forecasting consumer demand for a portable version of the IBM PC. which gained popularity that far execeded expectations. Forecasting played a role in Ford Motors’s early success and later demise. Henry Ford saw that the consumer wanted a simpler, less expensive car that was casier 10 ‘maintain than most manufacturers were offering in the carly 1900s. His Model T dominated the industry. However, Ford did not sce that consumers would tire of the ‘open Model T design. Ford’ failure to forecast consumer desires for other designs ncarly resulted in the end of a firm that had monopolized the industry only a few years before. Cam all events be accurately forecasted? The answer is clearly no. Consider the ex- perimentof tossing acoin. Assuming that it isa fair coin and the act of tossing doesnot introduce bias, the best you can suy is that the probability of getting heads is 50 per- Cent on any single (oss. No one has been able to consistently top the 50 percent p diction rate for such an experiment over a long period of time. Many real phenomena are accurately described by a type of coin-ilipping experiment. Games of chance played at casinos are random. By tipping the probabilities in its favor, the house is ‘always guarantced to win over the long term. There is evidence that daily prices of stocks follow a purely random process, much like « coin-flipping experiment. Studies have shown that professional money managers rarely outperform stock portfolios generated purely ai random, In production and operations management, we are primarily interested in forecasting product demand, Because demand is likely to he random in most circumstances, can forecasting methods provide any value? In most cases, the answer is yes. Although ‘some portions of the demand process may be unpredictable, other portions may be pre- dictable. Trends, cycles, and seasonal variation may be present. all of which give us an advantage over trying (o prodict the outcome of a coin toss. In this chapter we consider methods for prodicting future values of a series based on past observations.