National Institute of Technology Calicut

Department of Mechanical Engineering

Forecasting
Forecasting is the projection or estimation of the occurrence of uncertain future events or level of activity. Used for predicting Demand, Revenues, Costs, Profits, Prices, Technological changes, Environment problems, Rainfall, etc. Forecast is one input to many types of planning and control Policy decisions (economic, social, political, technological conditions)
Product design (product lines, services and market)

Forecasting

Process decision (process and methods)

Plant decision (facility location and layout)

Operations decisions (output scheduling and control)

Fig. 1 Master forecasting Financial planning (financial aggregate, cash flow, balance sheets, income statement) Market planning (product lines, pricing, and promotion Production planning (aggregate output levels)

Forecasting

Master scheduling (product output levels) Fig. 2 Functional forecasting Forecasting usually involves the following considerations Item to be forecasted (products, product groups, assemblies, etc) Top down or bottom up forecasting Forecasting techniques (quantitative or qualitative model) Demand Forecasting 1 March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

Units of measure (Rs, units, weights, etc) Time interval (weeks, months, quarters, etc) Forecast horizons (how many time intervals to include) Forecasting components (levels, trends, seasonal, cycles and random variations) Forecast accuracy (error measurement) Exception reporting and special situations Revision of forecasting model parameters

Sales Forecasting
Sales forecasts are used to establish product levels, facilitate scheduling, set inventory levels, determine manpower loading, make purchasing decisions, establish sales conditions pricing and advertising, and financial planning cash budgeting and capital budgeting Generally, sales forecast is used to estimate the demand of independent items Many environmental factors influence the demand for products and services of an organisation. Some major environmental factors are 1. General business conditions and state of the economy. 2. Competitor actions and reactions 3. Governmental legislative actions 4. Marketplace trend a) Product life cycle b) Style and fashion c) Changing consumer demands 5. Technological innovations Presence of randomness preclude a perfect forecast Forecast for groups of items tend to be more accurate than forecast for individual items Error potential increases as time horizon of a forecast increases We are interested in estimating the level of future demand. Statistical techniques are used to forecast. Statistical methods use historical (past) data All statistical forecasting techniques assume to some extent that forces that have existed in the past will persist in the future. New product demand (with little or no history of past demand) rely more on subjective phenomenon and solicitation of opinions Direct survey approach asking prospective customers of their buying interest Indirect survey approach information from salesmen, wholesalers, area managers, etc Demand Forecasting 2 March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

Comparison with substitute or comparable products Limited market test of the new product Basic demand forecasting models Time series analysis, soliciting opinions, economic indicators and econometric models These are short range forecasting models Generally, these forecasts give starting point for making the final forecast Final forecast usually requires an additional input in the form of judgment, intuition, and experience and requires periodic review

Note on economic indicators and econometric models Economic Indicators Knowledge of one variable is used to predict the value of another (prediction by association) Certain economic indicators are Gross domestic product (GDP), Personal income, Bank deposits, Freight car loadings, etc One or more of these indicators have relationship with the forecast variable Involves a set of simultaneous equations that explains the interactions of variables involved in a business situation Attempt to show the relationships between relevant variables such as supply, demand, prices and purchasing power of the consumer Econometric Models

Time Series Analysis

Time series analysis predict future demand from past interval data. A time series is a set of time ordered observations on a variable during successive and equal time periods Period Jan Feb Mar Apr May Jun 70 82 76 87 90 Demand (in units) 75

The above table shows a time series. This table shows the past demand in successive and equal interval of time Period Jan Mar Apr May Jul Sep 70 82 76 87 90 Demand (in units) 75

This table is not representing a time series as it is not showing demand in equal interval of time. Interactive components: levels, trends, seasonal variations, cyclical variations, and random variations Fig. 3 illustrates the various components of time series Levels indicates the scale or magnitude of a time series 3 March 2012

Demand Forecasting

National Institute of Technology Calicut

Department of Mechanical Engineering

Trend identify the rate of growth or decline of a series over time (Long-term historical pattern of demand over time) Seasonal variations consists of annually recurring movements above and below the trend line o Demand fluctuates in a repetitive pattern from year to year o Seasonal periodic peaks and valleys should occur at the same time every year o Seasonal variations should be of larger magnitude than the random variations

Cyclical variations are long term oscillations or swings about a trend line The cycles may or may not be periodic, but they often are the result of business cycles of expansion and contraction of economic activity over a number of years Business cycles may be due to one or more of the following: prosperity, recession, depression and recovery The cycles may vary with respect to the time of occurrence, the length of the phases, and the amplitude of the fluctuations

Raw Data

Trend Component

Seasonal Component

Cyclic Component

Random Component

Time (years) Fig. 3 Various components of a time series

Demand Forecasting

March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

Random variations have no particular pattern and usually are without specific assignable cause They represent all influences not included in trend, seasonal, and cyclical variations Erratic occurrence may be isolated and removed from the data, but there are no general techniques for doing so Averaging process will help to eliminate its influence Random variations are often referred to as noise, residuals, or irregular variations

Various techniques in time series analysis

Last period demand Arithmetic average Simple moving average Weighted moving average Exponentially weighted moving average (EWMA) Simple exponentially weighted moving average Trend adjusted exponentially weighted moving average Seasonally adjusted exponentially weighted moving average Trend and Seasonally adjusted exponentially weighted moving average Regression analysis (Linear forecasting technique) The time series contains interactive components. The models representing interactive components of demand are classified as o Multiplicative model o Additive model o Mixed model (partially additive, partially multiplicative) The demand in period (t) for a multiplicative model is represented as Demand = (Trend) (seasonal) (cycle) (random) Dt = b F c t The demand in period (t) for a additive model is represented as Demand = level + trend + seasonal + cyclic + random Dt = a + b t + Ft + Ct + t Generally, demand process can be modelled as Dt = a + t (level model additive type) Dt = a + b t + t (trend model additive type) Dt = (a + b t) Ft + t (mixed model type- trend part is additive and seasonal part is in multiplicative in form) Demand Forecasting 5 March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

Some Notations Dt Actual demand for the period t ft - forecast for the period t

Simple Moving Average

This method is used to represent a demand process of type Dt = a + t That is, the demand is represented as a level with random noise. Parameter a is not really known and is subjected to random changes from time to time. Using the simple moving average procedure we can get an estimate for a and it can be get updated as time progresses. The procedure involves the determination of average of demand of last N periods. As new period demand observation is available, the old period demand data is removed from average calculation. Number of periods considered for average calculation is same but, demand data considered for the calculation is different at different time periods. This way of estimation is actually an updating procedure also. MAt,N = (Dt + Dt-1 + Dt-2 + . Dt-N+1)/N Where, N is the period of moving average, Dt is the actual demand at period t and MAt,N is the moving average at period t based on demand of N periods. The estimate of a, as of the end of the period t is represented as
t a

Estimating procedure (updating procedure)

= MAt,N

This estimate of a results from minimizing the sum of squares of error over the preceding N period. A slightly simple updating procedure for this method is MAt,N = MAt-1,N +
Dt Dt N N

t a

minimizes the standard error, s =

2 t x j a j t = j N +1

Forecast equations are ft+1 = MAt,N ft+n = MAt,N (forecast for n period ahead)

Simple EWMA
Underlying demand model is Dt = at + t 6 March 2012

Demand Forecasting

National Institute of Technology Calicut

Department of Mechanical Engineering

where, t is normally distributed with mean zero A best estimates for at is the exponentially weighted smoothing average. The equation for simple exponential smoothing uses only two pieces of information: (1) actual demand for the most recent period and (2) the most recent average Let Xt = exponentially weighted moving average for the period t X t = Dt + (1 ) X t 1 Forecast equation is ft+1 = Xt The above equation for Xt can be written as X t = X t 1 + ( Dt X t 1 ) That is, X t = f t + ( Dt f t ) This equation indicates that using exponential average in one period as a forecast for the next period; it is possible to revise the average upward or downward, depending on the forecast error. Weights for the past data and for the initial average can be easily identified from the equation given below.
Xt =

(1 ) D
k =0

t 1

t k

+ (1 ) t X 0

The weight for demand in a period k from now (t) is (1 ) k Expansion of exponentially weighted moving average equation Xt = Dt + (1 )[Dt 1 + (1 ) X t 2 ] = Dt + (1 ) Dt 1 + (1 ) 2 X t 2
= Dt + (1 ) Dt 1 + (1 ) 2 [ Dt 2 + (1 ) X t 3 ] = Dt + (1 ) Dt 1 + (1 ) 2 Dt 2 + (1 ) 3 X t 3

If exponential average is determined for third period, the weight for the demand of various periods and the initial average can be clearly seen from the equation below X 3 = D3 + (1 ) D2 + (1 ) 2 D1 + (1 ) 3 X 0 For the demand process, the best estimate of at which minimize the following the sum of discounted squares of residuals S= d
j =0 j +1

(D

t j

t ) where, d = a distant factor (0 < d < 1) a

The resulting estimate of at satisfies the following updating formation t = Dt + (1 )a t 1 a Average age of data in a simple EWMA is 1/ period. In a N month moving average the average age of data is (N+1)/2 1/ = (N+1)/2 2 Relationship between N (period of moving average) and is = N +1

Demand Forecasting

March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

Initialization When significant historical data exists, simply use the average demand in the first several periods as the initial estimate of Xt. Forecast for future periods ft+1 = Xt ft+n = Xt (forecast for n period ahead)

Trend Adjusted EWMA

Dt = at + bt t + t is the demand process Estimation procedure Estimate for bt is Tt = (Xt - Xt-1) + (1- )Tt-1 Estimate for at is Xt = Dt + (1-)ft The above equation is written in terms of forecast. A trend adjusted forecast is the sum of the best average and trend available at the current time Hence, the average Xt can be written as Xt = Dt + (1-)(Xt-1+Tt-1) Forecast equations are ft+1 = Xt + Tt ft+n= Xt + (n-1) Tt

Seasonally adjusted EWMA

Dt = at t + t is a multiplicative demand process Where, t = seasonal factor Simple EWMA provides an estimate for at

An estimate for t be calculated by an index, It

It =

Dt Xt

Seasonal factors allow us to connect back and forth between periods of sales and the exponential average. Estimate for at is Xt =

Dt It m

+ (1 ) X t 1

where, m is the number of periods in seasonal pattern (m = 12 for monthly data and m = 4 for quarterly data with an annual seasonal pattern)

Demand Forecasting

March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

Estimate for t is It=

Dt + (1 )I t m Xt

Forecast equation is ft+1 = Xt It+1-m

Trend & seasonally adjusted EWMA

Demand process is Dt = (at + bt t ) t + t Estimate for at is

Xt =

Dt It m

+ (1 )( X t 1 + Tt 1 )

Estimate for bt is Tt = ( X t X t 1 ) + (1 )Tt 1

Estimate for I t is

It =

Dt + (1 )I t m Xt

Forecast equation is f t +1 = ( X t + Tt )I t +1 m

Forecast Error Measurement

The forecast error measurement belongs to any one of the following Error estimate to know the magnitude of error to get an idea on biasness of forecast to get an idea on revision of parameters Magnitude of Error (extent of error) Mean Absolute Deviation (MAD) MAD =
n | Dt f t | n t =1

where, n is the number deviations available

n ( Dt f t ) 2 n t =1

Mean Square Error, MSE =

MSE penalise deviations with large magnitude

2 Standard deviation, S r = n

(Dt f t )2
n2

t =1

The 2 in the denominator represents the number of degree of freedom. Sr =1.25MAD for error normally distributed.

Demand Forecasting

March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

Bias measurement Direction Running Average Forecast Error (RAFE) RAFE = Revision Tracking Signal (TS)
TS = RAFE MAD
n ( Dt f t ) n t =1

1 TS 1 The limiting conditions are achieved if all errors are positive or all errors are negative.

Error updating procedure

= smoothing constant
MADt = ( Dt f t ) + (1 ) MADt 1

MSEt = ( Dt f t ) 2 + (1 ) MSEt 1

Forecasting Problems
Moving Average Methods

Twelve-month demand data of a product is given below. Use this data to develop forecasts using three- and six-month moving averages, and three-month weighted moving average (weights for data: 0.25, 0.25 and 0.5 for most recent) method. TABLE 1 Demand data Month Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec. Demand 450 440 460 510 520 495 475 560 510 520 540 550

TABLE 2 Three and Six-Month Moving Averages Used as Forecasts

Three-Month Moving Average (MA t ) 450 470 497 508 497 510 515 530 523 537 Three-Month Moving Average Forecast* (ft) 450 470 497 508 497 510 515 530 523 Six-Month Moving Average (MA t ) 479 483 503 512 513 517 526 Six-Month Moving Average Forecast (ft) 479 483 503 512 513 517

Month January February March April May June July August September October November December

Demand (Dt) 450 440 460 510 520 495 475 560 510 520 540 550

Note: The average at time t becomes a forecast for time t+1 *Using ft as the forecast for period t, ft is set equal to the most recently calculated moving average, ft =MA t 1 Demand Forecasting 10 March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

TABLE 3 Forecast Using Moving Average and Weighted Moving Average Three-Month Moving Average (MA t ) 450 470 497 508 497 510 515 530 523 537 Three-Month Moving Average Forecast (ft) 450 470 497 508 497 510 515 530 523 Three -Month Weighted Moving Average (0.25,0.25.0.50) Most Recent (MA t ) 453 480 503 505 491 523 514 528 528 540 Three-Month Weighted Moving Average Forecast (ft) 453 480 503 505 491 523 514 528 528

Month January February March April May June July August September October November December

Demand (Dt) 450 440 460 510 520 495 475 560 510 520 540 550

Simple Exponential Smoothing Method Determine the forecast from March to December for the demand data given in Table 1. Given = 0.2 and initial average for March = 480. The last column of the Table 4 is the weights given to various months when exponentially weighted average of December month is calculated. The weight for a month can be calculated as (1 )k where, k varies from 0 to (10-1) for December to March with December having a value of zero. That is, the value of k is zero for the current month, 1 for just previous month and so on. Hence, the smoothing expression can be written as
X t = (1 )k Dt k + (1 )t X 0
k =0 t 1

where, t is the current month; here for December t = 10.

TABLE 4 Simple Exponential Smoothing Forecast

Month March April May June July August September October November December
a

Demand (D t ) 460 510 520 495 475 560 510 520 540 550

Smoothed Average ( Xt ) 476.00 482.80 490.24 491.19 487.95 502.36 503.89 507.11 513.69 520.95

Forecast (ft) 480 476 483 490 491 488 502 504 507 514

Weightsa 0.027 0.034 0.042 0.052 0.066 0.082 0.102 0.128 0.160 0.200

At the end of December, X DEC implicitly applies these weights to the sales from March through

December. To see this, calculate X DEC = 0.2(550)+0.16(540)+0.128(520)++0.027(460) = 520.95

Demand Forecasting

11

March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

Trend adjusted exponential smoothing method Twelve-month demand from March to February is given in Table 5. Determine the forecast for these months using trend adjusted exponential smoothing method. Given =0.2; =0.2; T0=9; X0= 480 TABLE 5 Trend adjusted exponential smoothed forecast
Month Demand (Dt) Simple exponential averagea (Xt) 476.00 482.80 490.24 491.19 487.95 502.36 503.89 507.11 513.69 520.95 527.76 536.01 Trend adjusted exponential average (Xt) 480.00 483.20 494.83 506.74 511.80 511.18 526.23 529.62 533.55 540.16 547.43 554.35 562.72 Trend (Tt) 9.00 7.84 8.60 9.26 8.42 6.61 8.30 7.32 6.64 6.63 6.76 6.79 7.11 Forecast (ft)

March April May June July August September October November December January February
a

460 510 520 495 475 560 510 520 540 550 555 569

489.00 491.04 503.43 516.00 520.22 517.79 534.53 536.94 540.20 546.79 554.19 561.15

Given for comparison purposes. Note how the simple exponential average lags the upward trend. Seasonally Adjusted Exponential Smoothing Method Monthly demand data for three years is given in Table 6. Use the first two years data to determine monthly seasonal index and determine monthly forecast of third year. TABLE 6 Demand data for a seasonal product
2006 80 75 80 90 115 110 100 90 85 75 75 80 Demand 2007 100 85 90 110 131 120 110 110 95 85 85 80 2008 95 75 90 105 120 117 102 98 95 75 85 75

Month January February March April May June July August September October November December

Consider the average demand of years 2006 and 2007 as initial average (X0) to start exponential smoothing forecast. Given =0.2, = 0.05 Seasonal index calculation Calculate the average demand for each month (eg:- Average demand of January = January month demands in 2006 + 2007) Average these to get average monthly demand Demand Forecasting 12 March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

Seasonal index of January = Average demand of January divided by average monthly demand Similarly calculate seasonal index of all other month. TABLE 7 Sample Seasonal Index Computation Demand 2006 2007 Month January 80 100 February 75 85 March 80 90 April 90 110 May 115 131 June 110 120 July 100 110 August 90 110 September 85 95 October 75 85 November 75 85 December 80 80 a Average monthly demand: 1128/12=94 Average Demanda 90 80 85 100 123 115 105 100 90 80 80 80 Seasonal Index (It) 0.957 0.851 0.904 1.064 1.309 1.223 1.117 1.064 0.957 0.851 0.851 0.851

TABLE 8 Computation of Seasonalized Forecast Average (Xt) X 0 =94 95.05 93.67 94.85 95.62 94.83 95.00 94.26 93.83 94.92 93.56 94.82 93.48 Old New Seasonal Seasonal Factor Factor (It-12) (It) 0.957 0.959 0.851 0.848 0.904 0.906 1.064 1.066 1.309 1.307 1.223 1.223 1.117 1.115 1.064 1.063 0.957 0.959 0.851 0.849 0.851 0.853 0.851 0.849

Month January February March April May June July August September October November December

Demand (Dt) 2008 95 75 90 105 120 117 102 98 95 75 85 75

Deseasonalized Demand (Dt/(It-12)) 99.27 88.13 99.56 98.68 91.67 95.67 91.32 92.11 99.27 88.13 99.88 88.13

Forecast (ft) 89.96 80.88 84.68 100.92 125.17 115.98 106.11 100.29 89.80 80.78 79.62 80.69

Problem from Economic Indicators

The General Manager of a building materials production plant feels the demand for plaster board shipments may be related to the number of construction permits issued in the district during the previous quarter. The manager has collected the data shown in the accompanying table. Derive a regression forecasting equation and determine a point estimate for plaster board shipments when the number of construction permits is 30

Demand Forecasting

13

March 2012

National Institute of Technology Calicut

Department of Mechanical Engineering

Construction permits 15 9 40 20 25 25 15 35 Plaster board shipments 6 4 16 6 13 9 10 16 Solution Consider construction permit as independent variable (X) and plaster board shipments as dependent variable (Y) and establish a linear relationship. Let the linear relationship be Y = aX + b Normal equations to find a and b are

Y = a X + nb

XY = a X

+ b x

Forecasting equation is

Y = 0.395 X = 0.915

The point estimate for the plaster board shipments is 12.765 13

Demand Forecasting

14

March 2012