FORCASTING

Nikhil Ghag
Business Analyst
TheGreenBillions Limited
WHAT IS FORECASTING
 Forecasting is by far the most important and frequently used application of
predictive analytics since it has significant impact on both top line and
bottom line of an organization.
 Every organization prepares long-range and short-range planning for the
organization and forecasting demand for product and service is an important input
for both long-range and short-range planning
 Different capacity planning problems such as manpower planning, machine
capacity, warehouse capacity, materials requirements planning (MRP) will
depend on the forecasted demand for the product/ service.
 Budget allocation for marketing promotions and advertisement are usually
made based on forecasted demand for the product
ROLE OF FORECASTING IN A
SUPPLY CHAIN
 The basis for all planning decisions in a supply chain
 Used for both push and pull processes
 Production scheduling, inventory, aggregate planning
 Sales force allocation, promotions, new production introduction
 Plant/equipment investment, budgetary planning
 Workforce planning, hiring, layoffs
 All of these decisions are interrelated
INTRODUCTION TO FORECASTING

 Boeing 747-400 has more than 6 million parts and several thousand unique
parts (Hill, 2011). Forecasting demand for spare parts is important since
non-availability of mission critical parts can result in aircraft on ground
(AOG) which can be very expensive for airlines.
 Amazon.com sells more than 350 million products through its E-commerce
portal. Amazon itself sells about 13 million SKUs and has more (about 2
million) retailers selling their products throughAmazon
 Demand for products and service is not the only application of forecasting,
even manpower planning requires the use of sophisticated models.
 Many products may have intermittent demands, that is, gap between two
demands can be long and the gap itself may be random
CHARACTERISTICS OF
FORECASTS
 Forecasts are always inaccurate and should thus include both
the expected value of the forecast and a measure of forecast
error
 Long-term forecasts are usually less accurate than short-term
forecasts
 Aggregate forecasts are usually more accurate than
disaggregate forecasts
 In general, the farther up the supply chain a company is, the
greater is the distortion of information it receives
COMPONENTS AND METHODS
 Companies must identify the factors that influence future demand and then
ascertain the relationship between these factors and future demand
 Past demand
 Lead time of product replenishment
 Planned advertising or marketing efforts
 Planned price discounts
 State of the economy
 Actions that competitors have taken
COMPONENTS AND METHODS
 Qualitative
 Primarily subjective
 Rely on judgment
 Time Series
 Use historical demand only
 Best with stable demand
 Causal
 Relationship between demand and some other factor
 Simulation
 Imitate consumer choices that give rise to demand
TIME-SERIES DATA AND COMPONENTS OF TIME-
SERIES DATA

 Trend Component (Tt): Trend is the consistent long-term upward or

downward movement
 Seasonal Component (St): Seasonal component (measured using
seasonality index) is the repetitive upward or downward movement (or
fluctuations) from the trend that occurs within a calendar year such as
seasons, quarters, months, days of the week.
 Cyclical Component (Ct): Cyclical component is fluctuation around the
trend line that happens due to macro-economic changes such as recession,
unemployment, etc.
 Irregular Component (It): Irregular component is the white noise or
random uncorrelated changes that follow a normal distribution with mean
value of 0 and constant variance.
TREND IN TIME-SERIES DATA.
 The time-series data can be modelled as an addition of the above
components or product of the above components. The additive time-series
model is given by
QUANTITATIVE METHOD

Simple Average- Moving average method Weighted moving Exponential Smoothing Equation of Exponential
Random values – when there is trend- average method method – include all the smoothing method.
five month moving data – weighted recent
average, three month observation much more
moving average. heavily than very old.
PROBLEM
SOLUTION
PROBLEM
AUTO REGRESSION, ARIMA
AND ARMA
 What is auto regression?
 How to identify the order?
 What are ACF and PACF?
 What is stationarity and seasonality?
 Equation of Auto regression.
 Pearsons's correlation coefficient [-1,1]
STATIONARITY AND
SEASONALITY
ARMA AND ARIMA
FORECASTING TECHNIQUES AND FORECASTING
ACCURACY

 There are many forecasting techniques developed based on different logics. Simple
techniques such as moving average and exponential smoothing predict the future
value of a time-series data as a function of the past observations.
 Usually, many different forecasting techniques such as moving average,
exponential smoothing, and ARIMA are used for forecasting before selecting the
best model. The model selection may depend on the chosen forecasting accuracy
measure. The following four forecasting accuracy measures are frequently used:
1. Mean absolute error
2. Mean absolute percentage error
3. Mean squared error
4. Root mean square error
MEAN ABSOLUTE ERROR (MAE)

 Mean absolute error (MAE) is the average absolute error and should be calculated
on the validation data set. Assume that the validation data has n observations and
forecasting is carried out on these n observations using the model developed. The
mean absolute error is given by

 It is one of the popular forecasting accuracy measures used by practitioners since it

expresses the average error in percentage terms and is easy to interpret.
MEAN ABSOLUTE PERCENTAGE ERROR (MAPE)

 Mean absolute percentage error (MAPE) is the average of absolute percentage error.
Assume that the validation data has n observations, and the forecasting is carried
out on these n observations. The mean absolute percentage error is given by

It is one of the popular forecasting accuracy measures used by

 It is
practitioners since it expresses the average error in percentage terms and
is easy to interpret.
MEAN SQUARE ERROR (MSE)

 Root mean square error (RMSE) is the square root of mean square error and is given
by

 Lower MSE implies better prediction. However, it depends on the range of the time-
series data.
ROOT MEAN SQUARE ERROR (RMSE)

 Root mean square error (RMSE) is the square root of mean square error and is given by

 RMSE along with MAPE are two most popular accuracy measures of forecasting. RMSE
is the standard deviation of errors or residuals. In 2006, Netflix, the movie portal,
announced a competition with a prize money worth one million dollars to predict the
rating on a 5-point scale likely to be given a customer for a movie2 (source: Wikipedia).
The participants were given a target RMSE of 0.8572 to qualify for the prize.