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Forecasting
Why are errors in this occupation tolerated when they would likely lead to dismissal in
other job roles? The answer lies in the fact that all organizations have a need to
understand and quantify future customer demands for its products and services. This
knowledge will facilitate decisions that can significantly increase the competiveness and
profitability of the organization. For example, an organization projecting 25% annual
growth will need to invest in manufacturing capacity upgrades and additions in the
future. Failure to do so on a timely basis would likely result in lost sales, expediting
costs, and low employee morale.
Forecasts are often wrong. Luckily, the decisions required to operate a successful
enterprise rarely require 100% accuracy. As long as the demand forecast is reasonably
accurate, the organization can still make the correct decision. Continuing with the
previous illustration, if forecasted growth was 25% while actual annual growth was 28%,
the company will still need to expand in the future. While the timing of their capacity
expansion may be slightly incorrect, the plan to add capacity is still valid. In other words,
the forecast was value adding.
This course will provide you with quantitative demand forecasting techniques that are
appropriate for a large number of the mature products sold today. In addition, forecast
performance measures will be discussed that evaluate the degree to which a demand
forecast is value adding.
Step 4: Round
Round the average to the number of decimal places that makes sense for the item
being forecast. As a guideline, if a product is manufactured and sold in units of one,
then round to the nearest whole number.
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A graph of sample data illustrates the outcome of the five-step process. In this case 8
periods of historical data are added, with a result of 600, and divided by 8 to create the
forecast of 75. The largest forecast error is 15. This was derived from the smallest
demand data, 60, subtracted from the forecast of 75. The published forecast becomes
75 +/- 15.
Simple averaging also treats all historical data equally. This is not appropriate when the
current marketplace conditions have changed dramatically. For example, consider a
product with three years of demand data. In the first year, distribution was limited to 100
retail outlets, and the unit selling price was $5.00. Today, the distribution network has
expanded to 300 retail locations, and the price has been reduced to $3.99. Clearly, the
inclusion of introductory product demand will distort the demand forecast moving
forward. This can be corrected by reducing the amount of historical data included in the
moving average calculations or by adopting a weighted moving average.
Last, the simple averaging technique is only suitable when the base component of
demand is present. If trends, seasonality, or cyclical patterns exist, more complex tools
are required. These can include regression, seasonal decomposition, and econometric
modeling.
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Step 1: Initialization
In this technique, a fixed window of the most recent historical data is utilized in the
averaging process. Most applications utilize a window size of three to six periods.
Smaller window sizes tend to be more reactive to any random elements in the demand
pattern. They would also detect any demand pattern shifts faster than larger window
sizes.
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The procedure used in this methodology closely parallels the moving average technique.
It begins by setting the window size and weights. Following this step, historical demand
data is gathered to fill the window. Data cleansing is performed as required. Each of the
data points is then multiplied by an appropriate weight. The weighted numbers are
added to generate a future forecast that can be rounded as desired. Forecast error is
computed as before to complete the process.
Subsequent periods follow the same procedure after the window has been shifted to
drop off the oldest historical data.
The last table summarizes the forecasts generated by the moving average and
weighted moving average examples. Notice how the weighted average technique tends
to be more reactive to the most recent demands as evidenced by the close proximity of
the forecast to the latest demand value. This sensitivity is increased by selecting greater
values for the most recent weight, 0.6 in this example, relative to the other weights
utilized.
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In this lesson, you listed the steps required to perform a simple averaging forecast. In
addition, you updated a simple average forecast and discussed weaknesses associated
with this technique. You also developed an initial forecast using either moving average
or weighted moving average methods. Finally, you reviewed how to update forecasts
using the same methods as new historical data becomes available.
Exponential smoothing demand forecasts are calculated based upon the formula
NF = OF + (A - OF)
In this equation NF is the new or updated forecast, OF is the current or old forecast, A is
the actual demand this period, and is a smoothing constant that ranges between 0
and 1. The new forecast is equal to the old forecast plus the product of the difference
between actual demand and the old forecast and the smoothing constant. In effect, the
exponential smoothing formula updates the current forecast with a percentage of the
forecast error. The exact percentage is determined by the smoothing constant.
= 2/(n + 1)
In this equation, is the smoothing constant, and n represents the number of periods
included in the moving average forecasting method. The smoothing constant equals two
divided by the sum of the number of periods plus 1. For example, a smoothing constant
of 50% would give results similar to a three-month moving average.
Two general guidelines that can be utilized when selecting a smoothing constant are:
1. If you have a flexible supply chain, use a higher alpha value.
2. If your supply chain is less flexible, use a lower alpha value.
To illustrate these guidelines, some of the previous demonstration data has been
recalculated for a relatively high smoothing constant of 80%. In addition, the forecast
has been updated for an additional two periods. Examination of the results reveals the
most important principle of smoothing constants: higher smoothing constant values
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This simple calculation is repeated each time new data becomes available. The
calculations are shown for the next period actual of 100. In this case the resulting
forecast is reduced to 106 +/-9. This forecast was rounded from 105.6. Last, a table
summarizing the previous results compared to a nine-month moving average illustrates
the similarity between the two methods as predicted by the formula alpha equals 2
divided by n plus 1.
In this lesson, you explored the exponential smoothing formula and how it relates to the
moving average technique. In addition, you developed and updated a demand forecast
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Mathematicians have studied normal curves for decades. As a result, a complete set of
terminology and measurement systems have been developed for normal curves. The
spread of the normal curve, in this example 50150, is referred to as the dispersion.
The size of this dispersion can be measured in a variety of ways including by standard
deviation. This measure is often referred to as the Greek letter sigma. A simpler
measure of dispersion is mean absolute deviation. This measure can be utilized to
approximate the standard deviation by using the formula
= 1.25 MAD
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Using the formula, the standard deviation can be approximated by multiplying by 1.25.
This results in a value of 16.25, which compares favorably as an approximation of the
actual standard deviation of 17.53.
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MAPE is the most common measure of forecast error used in industry. For positive
thinkers, it can be transformed into a forecast accuracy measure by subtracting it from
100%. The previous example would therefore represent 11.2% error, or 88.8% accuracy.
In this lesson, you calculated mean absolute deviation (MAD) and absolute percent
errors (APE). In addition, you examined the relationship of the normal curve distribution
as it relates to forecast errors and developing the mean absolute percent error (MAPE)
for any product forecast.
TS = errors/MAD
Where TS is the tracking signal, errors is actual demand minus forecasted demand, and
MAD is the mean absolute deviation.
Conversely, any tracking signal values between -3 and 3 have little to no bias
associated with them.
Tracking signals are calculated for two sets of data to illustrate these guidelines. The
first table is characterized by a tracking signal of 0.37 and is clearly unbiased.
The second table of data is heavily biased and has a tracking signal of 7.0.
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Large negative tracking signals are also associated with poor performance. In this case
lower than expected customer demand creates excessive inventory levels. Inventory
carrying costs naturally rise. Examples include extra storage charges and higher than
expected inventory write-offs. This could be especially troublesome for food and
pharmaceutical products with expiry dating concerns.
Supply chain professionals must continually monitor the forecast process for forecast
bias. When detected, the root cause of the bias must be addressed and eliminated.
In this lesson, you explored the concept of bias and its implications on supply chain
performance. In particular, you calculated and detected forecast bias utilizing tracking
signals.
Specifically, you developed demand forecasts using averaging methods and single
exponential smoothing. These averaging methods include simple, moving, and
weighted moving techniques. You measured forecast performance along two major
dimensions. You also calculated mean absolute deviation, absolute percent error, and
mean absolute percent error as a measure of forecast error. Similarly, you detected
forecast bias by calculating and interpreting a tracking signal.
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