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Forecasting for Operations

Dr. Everette S. Gardner, Jr.

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Forecasting for operations
 Why we should forecast with models
 The importance of forecasting
 Exponential smoothing in a nutshell
 Case studies
1. Customer service: U.S. Navy distribution system
2. Inventory investment: Mfg. of snack foods
3. Inventory investment: Auto parts distributor
4. Purchasing workload: Mfg. of water filtration systems
 Recommendations: How to improve forecast
accuracy

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Paper folding forecast
A sheet of notebook paper is 1/100 of
an inch thick.
I fold the paper 40 times.

How thick will it be after 40 folds?

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Fold Inches Miles
Start 0.01
1 0.02
5 0.32
10 10.24
20 10,485.76 0.17
25 335,544.32 5.30
30 10,737,418.24 169.47
35 343,597,383.68 5,422.94
40 10,995,116,277.76 173,534.03

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The Importance of Forecasting
 Forecasts determine:
 Master schedules
 Economic order quantities
 Safety stocks
 JIT requirements to both internal and external
suppliers

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The Importance of Forecasting (cont.)
 Better forecast accuracy always cuts inventory
investment. Example:
 Forecast accuracy is measured by the standard
deviation of the forecast error
 Safety stocks are usually set at 3 times the
standard deviation
 If the standard deviation is cut by $1, safety stocks
are cut by $3

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Exponential smoothing methods
 Forecasts are based on weighted moving
averages of
 Level
 Trend
 Seasonality

 Averages give more weight to recent data

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Origins of exponential smoothing
 Simple exponential smoothing –
The thermostat model
 Error = Actual data – forecast
 New forecast = Old Forecast + (Weight x Error)

 Invented by Navy operations analyst


Robert G. Brown in 1944
 First application: Using sonar data to
forecast the tracks of Japanese submarines

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Exponential smoothing at work
“A depth charge has a
magnificent laxative
effect on a submariner.”
Lt. Sheldon H. Kinney,
Commander,
USS Bronstein (DE 189)

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Forecast profiles from exponential smoothing
Additive Multiplicative
Nonseasonal Seasonality Seasonality

Constant
Level

Linear
Trend

Exponential
Trend

Damped
Trend

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Automatic Forecasting with the damped trend
In constant-level data, the forecasts emulate simple
exponential smoothing:

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Automatic Forecasting with the damped trend
In data with consistent growth and little noise, the
forecasts usually follow a linear trend:

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50

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40

35

30

25

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Automatic Forecasting with the damped trend
When the trend is erratic, the forecasts are damped:

50 Saturation level

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40

35

30

25

20

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Automatic Forecasting with the damped trend
The damping effect increases with noise in the data:

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Saturation level
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40

35

30

25

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Case 1: U.S. Navy distribution system
 Scope
 50,000 line items stocked at 11 supply centers

 240,000 demand series

 $425 million inventory investment

 Decision Rules
 Simple exponential smoothing

 Replenishment by economic order quantity

 Safety stocks set to minimize backorder delay time

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U.S. Navy distribution system (cont.)
 Problems
 Customer pressure to reduce backorder delay

 No additional inventory budget available

 Characteristics of demand series


 90% nonseasonal

 Frequent outliers and jump shifts in level

 Trends, usually erratic, in most series

 Solution
 Automatic forecasting with the damped trend

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U.S. Navy distribution system (cont.)
 Research design 1
 Random sample (5,000 items) selected

 Models tested
 Random walk benchmark
 Simple, linear-trend, and damped-trend smoothing
 Error measure
 Mean absolute percentage error (MAPE)
 Results 1
 Damped trend gave the best MAPE

 Impact of backorder delay unknown

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U.S. Navy distribution system (cont.)
 Research design 2
 The mean absolute percentage error was discarded

 Monthly inventory values were computed:


 EOQ
 Standard deviation of forecast error
 Safety stock
 Average backorder delay
 Results 2
 Damped trend gave the best backorder delay

 Management was not convinced

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U.S. Navy distribution system (cont.)
 Research design 3
 6-year simulation of inventory performance, using
actual daily demand and lead time data
 Stock levels updated after each transaction

 Forecasts updated monthly

 Results 3
 Again, damped trend was the clear winner

 Results very similar to steady-state predictions

 Backorder delay reduced by 6 days (19%) with no


additional inventory investment

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Average delay in filling backorders
U.S. Navy distribution system
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Random walk

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Backorder days

Linear trend
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35 Simple smoothing

30 Damped trend

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370 380 390 400 410 420 430
Inventory investment (millions)

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Case 2: Snack-food manufacturer
 Scope
 82 snack foods

 Food stocks managed by commodity traders

 Packaging materials managed with subjective


forecasts and inventory levels
 Problems
 Excess stocks of packaging materials

 Impossible to predict inventory on the balance sheet

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11-Oz. corn chips
Monthly packaging inventory and usage
$2,500,000
Actual Inventory
from subjective
$2,000,000 forecasts

$1,500,000

$1,000,000

$500,000

$0

Month
Monthly Usage

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Snack-food manufacturer (cont.)
 Solution
 Automatic forecasting with the damped trend

 Replenishment by economic order quantity

 Safety stocks set to meet target probability of


shortage

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Damped-trend performance
11-oz. corn chips
$500,000

Outlier Actual
Forecast
$450,000

$400,000

$350,000

$300,000

$250,000

$200,000

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Investment analysis: 11-oz. corn chips
Forecast annual usage $4,138,770
Economic order quantity $318,367
Standard deviation of forecast errors $34,140

Nbr. shortages
per 1,000 Probability Safety Order Maximum
order cycles of shortage stock quantity investment
100.0000 0.1000 $43,758 $318,367 $362,125
50.0000 0.0500 $56,167 $318,367 $374,534
1.0000 0.0010 $105,510 $318,367 $423,877
0.0100 0.0000 $145,601 $318,367 $463,968
0.0001 0.0000 $177,496 $318,367 $495,863

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Safety stocks vs. shortages
11-oz. corn chips
$200,000

$180,000
Target
$160,000

$140,000
Safety stock

$120,000

$100,000

$80,000

$60,000

$40,000

$20,000

$0
0 10 20 30 40 50 60 70 80 90 100

Shortages per 1,000 order cycles


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Safety stocks vs. forecast errors
11-oz. corn chips
$200,000
Safety stock
$150,000

$100,000

$50,000

$0

($50,000) Forecast errors


($100,000)

($150,000)

($200,000)

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11-Oz. corn chips
Target vs. actual packaging inventory
$2,500,000
Actual Inventory
from subjective
Actual Inventory
$2,000,000 forecasts
from subjective
forecasts

$1,500,000

$1,000,000

$500,000

$0
Target maximum
inventory based on
damped trend Month
Monthly Usage

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How to forecast regional demand
 Forecast total units with the damped trend
 Forecast regional percentages with simple
exponential smoothing

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Damped-trend performance
11-oz. corn chips
$500,000

Outlier Actual
Forecast
$450,000

$400,000

$350,000

$300,000

$250,000

$200,000

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Regional sales percentages: Corn chips
50%

East
40%

30% South

North
20%

West
10%

0%
Mar Jun Sep Dec Mar Jun Sep Dec

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Case 3: Auto parts distributor
 Scope
 24 distribution centers
 350 company-owned stores, 1,600 affiliated stores
 Millions of time series
 Independent marketing, finance, and operations forecasts
 Inventory system
 Standard EOQ/safety stock
 Operations forecasting system
 Multiplicative seasonal adjustment for all time series
 Simple exponential smoothing of seasonally-adjusted data

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Forecast profiles from exponential smoothing
Additive Multiplicative
Nonseasonal Seasonality Seasonality

Constant
Level

Linear
Trend

Exponential
Trend

Damped
Trend

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Seasonal adjustment procedures
 Multiplicative
 Range of seasonal fluctuation grows with the data

 Seasonal index is a ratio

 Seasonally adjusted data = Actual sales / Index

 Additive
 Range of seasonal fluctuation is constant

 Seasonal index is stated in units

 Seasonally adjusted data = Actual sales – index

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Auto parts distributor (cont.)
 Multiplicative seasonality is infeasible for data with
zeroes
 Company solution for data with zeroes
 Add a large constant to each month’s sales before
seasonal adjustment
 Subtract the constant afterward

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Auto parts distributor (cont.)
 Effects of company seasonal adjustment
procedure
 Many non-seasonal time series were adjusted
 Variance of seasonally-adjusted data was almost
always greater than original data
 Inflated variance led to
 Excess safety stocks
 Purchases much larger than true requirements
 Frequent subjective adjustments of forecasts

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Auto parts distributor
Example of inflated variance
80 Original data

Company seas. adjustment


70

60

50

40

30

20

10

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Auto parts distributor (cont.)
 Proposals to Management
 Test for seasonality before adjustment

 Use additive seasonal adjustment, which works


regardless of zeroes in the data:
Actual data – index = Adjusted data
 Develop tradeoff curves between inventory investment
and customer service

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Auto parts distributor
Seasonal adjustment comparisons: no zeroes
80 Original data
Company seas. adjustment
70 Additive seas. adjustment

60

50

40

30

20

10

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Auto parts distributor
Seasonal adjustment comparisons: With zeroes
180
Original data
160 Company seas. adjustment
Additive seas. adjustment
140

120

100

80

60

40

20

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Auto parts distributor:
Estimated savings
Safety stock 95% confidence limits
Inventory reduction lower upper
Florida
Fast-movers 16% 14% 18%
Temperature control 22% 16% 28%
Minnesota
Fast-movers 18% 15% 20%
Temperature control 43% 33% 52%
Missouri
Fast-movers 17% 15% 19%
Temperature control 19% 11% 27%
California
Fast-movers 19% 16% 21%
Temperature control 20% 13% 27%

Total percentage 19% 17% 21%


Total dollars (millions) $5.1 $4.7 $5.4

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Case 4: Water filtration systems company
 Scope
Annual sales of $15 million

 Inventory of $5.8 million, with 24,000 stock records

 Inventory system
 Reorder monthly to maintain 3 months of stock

 Numerous subjective adjustments

 Forecasting system
 6-month moving average
 No update to average if demand = 0
 Numerous subjective adjustments

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Problems
 Purchasing and receiving workload
 70,000 orders per year
 Forecasting
 Total forecasts on the stock records = $28 million
 Annual sales = $15 million
 Frequent stockouts due to forecast errors

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Solutions
 Develop a decision rule for what to stock
 Forecast demand for all items with the
damped trend
 Use the forecasts to do an ABC classification
 Replace the monthly ordering policy with a
hybrid inventory control system:
 Class A JIT
 Class B EOQ/safety stock
 Class C Annual buys

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What to stock?
 Cost to stock
Average inventory balance x holding rate +
Number of stock orders x transportation cost
 Cost to not stock
Number of customer orders x drop-ship transportation cost

Note: Transportation costs for not stocking may be both


in-and out bound, depending on whether we choose to
drop-ship from the vendor.

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Water filtration company:
Inventory status

7,526 with no hits 2,200 obsolete


in 12 months 9% 2,928 substitute
33% items
13%

4,202 with
inadequate
6,336 active items demand to stock
27% 18%

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ABC classification based on
damped-trend forecasts
Class Sales forecast System Items Dollars

A > $36,000 JIT 3% 75%

B $600 - $35,999 EOQ 49% 18%

C < $600 Annual buy 48% 7%

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The hybrid inventory control system
Inventory Production Lead-time
Control System
Class Schedule Behavior

JIT A, B Level Certain

MRP A, B Variable Reliable

EOQ / Safety stock A, B Variable Variable

Annual buy C Any Any

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Annual purchasing workload
Total savings = 58,000 orders (76%)

40,000
Monthly ordering
ABC system
35,000

30,000

25,000
EOQ
20,000
EOQ
15,000
JIT Annual
10,000 buys
JIT
5,000

0
A B C

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Inventory investment
Total savings = $591,000 (15%)

Monthly ordering
3,000,000 ABC system

2,500,000 JIT

2,000,000
EOQ
1,500,000
EOQ
1,000,000 JIT Annual
buys
500,000

0
A B C
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Conclusions
 Test all demand series for seasonality
 For series that pass the test, compare additive
and multiplicative seasonal adjustment
 Forecast at the highest possible level of
aggregation
 For total units, forecast with the damped trend
model

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Conclusions (cont.)
 Break down total forecasts with simple smoothing
applied to category percentages
 Regions
 Pack sizes
 Colors
 Benchmark the forecasts with a random walk
 Get operations and marketing together and
produce one corporate forecast

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Conclusions (cont.)
 Judge forecast accuracy in financial and
operational terms
 Customer service measures
 Backorder delay time
 Percent of time in stock
 Probability of stockout
 Dollars backordered
 Inventory investment on the balance sheet
 Purchasing workload or production setups

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www.bauer.uh.edu/gardner

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