Chapter Three

Forecasting

1
WHAT IS FORECASTING?
 Predictions, projections or estimates of future
events or conditions in which an enterprise
operates.

 The estimates can be: Demand?

 Occurrence of an event
 Timing of happening
 Magnitude or volume
2
 CONT’D
 The purpose of forecasting is to use the
best available information to guide future
activities toward organizational goals.
 Underlying basis of all business decisions
 Production
 Inventory
 Personnel
 Facilities

3
FORECASTING TIME HORIZONS
 Short-range forecast
 Up to 1 year, generally less than 3 months
 Purchasing, job scheduling, workforce levels, job
assignments, production levels
 Medium-range forecast
 3 months to 3 years
 Sales and production planning, budgeting

4
FORECASTING TIME HORIZONS

 Long-range forecast
 3+ years
 New product planning, facility location, research
and development

5
Forecasting system

INPUTS OUTPUT

6
INFLUENCE OF PRODUCT LIFE CYCLE

Introduction – Growth – Maturity – Decline

 Introduction and growth require longer

forecasts than maturity and decline
 As product passes through life cycle,
forecasts are useful in projecting
 Staffing levels
 Inventory levels
 Factory capacity
7
PRODUCT LIFE CYCLE
Introduction Growth Maturity Decline

 Product design  Forecasting  Standardization  Little product

OM Strategy/Issues

and development critical  Fewer product differentiation

critical  Product and changes, more  Cost
 Frequent product process reliability minor changes minimization
process design  Competitive  Optimum capacity  Overcapacity
changes product in the industry
 Increasing
 Short production improvements and stability of  Prune line to
runs options process eliminate items
 High production  Increase capacity  Long production not returning
costs  Shift toward runs good margin
 Limited models product focus  Product  Reduce
 Enhance improvement and capacity
 Attention to
quality distribution cost cutting

8
TYPES OF FORECASTS
 Economic forecasts
 Address business cycle – inflation rate, money
supply, housing starts, etc.
 Technological forecasts
 Predict rate of technological progress
 Impacts development of new products
 Demand forecasts
 Predict sales of existing products and services

9
STRATEGIC IMPORTANCE OF FORECASTING

 Human Resources – Hiring, training, laying

off workers
 Capacity – Capacity shortages can result in
undependable delivery, loss of customers,
loss of market share
 Supply Chain Management – Good supplier
relations and price advantages

10
 FORECASTING PROCESS
1. Identify the 2. Collect 3. Plot data and
purpose of forecast historical data identify patterns

6. Check forecast 5. Develop/compute

accuracy with one forecast for period 4. Select a forecast
or more measures of historical data model

7.
Is accuracy
8b. Select new
of forecast forecast model or
acceptable? adjust parameters
of existing model

9. Adjust forecast 10. Monitor results

8a. Forecast over and measure
based on additional
planning horizon forecast accuracy
qualitative information
11
 THE REALITIES!

 Forecasts are seldom perfect

 Most techniques assume an underlying
stability in the system
 Product family and aggregated forecasts
are more accurate than individual product
forecasts

12
FORECASTING APPROACHES

Qualitative Methods
 Used when situation is vague and little
data exist
 New products
 New technology
 Involves intuition, experience
 e.g., forecasting sales on Internet
13
FORECASTING APPROACHES

Quantitative Methods
 Used when situation is ‘stable’ and
historical data exist
 Existing products
 Current technology
 Involves mathematical techniques
 e.g., forecasting sales of color
14 televisions
OVERVIEW OF QUALITATIVE METHODS

1. Jury of executive opinion

2. Delphi method
3. Opinion of sales person
4. Consumer Market Survey

15
JURY OF EXECUTIVE OPINION

 Involves small group of high-level experts and

managers
 Group estimates demand by working together
 Combines managerial experience with statistical
models
 Relatively quick
 ‘Group-think’ disadvantage

16
DELPHI METHOD

 Iterative group
process, continues Decision Makers
until consensus is
(Sales will be
reached Staff
50!)
(What will sales
 3 types of be? survey)
participants
 Decision makers
 Staff Respondents
 Respondents (Sales will be 45, 50,
17 55)
Opinions of sales person
 Each salesperson projects his or her sales
 Combined at district and national levels
 Sales represents customers’ wants
 Tends to be overly optimistic
 Good for short range of planning

18
CONSUMER MARKET SURVEY

 Ask customers about purchasing plans.

 What consumers say, and what they

actually do are often different.

 Sometimes difficult to answer.

19
OVERVIEW OF QUANTITATIVE APPROACHES

1. Naive approach/Last data

point
Time-series
2. Moving averages models
3. Exponential smoothing
4. Trend projection
5. Linear regression Associative
model

20
TIME SERIES FORECASTING

 Set of evenly spaced numerical data

 Obtained by observing response variable at
regular time periods

 Forecast based only on past values, no other

variables important
 Assumes that factors influencing past and
present will continue influence in future

21
 Demand Pattern

Trend Cyclical

Seasonal Random

22
 Components of Time Series

Constant Linear Trend

Seasonal
Cyclical
NAIVE APPROACH

 Assumes demand in next

period is the same as
demand in most recent period
 e.g., If January sales were 68, then
February sales will be 68
 Sometimes cost effective and
efficient
 Can be good starting point
24
 MOVING AVERAGE METHOD

 MA is a series of arithmetic means

 Used if little or no trend
 Used often for smoothing
 Provides overall impression of data over time

∑ demand in previous n periods

Moving average = n
25
 Moving Average Example
Actual 3-Month
Month Shed Sales Moving Average

January 10
February 12
March 13
April 16 (10 + 12 + 13)/3 = 11 2/3
May 19 (12 + 13 + 16)/3 = 13 2/3
June 23 (13 + 16 + 19)/3 = 16
July 26 (16 + 19 + 23)/3 = 19 1/3
26 August X ???
 Simple Moving Average Problem

Week Demand Question: What is the 3

1 820 and 5 week moving
2 775 average forecast for
3 680
this data?
4 655
5 620 Assume you only have 3
6 600 weeks and 5 weeks of
7 575 actual demand data
for the respective
forecasts
Graph of Moving Average
30 –
28 – Moving
26 – Average
24 – Forecast
Actual
Shed Sales

22 – Sales
20 –
18 –
16 –
14 –
12 –
10 –
| | | | | | | | | | | |
J F M A M J J A S O N D
 WEIGHTED MOVING AVERAGE

 Used when some trend might be present

 Older data usually less important
 Weights based on experience and intuition

∑ (Weight for period n) x

Weighted (Demand in period n)
Moving Average = ∑ Weights

29
WEIGHTED MOVING AVERAGE
Weights Applied Period
3 Last month
2 Two months ago
1 Three months ago
6 Sum of weights

Actual 3-Month Weighted

Month Shed Sales Moving Average
January 10
February 12
March 13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 =121/6
May 19 [(3 x 16) + (2 x 13) + (12)]/6 = 141/3
June 23 [(3 x 19) + (2 x 16) + (13)]/6 = 17
July
30
26 [(3 x 23) + (2 x 19) + (16)]/6 = 201/2
 Problem 1

Question: Given the weekly demand information

and weights, what is the weighted moving
average forecast of the 5th period or week?

Week Demand
1 820
Weights:
2 775 t-1 .7
3 680
4 655
t-2 .2
t-3 .1
POTENTIAL PROBLEMS WITH MOVING AVERAGE

 Increasing n smoothes the forecast but

makes it less sensitive to changes.

 Do not forecast trends well.

 Require extensive historical data.

32
 MOVING AVERAGE AND WEIGHTED MOVING AVERAGE

30 –
Weighted
25 – moving
Sales demand

average
20 – Actual
sales
15 –
Moving
10 – average

5 –
| | | | | | | | | | | |
J F M A M J J A S O N D
 EXPONENTIAL SMOOTHING

 Form of weighted moving average

 Weights decline exponentially
 Most recent data weighted most
 Requires smoothing constant (a)
 Ranges from 0 to 1
 Subjectively chosen
 Involves little record keeping of past data

34
 EXPONENTIAL SMOOTHING

New forecast = Last period’s forecast +

a (Last period’s actual demand
– Last period’s forecast)

Ft = Ft – 1 + a(At – 1 - Ft – 1)

Where Ft = new forecast

Ft – 1 = previous forecast
a = smoothing (or weighting) constant
35 (0 ≤ a ≤ 1)
Exponential Smoothing Example

 Predicted demand = 142 Ford Mustangs

 Actual demand = 153
 Smoothing constant a = 0.20

New forecast = 142 + 0.2(153 – 142)

= 142 + 2.2
= 144.2 ≈ 144 cars
Problem 2
 A furniture manufacturing company produces different
sizes of cabinets and records the demand monthly. The
following demand data are for a specific cabinet model:
January 60; February 55; March 70. Using 56 as the forecast
for January and a smoothing constant of 0.20, what is the
April sale? Is 0.20 a good choice as a smoothing constant?
IMPACT OF DIFFERENT a

225 –

200 – Actual
demand a = 0.5
Demand

175 –

150 – a = 0.1
| | | | | | | | |
1 2 3 4 5 6 7 8 9
38
Quarter
CHOOSING a

 The objective is to obtain the most

accurate forecast no matter the technique.
 We generally do this by selecting the
model that gives us the lowest forecast
error.

Forecast error = Actual demand - Forecast value

= At - Ft
39
COMMON MEASURES OF ERROR

 Mean Absolute Deviation (MAD)

∑ |Actual - Forecast|
MAD =
n
 Mean Squared Error (MSE)
∑ (Forecast Errors)2
MSE =
n
40
COMMON MEASURES OF ERROR

 Mean Absolute Percent Error (MAPE)

n
∑100|Actuali - Forecasti|/Actuali
MAPE = i = 1
n

41
COMPARISON OF FORECAST ERROR
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = 0.10 a = 0.10 a = 0.50 a = 0.50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
42
82.45 98.62
COMPARISON OF FORECAST ERROR

Rounded Absolute Rounded Absolute

Actual Forecast Deviation Forecast Deviation
Tonnage∑ |deviations|
with for with for
MAD
Quarter =
Unloaded a = .10 a = .10 a = 0.50 a = 0.50
n
1 For = 0.10175
a180 5.00 175 5.00
2 = 82.45/8
168 175.5 = 10.31
7.50 177.50 9.50
3 For a159
= 0.50174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5
=
190
98.62/8
173.36
= 12.33
16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
43 82.45 98.62
COMPARISON OF FORECAST ERROR
Rounded Absolute Rounded Absolute
∑ (forecast
Actual Forecast errors) 2
Deviation Forecast Deviation
MSE =Tonnage with for with for
Quarter Unloaded n
a = .10 a = .10 a = 0.50 a = 0.50
1 180 175 5.00 175 5.00
For
2 a =168
0.10 175.5 7.50 177.50 9.50
3 =159
1,526.54/8
174.75 = 190.82
15.75 172.75 13.75
For
4 a =175
0.50 173.18 1.82 165.88 9.12
5
6
=190
205
173.36
1,561.91/8
175.02
= 16.64
195.24
29.98
170.44
180.22
19.56
24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
44 MAD 10.31 12.33
COMPARISON OF FORECAST ERROR
n Rounded Absolute Rounded Absolute
∑
Actual
Tonnage
Forecast
with
Deviation
100|deviation i
for
Forecast
|/actual i
with
Deviation
for
MAPE Unloaded
Quarter = i = 1 a = .10 a = .10 a = .50 a = 0.50
1 180 175 n 5.00 175 5.00
2 For 168
a = 0.10
175.5 7.50 177.50 9.50
3 159 174.75
4 175
= 44.75/8
173.18
= 15.75
5.59%
1.82
172.75
165.88
13.75
9.12
5 For 190
a = 0.50
173.36 16.64 170.44 19.56
6 205 = 54.05/8
175.02 = 29.98
6.76% 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
45
MSE 190.82 195.24
COMPARISON OF FORECAST ERROR
Actual Rounded Absolute Rounded Absolute
Tonnage Forecast Deviation Forecast Deviation
Quarter Unloaded a = 0.10 a = 0.10 a = 0.50 a = 0.50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 190.82 195.24
46 MAPE 5.59% 6.76%
EXPONENTIAL SMOOTHING WITH TREND ADJUSTMENT

 When a trend is present, exponential smoothing

must be modified
Forecast Exponentially Exponentially
including (FITt) = smoothed (Ft) + smoothed (Tt)
trend forecast trend

Ft = a (At - 1) + (1 - a)(Ft - 1 + Tt - 1)

Tt = b(Ft - Ft - 1) + (1 - b)Tt - 1
47
 Exponential Smoothing with Trend Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17
3 20
4 19
5 24
6 21
7 31
8 28
9 36
10

48
 Exponential Smoothing with Trend Adjustment Example
for a= 0.2 and for b=0.4
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, TtTrend, FITt
1 12 11 2 13.00
2 17
3 20 Step 1: Forecast for Month 2
4 19
5 24 F2 = a A1 + (1 - a)(F1 + T1)
6 21
7 31 F2 = (0.2)(12) + (1 - 0.2)(11 + 2)
8 28 = 2.4 + 10.4 = 12.8 units
9 36
10
49
 Exponential Smoothing with Trend Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.8
3 20
4 19 Step 2: Trend for Month 2
5 24 T2 = b (F2 - F1) + (1 - b)T1
6 21
7 31 T2 = (0.4)(12.8 - 11) + (1 - 0.4)(2)
8 28
9 36
= 0.72 + 1.2 = 1.92 units
10

50
 Exponential Smoothing with Trend Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.8 1.92
3 20
4 19 Step 3: Calculate FIT for Month 2
5 24
6 21 FIT2 = F2 + T2
7 31
8 28 FIT2 = 12.8 + 1.92
9 36 = 14.72 units
10

51
 Exponential Smoothing with Trend Adjustment
Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80 1.92 14.72
3 20 15.18 2.10 17.28
4 19 17.82 2.32 20.14
5 24 19.91 2.23 22.14
6 21 22.51 2.38 24.89
7 31 24.11 2.07 26.18
8 28 27.14 2.45 29.59
9 36 29.28 2.32 31.60
10 32.48 2.68 35.16
52
 Exponential Smoothing with Trend Adjustment
Example
30 –

25 –
Actual demand (At)
Product demand

20 –

15 –

10 –
Forecast including trend (FITt)
5 –
with a = 0.2 and b = 0.4
0 –
| | | | | | | | |
1 2 3 4 5 6 7 8 9
53
Time (month)
 Problem 3
A company uses exponential smoothing with trend to forecast
usage of its lawn care products. At the end of July the company
wishes to forecast sales for August. July demand was 62. The trend
through June has been 15 additional gallons of product sold per
month. Average sales have been 57 gallons per month. The
company uses alpha+0.2 and beta +0.10. Forecast for August.
TREND PROJECTIONS

 Fitting a trend line to historical data points to

project into the medium to long-range
 Linear trends can be found using the least squares
technique
y^ = a + bx
Where y^ =computed value of the variable to be
predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
55
x = the independent variable
LEAST SQUARES METHOD

Values of Dependent Variable

Actual observation Deviation7
(y-value)
Deviation5 Deviation6

Deviation3

Deviation4

Deviation1
(error) Deviation2
Trend line, y^ = a + bx

Time period
LEAST SQUARES METHOD

Values of Dependent Variable

Actual observation Deviation7
(y-value)
Deviation5 Deviation6

Deviation3 Least squares method

minimizes
Deviation the sum of the
squared errors (deviations)
4

Deviation1
(error) Deviation2
Trend line, y^ = a + bx

Time period
LEAST SQUARES METHOD

 Equations to calculate the regression variables

y^ = a + bx
Sxy - nxy
b =
Sx2 - nx2
a = y - bx
 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
2003 1 74 1 74
2004 2 79 4 158
2005 3 80 9 240
2006 4 90 16 360
2007 5 105 25 525
2008 6 142 36 852
2009 7 122 49 854
∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063
x = 4 y = 98.86
∑xy - nxy 3,063 - (7)(4)(98.86)
b = = = 10.54
∑x2 - nx2 140 - (7)(4 )
2

59
a = y - bx = 98.86 - 10.54(4) = 56.70
 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
2003 1 74 1 74
2004 2 79 4 158
2005 3 80 9 240
2006 4 90 16 360
2007 5 105 25 525
2008 6 142 36 852
2009 7 The trend 122 line is 49 854
∑x = 28 ^==692
∑yy 56.70∑x2+= 10.54x
140 ∑xy = 3,063
x = 4 y = 98.86
∑xy - nxy 3,063 - (7)(4)(98.86)
b = = = 10.54
∑x - nx
2 2 140 - (7)(4 )
2
60
a = y - bx = 98.86 - 10.54(4) = 56.70
 Least Squares Example

Trend line,
130 – y^ = 56.70 + 10.54x
120 –
Power demand

110 –
100 –
90 –
80 –
70 –
60 –
50 –
| | | | | | | | |
2003 2004 2005 2006 2007 2008 2009 2010 2011
61 Year
SEASONAL VARIATIONS IN DATA

Steps in the process:

1. Find average historical demand for each season
2. Compute the average demand over all seasons
3. Compute a seasonal index for each season
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the
number of seasons, then multiply it by the
seasonal index for that season
63
 Seasonal Index Example
Demand Average Average Seasonal
Month 2007 2008 2009 2007-2009 Monthly Index
Jan 80 85 105 90 94
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Apr 90 95 115 100 94
May 113 125 131 123 94
Jun 110 115 120 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
64 Dec 82 78 80 80 94
 Seasonal Index Example
Demand Average Average Seasonal
Month 2007 2008 2009 2007-2009 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Apr 90 95 Average
115 2007-2009
100 monthly demand
94
Seasonal index =
May 113 125 131 Average monthly
123 demand94
Jun 110 115 = 90/94
120 = 0.957 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
65 Dec 82 78 80 80 94
 Seasonal Index Example
Demand Average Average Seasonal
Month 2007 2008 2009 2007-2009 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90 95 115 100 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 115 94 1.223
Jul 100 102 113 105 94 1.117
Aug 88 102 110 100 94 1.064
Sept 85 90 95 90 94 0.957
Oct 77 78 85 80 94 0.851
Nov 75 72 83 80 94 0.851
66 Dec 82 78 80 80 94 0.851
 Seasonal Index Example
Demand Average Average Seasonal
Month 2007 2008 2009 2007-2009 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94 0.851
Mar 80 93 Forecast
82 for852010 94 0.904
Apr 90 95 115 100 94 1.064
May
Expected annual demand
113 125 131 123
= 1,200
94 1.309
Jun 110 115 120 1,200 115 94 1.223
Jul 100 102Jan113 x 0.957 = 94
96
12 105 1.117
Aug 88 102 110
1,200 100 94 1.064
Sept 85 Feb 95
90 x900.851 = 94
85 0.957
Oct 77 78 85 12 80 94 0.851
Nov 75 72 83 80 94 0.851
67 Dec 82 78 80 80 94 0.851
 Seasonal Index Example
140 –
130 –
2010 Forecast
2009 Demand
120 –
2008 Demand
110 –
2007 Demand
Demand

100 –
90 –
80 –
70 –
| | | | | | | | | | | |
J F M A M J J A S O N D
68 Time
CORRELATION

 How strong is the linear relationship between

the variables?
 Correlation does not necessarily imply
causality!
 Coefficient of correlation, r, measures degree
of association
 Values range from -1 to +1

69
CORRELATION COEFFICIENT

70
CORRELATION COEFFICIENT
y y

x x
(a) Perfect positive correlation: r = +1 (b) Positive correlation: 0 < r < 1

y y

x x
(c) No correlation: r = 0
71 (d) Perfect negative correlation: r = -1
CORRELATION

 Coefficient of Determination, r2, measures

the percent of change in y predicted by the
change in x
 Values range from 0 to 1
 Easy to interpret

72
MULTIPLE REGRESSION ANALYSIS

 If more than one independent variable is to be

used in the model, linear regression can be
extended to multiple regression to accommodate
several independent variables

y^ = a + b1x1 + b2x2 …
Computationally, this is quite
complex and generally done on the
computer
73
MONITORING AND CONTROLLING FORECASTS

Tracking Signal
 Measures how well the forecast is predicting
actual values
 Ratio of cumulative forecast errors to mean
absolute deviation (MAD)
 Good tracking signal has low values
 If forecasts are continually high or low, the
forecast has a bias error

74
MONITORING AND CONTROLLING FORECASTS

Tracking = Cumulative error

signal MAD

∑(Actual demand in period i – Forecast

Tracking demand in period i)
signal =
(∑|Actual - Forecast|/n)

75
TRACKING SIGNAL

Signal exceeding limit

Tracking signal
Upper control limit
+

Acceptable
0 MADs range

–
Lower control limit
Time
76
ADAPTIVE FORECASTING

 It’s possible to use the computer to

continually monitor forecast error and
adjust the values of the a and b
coefficients used in exponential smoothing
to continually minimize forecast error.

 This technique is called adaptive

smoothing.
77