Forecasting

O P E R AT I O N S M A N A G E M E N T
 The Role of Forecasting

Forecasting is a vital function and affects every significant management decision.

◦ Finance and accounting use forecasts as the basis for budgeting and cost control.
◦ Marketing relies on forecasts to make key decisions such as new product
planning and personnel compensation.
◦ Production uses forecasts to select suppliers; determine capacity requirements;
and drive decisions about purchasing, staffing, and inventory.

Different roles require different forecasting approaches.

◦ Decisions about overall directions require strategic forecasts.
◦ Tactical forecasts are used to guide day-to-day decisions.
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 The Effect of
Inaccurate
Forecasting

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 Forecasting Time Horizons
1. Short-range forecast
► Up to 1 year, generally less than 3 months
► Purchasing, job scheduling, workforce levels, job
assignments, production levels
2. Medium-range forecast
► 3 months to 3 years
► Sales and production planning, budgeting
3. Long-range forecast
► 3+ years
► New product planning, facility location, research and
development

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 Types of Forecasts

1. Economic forecasts
► Address business cycle – inflation rate, money
supply, housing starts, etc.
2. Technological forecasts
► Predict rate of technological progress
► Impacts development of new products
3. Demand forecasts
► Predict sales of existing products and services

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 Seven Steps in Forecasting

1. Determine the use of the forecast

2. Select the items to be forecasted
3. Determine the time horizon of the forecast
4. Select the forecasting model(s)
5. Gather the data needed to make the forecast
6. Make the forecast
7. Validate and implement results

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 Forecasting Principles

▪ There is no such things as 100% reliable forecast

▪ Forecast for more accurate for the larger group of items
▪ Forecast are more accurate over shorter time periods
▪ Every forecast should be accompanied by an estimate of forecast error for the planning purposes

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 Hierarchy of Forecasting

Top Down Approach Bottom Up Approach

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 Overview of Forecasting Approaches

1. Naive approach
2. Moving averages Quantitative Methods

3. Exponential smoothing i) Time-series models

4. Trend projection
ii) Associative models
5. Linear regression

1. Market research
2. Jury/Executive Opinion
Qualitative method
3. Historical analogy
4. Delphi method
5. Sales Force Composite
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 Qualitative Forecasting Techniques
Generally used to take advantage of expert knowledge.

Useful when judgment is required, when products are new, or if the firm has little experience in a
new market.

Examples
◦ Market research
◦ Panel consensus
◦ Delphi method
◦ Sales Force Composite

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 Model Selection

Choosing an appropriate forecasting model depends upon

◦ Time horizon to be forecast

◦ Data availability
◦ Accuracy required
◦ Size of forecasting budget
◦ Availability of qualified personnel

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 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

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 Time-Series Components

Trend Cyclical

Seasonal Random

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 Components of Demand
Trend
component

Demand for product or service

Seasonal peaks

Actual demand
line

Average demand
over 4 years

Random variation
| | | |
1 2 3 4
Time (years)

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 Seasonal Component

► Regular pattern of up and down fluctuations

► Due to weather, customs, etc.
► Occurs within a weeks, months or quarter

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 Cyclical Component

► Repeating up and down movements

► Affected by business cycle, political, and economic factors
► Multiple years duration
► Often causal or
associative
relationships

0 5 10 15 20

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 Random Component

► Erratic, unsystematic, ‘residual’ fluctuations

► Due to random variation or unforeseen events
► Short duration and nonrepeating

M T W T
F
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 Forecasting Method Selection Guide

Forecast
Forecasting Method Amount of Historical Data Data Pattern
Horizon
6 to 12 months; weekly data Stationary (i.e., no trend
Simple moving average Short
are often used or seasonality)

Weighted moving average

5 to 10 observations needed to
and simple exponential Stationary Short
start
smoothing
5 to 10 observations needed to
Exponential smoothing with
start Stationary and trend Short
trend

Stationary, trend, and Short to

Linear regression 10 to 20 observations
seasonality medium

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 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

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 Simple Moving Average

Forecast is the average of a fixed number of past periods.

Useful when demand is not growing or declining rapidly, and no seasonality is
present.
Removes some of the random fluctuation from the data.
Selecting the period length is important.
◦ Longer periods provide more smoothing.
◦ Shorter periods react to trends more quickly.
◦ Moving averages does not capture the trend
◦ Requires extensive record of data

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 Simple Moving Average Formula

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 Problem
Historical demand for a product is as follows:
Month Demand
April 60
May 55
June 75
July 60
August 80
September 75

Use a simple four month moving average, calculate a forecast for October

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 Month Demand Forecast
April 60
May 55
June 75
July 60
August 80 62.5
September 75 67.5
October 72.5

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 Simple Moving Average – Example

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 Weighted Moving Average

The simple moving average formula implies equal weighting for all periods.
A weighted moving average allows unequal weighting of prior time periods.
◦ The sum of the weights must be equal to one.
◦ Often, more recent periods are given higher weights than periods farther
in the past.

𝐹𝑡 = 𝑤1𝐴𝑡 − 1 + 𝑤2𝐴𝑡 − 2 + …+
𝑤𝑛𝐴𝑡 − 𝑛

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 Selecting Weights
▪ Experience and/or trial-and-error are the simplest approaches.

▪ The recent past is often the best indicator of the future, so weights are generally
higher for more recent data.
▪ If the data are seasonal, weights should reflect this appropriately.

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 Exponential Smoothing
▪The most used of all forecasting techniques
▪ An integral part of computerized forecasting
▪ Requires smoothing constant (α)
► Ranges from 0 to 1
► Subjectively chosen

Well accepted for six reasons

◦ Formulating an exponential model is relatively easy
◦ The user can understand how the model works
◦ Little computation is required to use the model
◦ Computer storage requirements are small
◦ Tests for accuracy are easy to compute

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 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 period’s forecast
a = smoothing (or weighting) constant (0 ≤ a ≤ 1)
At – 1 = previous period’s actual demand

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 Exponential Smoothing Example

Predicted demand for the last period = 142 Ford Mustangs

Actual demand for the last period = 153
Smoothing constant a = .20

New forecast = 142 + .2(153 – 142)

= 144.2 ≈ 144 cars

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 Problem
Historical demand for a product is as follows:
Month Demand
April 60
May 55
June 75
July 60
August 80
September 75
Use a simple exponential smoothing with alpha = 0.2 and a September forecast is 65,
calculate a forecast for October.

FOctober = FSeptember + (ASeptember – FSeptember) = 65 + .2(75 – 65) = 67.0

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 Exponential Smoothing

FORECAST, Ft + 1
PERIOD MONTH DEMAND ( = 0.3) ( = 0.5)

1 Jan 37 – –
2 Feb 40 37.00 37.00
3 Mar 41 37.90 38.50
4 Apr 37 38.83 39.75
5 May 45 38.28 38.37
6 Jun 50 40.29 41.68
7 Jul 43 43.20 45.84
8 Aug 47 43.14 44.42
9 Sep 56 44.30 45.71
10 Oct 52 47.81 50.85
11 Nov 55 49.06 51.42
12 Dec 54 50.84 53.21
13 Jan – 51.79 53.61
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 Exponential Smoothing

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 Choosing 

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

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 Exponential Smoothing Example

Week Demand Forecast

1 820 820
2 775 820
3 680 811
4 655 785
5 750 759
6 802 757
7 798 766
8 689 772
9 775 756
10 760

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 Exponential Smoothing – Effect of Trends

The presence of a trend in the data causes the exponential

smoothing forecast to always lag behind the actual data

This can be corrected by adding a trend adjustment

◦ The trend smoothing constant is delta (δ)

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Example – Exponential Smoothing with Trend Adjustment

Calculate the new forecast, assuming the following:

◦ The previous forecast including trend (FITt-1) is 110 and the previous
estimate of the trend (Tt-1) is 10
◦ α = 0.2 and δ = 0.3
◦ Actual demand for period t-1 is 115

Ft = FITt-1 + α(At-1 – FITt-1) = 110 + 0.2(115-110) = 111.0

Tt = Tt-1 + δ(Ft – FITt-1) = 10 + 0.3(111-110) = 10.3

FITt = Ft + Tt = 111.0 + 10.3 = 121.3

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 Choosing Alpha and Delta

Relatively small values for α and δ are common

◦ Usually in the range 0.1 to 0.3
α depends upon how much random variation is present
δ depends upon how steady the trend is
Measurement of forecast error can be used to select values of α and δ to minimize
overall forecast error

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 Forecast Errors

Forecast error is the difference between the forecast value and what actually occurred.

All forecasts contain some level of error.

Sources of error
◦ Bias – when a consistent mistake is made
◦ Random – errors that are not explained by the model being used

Measures of error
◦ Mean absolute deviation (MAD)
◦ Mean Squared Error (MSE)
◦ Mean absolute percent error (MAPE)
◦ Tracking signal

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 Forecast Error Measurements

Ideally, MAD will be zero (no • MAPE scales the forecast error to the
forecasting error). magnitude of demand.
Larger values of MAD indicate a less
accurate model.

• Tracking signal indicates whether

forecast errors are accumulating over
time (either positive or negative errors).

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 Mean Squared Error (MSE)

å (Forecast errors)
2

MSE = = 1,526.52 / 8 = 190.8

n
FORECAST
QUARTER ACTUAL TONNAGE UNLOADED (ERROR)2
FOR a = .10

1 180 175 52 = 25
2 168 175.50 (–7.5)2 = 56.25
3 159 174.75 (–15.75)2 = 248.06
4 175 173.18 (1.82)2 = 3.31
5 190 173.36 (16.64)2 = 276.89
6 205 175.02 (29.98)2 = 898.80
7 180 178.02 (1.98)2 = 3.92
8 182 178.22 (3.78)2 = 14.29
Sum of errors squared = 1,526.52

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 Computing Forecast Error

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 Problem
A particular forecasting model was used to forecast a six month period. Here are the forecast and
actual demands that resulted:
Month Forecast Actual
April 250 200
May 325 250
June 400 325
July 350 300
August 375 325
September 450 400

Find the tracking signal and state whether you think the model being used is giving acceptable
answers.

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 Sum of
Absolute
Month Forecast Actual Deviation RSFE absolute MAD TS
deviation
deviations
April 250 200 -50 -50 50 50 50.0 -1
May 325 250 -75 -125 75 125 62.5 -2
June 400 325 -75 -200 75 200 66.7 -3
July 350 300 -50 -250 50 250 62.5 -4
August 375 325 -50 -300 50 300 60.0 -5

September 450 400 -50 -350 50 350 58.3 -6

1 2 3 4 5 6
0

-1
For September, the MAD is 58.3 and the TS is –6. The model is
-2
performing poorly since the tracking signal is –6 and moving in a
TS

-3 downward direction. The model is consistently over-forecasting

-4 demand.
-5

-6 Period

-7

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 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
x = the independent variable

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 Least Squares Method

Values of Dependent Variable (y-values)

Actual observation Deviation7
(y-value)

Deviation5 Deviation6

Deviation3
Least squares method minimizes the
sum of Deviation
the squared
4
errors (deviations)

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

| | | | | | |
1 2 3 4 5 6 7
Time period
© 2014 Pearson Education, Inc. 4 - 45
 Linear Regression Analysis

▪ Regression is used to identify the functional relationship between two or

more correlated variables, usually from observed data.
▪ One variable (the dependent variable) is predicted for given values of the
other variable (the independent variable).
▪ Linear regression is a special case that assumes the relationship between
the variables can be explained with a straight line.

Y = a + bt

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 Linear Regression Analysis

▪ Regression is used to identify the functional relationship between two or

more correlated variables, usually from observed data.
▪ One variable (the dependent variable) is predicted for given values of the
other variable (the independent variable).
▪ Linear regression is a special case that assumes the relationship between
the variables can be explained with a straight line.

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 Linear Regression
y = a + bx
a = y-bx
 xy - nxy
b =  x2 - nx2

where
a = intercept
b = slope of the line
x
x = n = mean of the x data
y
y = n = mean of the y data

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 Least Squares Method
The least squares method determines the parameters a and b such that the
sum of the squared errors is minimized – “least squares”

Quarter Sales Quarter Sales

1 600 7 2,600
2 1,550 8 2,900
3 1,500 9 3,800
4 1,500 10 4,500
5 2,400 11 4,000
6 3,100 12 4,900

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 Calculations

1 600 600 1 360,000 801.3

2 1,550 3,100 4 2,402,500 1,160.9

3 1,500 4,500 9 2,250,000 1,520.5

4 1,500 6,000 16 2,250,000 1,880.1

5 2,400 12,000 25 5,760,000 2,239.7

6 3,100 18,600 36 9,610,000 2,599.4

7 2,600 18,200 49 6,760,000 2,959.0

The forecast is extended to periods 13-16 8 2,900 23,200 64 8,410,000 3,318.6

9 3,800 34,200 81 14,440,000 3,678.2

10 4,500 45,000 100 20,250,000 4,037.8

11 4,000 44,000 121 16,000,000 4,397.4

12 4,900 58,800 144 24,010,000 4,757.1

Sum 78 33,350 268,200 650 112,502,500

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 Time Series Decomposition
▪ Chronologically ordered data are referred to as a time series.
▪ A time series may contain one or many elements.
▪ Identifying these elements and separating the time series data into these
components is known as decomposition.

The additive model is useful when the seasonal variation is relatively constant over
time.
The multiplicative model is useful when the seasonal variation increases over time.

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 Seasonal Variation
Seasonal variation may be either additive or multiplicative (shown here with a
changing trend).

• The additive model is useful when the seasonal variation is relatively constant over
time.
• The multiplicative model is useful when the seasonal variation increases over time.

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 Additive or multiplicative
(shown here with a changing trend).

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 Determining Seasonal Factors :
Simple Proportions
The seasonal factor (or index) is the ratio of the amount sold during each season divided by the
average for all seasons.

Average Sales for

Season Past Sales Seasonal Factor
Each Season

1000 200
Spring 200 = 250 = 0.8
4 250
1000 350
Summer 350 = 250 = 1.4
4 250
1000 300
Fall 300 = 250 = 1.2
4 250
1000 150
Winter 150 = 250 = 0.6
4 250
Total 1000

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 Example

Expected Average Next

Demand Sales for Seasonal Year’s
for Each Season Factor Seasonal
Next Year (1,100y4) Forecast
Spring 275 X 0.8 = 220
Summer 275 X 1.4 = 385
Fall 275 X 1.2 = 330
Winter 275 X 0.6 = 165
1100

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 Decomposition Using Least Squares Regression
Decompose the time series into its components
◦ Find seasonal component
◦ Deseasonalize the demand
◦ Find trend component

Forecast future values of each component

◦ Project trend component into the future
◦ Multiply trend component by seasonal component

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 Decomposition – Steps 1 and 2

Using the data for periods 1-12, apply time series analysis (decomposition,
linear regression, trend estimate & seasonal indices) to forecast for periods
13-16

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 Decomposition – Steps 3 and 4
Develop a least squares regression line for the deseasonalized data.
Project the regression line through the period of the forecast.

Regression Results:
Y = 555.0 + 342.2t
Forecast for
periods 13-16

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 Decompostion – Step 5
Create the final forecast by adjusting the regression line by the seasonal factor.

Seasonal Forecast (F x
Period Quarter Y from Regression
Factor Seasonal Factor
13 I 5,003.5 0.82 4,102.87
14 II 5,345.7 1.10 5,880.27
15 III 5,687.9 0.97 5,517.26
16 IV 6,030.1 1.12 6,753.71

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 Associative Forecasting

▪ Used when changes in one or more independent variables can

be used to predict the changes in the dependent variable

▪ Causal relationship forecasting uses independent variables

other than time to predict future demand.

▪ This independent variable must be a leading indicator

▪ Most common technique is linear regression analysis

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 Associative Forecasting

Forecasting an outcome based on predictor variables using

the least squares technique

y^ = a + bx

where y^ = value of the dependent variable (in our example,

sales)
a = y-axis intercept
b = slope of the regression line
x = the independent variable

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 Associative Forecasting Example
NODEL’S SALES AREA PAYROLL NODEL’S SALES AREA PAYROLL
(IN $ MILLIONS), y (IN $ BILLIONS), x (IN $ MILLIONS), y (IN $ BILLIONS), x
2.0 1 2.0 2
3.0 3 2.0 1
2.5 4 3.5 7

4.0 –

Nodel’s sales
(in$ millions)
3.0 –

2.0 –

1.0 –

| | | | | | |

0 1 2 3 4 5 6 7
Area payroll (in $ billions)

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 Associative Forecasting Example
SALES, y PAYROLL, x x2 xy
2.0 1 1 2.0
3.0 3 9 9.0
2.5 4 16 10.0
2.0 2 4 4.0
2.0 1 1 2.0
3.5 7 49 24.5
Σy = 15.0 Σx = 18 Σx2 = 80 Σxy = 51.5

x=
å x 18
= =3 y=
å y 15
= = 2.5
6 6 6 6

b=
å xy - nxy 51.5 - (6)(3)(2.5)
= = .25 a = y - bx = 2.5 - (.25)(3) = 1.75
å x - nx
2 2
80 - (6)(3 ) 2

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 Associative Forecasting Example
SALES, y PAYROLL, x x2 xy
2.0 1 1 2.0
3.0 3 9 9.0
ŷ = 1.75 + .25x
2.5 4 16 10.0
2.0 2 Sales = 1.75
4 + .25(payroll)
4.0
2.0 1 1 2.0
3.5 7 49 24.5
Σy = 15.0 Σx = 18 Σx2 = 80 Σxy = 51.5

x=
å x 18
= =3 y=
å y 15
= = 2.5
6 6 6 6

b=
å xy - nxy 51.5 - (6)(3)(2.5)
= = .25 a = y - bx = 2.5 - (.25)(3) = 1.75
å x - nx
2 2
80 - (6)(3 ) 2

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 Standard Error of the Estimate
► A forecast is just a point estimate of a future value
► This point is
actually the
mean of a
probability 4.0 –
distribution 3.25

Nodel’s sales
3.0 –

(in$ millions)
Regression line,
2.0 – ŷ =1.75+.25x

1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Figure 4.9 Area payroll (in $ billions)

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 Standard Error of the Estimate

S y,x =
å ( y - y c
) 2

n-2

where y = y-value of each data point

yc = computed value of the dependent variable,
from the regression equation
n = number of data points

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 Standard Error of the Estimate

Computationally, this equation is considerably

easier to use

S y,x =
å - aå y - bå xy
y 2

n-2

We use the standard error to set up prediction

intervals around the point estimate

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 Standard Error of the Estimate

S y,x =
å - aå y - bå xy
y 2

=
39.5 -1.75(15.0) - .25(51.5)
n-2 6-2
= .09375
= .306 (in $ millions)
4.0 –
3.25

Nodel’s sales
3.0 –

(in$ millions)
The standard error of the 2.0 –
estimate is $306,000 in
sales 1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll (in $ billions)

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 Correlation and Coefficient of Determination

Correlation, r
◦ Measure of strength of relationship
◦ Varies between -1.00 and +1.00
Coefficient of determination, r2
◦ Percentage of variation in dependent variable resulting from changes in
the independent variable

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 Computing Correlation

r= n xy -  x y
[n x2 - ( x)2] [n y2 - ( y)2]

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 Multiple Regression Techniques
Often, more than one independent variable may be a valid
predictor of future demand.

In this case, the forecast analyst may utilize multiple regression.

◦ Analogous to linear regression analysis, but with multiple
independent variables.
◦ Multiple regression supported by statistical software packages.

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 Multiple Regression

Study the relationship of demand to two or more independent

variables

y = 0 + 1x1 + 2x2 … + kxk

where
0 = the intercept
1, … , k = parameters for the independent variables
x1, … , xk = independent variables

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 Problem

Sales data for two years are as follows. Data are aggregated with the two months of sales in
each period:
Months Sales Months Sales
January-February 109 January-February 115
March-April 104 March-April 112
May-June 150 May-June 159
July-August 170 July-August 182
September-October 120 September-October 126
November- November-
December 100 December 106

a) Plot the data

b) Fit a simple regression model to the sales data
c) Determine the multiplicative seasonal index factors. A full cycle is assumed to be a full year.
d) Using the results from part (b) and part (c). prepare a forecast for the next period.

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