Because learning changes everything.

Chapter 3

Forecasting

Operations Management
FOURTEENTH EDITION
William J. Stevenson

© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 Forecast

Forecast – a statement about the future value of a

variable of interest
• We make forecasts about such things as weather,
demand, and resource availability
• Forecasts are important to making informed decisions
(budgeting, capacity planning and staffing, production,
inventory, etc)

LO 3.1
© McGraw Hill 3
 Two Important Aspects of Forecasts

Expected level of demand

• The level of demand may be a function of some structural
variation such as trend or seasonal variation

Accuracy
• Related to the potential size of forecast error

LO 3.1
© McGraw Hill 4
 Forecasts in Business Organizations

Accounting. New product/process cost estimates, profit projections,

cash management.
Finance. Equipment/equipment replacement needs, timing
and amount of funding/borrowing needs.
Human resources. Hiring activities, including recruitment,
interviewing, and training; layoff planning, including
outplacement counseling.
Marketing. Pricing and promotion, e-business strategies, global
competition strategies.
MIS. New/revised information systems, internet services.
Operations. Schedules, capacity planning, work assignments and
workloads, inventory planning, make-or-buy decisions, outsourcing,
project management.
Product/service design. Revision of current features, design of new
products or services.
LO 3.1
© McGraw Hill 5
 Forecast Uses

Plan the system

• Generally involves long-range plans related to:
• Types of products and services to offer
• Facility and equipment levels
• Facility location
Plan the use of the system
• Generally involves short- and medium-range plans related to:
• Inventory management
• Workforce levels
• Purchasing
• Production
• Budgeting
• Scheduling
LO 3.1
© McGraw Hill 6
 Features Common to All Forecasts

1. Techniques assume some underlying causal system that

existed in the past will persist into the future

2. Forecasts are not perfect

3. Forecasts for groups of items are more accurate than

those for individual items

4. Forecast accuracy decreases as the forecasting horizon

increases

LO 3.1
© McGraw Hill 7
 Forecasts Are Not Perfect

Forecasts are not perfect:

• Because random variation is always present, there will
always be some residual error, even if all other factors
have been accounted for.

LO 3.2
© McGraw Hill 8
 Elements of a Good Forecast

The forecast
• Should be timely
• Should be accurate
• Should be reliable
• Should be expressed in meaningful units
• Should be in writing
• Technique should be simple to understand and use
• Should be cost-effective

LO 3.3
© McGraw Hill 9
 Steps in the Forecasting Process

1. Determine the purpose of the forecast

2. Establish a time horizon
3. Obtain, clean, and analyze appropriate data
4. Select a forecasting technique
5. Make the forecast
6. Monitor the forecast errors

LO 3.4
© McGraw Hill 10
 Forecasting Approaches

Qualitative forecasting
• Qualitative techniques permit the inclusion of soft
information (intangibles) such as:
• Human factors
• Personal opinions
• Hunches
• These factors are difficult, or impossible, to quantify
Quantitative forecasting
• These techniques rely on hard data
• Quantitative techniques involve either the projection of
historical data or the development of associative methods
that attempt to use causal variables to make a forecast
LO 3.6
© McGraw Hill 11
 Qualitative Forecasts

Forecasts that use subjective inputs such as opinions from consumer surveys,
sales staff, managers, executives, and experts
• Executive opinions
• A small group of upper-level managers may meet and collectively develop a forecast
• Salesforce opinions
• Members of the sales or customer service staff can be good sources of information
due to their direct contact with customers and may be aware of plans customers may
be considering for the future
• Consumer surveys
• Since consumers ultimately determine demand, it makes sense to solicit input from
them
• Consumer surveys typically represent a sample of consumer opinions
• Other approaches
• Managers may solicit opinions from other managers or staff people or outside
experts to help with developing a forecast
• The Delphi method (panel of experts) is an iterative process intended to achieve a
consensus
LO 3.6
© McGraw Hill 12
 Time-Series Forecasts

Forecasts that project patterns identified in recent time-series

observations
• Time-series – a time-ordered sequence of observations
taken at regular time intervals

Assume that future values of the time-series can be

estimated from past values of the time-series

LO 3.6
© McGraw Hill 13
 Time-Series Behaviors

Trend

Seasonality

Cycles

Irregular variations

Random variation

LO 3.6
© McGraw Hill 14
 Trends and Seasonality

Trend
• A long-term upward or downward movement in data
• Population shifts
• Changing income

Seasonality
• Short-term, fairly regular variations related to the calendar
or time of day
• Restaurants, service call centers, and theaters all
experience seasonal demand

LO 3.6
© McGraw Hill 15
 Cycles and Variations

Cycle
• Wavelike variations lasting more than one year
• These are often related to a variety of economic, political, or even
agricultural conditions
Irregular variation
• Due to unusual circumstances that do not reflect typical
behavior
• Labor strike
• Weather event
Random Variation
• Residual variation that remains after all other behaviors
have been accounted for
LO 3.6
© McGraw Hill 16
 Time-Series Forecasting - Naïve Forecast

Naïve forecast
• Uses a single previous value of a time series as the basis
for a forecast
• The forecast for a time period is equal to the previous time period’s
value

• Can be used with

• A stable time series
• Seasonal variations
• Trend

LO 3.7
© McGraw Hill 17
 Time-Series Forecasting - Naïve Forecast

Example 1 – stable series or seasonal variations

2022 2023
Month Actual Demand Month Demand Forecast
101
November 101 November ?

Example 2 – data with trend

2023
Change From
Month Actual Demand Demand Forecast
Previous Month

September 100 - -
October 105 5 -
November - - 105 + 5?= 110

LO 3.7
© McGraw Hill 18
 Time-Series Forecasting - Averaging

These techniques work best when a series tends to vary

about an average
• Averaging techniques smooth variations in the data
• They can handle step changes or gradual changes in the
level of a series
• Techniques
1. Moving average
2. Weighted moving average
3. Exponential smoothing

LO 3.7
© McGraw Hill 19
 Moving Average 1

Technique that averages a number of the most recent actual

values in generating a forecast
n

A t i
At n    At 2  At 1
Ft  MA n  i 1

n n
where
Ft  Forecast for time period t
MA n  n period moving average
At i  Actual value in period t  i
n  Number of periods in the moving average
LO 3.8
© McGraw Hill 20
 Moving Average 2

As new data become available, the forecast is updated by

adding the newest value and dropping the oldest and then
recomputing the average

The number of data points included in the average

determines the model’s sensitivity
• Fewer data points used—more responsive
• More data points used—less responsive

LO 3.7
© McGraw Hill 21
 Moving Average 2

Example – use 3 months moving average to forecast succeeding months demand

2023 2023
Demand Demand
Month Demand Month Demand
Forecast Forecast
January 100 - January 100 -
February 105 - February 105 -
March 100 - March 100 -
April 110 - April 110 -
May 107 - May 107 -
Average
June 103 - June 103 -
July 115 - July 115 -
August 112 - August 112 -
September 100 - September 100 -
October - ? October - ?
109

LO 3.7
© McGraw Hill 22
 Moving Average 2

Example – use 3 months moving average to forecast succeeding months demand

2023 2023
Month Demand Demand Forecast Month Demand Demand Forecast
January 100 - January 100 -
February 105 - February 105 -
March 100 - March 100 -
April 110 - April 110 -
May 107 - May 107 -
June 103 - June 103 -
Average
July 115 - July 115 -
August 112 - August 112 -
September 100 - September 100 -
October 106 109 October 106 109.00
November - ? November - ?
106

LO 3.7
© McGraw Hill 23
 Weighted Moving Average

The most recent values in a time series are given more

weight in computing a forecast
• The choice of weights, w, is somewhat arbitrary and
involves some trial and error
Ft  wt ( At )  wt 1 ( At 1 )    wt n ( At n )

where
wt  weight for period t , wt 1  weight for period t  1, etc.
At  the actual value for period t , At 1  the actual value for period t  1, etc.

LO 3.9
© McGraw Hill 24
 Weighted Moving Average

2023
Demand
Month Demand Weights
Forecast
January 100 - -
February 105 - -
March 100 - -
April 110 - -
May 107 - -
June 103 - -
July 115 0.2 -
August 112 0.3 -
September 100 0.5 -
October - - ?
106.60

FOct = (115*0.2) + (112*0.3) + (100*.5)

LO 3.9
© McGraw Hill 25
 Weighted Moving Average

2023
Month Demand Weights Demand Forecast
January 100 - -
February 105 - -
March 100 - -
April 110 - -
May 107 - -
June 103 - -
July 115 - -
August 112 0.2 -
September 100 0.3 -
October 106 0.5 -
November - ?
105.40

FOct = (112*0.2) + (100*0.3) + (106*.5)

LO 3.9
© McGraw Hill 26
 Exponential Smoothing

A weighted averaging method that is based on the previous

forecast plus a percentage of the difference between the
forecast and the actual value of the time series at that point.

where

LO 3.10
© McGraw Hill 27
 Exponential Smoothing
Forecasted
Month Actuals
Demand
January 100 101
February 105 104
March 100 99
April 110 110
May 107 108
June 103 103
July 115 110
August 112 115
September 100 95
October ? -
𝒕 𝒕 𝟏 𝒕 𝟏 𝒕 𝟏

= 0.10

FOct = FSept + (ASept - FSept)

FOct = 100 + 0.10 (95-100)
FOct = 99.50
LO 3.10
© McGraw Hill 28
 Linear Trend

A simple data plot can reveal the existence and nature of a

trend

Linear trend equation

Ft  a  bt

where

Ft  Forecast for period t

a  Value of Ft at t  0
b  Slope of the line
t  Specified number of time periods from t  0
LO 3.11
© McGraw Hill 29
 Estimating Slope and Intercept

Slope and intercept can be estimated from historical data

n ty   t  y
b
n t    t 
2 2

a
 y  b t
or y  bt
n

where
n  Number of periods
y  Value of the time series

LO 3.11
© McGraw Hill 30
 Linear Trend Example

Week Actual Sales

1 700
2 724
3 720
4 728
5 740
6 742
7 758 Sales
8 750 800

9 770 780

10 775 760

740

720

700

680

660

640

620

600
1 2 3 4 5 6 7 8 9 10

Actual Sales

© McGraw Hill 31
 Associative Forecasting Techniques

Associative techniques are based on the development of an

equation that summarizes the effects of predictor variables
• Predictor variables – variables that can be used to
predict values of the variable of interest
• Real Property (house and lot, condominium) prices may be related
to such factors as home and property size, location, number of
bedrooms, and number of bathrooms.

LO 3.14
© McGraw Hill 36
 Simple Linear Regression

Regression – a technique for fitting a line to a set of data

points
• Simple linear regression – the simplest form of regression
that involves a linear relationship between two variables
• The object of simple linear regression is to obtain an equation of a
straight line that minimizes the sum of squared vertical deviations
from the line (that is, the least squares criterion)

LO 3.14
© McGraw Hill 37
 Least Squares Line

ye  a  bx
where
yc = Predicted (dependent) variable
x = Predictor (independent) variable
b = Slope of the line
a = Value of yc when x  0 (that is, the height of the line at the y intercept)
and
n   xy     x   y 
b
n   x2     x 
2

a
 y  b x
or y  bx
n
where
n  Number of paired observations
LO 3.14
© McGraw Hill 38
 Correlation Coefficient

Correlation, r
• A measure of the strength and direction of relationship
between two variables
• Ranges between −1.00 and +1.00
n   xy     x   y 
r
n x    x n  y    y 
2 2 2 2

r2, square of the correlation coefficient

• A measure of the percentage of variability in the values of
y that is “explained” by the independent variable
• Ranges between 0 and 1.00
LO 3.14
© McGraw Hill 39
 Simple Linear Regression Assumptions

1. Variations around the line are random

2. Deviations around the average value (the line) should be

normally distributed

3. Predictions are made only within the range of observed

values

LO 3.14
© McGraw Hill 40
 Issues to Consider:

Always plot the line to verify that a linear relationship is

appropriate

The data may be time-dependent

• If they are
• use analysis of time series

• use time as an independent variable in a multiple regression

analysis

A small correlation may indicate that other variables are

important

LO 3.14
© McGraw Hill 41
 Forecast Accuracy and Control

Allowances should be made for forecast errors

• It is important to provide an indication of the extent to
which the forecast might deviate from the value of the
variable that actually occurs

Forecast errors should be monitored

• Error = Actual − Forecast
 Positive errors result when the forecast is too high
 Negative errors results when the forecast is too low

• If errors fall beyond acceptable bounds, corrective action

may be necessary
LO 3.5
© McGraw Hill 42
 Forecast Accuracy Metrics

Mean Absolute Deviation

MAD 
 Actual t  Forecast t
MAD weights all errors evenly
n
Mean Squared Error

  Actual  Forecast t 
2
MSE weights errors according
MSE  t
to their squared values
n 1

Mean Absolute Percent Error

Actual t  Forecast t
 Actual t
100 MAPE weights errors
MAPE  according to relative error
n

LO 3.5
© McGraw Hill 43
 Forecast Error Calculation

Actual Forecast (A − F)
Period
(A) (F) Error |Error| Error2 [|Error|/Actual] × 100
1 107 110 −3 3 9 2.80%

2 125 121 4 4 16 3.20%

3 115 112 3 3 9 2.61%

4 118 120 −2 2 4 1.69%

5 108 109 1 1 1 0.93%

Sum 13 39 11.23%

n=5 n−1=4 n=5

MAD MSE MAPE

= 2.6 = 9.75 = 2.25%

LO 3.5
© McGraw Hill 44
 Monitoring the Forecast

Tracking forecast errors and analyzing them can provide useful

insight into whether forecasts are performing satisfactorily
Sources of forecast errors:
• The model may be inadequate due to
a. omission of an important variable
b. a change or shift in the variable the model cannot handle
c. the appearance of a new variable
• Irregular variations may have occurred
• Random variation
Control charts are useful for identifying the presence of non-
random error in forecasts
Tracking signals can be used to detect forecast bias
LO 3.15
© McGraw Hill 45
 Control Chart Construction

1. Compute the MSE.

2. Estimate of standard deviation of the distribution of errors
s  MSE
3. UCL: 0  z MSE
4. LCL: 0  z MSE
where z = Number of standard deviations from the mean (+/- 2)
*Under normal distribution, 95.5% of the “errors” can be expected to fall within limits of +/- 2 of the
standard deviation

LO 3.15 Access the text alternative for slide images.

© McGraw Hill 46
 Choosing a Forecasting Technique

Factors to consider
• Cost
• Accuracy
• Availability of historical data
• Availability of forecasting software
• Time needed to gather and analyze data and prepare a
forecast
• Forecast horizon

LO 3.16
© McGraw Hill 47
 Operations Strategy

The better forecasts are, the more able organizations will be

to take advantage of future opportunities and reduce
potential risks
• A worthwhile strategy is to work to improve short-term forecasts
• Accurate up-to-date information can have a significant effect on
forecast accuracy:
• Prices
• Demand
• Other important variables
• Reduce the time horizon forecasts have to cover
• Sharing forecasts or demand data through the supply chain can
improve forecast quality

LO 3.16
© McGraw Hill 48
Because learning changes everything. ®

www.mheducation.com

© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw Hill.