CHAPTER TWO

FORECASTING
 Meaning and Use of
2 Forecasting
 Forecasting Techniques

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 1.1. INTRODUCTION

 Forecasting involves making the best possible judgment

about some future event.
 Forecasting is about predicting the future as accurately as
possible, given all the information available including
historical data and knowledge of any future events that
might impact on the forecasts.
 Organizations require short, medium and long term
forecasts, depending on the specific application.
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 FORECASTING FUNDAMENTALS
 Types of Forecasts
1. Economic forecasts
 Predict a variety of economic indicators, like money supply,
inflation rates, interest rates, etc.
2. Technological forecasts
 Predict rates of technological progress and innovation.
3. Demand forecasts
 Predict the future demand for a company’s products or
services.
 Since virtually all the operations management decisions (in both
the strategic category and the tactical category) require as input a
good estimate of future demand, this is the type of forecasting.
 Types Of Forecasting Methods
 Qualitative methods: These types of forecasting methods are
based on judgments, opinions, intuition, emotions, or personal
experiences and
 They are subjective in nature.
 They do not rely on any rigorous mathematical
computations.
 Quantitative methods: These types of forecasting methods
are based on mathematical (quantitative) models,
 They are objective in nature.
 They rely heavily on mathematical computations
 Types Of Forecasting Methods

 Qualitative methods: These types of forecasting methods are based on

judgments, opinions, intuition, emotions, or personal experiences and

 They are subjective in nature.

 They do not rely on any rigorous mathematical computations.

 Quantitative methods: These types of forecasting methods are based

on mathematical (quantitative) models,
 They are objective in nature.

 They rely heavily on mathematical computations

Qualitative Forecasting Methods
Quantitative Forecasting Methods
Quantitative Forecasting Methods
 Time Series Models
Model Description
Naive Uses last period’s actual value as a forecast
Uses an average of all past data as a forecast
Simple Mean (Average)
Uses an average of a specified number of the most recent
Simple Moving Average observations, with each observation receiving the same
emphasis (weight)
Uses an average of a specified number of the most recent
Weighted Moving observations, with each observation receiving a different
Average emphasis (weight)
A weighted average procedure with weights declining
Exponential Smoothing exponentially as data become older
Technique that uses the least squares method to fit a
Trend Projection straight line to the data
A mechanism for adjusting the forecast to accommodate
Seasonal Indexes any seasonal patterns inherent in the data
 Naive method
The forecast for next period (period t+1) will be equal to this period's
actual demand (At). In this method we assume that each year (beginning
with year 2) we made a forecast, then waited to see what demand unfolded
during the year. We then made a forecast for the subsequent year, and so on
right through to the forecast for year 7.
Year Actual Demand Forecast (Ft) Notes
(At)

There was no prior demand data on which to

1 310 --
base a forecast for period 1
These forecasts were made on a year-by-year
2 365 310
basis.
3 395 365
4 415 395
5 450 415
6 465 450 10

7 465 B
 Mean (Simple Average) Method
The forecast for next period (period t+1) will be equal to the average
of all past historical demands.
Year Actual Demand Forecast Notes
(At) (Ft)

This forecast was a guess at the

1 310 300
beginning.
These forecasts were made on a year-by-
2 365 310.000 year basis using a simple
average approach.

3 395 337.500
4 415 356.667
5 450 371.250
6 465 387.000 11

7 400.000 .
 SIMPLE MOVING AVERAGE METHOD
The forecast for next period (period t+1) will be equal to the
average of a specified number of the most recent observations, with
each observation receiving the same emphasis (weight).

Year Actual Forecast Notes

Demand (At) (Ft)

1 310 300 This forecast was a guess at the beginning.

This forecast was made using a naïve

2 365 310 approach.
These forecasts were made on a year-by- year
3 395 337.500 basis using a 2-yr moving average approach.

4 415 380.000
5 450 405.000
6 465 432.500 12

7 457.500
 Weighted Moving Average Method
The forecast for next period (period t+1) will be equal to a weighted
average of a specified number of the most recent observations.
Most recent year, .5; year prior to that, .3; year prior to that, .2
Year Actual Demand Forecast Notes
(At) (Ft)
1 310 300 This forecast was a guess at the beginning.
This forecast was made using a naïve
2 365 310 approach.
This forecast was made using a naïve
3 395 365 approach.
These forecasts were made on a year-by-year
4 415 369.000 basis using a 3-yr wtd. Moving avg.
approach.
5 450 399.000
6 465 428.500 14

7 450.500
 Exponential Smoothing Method
The new forecast for next period (period t+1) will be calculated as: New
forecast = Last period’s forecast + (Last period’s actual demand –
Last period’s forecast), Ft = Ft-1 + (At-1 – Ft-1)
Year Actual Forecast Notes
Demand (A) (F)
This was a guess, since there was no prior
1 310 300
demand data.

These forecasts were made on a year-by-year

2 365 301
basis using exponential smoothing with =0.1

3 395 307.4
4 415 316.16
5 450 326.044
6 465 338.4396
7 351.0956
 Stability Vs Responsiveness In Forecasting
All demand forecasting methods vary in the degree to which they
emphasize recent demand changes when making a forecast.
Forecasting methods that react very strongly (or quickly) to
demand changes are said to be responsive. Forecasting methods
that do not react quickly to demand changes are said to be stable.

If demand has been showing a steady pattern of increase (or

decrease), then more responsiveness is desirable, for we would like
to react quickly to those demand increases (or decreases) when we
make our next forecast. On the other hand, if demand has been
fluctuating upward and downward, then more stability is
desirable, for we do not want to “over react” to those up and down
fluctuations in demand.
 For Some Of The Simple Forecasting Methods
We Have Examined

Moving Average Approach: Using more periods in your moving

average forecasts will result in more stability in the forecasts.
Using fewer periods in your moving average forecasts will result
in more responsiveness in the forecasts.
 Weighted Moving Average Approach: Using more periods in your
weighted moving average forecasts will result in more stability in
the forecasts. Using fewer periods in your weighted moving
average forecasts will result in more responsiveness in the
forecasts. Furthermore, placing lower weights on the more recent
demand will result in more stability in the forecasts. Placing higher
weights on the more recent demand will result in more
responsiveness in the forecasts.

 Simple Exponential Smoothing Approach: Using a lower alpha (α)

value will result in more stability in the forecasts. Using a higher
alpha (α) value will result in more responsiveness in the forecasts
 Trend Projection Method:
This method is a version of the linear regression technique. It
attempts to draw a straight line through the historical data
points in a fashion that comes as close to the points as possible.
(Technically, the approach attempts to reduce the vertical
deviations of the points from the trend line, and does this by
minimizing the squared values of the deviations of the points
from the line).

a  y  bx
Ultimately, the statistical formulas compute a slope for
the trend line (b) and the point where the line crosses the
y-axis (a). This results in the straight line equation
• Y = a + bX
• Y= predicted dependent variable
• a = Value of Y when x=0
• b= slope of the line
• X = Predicted independent variable

a  y  bx b
 xy  nx y
 x  nx
2 2
 Example
The owner of a small hardware store has noted a sales
pattern for window locks that seems to parallel the
number of break-ins reported each week in the news
paper. The data are:
Sales 46 18 20 22 27 34 14 37 30

Break - ins 9 3 3 5 4 7 2 6 4

a) obtain a regression equation for the data

b) Estimate sales when the number of break-ins is five
 Solution
X Y XY X2 y2

9 46 414 81 2116
3 18 54 9 324
3 20 60 9 400
5 22 110 25 484
4 27 108 16 729
7 34 238 49 1156
2 14 28 4 196
6 37 222 36 1369
4 30 120 16 900
43 248 1354 245 7674

b
 xy  nx y

1,354  (9  4.78  27.55)
 4.275
 x  nx
2 2
245  (9  22.85)
a  y  bx  27.55  4.275  4.78  7.12
Y  7.12  4.75(5)  28.50
 Measuring Forecasts Accuracy
Forecast error is the difference between the forecast and actual value
for a given period.
Two of the most commonly used error measures are the mean absolute
deviation (MAD) and the mean squared error (MSE). MAD is the average
of the sum of the absolute errors:

• Mean absolute deviation (MAD) The average absolute

forecast error.

• Mean squared error (MSE) The average of squared forecast

errors.
Although the MAD and the MSE are the two most
common measures of forecast accuracy, other measures
are used as well. One that is not dependent on the
magnitude of the values of demand is known as the
mean absolute percentage error (MAPE) and is given
by the formula
 Example
Perio Actual Forecast Error (A- |error| Error 2 |error|
d demand F) /actual*100

1 217 215 2 2 4 0.9

2 213 216 -3 3 9 1.41
3 216 215 1 1 1 0.5
4 210 214 -4 4 16 1.9
5 213 211 2 2 4 1.41
6 219 214 5 5 25 2.3
7 216 217 -1 1 1 0.5
8 212 216 -4 4 16 1.88
• Solution :Using calculations shown in the table -2 22 76 10.8
• MAD = ∑|e|/n=22/8=2.75
• MSE= ∑𝑒 2 /n = 76/8=9.5
 Comparison of forecast error
• From a computational standpoint, the difference between these two
measures is that MAD weights all errors evenly, while MSE weights
errors according to their squared values.

• MAD does have the advantage of simpler calculations. However, there

is a benefit to the MSE method. Since this method squares the error
term, large errors tend to be magnified. Consequently, MSE places a
higher penalty on large errors. This can be useful in situations where
small forecast errors don’t cause much of a problem, but large errors
can be devastating.
For instance, for the following example using either
MAD or MSE, a manager could compare the results
of exponential smoothing with values of .1, and .5,
to determine one which yields the lowest MAD or
MSE for a given set of data.
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