Chapter 8 - Forecasting

Operations Management
by
R. Dan Reid & Nada R. Sanders
4th Edition © Wiley 2010

© Wiley 2010 1
 Learning Objectives
 Identify Principles of Forecasting
 Explain the steps in the forecasting process
 Identify types of forecasting methods and their
characteristics
 Describe time series and causal models
 Generate forecasts for data with different patterns: level,
trend, seasonality, and cyclical
 Using linear regression to account for trend
 Method to forecast demand with seasonality and trend
 Compute forecast accuracy
 Explain how forecasting models should be selected

© Wiley 2010 2
Principles of Forecasting
1. Many types of forecasting models
differ in complexity and amount of
data & way they generate forecasts
2. Forecasts are rarely perfect
3. Forecasts are more accurate for
grouped data than for individual items
4. Forecast are more accurate for shorter
than longer time periods

© Wiley 2010 3
Forecasting Steps
 Decide what needs to be forecast
 Level of detail, units of analysis & time horizon
required
 Evaluate and analyze appropriate data
 Identify needed data & whether it’s available
 Select and test the forecasting model
 Cost, ease of use & accuracy
 Generate the forecast
 Monitor forecast accuracy over time

© Wiley 2010 4
Types of Forecasting Methods
 Forecasting methods are classified into
two groups:

© Wiley 2010 5
 Types of Forecasting Models
 Qualitative methods – judgmental methods
 Forecasts generated subjectively by the

forecaster
 Educated guesses

 Quantitative methods – based on

mathematical modeling:
 Forecasts generated through mathematical

modeling

© Wiley 2010 6
 Qualitative Methods
Type Characteristics Strengths Weaknesses
Executive A group of managers Good for strategic or One person's opinion
opinion meet & come up with new-product can dominate the
a forecast forecasting forecast

Market Uses surveys & Good determinant of It can be difficult to

research interviews to identify customer preferences develop a good
customer preferences questionnaire

Delphi Seeks to develop a Excellent for Time consuming to

method consensus among a forecasting long-term develop
group of experts product demand,
technological
changes, and
© Wiley 2010 7
Quantitative Methods
 Time Series Models:
 Assumes information needed to generate a
forecast is contained in a time series of data
 Assumes the future will follow same patterns as
the past
 Causal Models or Associative Models
 Explores cause-and-effect relationships
 Uses leading indicators to predict the future
 Housing starts and appliance sales

© Wiley 2010 8
 Time Series Models
 Forecaster looks for data patterns as
 Data = historic pattern + random variation
 Historic pattern to be forecasted:
 Level (long-term average) – data fluctuates around a constant
mean
 Trend – data exhibits an increasing or decreasing pattern
 Seasonality – any pattern that regularly repeats itself and is of a
constant length
 Cycle – patterns created by economic fluctuations
 Random Variation cannot be predicted
© Wiley 2010 9
Time Series Patterns

© Wiley 2010 10
Time Series Models
 Naive: Good for level patterns Ft 1  At
where Ft+1 = Forecast for period t + 1,
A t = Actual value for period t.
 Moving Average: Ft 1   A t / n
 where n = number of periods
 The average value over a set time period
(e.g.: the last four weeks)
 Each new forecast drops the oldest data point & adds a
new observation
 More responsive to a trend but still lags behind actual
data

© Wiley 2010 11
Time Series Models (cont.)
 Weighted Moving Average: Ft 1   Ct A t
where Ct = weight used for period t (Ct < 1)
All weights must add to 100% or 1.00
e.g. Ct .5, Ct-1 .3, Ct-2 .2 (weights add to 1.0)

Allows emphasizing one period over others; above

indicates more weight on recent data (Ct=.5)

Differs from the simple moving average that weighs

all periods equally - more responsive to trends

© Wiley 2010 12
Time Series Models (con’t.)
 Exponential Smoothing: F  αA  1  α F
t 1 t t
Most frequently used time series method because of
ease of use and minimal amount of data needed

 Need just three pieces of data to start:

 Last period’s forecast (Ft)

 Last periods actual value (At)
 Select value of smoothing coefficient,,between 0 and 1.0
 If no last period forecast is available, average the
last few periods or use naive method
 
Higher values (e.g. .7 or .8) may place too much
weight on last period’s random variation
© Wiley 2010 13
Time Series Problem
 Determine forecast for Period Actual
periods 7 & 8 1 300
2-period moving average

2 315
 4-period moving average
3 290
 2-period weighted moving
4 345
average with t-1 weighted 0.6
and t-2 weighted 0.4 5 320
 Exponential smoothing with 6 360
alpha=0.2 and the period 6 7 375
forecast being 375
8
© Wiley 2010 14
Time Series Problem Solution
Period Actual 2-Period 4-Period 2-Per.Wgted. Expon. Smooth.

1 300

2 315

3 290

4 345

5 320

6 360

7 375 340.0 328.8 344.0 372.0

8 367.5 350.0 369.0 372.6

© Wiley 2010 15
 Time Series: Linear Regression
A time series technique that computes a
forecast with trend by drawing a straight line
through a set of data using this formula:
Y = a + bx where
Y = forecast for period X
X = the number of time periods from X = 0
a = value of y at X = 0 (Y intercept)
b = slope of the line

© Wiley 2010 16
Linear Regression
 Identify dependent (y) and
independent (x) variables
b
 XY  X  Y  Solve for the slope of the
 X 2  X  X 


line
b
 XY  n X Y

 X  nX
2 2

 Solve for the y intercept

a  Y  bX
 Develop your equation for
the trend line
Y=a + bX

© Wiley 2010 17
 Linear Regression Problem: A maker of golf shirts has been
tracking the relationship between sales and advertising dollars. Use
linear regression to find out what sales might be if the company
invested $53,000 in advertising next year.

Sales $ Adv.$ XY X^2 Y^2 b

 XY  n X Y
(Y) (X)
 X  nX 2 2

1 130 32 4160 2304 16,900

28202  447.25147.25
2 151 52 7852 2704 22,801 b  1.15
9253  447.25
2

3 150 50 7500 2500 22,500 a  Y  b X  147.25  1.1547.25

a  92.9
4 158 55 8690 3025 24964
Y  a  bX  92.9  1.15X
5 153.85 53 Y  92.9  1.1553   153.85

Tot 589 189 28202 9253 87165

Avg 147.25 47.25

© Wiley 2010 18
 Correlation Coefficient
How Good is the Fit?
 Correlation coefficient (r) measures the direction and strength of the linear
relationship between two variables. The closer the r value is to 1.0 the better
the regression line fits the data points.
n XY    X  Y 
r
 X    X 
* n Y   Y 
2 2
2 2
n
428,202  189589
r  .982
4(9253) - (189) * 487,165  589
2 2

r 2  .982  .964
2

2
 Coefficient of determination ( r ) measures the amount of variation in the
dependent variable about its mean that is explained by the regression line.
2
Values of ( r ) close to 1.0 are desirable.

© Wiley 2010 19
Forecasting Demand with Trend
and Seasonal Characteristics
 Step 1: Calculate the seasonal index
 Step 2: Use linear regression to forecast the
total demand. (In the following example, use
the year as dependent variable, and yearly
demand as independent variable)
 Step 3: Use the forecasted total demand
(obtained in Step 2) and multiply by the
seasonal index to determine the seasonal
demand.
 Step 1: Calculation of Seasonal Index

Seasonality: repetitive increase/ decrease in

demand
 Let i = season and j = year
 Let jDij = sum of demands for all the i seasons
 Let ijDij = sum of all demands
j Dij
Season i index = Si = ijDij
 Step 1: Illustration
DEMAND (1000’S PER QUARTER)
YEAR 1 2 3 4 Total
2007 12.6 8.6 6.3 17.5 45.0
2008 14.1 10.3 7.5 18.2 50.1
2009 15.3 10.6 8.1 19.6 53.6
Total 42.0 29.5 21.9 55.3 148.7

D1 42.0 D3 21.9

S1 = = = 0.28 S3 = = = 0.15
D 148.7 D 148.7
D2 29.5 D4 55.3
S2 = = = 0.20 S4 = = = 0.37
D 148.7 D 148.7
Step 2: Use linear regression to
forecast the total demand
A B A B
1 Year Demand 1 Year Demand
2 2007 45 2 2007 45
3 2008 50.1 3 2008 50.1
4 2009 53.6 4 2009 53.6
5 2010 =B7+2010*B8 5 2010 58.16666667
6 6
7 a =INTERCEPT(B2:B4,A2:A4) 7 a -8584.833333
8 b = SLOPE(B2:B4, A2:A4) 8 b 4.3

Using Linear regression, for 2010

y = - 8584.83 + 4.30(2010) = 58.17
Step 3: Calculation of seasonal
demand
 Multiply the seasonal index by the forecasted
total demand to determine the seasonal
demand.
SF1 = (S1) (F2010) = (0.28)(58.17) = 16.28

SF2 = (S2) (F2010) = (0.20)(58.17) = 11.63

SF3 = (S3) (F2010) = (0.15)(58.17) = 8.73

SF4 = (S4) (F2010) = (0.37)(58.17) = 21.53

Measuring Forecast Error
 Forecasts are never perfect
 Need to know how much we should
rely on our chosen forecasting method
 Measuring forecast error:
E t  A t  Ft
 Note that over-forecasts = negative
errors and under-forecasts = positive
errors

© Wiley 2010 25
 Measuring Forecasting Accuracy
 Mean Absolute Deviation (MAD) MAD   actual  forecast
 measures the total error in a n
forecast without regard to sign
Cumulative Forecast Error (CFE) CFE  actual  forecast 

 Measures any bias in the forecast
 actual - forecast 2

 Mean Square Error (MSE) MSE 

 Penalizes larger errors
n
CFE
 Tracking Signal TS 
M AD
 Measures if your model is working

© Wiley 2010 26
 Accuracy & Tracking Signal Problem: A company is comparing the
accuracy of two forecasting methods. Forecasts using both methods are
shown below along with the actual values for January through May. The
company also uses a tracking signal with ±4 limits to decide when a
forecast should be reviewed. Which forecasting method is best?

Method A Method B
Month Actual F’cast Error Cum. Tracking F’cast Error Cum. Tracking
sales Signal Error Signal
Error

Jan. 30 28 2 2 1 27 2 2 1

Feb. 26 25 1 3 2 25 1 3 2
March 32 32 0 3 3 29 3 6 3
April 29 30 -1 2 2 27 2 8 4
May 31 30 1 3 3 29 2 10 5

MAD 1 2
MSE 1.4 4.4
© Wiley 2010 27
 Selecting the Right Forecasting Model
1. The amount & type of available data
 Some methods require more data than others
2. Degree of accuracy required
 Increasing accuracy means more data
3. Length of forecast horizon
 Different models for 3 month vs. 10 years
4. Presence of data patterns
 Lagging will occur when a forecasting model
meant for a level pattern is applied with a trend
© Wiley 2010 28
Forecasting Software
 Spreadsheets
 Microsoft Excel, Quattro Pro, Lotus 1-2-3
 Limited statistical analysis of forecast data
 Statistical packages
 SPSS, SAS, NCSS, Minitab
 Forecasting plus statistical and graphics
 Specialty forecasting packages
 Forecast Master, Forecast Pro, Autobox, SCA

© Wiley 2010 29
Guidelines for Selecting Software
 Does the package have the features you want?
 What platform is the package available for?
 How easy is the package to learn and use?
 Is it possible to implement new methods?
 Do you require interactive or repetitive forecasting?
 Do you have any large data sets?
 Is there local support and training available?
 Does the package give the right answers?

© Wiley 2010 30
 Other Forecasting Methods
 Focus Forecasting
 Developed by Bernie Smith
 Relies on the use of simple rules
 Test rules on past data and evaluate how they
perform
 Combining Forecasts
 Combining two or more forecasting methods can
improve accuracy
© Wiley 2010 31
 Forecasting within OM: How it
all fits together
Forecasts impact all business decisions such as:
 product designs that are expected to sell (Ch 2),
 choice of competitive priorities, changes in processes, and
large technology purchases (Ch 3),
 the quality of product to produce (Chs 5 and 6),
 capacity and location needs (Ch 9),
 future space requirements (Ch 10),
 the amount of labor needed (Ch 11),
 the amount of needed supplies and materials (Ch 12)
 tactical planning & developing worker schedules (Ch 15).

© Wiley 2010 32
 Chapter 8 Highlights
 Forecasts are rarely perfect; they are more accurate for groups than individual items,
and are more accurate in the shorter term than longer time horizons.
 The forecasting process involves five steps: decide what to forecast, evaluate and
analyze appropriate data, select and test model, generate forecast, and monitor
accuracy.
 Forecasting methods can be classified into two groups: qualitative and quantitative.
 There are four basic patterns of data: random variation, trend, seasonality, and cycles.
 Forecast models: naïve, simple mean, simple moving average, weighted moving
average, and exponential smoothing. Linear regression model is used to forecast
trends.
 Three useful measures of forecast error are mean absolute deviation (MAD), mean
square error (MSE) and tracking signal.
 There are four factors to consider when selecting a model: amount and type of data
available, degree of accuracy required, length of forecast horizon, and patterns present
in the data.

© Wiley 2010 33