Chapter 3

Forecasting

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Chapter 3: Learning Objectives
You should be able to:
LO 3.1 List features common to all forecasts
LO 3.2 Explain why forecasts are generally wrong
LO 3.3 List elements of a good forecast
LO 3.4 Outline the steps in the forecasting process
LO 3.5 Summarize forecast errors and use summaries to make decisions
LO 3.6 Describe four qualitative forecasting techniques
LO 3.7 Use a naïve method to make a forecast
LO 3.8 Prepare a moving average forecast
LO 3.9 Prepare a weighted-average forecast
LO 3.10 Prepare an exponential smoothing forecast
LO 3.11 Prepare a linear trend forecast
LO 3.12 Prepare a trend-adjusted exponential smoothing forecast
LO 3.13 Compute and use seasonal relatives
LO 3.14 Compute and use regression and correlation coefficients
LO 3.15 Construct control charts and use them to monitor forecast errors
LO 3.16 Describe the key factors and trade-offs to consider when choosing a forecasting technique

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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

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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

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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

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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

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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.

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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

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 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

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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
 If errors fall beyond acceptable bounds, corrective action
may be necessary

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Forecast Accuracy Metrics

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

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

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

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Forecast Error Calculation
Actual Forecast (A-F)
Period
(A) (F) Error |Error| Error2 [|Error|/Actual]x100
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%

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 Forecasting Approaches
 Qualitative forecasting
 Qualitative techniques permit the inclusion of soft information
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

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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
 Sales force 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 0pinions from other managers or staff people or outside experts
to help with developing a forecast.
The Delphi method is an iterative process intended to achieve a consensus

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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

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Time-Series Behaviors
Trend
Seasonality
Cycles
Irregular variations
Random variation

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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

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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

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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

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 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

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Moving Average
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
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 Moving Average (cont.)
As new data become available, the forecast is updated
by adding the newest value and dropping the oldest
and then re-computing 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

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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.

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 Exponential Smoothing
A weighted averaging method that is based on the
previous forecast plus a percentage of the forecast
error
Ft  Ft 1   ( At 1  Ft 1 )
where
Ft  Forecast for period t
Ft 1  Forecast for the previous period
 = Smoothing constant
At 1  Actual demand or sales from the previous period

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 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

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 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

3-26
LO 
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 Trend-Adjusted Exponential Smoothing
The trend adjusted forecast consists of two
components
 Smoothed error
 Trend factor

TAFt +1  St  Tt
where
St  Previous forecast plus smoothed error
Tt  Current trend estimate

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 Trend-Adjusted Exponential Smoothing (cont.)
Alpha and beta are smoothing constants
Trend-adjusted exponential smoothing has the ability
to respond to changes in trend

TAFt +1  St  Tt
St  TAFt +  At  TAFt 
Tt  Tt1   TAFt  TAF t1  Tt1 

 3-28
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 Techniques for Seasonality
Seasonality – regularly repeating movements in
series values that can be tied to recurring events
 Expressed in terms of the amount that actual values
deviate from the average value of a series
 Models of seasonality
 Additive
 Seasonality is expressed as a quantity that gets added to or
subtracted from the time-series average in order to
incorporate seasonality
 Multiplicative
 Seasonality is expressed as a percentage of the average (or
trend) amount which is then used to multiply the value of a
series in order to incorporate seasonality

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 Seasonal Relatives
 Seasonal relatives
 The seasonal percentage used in the multiplicative seasonally
adjusted forecasting model
 Using seasonal relatives
 To deseasonalize data
 Done in order to get a clearer picture of the nonseasonal (e.g.,
trend) components of the data series
 Divide each data point by its seasonal relative
 To incorporate seasonality in a forecast
1. Obtain trend estimates for desired periods using a trend
equation
2. Add seasonality by multiplying these trend estimates by the
corresponding seasonal relative

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 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
Home values may be related to such factors as home and
property size, location, number of bedrooms, and number of
bathrooms

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 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 (i.e., the least squares
criterion)

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 Least Squares Line
yc  a  bx
where
yc  Predicted (dependent) variable
x  Predictor (independe nt) variable
b  Slope of the line
a  Value of yc when x  0 (i.e., the height of the line at the y intercept)
and
n  xy     x   y 
b
n  x 2     x 
2

a
 y  b x
or y  b x
n
where
n  Number of paired observatio ns
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 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  x2   x
2
 
n  y2   y
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

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 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

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 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

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 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

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 Control Chart Construction

1. Compute the MSE.

2. Estimate of standard deviation of the distributi on of errors
s  MSE
3. UCL : 0  z MSE
4. LCL : 0  z MSE
where z  Number of standard deviations from the mean
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 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

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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

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