NATIONAL ECONOMICS UNIVERSITY

OPERATIONS
MANAGEMENT
FORECASTING

MSc. Bui Cam Van

 CONTENT

1. DEFINITION
2. TYPES OF FORECASTING
3. IMPORTANCE OF FORECASTING
4. FORECASTING APPROACH
5. MONITORING AND CONTROLLING FORECAST
6. FORECASTING IN SERVICE SECTOR
DEFINITION
WHAT IS FORECASTING?
 Process of predicting a
future event
 Underlying basis of
??
all business decisions
 Production
 Inventory
 Personnel
 Facilities
INFLUENCE OF PRODUCT LIFE
CYCLE
Introduction – Growth – Maturity – Decline

 Introduction and growth require longer forecasts

than maturity and decline
 As product passes through life cycle, forecasts are
useful in projecting
 Staffing levels
 Inventory levels
 Factory capacity
INFLUENCE OF PRODUCT LIFE
CYCLE
Introduction Growth Maturity Decline
Best period to Practical to change Poor time to Cost control
Company Strategy/Issues increase market price or quality change image, critical
share image price, or quality

R&D engineering is Strengthen niche Competitive costs

critical become critical
Defend market
position
CD-ROMs
Internet search engines
Analog TVs
Drive-through
LCD & plasma TVs restaurants

Sales iPods

3 1/2”
Xbox 360 Floppy
disks

Figure 2.5
THE REALITY

 Forecasts are seldom perfect

 Most techniques assume an underlying stability
in the system
 Product family and aggregated forecasts are
more accurate than individual product forecasts
TYPES OF FORECASTING
FORECASTING TIME
HORIZONS
 Short-range forecast
 Up to 1 year, generally less than 3 months
 Purchasing, job scheduling, workforce levels, job assignments,
production levels
 Medium-range forecast
 3 months to 3 years
 Sales and production planning, budgeting
 Long-range forecast
 3+ years
 New product planning, facility location, research and
development
TYPES OF
FORECASTING
 Economic forecasts
 Address business cycle – inflation rate, money supply, housing
starts, etc.
 Technological forecasts
 Predict rate of technological progress
 Impacts development of new products
 Demand forecasts
 Predict sales of existing products and services
IMPORTANCE OF
FORECASTING
STRATEGIC IMPORTANCE OF
FORECASTING
 Human Resources – Hiring, training, laying off
workers
 Capacity – Capacity shortages can result in
undependable delivery, loss of customers, loss of
market share
 Supply Chain Management – Good supplier
relations and price advantages
FORECASTING
APPROACHES
 FORECASTING
APPROACHES
Qualitative Methods Quantitative Methods
 Used when situation is  Used when situation is
vague and little data exist ‘stable’ and historical data
 New products exist
 New technology  Existing products
 Current technology
 Involves intuition,
experience  Involves mathematical
 e.g., forecasting sales on techniques
Internet  e.g., forecasting sales of
color televisions
QUALITATIVE METHOD
OVERVIEW OF QUALITATIVE
METHOD
 Jury of executive opinion
 Pool opinions of high-level experts, sometimes
augment by statistical models
 Delphi method
 Panel of experts, queried iteratively
 Sales force composite
 Estimates from individual salespersons are
reviewed for reasonableness, then aggregated
 Consumer Market Survey
 Ask the customer
 GROUP
WORK
In group, discuss about the assigned method regarding:
• How to implement
• Advantage
• Disadvantage
• When is the most suitable to use?
JURY OF EXECUTIVE
OPINION
 Involves small group of high-level experts
and managers
 Group estimates demand by working
together
 Combines managerial experience with
statistical models
 Relatively quick
 ‘Group-think’
disadvantage
SALE FORCE
COMPOSITE
 Each salesperson projects his or her sales
 Combined at district and national levels
 Sales reps know customers’ wants
 Tends to be overly optimistic
DELPHI
METHOD
 Iterative group process,
Staff
continues until consensus is (Administering
reached survey)
Decision Makers
 3 types of participants (Evaluate
 Decision makers Respondents responses and
 Staff (People who can make decisions)
 Respondents make valuable
judgments)
CONSUMER MARKET
SURVEY
 Ask customers about purchasing plans
 What consumers say, and what they actually do are
often different
 Sometimes difficult to answer
GROUP
WORK
Design and conduct a market research
• Objectrives: to investigate market demand and
customer taste
• Market: your class
• Product: any product for your class (uniform/logo/clip/..)

Notes: you will have to actually design the product in chapter 5

QUANTITATIVE METHOD
OVERVIEW OF QUANTITATIVE
APPROACHES
1. Naive approach
2. Moving averages
Time-Series
3. Exponential Models
smoothing
4. Trend projection
Associative
5. Linear regression Model
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
TIME SERIES
COMPONENTS

Trend Cyclical

Seasonal Random
TREND COMPONENT SEASONAL COMPONENT

 Persistent, overall upward or  Regular pattern of up and dow

downward pattern fluctuations
 Changes due to population,  Due to weather, customs, etc.
technology, age, culture, etc.  Occurs within a single year
 Typically several years duration
 CYCLICAL COMPONENT RANDOM COMPONENT
 Repeating up and down  Erratic, unsystematic, ‘residual’
movements fluctuations
 Affected by business cycle,  Due to random variation or
political, and economic factors unforeseen events
 Multiple years duration  Short duration and
 Often causal or associative nonrepeating
relationships

0 5 10 15 20 M T W T
COMPONENTS OF DEMAND
Trend
component

Demand for product or service

Seasonal peaks

Actual
demand

Average
demand over
Random four years
variation
| | | |
1 2 3 4
Year Figure 4.1
QUANTITATIVE
METHODS
1. Naive approach
2. Moving averages
Time-Series
3. Exponential Models
smoothing
4. Trend projection
Associative
5. Linear regression Model

HOW TO FORECAST USING DIFFERENT METHODS?

WHICH METHOD IS BETTER?
1. 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
2. MOVING AVERAGE
METHOD
 MA is a series of arithmetic means
 Used if little or no trend
 Used often for smoothing
Provides overall impression of data over time

∑ demand in previous n periods

Moving average = n
Moving Average Example
Actual 3-Month
Month Shed Sales Moving Average
January 10
10
February 12
March 12
13
April 13
16
May 19 (10 + 12 + 13)/3 = 11 2/3
June 23
July 26 (12 + 13 + 16)/3 = 13 2/3
(13 + 16 + 19)/3 = 16
(16 + 19 + 23)/3 = 19 1/3
Graph of Moving Average
Moving
Average
30 –
28 –
Forecast
26 – Actual
24 – Sales
Shed Sales

22 –
20 –
18 –
16 –
14 –
12 –
10 –
| | | | | | | | | | | |
J F M A M J J A S O N D
WEIGHTED MOVING
AVERAGE
 Used when trend is present
 Older data usually less important
 Weights based on experience and intuition

∑ (weight for period n)

Weighted x (demand in period n)
moving average = ∑ weights
 Weights Applied Period
Weighted Moving Average
3 Last month
2 Two months ago
1 Three months ago
6 Sum of weights

Actual 3-Month Weighted

Month Shed Sales Moving Average
January 10
February 12
March 13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 = 121/6
May 19 [(3 x 16) + (2 x 13) + (12)]/6 = 141/3
June 23 [(3 x 19) + (2 x 16) + (13)]/6 = 17
July 26 [(3 x 23) + (2 x 19) + (16)]/6 = 201/2
 Potential Problems With
Moving Average
 Increasing n smooths the forecast but makes it
less sensitive to changes
 Do not forecast trends well
 Require extensive historical data
 Moving Average And
Weighted Moving Average
Weighted
moving
30 – average
25 –
Sales demand

20 – Actual
sales
15 –
Moving
10 – average

5 –
| | | | | | | | | | | |
Figure 4.2
J F M A M J J A S O N D
 COMMON MEASURES OF
ERROR
Mean Absolute Deviation (MAD)
∑ |Actual - Forecast|
MAD =
n
Mean Squared Error (MSE)
∑ (Forecast Errors)2
MSE =
n
Mean Absolute Percent Error (MAPE)

n
∑100|Actuali - Forecasti|/Actuali
MAPE = i=1
Use quantitative Month Sales
methods (MA, 1 40
WMA) to forecast
for September 2 42
sales? 3 38
Weighted: 0.1; 0.3; 4 44
0.2 5 45
Which method is 6 49
better?
7 48
8 50
3. EXPONENTIAL
SMOOTHING
 Form of weighted moving average
 Weights decline exponentially
 Most recent data weighted most
 Requires smoothing constant ()
 Ranges from 0 to 1
 Subjectively chosen
 Involves little record keeping of past data
 EXPONENTIAL
SMOOTHING
w 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 forecast
a = smoothing (or weighting)
constant (0 ≤ a ≤ 1)
EXPONENTIAL
SMOOTHING
Predicted demand = 142 Ford Mustangs
Actual demand = 153
Smoothing constant a = .20
Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs

Actual demand = 153
Smoothing constant a = .20

New forecast = 142 + .2(153 – 142)

Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs

Actual demand = 153
Smoothing constant a = .20

New forecast = 142 + .2(153 – 142)

= 142 + 2.2
= 144.2 ≈ 144 cars
 Effect of
Smoothing Constants

Weight Assigned to
Most 2nd Most 3rd Most 4th Most 5th Most
Recent Recent Recent Recent Recent
Smoothing Period Period Period Period Period
Constant (a) a(1 - a) a(1 - a) 2
a(1 - a) 3
a(1 - a)4

a = .1 .1 .09 .081 .073 .066

a = .5 .5 .25 .125 .063 .031

 Impact of Different 

225 –
Actual a = .5
demand
Demand

200 –

175 –
a = .1
| | | | | | | | |
150 –
1 2 3 4 5 6 7 8 9
Quarter
 Impact of Different 

225 –
Actual a = .5
 Chose high values of
demand 
when underlying average
Demand

200 –
is likely to change
 Choose
175 – low values of 
when underlying average
a = .1
is stable
| | | | | | | | |
150 –
1 2 3 4 5 6 7 8 9
Quarter
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 - F t
 Comparison of Forecast Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
Comparison of Forecast Error
∑ |deviations|
Rounded Absolute Rounded Absolute
MADActual
= Forecast Deviation Forecast Deviation
Tonnage n
with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1
For a =
180
.10 175 5.00 175 5.00
2 168 = 82.45/8
175.5 = 10.31
7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 For a175
= .50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 = 98.62/8
175.02 = 12.33
29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
 Comparison of Forecast Error
∑ (forecast
Rounded
errors) 2
Absolute Rounded Absolute
MSE = Actual Forecast Deviation Forecast Deviation
Tonnage n
with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1
For a =
180
.10 175 5.00 175 5.00
2 = 1,526.54/8
168 175.5 = 190.82
7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 For a175
= .50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 = 1,561.91/8
205 175.02 = 195.24
29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
 Comparison of Forecast Error
n
∑100|deviation
Rounded i|/actual
Absolute Rounded
i Absolute
MAPE =Actual
i=1 Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 n a = .10 a = .50 a = .50
1
a = .10 175
For 180 5.00 175 5.00
2 168 = 44.75/8
175.5 = 7.50
5.59% 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 a=
For 175 .50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 = 54.05/8
175.02 =29.98
6.76% 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 190.82 195.24
 Comparison of Forecast Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 190.82 195.24
MAPE 5.59% 6.76%
Exponential Smoothing with Trend
Adjustment
When a trend is present, exponential
smoothing must be modified

Forecast Exponentially Exponentially

including (FITt) = smoothed (Ft) + (Tt) smoothed
trend forecast trend
Exponential Smoothing with Trend
Adjustment

Ft = a(At - 1) + (1 - a)(Ft - 1 + Tt - 1)

Tt = b(Ft - Ft - 1) + (1 - b)Tt - 1

Step 1: Compute Ft
Step 2: Compute Tt
Step 3: Calculate the forecast FITt = Ft + Tt
 Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17
3 20
4 19
5 24
6 21
7 31
8 28
9 36
10
Table 4.1
 Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17
3 20
4 19
5 24 Step 1: Forecast for Month 2
6 21
7 31 F2 = aA1 + (1 - a)(F1 + T1)
8 28
9 36 F2 = (.2)(12) + (1 - .2)(11 + 2)
10 = 2.4 + 10.4 = 12.8 units
Table 4.1
 Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80
3 20
4 19
5 24 Step 2: Trend for Month 2
6 21
7 31 T2 = b(F2 - F1) + (1 - b)T1
8 28
9 36 T2 = (.4)(12.8 - 11) + (1 - .4)(2)
10 = .72 + 1.2 = 1.92 units
Table 4.1
 Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80 1.92
3 20
4 19
5 24 Step 3: Calculate FIT for Month 2
6 21
7 31 FIT2 = F2 + T1
8 28
9 36
FIT2 = 12.8 + 1.92
10 = 14.72 units
Table 4.1
 Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80 1.92 14.72
3 20 15.18 2.10 17.28
4 19 17.82 2.32 20.14
5 24 19.91 2.23 22.14
6 21 22.51 2.38 24.89
7 31 24.11 2.07 26.18
8 28 27.14 2.45 29.59
9 36 29.28 2.32 31.60
10 32.48 2.68 35.16
Table 4.1
Exponential Smoothing with Trend
Adjustment Example
35 –
Actual demand (At)
Product demand 30 –

25 –

20 –

15 –

10 –
Forecast including trend (FITt)
with  = .2 and  = .4
5 –

0 – | | | | | | | | |
1 2 3 4 5 6 7 8 9
Figure 4.3
Time (month)
4. 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
Least Squares Method

Values of Dependent Variable

Actual observation Deviation7
(y value)

Deviation5 Deviation6

Deviation3

Deviation4

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

Time period Figure 4.4

Least Squares Method

Values of Dependent Variable

Actual observation Deviation7
(y value)

Deviation5 Deviation6

Deviation3 Least squares method

minimizes the sum of the
squared errors (deviations)
Deviation 4

Deviation1
Deviation2
Trend line, y^ = a + bx

Time period Figure 4.4

Least Squares Method
Equations to calculate the regression variables

y^ = a + bx

Sxy - nxy
b=
Sx2 - nx2

a = y - bx
Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
2001 1 74 1 74
2002 2 79 4 158
2003 3 80 9 240
2004 4 90 16 360
2005 5 105 25 525
2005 6 142 36 852
2007 7 122 49 854
∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063
x=4 y = 98.86

∑xy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
∑x - nx
2 2 140 - (7)(4 )
2

a = y - bx = 98.86 - 10.54(4) = 56.70

Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
1999 1 74 1 74
2000 2 79 4 158
2001The trend
3 line is 80 9 240
2002 4 90 16 360
2003 y^ 5= 56.70 + 10.54x
105 25 525
2004 6 142 36 852
2005 7 122 49 854
Sx = 28 Sy = 692 Sx2 = 140 Sxy = 3,063
x=4 y = 98.86

Sxy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
Sx - nx
2 2 140 - (7)(4 )
2

a = y - bx = 98.86 - 10.54(4) = 56.70

 Least Squares Example
Trend line,
160 – y^ = 56.70 + 10.54x
150 –
140 –
Power demand

130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
50 –
| | | | | | | | |
2001 2002 2003 2004 2005 2006 2007 2008 2009
Year
 Seasonal Variations In Data

The multiplicative
seasonal model
can adjust trend
data for seasonal
variations in
demand
 Seasonal Variations In Data
Steps in the process:
1. Find average historical demand for each
season
2. Compute the average demand over all
seasons
3. Compute a seasonal index for each season
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the
number of seasons, then multiply it by the
seasonal index for that season
 Seasonal Index Example
Demand Average Average Seasonal
Month 2005 2006 2007 2005-2007 Monthly Index
Jan 80 85 105 90 94
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Apr 90 95 115 100 94
May 113 125 131 123 94
Jun 110 115 120 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
 Seasonal Index Example
Demand Average Average Seasonal
Month 2005 2006 2007 2005-2007 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94
Mar 80 93 average
82 85 monthly demand
2005-2007 94
Seasonal90index95= 115
Apr 100 94
average monthly demand
May 113 125 131 123 94
Jun 110 115= 90/94
120 = .957 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
 Seasonal Index Example
Demand Average Average Seasonal
Month 2005 2006 2007 2005-2007 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90 95 115 100 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 115 94 1.223
Jul 100 102 113 105 94 1.117
Aug 88 102 110 100 94 1.064
Sept 85 90 95 90 94 0.957
Oct 77 78 85 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
 Seasonal Index Example
Demand Average Average Seasonal
Month 2005 2006 2007 2005-2007 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 Forecast
85 for802008 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90Expected
95 115annual demand
100 = 1,200
94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 1,200 115 94 1.223
Jul Jan 113
100 102 x .957 = 96 94
105 1.117
12
Aug 88 102 110 100 94 1.064
Sept 85 90 95 1,200 90 94 0.957
Feb x .851 = 85
Oct 77 78 85 12 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
Seasonal Index Example
2008 Forecast
140 – 2007 Demand
130 – 2006 Demand
2005 Demand
120 –
Demand

110 –
100 –
90 –
80 –
70 –
| | | | | | | | | | | |
J F M A M J J A S O N D
Time
 San Diego Hospital
Trend Data

10,200 –

10,000 –
Inpatient Days

9745
9,800 – 9702
9616 9659
9573 9724 9766
9,600 – 9530 9680
9594 9637
9551
9,400 –

9,200 –
| | | | | | | | | | | |
9,000 –
Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec
67 68 69 70 71 72 73 74 75 76 77 78
Month
Figure 4.6
San Diego Hospital
Seasonal Indices

1.06 –
1.04 1.04
Index for Inpatient Days

1.04 – 1.03
1.02
1.02 – 1.01
1.00
1.00 – 0.99
0.98
0.98 – 0.99
0.96 – 0.97 0.97
0.96
0.94 –
| | | | | | | | | | | |
0.92 –
Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec
67 68 69 70 71 72 73 74 75 76 77 78
Month
Figure 4.7
 San Diego Hospital
Combined Trend and Seasonal Forecast

10,200 – 10068
9949
10,000 – 9911
Inpatient Days

9764 9724
9,800 – 9691
9572
9,600 –
9520 9542
9,400 –
9411
9265 9355
9,200 –
| | | | | | | | | | | |
9,000 –
Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec
67 68 69 70 71 72 73 74 75 76 77 78
Month
Figure 4.8
5. ASSOCIATIVE
FORECASTING
Used when changes in one or more
independent variables can be used to predict
the changes in the dependent variable

Most common technique is linear

regression analysis

We apply this technique just as we did

in the time series example
Associative Forecasting
Forecasting an outcome based on predictor
variables 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
though to predict the value of the
dependent variable
Least Squares Method
Equations to calculate the regression variables

y^ = a + bx

Sxy - nxy
b=
Sx2 - nx2

a = y - bx
 Associative Forecasting Example
Sales Local Payroll
($ millions), y ($ billions), x
2.0 1
3.0 3
2.5 4
2.0 2 4.0 –
2.0 1
3.0 –

Sales
3.5 7
2.0 –

1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
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
∑y = 15.0 ∑x = 18 ∑x2 = 80 ∑xy = 51.5

∑xy - nxy 51.5 - (6)(3)(2.5)

x = ∑x/6 = 18/6 = 3 b= = = .25
∑x - nx
2 2 80 - (6)(3 2
)

y = ∑y/6 = 15/6 = 2.5 a = y - bx = 2.5 - (.25)(3) = 1.75

 Associative Forecasting Example

y^ = 1.75 + .25x Sales = 1.75 + .25(payroll)

If payroll next year

is estimated to be 4.0 –
$6 billion, then: 3.25

Sales
3.0 –

Sales = 1.75 + .25(6) 2.0 –

Sales = $3,250,000
1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
Standard Error of the Estimate
 A forecast is just a point estimate of a
future value
 This point is
4.0 –
actually the 3.25
mean of a

Sales
3.0 –
probability
2.0 –
distribution
1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
Figure 4.9
Standard Error of the Estimate

∑(y - yc)2
Sy,x =
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
Standard Error of the Estimate
Computationally, this equation is
considerably easier to use

∑y2 - a∑y - b∑xy

Sy,x =
n-2

We use the standard error to set up

prediction intervals around the
point estimate
 Standard Error of the Estimate
39.5 - 1.75(15) - .25(51.5)
Sy,x = ∑y2 - a∑y - b∑xy =
6-2
n-2

Sy,x = .306 4.0 –

3.25

Sales
3.0 –
The standard error
of the estimate is 2.0 –
$306,000 in sales
1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
Correlation
 How strong is the linear relationship between
the variables?
 Correlation does not necessarily imply
causality!
 Coefficient of correlation, r, measures degree
of association
 Values range from -1 to +1
Correlation Coefficient
nSxy - SxSy
r=
[nSx2 - (Sx)2][nSy2 - (Sy)2]
Correlation Coefficient
y y

nSxy - SxSy
r=
[nSx
(a) Perfect positive x
2
- (Sx) 2
][nSy
(b) Positive ]
2
- (Sy) 2
x
correlation: correlation:
r = +1 0<r<1

y y

(c) No correlation: x (d) Perfect negative x

r=0 correlation:
r = -1
Correlation
 Coefficient of Determination, r2, measures the
percent of change in y predicted by the change
in x
 Values range from 0 to 1
 Easy to interpret

For the Nodel Construction example:

r = .901
r2 = .81
Multiple Regression Analysis

If more than one independent variable is to be

used in the model, linear regression can be
extended to multiple regression to
accommodate several independent variables
^y = a + b x + b x …
1 1 2 2

Computationally, this is quite

complex and generally done on the
computer
Multiple Regression Analysis

In the Nodel example, including interest rates in

the model gives the new equation:

^
y = 1.80 + .30x1 - 5.0x2

An improved correlation coefficient of r = .96

means this model does a better job of predicting
the change in construction sales

Sales = 1.80 + .30(6) - 5.0(.12) = 3.00

Sales = $3,000,000
 MONITORING AND
CONTROLLING FORECAST
Monitoring and Controlling
Forecasts
Tracking Signal
 Measures how well the forecast is predicting
actual values
 Ratio of running sum of forecast errors (RSFE) to
mean absolute deviation (MAD)
 Good tracking signal has low values
 If forecasts are continually high or low, the forecast
has a bias error
Monitoring and Controlling
Forecasts

Tracking RSFE
signal =
MAD

∑(Actual demand in
period i -
Forecast demand
Tracking in period i)
signal = (∑|Actual - Forecast|/n)
 Tracking Signal
Signal exceeding limit
Tracking signal
Upper control limit
+

Acceptable
0 MADs range

– Lower control limit

Time
Tracking Signal Example
Cumulative
Absolute Absolute
Actual Forecast Forecast Forecast
Qtr Demand Demand Error RSFE Error Error MAD
1 90 100 -10 -10 10 10 10.0
2 95 100 -5 -15 5 15 7.5
3 115 100 +15 0 15 30 10.0
4 100 110 -10 -10 10 40 10.0
5 125 110 +15 +5 15 55 11.0
6 140 110 +30 +35 30 85 14.2
Tracking Signal Example
Cumulative
Tracking Absolute Absolute
Actual Signal
Forecast Forecast Forecast
Qtr (RSFE/MAD)
Demand Demand Error RSFE Error Error MAD
1 90-10/10
100
= -1 -10 -10 10 10 10.0
2 95 100 -5 -15 5 15 7.5
3 -15/7.5
115 100= -2 +15 0 15 30 10.0
4 100 0/10110
=0 -10 -10 10 40 10.0
5 125-10/10
110
= -1 +15 +5 15 55 11.0
6 140 110 +30 +35 30 85 14.2
+5/11 = +0.5
+35/14.2 = +2.5

The variation of the tracking signal

between -2.0 and +2.5 is within acceptable
limits
Adaptive Forecasting

It’s possible to use the computer to

continually monitor forecast error and
adjust the values of the a and b
coefficients used in exponential
smoothing to continually minimize
forecast error
This technique is called adaptive
smoothing
Focus Forecasting
Developed at American Hardware Supply,
focus forecasting is based on two principles:
1. Sophisticated forecasting models are not
always better than simple ones
2. There is no single technique that should
be used for all products or services

This approach uses historical data to test

multiple forecasting models for individual items
The forecasting model with the lowest error is
then used to forecast the next demand
FORECASTING IN
SERVICE SECTOR
Forecasting in the Service Sector

 Presents unusual challenges

 Special need for short term records
 Needs differ greatly as function of industry and
product
 Holidays and other calendar events
 Unusual events
 Fast Food Restaurant Forecast
20% –
Percentage of sales

15% –

10% –

5% –

11-12 1-2 3-4 5-6 7-8 9-10

12-1 2-3 4-5 6-7 8-9 10-11
(Lunchtime) (Dinnertime)
Hour of day Figure 4.12
THANK YOU!