Chapter 3

Forecasting

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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

3-2
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

3-3
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

3-4
 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

3-5
LO 3.1
 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.

3-6
LO 3.2
 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

3-7
LO 3.3
 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

3-8
LO 3.4
 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

3-9
LO 3.5
 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
3-10
LO 3.6
 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

3-11
LO 3.6
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

3-12
Time-Series Behaviors
Trend
Seasonality
Cycles
Irregular variations
Random variation

3-13
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

3-14
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

3-15
 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

3-16
LO 3.7
 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

3-17
LO 3.8
 Moving Average
Technique that averages a number of the
most recent actual values in generating a
forecast n

 At  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
3-18
LO 3.8
 Moving Average
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

3-19
LO 3.8
 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.

3-20
LO 3.9
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

LO 3-21
3.10
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

LO 3-22
3.14
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)

LO 3-23
3.14
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 3-24
3.14
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
LO 3-25
3.15
Control Chart Construction

LO 3-26
3.15