FORECASTING

Chapter # 3
INTRODUCTION
 Forecasts are a basic input in the decision processes of operations
management because they provide information on future demand.
 The importance of forecasting to operations management cannot be
overstated.
 The primary goal of operations management is to match supply to
demand.
 Having a forecast of demand is essential for determining how much
capacity or supply will be needed to meet demand.
 For instance, operations needs to know what capacity will be needed
to make staffing and equipment decisions, budgets must be
prepared, purchasing needs information for ordering from
suppliers, and supply chain partners need to make their plans.
INTRODUCTION
 Businesses make plans for future operations based on
anticipated future demand.
 Anticipated demand is derived from two possible sources, actual
customer orders and forecasts.
 For businesses where customer orders make up most or all of
anticipated demand, planning is straightforward, and little or no
forecasting is needed.
 However, for many businesses, most or all of anticipated demand is
derived from forecasts.
INTRODUCTION
 Forecasts are made with reference to a specific time horizon.
 The time horizon may be fairly short (e.g., an hour, day, week, or
month), or somewhat longer (e.g., the next six months, the next year,
the next five years, or the life of a product or service).
 Short-term forecasts refers to ongoing operations.
 Long-range forecasts can be an important strategic planning tool.
 Long- term forecasts pertain to new products or services, new
equipment, new facilities, or something else that will require a
somewhat long lead time to develop, construct, or otherwise
implement.
INTRODUCTION
 Forecasts are the basis for budgeting, planning capacity,
sales, production and inventory, personnel, purchasing, and
more.
 Forecasts play an important role in the planning process because
they enable managers to anticipate the future so they can plan
accordingly.
 Forecasts affect decisions and activities throughout an organization,
in accounting, finance, human resources, marketing, and management
information systems (MIS), as well as in operations and other parts of
an organization.
INTRODUCTION
 Accounting
New product/process cost estimates, profit projections, cash
management.

 Finance
Equipment/equipment replacement needs, timing and amount of
funding/ borrowing needs.

 Human Resources
Hiring activities, including recruitment, interviewing, and training;
layoff planning, including outplacement counseling.
INTRODUCTION
 Marketing
Pricing and promotion, e-business strategies, global competition
strategies.
 MIS
New/revised information systems, internet services.

 Operations
Schedules, capacity planning, work assignments and workloads,
inventory planning, make-or-buy decisions, outsourcing, project
management.

 Product/service design
Revision of current features, design of new products or services.
INTRODUCTION
 Forecasting is also an important component of yield
management, which relates to the percentage of capacity
being used.
 Accurate forecasts can help managers plan tactics (e.g.,
offer discounts, don’t offer discounts) to match capacity with
demand, thereby achieving high-yield levels.
INTRODUCTION
 There are two uses for forecasts.
 One is to help managers plan the system, and the other is to help
them plan the use of the system.
 Planning the system generally involves long-range plans about the
types of products and services to offer, what facilities and equipment
to have, where to locate, and so on.
 Planning the use of the system refers to short-range and
intermediate-range planning, which involve tasks such as planning
inventory and workforce levels, planning purchasing and
production, budgeting, and scheduling.
FEATURES COMMON TO ALL FORECASTS
 A wide variety of forecasting techniques are in use.
 In many respects, they are quite different from each other, as you
shall soon discover.
 Nonetheless, certain features are common to all, and it is important
to recognize them.
 Forecasting techniques generally assume that the same underlying
causal system that existed in the past will continue to exist in the
future.
FEATURES COMMON TO ALL FORECASTS
 Forecasts are not perfect; actual results usually differ from
predicted values; the presence of randomness precludes a
perfect forecast. Allowances should be made for forecast
errors.
 Forecasts for groups of items tend to be more accurate than
forecasts for individual items because forecasting errors among items
in a group usually have a canceling effect. Opportunities for grouping
may arise if parts or raw materials are used for multiple products or if
a product or service is demanded by a number of independent sources.
 Forecast accuracy decreases as the time period covered by the
forecast—the time horizon—increases. Generally speaking, short-range
forecasts must contend with fewer uncertainties than longer-range
forecasts, so they tend to be more accurate.
ELEMENTS OF A GOOD FORECAST
A properly prepared forecast should fulfill certain requirements:
 The forecast should be timely. Usually, a certain amount of time is
needed to respond to the information contained in a forecast. For
example, capacity cannot be expanded overnight, nor can inventory
levels be changed immediately. Hence, the forecasting horizon must
cover the time necessary to implement possible changes.
 The forecast should be accurate, and the degree of accuracy should
be stated. This will enable users to plan for possible errors and will
provide a basis for comparing alternative forecasts.
ELEMENTS OF A GOOD FORECAST
 The forecast should be reliable; it should work consistently. A
technique that sometimes provides a good forecast and sometimes a
poor one will leave users with the uneasy feeling that they may get
burned every time a new forecast is issued.
 The forecast should be expressed in meaningful units. Financial
planners need to know how many dollars will be needed, production
planners need to know how many units will be needed, and
schedulers need to know what machines and skills will be required.
The choice of units depends on user needs.
 The forecast should be in writing. Although this will not guarantee
that all concerned are using the same information, it will at least
increase the likelihood of it. In addition, a written forecast will permit
an objective basis for evaluating the forecast once actual results are in.
ELEMENTS OF A GOOD FORECAST
 The forecasting technique should be simple to understand and
use. Users often lack confidence in forecasts based on sophisticated
techniques; they do not understand either the circumstances in which
the techniques are appropriate or the limitations of the techniques.
Misuse of techniques is an obvious consequence. Not surprisingly,
fairly simple forecasting techniques enjoy widespread popularity
because users are more comfortable working with them.
 The forecast should be cost-effective: The benefits should outweigh
the costs.
APPROACHES TO FORECASTING
 There are two general approaches to forecasting: qualitative and
quantitative.
 Qualitative methods consist mainly of subjective inputs, which
often confront precise numerical description.
 Quantitative methods involve either the projection of historical
data or the development of associative models that attempt to utilize
causal (explanatory) variables to make a forecast.
 Qualitative techniques permit inclusion of soft information (e.g.,
human factors, personal opinions) in the forecasting process.
 Those factors are often omitted or downplayed when quantitative
techniques are used because they are difficult or impossible to
quantify.
 Quantitative techniques consist mainly of analyzing objective, or
APPROACHES TO FORECASTING
The following pages present a variety of forecasting techniques that
are classified as judgmental, time-series, or associative.
 Judgmental forecasts rely on analysis of subjective inputs
obtained from various sources, such as consumer surveys, the sales
staff, managers and executives, and panels of experts.
Quite frequently, these sources provide insights that are not otherwise
available.
APPROACHES TO FORECASTING
 Time-series forecasts simply attempt to project past experience
into the future.
These techniques use historical data with the assumption that the
future will be like the past.
Some models merely attempt to smooth out random variations in
historical data; others attempt to identify specific patterns in the data
and project or extrapolate those patterns into the future, without trying
to identify causes of the patterns.
APPROACHES TO FORECASTING
 Associative models use equations that consist of one or more
explanatory variables that can be used to predict demand.
For example, demand for paint might be related to variables such as
the price per gallon and the amount spent on advertising, as well as to
specific characteristics of the paint (e.g., drying time, ease of cleanup).
FORECASTS BASED ON TIME-SERIES DATA
 A time series is a time-ordered sequence of observations taken at
regular intervals (e.g., hourly, daily, weekly, monthly, quarterly,
annually).
 The data may be measurements of demand, sales, earnings, profits,
shipments, accidents, output, precipitation, productivity, or the
consumer price index.
 Forecasting techniques based on time-series data are made on the
assumption that future values of the series can be estimated from past
values.
 Analysis of time-series data requires the analyst to identify the
underlying behavior of the series.
 This can often be accomplished by merely plotting the data and
visually examining the plot.
 One or more patterns might appear: trends, seasonal variations,
FORECASTS BASED ON TIME-SERIES DATA
1. Trend refers to a long-term upward or downward movement in the
data.
Population shifts, changing incomes, and cultural changes often
account for such movements.
2. Seasonality refers to short-term, fairly regular variations
generally related to factors such as the calendar or time of day.
Restaurants, supermarkets, and theaters experience weekly and even
daily “seasonal” variations.
3. Cycles are wavelike variations of more than one year’s duration.
These are often related to a variety of economic, political, and even
agricultural conditions.
FORECASTS BASED ON TIME-SERIES DATA
4. Irregular variations are due to unusual circumstances such as
severe weather conditions, strikes, or a major change in a product or
service.
They do not reflect typical behavior, and their inclusion in the series
can distort the overall picture.
Whenever possible, these should be identified and removed from the
data.
5. Random variations are residual variations that remain after all
other behaviors have been accounted for.
FORECASTS BASED ON TIME-SERIES DATA
FORECASTS BASED ON TIME-SERIES DATA
 Naive Methods
A simple but widely used approach to forecasting is the naive
approach.
A naive forecast uses a single previous value of a time series as the
basis of a forecast.
The naive approach can be used with a stable series (variations around
an average), with seasonal variations, or with trend.
With a stable series, the last data point becomes the forecast for the
next period.
Thus, if demand for a product last week was 20 cases, the forecast for
this week is 20 cases.
FORECASTS BASED ON TIME-SERIES DATA
Naive Methods
For example, suppose the last two values were 50 and 53.
The next forecast would be 56:
Change from:
Period Actual Previous Value Forecast
1 50 ---
2 53 +3
3 53+3=56
FORECASTS BASED ON TIME-SERIES DATA
Naive Methods
Change from:
Period Sales
1 50
2 53
3 55
4 58
5 ???
Forecast for F5 = 58, as the interval is not consistent, therefore have to take the
most recent value.
TECHNIQUES FOR AVERAGING
 Averaging techniques generate forecasts that reflect recent values of
a time series (e.g., the average value over the last several periods).
 These techniques work best when a series tends to vary around an
average, although they also can handle step changes or gradual
changes in the level of the series.
 Three techniques for averaging are described in this section:
1. Moving average
2. Weighted moving average
3. Exponential smoothing
TECHNIQUES FOR AVERAGING
 Moving Average
One weakness of the naive method is that the forecast just traces the
actual data, with a lag of one period; it does not smooth at all.
But by expanding the amount of historical data a forecast is based on,
this difficulty can be overcome.
A moving average forecast uses a number of the most recent actual
data values in generating a forecast.
TECHNIQUES FOR AVERAGING
The moving average forecast can be computed using the following
n
equation:
 A t-i
Ft = MAn = i=1

n
Ft = Forecast for time period t
MAn = n period moving average
At-1 = Actual value in period t-1

More recent values in a series are given more weight in computing the
forecast.
For example, MA3 would refer to a three-period moving average
forecast, and MA 5 would refer to a five-period moving average
forecast.
TECHNIQUES FOR AVERAGING
Computing a Moving Average
Compute a three-period moving average forecast given demand for
shopping carts for the last five periods.
TECHNIQUES FOR AVERAGING
 Weighted Moving Average
A weighted average is similar to a moving average, except that it
typically assigns more weight to the most recent values in a time
series.
For instance, the most recent value might be assigned a weight of .40,
the next most recent value a weight of .30, the next after that a weight
of .20, and the next after that a weight of .10.
Note that the weights must sum to 1.00, and that the heaviest weights
are assigned to the most recent values.
 TECHNIQUES FOR AVERAGING
 Weighted Moving Average
Computing a Weighted Moving Average
Given the following demand data:
Period Demand
1 42
2 40
3 43
4 40
5 41
a. Compute a weighted average forecast using a weight of .40 for the most recent
period, .30 for the next most recent, .20 for the next, and .10 for the next.
b. If the actual demand for period 6 is 39, forecast demand for period 7 using the
same weights as in part a.
 TECHNIQUES FOR AVERAGING
 Weighted Moving Average
Computing a Weighted Moving Average

a. Compute a weighted average forecast using a weight of .40 for the most recent
period, .30 for the next most recent, .20 for the next, and .10 for the next.
F6 = .10(40) + .20(43) + .30(40) + .40(41) = 41.0
b. If the actual demand for period 6 is 39, forecast demand for period 7 using the
same weights as in part a.
F7 = .10(43) + .20(40) + .30(41) + .40(39) = 40.2
TECHNIQUES FOR AVERAGING
 Exponential Smoothing
Exponential smoothing is a sophisticated weighted averaging
method that is still relatively easy to use and understand.
Each new forecast is based on the previous forecast plus a percentage
of the difference between that forecast and the actual value of the
series at that point
TECHNIQUES FOR AVERAGING
 Exponential Smoothing
Next forecast = Previous forecast + α(Actual − Previous forecast)
where (Actual − Previous forecast) represents the forecast error and α
is a percentage of the error.
More concisely,
Ft = Ft−1 + α( At−1 − Ft−1)
Where,
Ft = Forecast for period t
Ft−1 = Forecast for the previous period (i.e., period t − 1)
α = Smoothing constant (percentage, usually less than 50%)
At−1 = Actual demand or sales for the previous period
TECHNIQUES FOR AVERAGING
 Exponential Smoothing
The smoothing constant α represents a percentage of the forecast
error.
Each new forecast is equal to the previous forecast plus a percentage
of the previous error.
α = 15% = 0.15
Period Data
1 10
2 14
3 12
4 19
5 8
Calculate the Forecasted Value of Period 6?
Therefore, F(6) = F(5) + α (A5 - F5)
TECHNIQUES FOR AVERAGING
 Exponential Smoothing
Period Data
1 10
2 14
3 12
4 19
5 8
F(1) = Not Applicable
F(2) = A1 = 10
F(3) = F(2) + α (A2 – F2) = 10 + 0.15 (14-10) = 10.60
F(4) = F(3) + α (A3 – F3) = 10.60 + 0.15 (12-10.60) = 10.81
F(5) = F(4) + α (A4 – F4) = 10.81 + 0.15 (19-10.81) = 12.03
F(6) = F(5) + α (A5 – F5) = 12.03 + 0.15 (8-12.03) = 11.43
TECHNIQUES FOR AVERAGING
 Exponential Smoothing
For example, suppose the previous forecast was 42 units, actual
demand was 40 units, and α = .10.
The new forecast would be computed as follows:
Ft = 42 + .10(40 − 42 ) = 41.8
Then, if the actual demand turns out to be 43, the next forecast would
be
Ft = 41.8 + .10(43 − 41.8)= 41.92
TECHNIQUES FOR AVERAGING

Exponential
Smoothing
F12=???
F2

F12= F11+ α (A11-

F11)

= 41.92+ 0.1(40-
41.92)
= 41.73

F3= F2+ α(A2-F2)

= 42+ 0.1 (40-42)
= 41.8
TECHNIQUES FOR AVERAGING
 TECHNIQUES FOR AVERAGING

a.

b.
TECHNIQUES FOR AVERAGING
SUMMARIZING FORECAST ACCURACY
 Forecast accuracy is a significant factor when deciding among
forecasting alternatives.
 Accuracy is based on the historical error performance of a forecast.
 Three commonly used measures for summarizing historical errors
are the mean absolute deviation (MAD), the mean squared error
(MSE), and the mean absolute percent error (MAPE).
 MAD is the average absolute error, MSE is the average of squared
errors, and MAPE is the average absolute percent error.
SUMMARIZING FORECAST ACCURACY
The formulas used to compute MAD, MSE, and MAPE are as follows:
SUMMARIZING FORECAST ACCURACY

+8, +2, +1, -1, -3, -7 =

0

E= 0,
SUMMARIZING FORECAST ACCURACY
SUMMARIZING FORECAST ACCURACY
Solution: Technique 1
Period Actual (A) Forecast (F) A-F |A-F| (|A-F|)2 (|A-F|/A) × 100
1 492 488 4 4 16 0.81
2 470 484 -14 14 196 2.98
3 485 480 5 5 25 1.03
4 493 490 3 3 9 0.61
5 498 497 1 1 1 0.20
6 492 493 -1 1 1 0.20
TOTAL 28 248 5.83%

Mean Absolute Deviation (MAD) = 28/6 = 4.67

Mean Squared Error (MSE) = 248/ (6-1) = 248/5 = 49.6
Mean Absolute Percent Error (MAPE) = 5.83/6 = 0.97%
SUMMARIZING FORECAST ACCURACY
Solution: Technique 2
Period Actual (A) Forecast (F) A-F |A-F| (|A-F|)2 (|A-F|/A) × 100
1 492 495 -3 3 9 0.61
2 470 482 -12 12 144 2.55
3 485 478 7 7 49 1.44
4 493 488 5 5 25 1.01
5 498 492 6 6 36 1.20
6 492 493 -1 1 1 0.20
TOTAL 34 264 7.01%

Mean Absolute Deviation (MAD) = 34/6 = 6.67

Mean Squared Error (MSE) = 264/ (6-1) = 264/5 = 52.8
Mean Absolute Percent Error (MAPE) = 7.01/6 = 1.17%
SUMMARIZING FORECAST ACCURACY
Solution: Technique 1
Mean Absolute Deviation (MAD) = 28/6 = 4.67
Mean Squared Error (MSE) = 248/ (6-1) = 248/5 = 49.6
Mean Absolute Percent Error (MAPE) = 5.83/6 = 0.97%

Solution: Technique 2
Mean Absolute Deviation (MAD) = 34/6 = 6.67
Mean Squared Error (MSE) = 264/ (6-1) = 264/5 = 52.8
Mean Absolute Percent Error (MAPE) = 7.01/6 = 1.17%
As we got, MAD Technique 1 < MAD Technique 2, which indicates that
Technique # 1 will be more accurate than Technique # 2.
Similarly we can compare, MSE Technique 1 and MSE Technique 2, and
MAPE Technique 1 and MAPE Technique 2, which eventually indicates that,
the lesser deviated value will indicate more Accuracy.
TECHNIQUES FOR TREND
Analysis of trend involves developing an equation that will suitably
describe trend (assuming that trend is present in the data).
Trend Equation A linear trend equation has the form

Regression
analysis
TECHNIQUES FOR TREND

62.97
64.72
TECHNIQUES FOR TREND
TECHNIQUES FOR TREND

Regression
analysis
Practice # 1 Week
Passengers
Travelled
1 1000
2 1200
3 1500
4 2000
5 1700
Week (t) t2 Passengers ty
6 1800
(y)
1 1 1000 1000
2 4 1200 2400
3 9 1500 4500
4 16 2000 8000
5 25 1700 8500
6 36 1800 10800
21 91 9200 35200
 Week (t) t2 Passengers (y) ty

Practice # 1 1 1 1000 1000

2 4 1200 2400

3 9 1500 4500

4 16 2000 8000

5 25 1700 8500

6 36 1800 10800

21 91 9200 35200

b = 6(35200)- 21(9200)/ 6(91) – (21)2 a = 9200 – 171.43 (21)/ 6

= 211200 – 193200 / 546 – 441 = 9200 – 3600.03 /
6
= 18000/ 105 = 5599.97/ 6
= 171.43 = 933.33
Thus, the trend equation is Ft = a + b t = 933.33 + 171.43t
F7 = 933.33+ 171.43(7) = 933.33 + 1200.01 = 2133.34
F8 = 933.33+ 171.43(8) = 933.33 + 1371.44 = 2304.77
Practice # 2
Cell phone sales for a New firm is based over the last ten
weeks as shown.
Determine the linear equation and predict the sales for
the weeks of 11 and 12..40+7.51t
Wee
1 2 3 4 5 6 7 8 9 10
k
72
Sales 700 724 720 740 742 758 750 770 775
8
Practice # 2
Week (t) t2 Sales (y) ty
1 1 700 700
2 4 724 1448
3 9 720 2160
4 16 728 2912
5 25 740 3700
6 36 742 4452
7 49 758 5306
8 64 750 6000
9 81 770 6930
10 100 775 7750
55 385 7407 41358
 Week (t) t2 Sales (y) ty

Practice # 2 1 1
700
700

2 4 1448
724
b = 10(41358) - 55(7407)/ 10(385) – (55)23 9 720 2160
= 413580 – 407385 / 3850 – 3025 4 16
728
2912

= 6195/825 5 25
740
3700

= 7.51 6 36
742
4452

a = 7407 – 7.51(55)/10 7
8
49
64
758
750
5306
6000
= 7407 – 413.05/10 9 81 770 6930
= 6993.95/10 10 100 775 7750
= 699.40
55 385 7407 41358

Thus, the trend equation is Ft = a + b t = 699.40 + 7.51t

F11 = 699.40 + 7.51(11) = 699.40 + 82.61 = 782
F12 = 699.40 + 7.51(12) = 699.40 + 90.12 = 790
3-58 Forecasting

Exercise-3

e. Calculate the accuracy of forecasting by measuring the parameters

MAD, MSE and MAPE of the solution generated from question (d)
3-59 Forecasting

Exercise-3- Solution

a
.
b
.
3-60 Forecasting

Exercise-3- Solution
3-61 Forecasting

Exercise-3- Solution
END OF THE CHAPTER