Chapter 3

Forecasting

Operations Management
FOURTEENTH EDITION
William J. Stevenson

© McG © 2 021 McGraw Hill. All rights reserved. Authorized only for instructor use in
raw Hill 1
 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 the elements of a good forecast
LO 3.4 Outline the steps in the forecasting process
LO 3.5 Summarize forecast errors and use
LO 3.6 summaries to make decisions
LO 3.7 Describe four qualitative forecasting techniques
LO 3.8 Use a naïve method to make a forecast
LO 3.9 Prepare a moving average forecast
LO 3.10 Prepare a weighted-average forecast
LO 3.11 Prepare an exponential smoothing forecast
LO 3.12 Prepare a linear trend forecast
LO 3.13 Prepare a trend-adjusted exponential smoothing forecast
LO 3.14 Compute and use seasonal relatives
LO 3.15 Compute and use regression and correlation coefficients
LO 3.16 Construct control charts and use them to monitor forecast errors
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

LO 3.1
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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

LO 3.1
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 Forecasts in Business Organizations

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.
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
LO new
3.1 products or services.
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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

LO 3.1
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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

LO 3.1
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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.

LO 3.2
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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

LO 3.3
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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

LO 3.4
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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

LO 3.6
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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
Salesforce 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 opinions 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
LO 3.6
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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

LO 3.6
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 Time-Series Behaviors

Trend
Seasonality
Cycles
Irregular
variations
Random
variation

LO 3.6
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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

LO 3.6
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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

LO 3.6
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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

LO 3.7
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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

LO 3.7
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 Moving Average
1

Technique that averages a number of the most recent actual

values in generating a forecast
n

A ti
A  A 
Ft  MA  i1
 A tn t2 t
n n n
1

where
Ft  Forecast for time period t
MAn  n period moving
average
Ati  Actual value in period t
i
LO 3.8
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n  Number of periods in 19
 Moving Average 2

As new data become available, the forecast is updated by

adding the newest value and dropping the oldest and then
recomputing 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

LO 3.8
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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
 wt n ( At n )
1 ) 
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.

LO 3.9
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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 α( At 1  Ft 1 )

where
Ft  Forecast for period t
Ft1  Forecast for the previous period
α Smoothing constant
At1  Actual demand or sales for the previous
period
LO 3.10
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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
LO 3.11
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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

 y nb  t
a or y  bt
where
n  Number of periods
y  Value of the time
series

LO 3.11
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 Trend-Adjusted Exponential Smoothing 1

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

LO 3.12
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 Trend-Adjusted Exponential Smoothing 2

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 α( At  TAFt )
Tt  Tt 1  β(TAFt  TAFt 1  Tt 1 )

LO 3.12
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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

LO 3.12
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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 (for
example, 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

LO 3.13
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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

LO 3.14
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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 (that is, the least squares criterion)

LO 3.14
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 Least Squares Line

ye  a  bx
where
yc = Predicted (dependent) variable
x = Predictor (independent) variable
b = Slope of the line
a = Value of yc when x  0 (that is, the height of the line at the y
intercept)
and
b n  xy    x2 

n  x2   
y
a  x n
y  b x
or y  bx
where
n  Number of paired
LOobservations
3.14
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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

r n  xy    x y 


r2, square of the correlation coefficient  

    
2
n  x 2
  x n  y 2

A measure of the percentage of variability in the values of y
y
2
that is “explained” by the independent variable
Ranges between 0 and 1.00

LO 3.14
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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

LO 3.14
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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

LO 3.14
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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

LO 3.5
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 Forecast Accuracy Metrics

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

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

Actualt  Forecastt 10 MAPE weights errors

MAPE
 Actualt 0 according to relative error
 n

LO 3.5
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 Forecast Error Calculation

Actual Forecast (A − F)
Period
(A) (F) Error |Error| Error2 [|Error|/Actual] × 100
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%

LO 3.5
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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

LO 3.15
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 Control Chart Construction

1. Compute the MSE.

2. Estimate of standard deviation of the distribution of errors

s MSE
3. UCL: 0  z MSE
4. LCL: 0  z MSE
where z = Number of standard deviations from the mean

LO 3.15 Access the text alternative for slide images.

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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

LO 3.16
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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

LO 3.16
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