Forecasting

Chapter 3
(W. Stevenson)

Learning Objectives

List the elements of a good forecast.

Outline the steps in the forecasting process.
Compare and contrast qualitative and
quantitative approaches to forecasting.
Briefly describe averaging techniques, trend and
seasonal techniques, and regression analysis,
and solve typical problems.
Describe measure(s) of forecast accuracy.
Describe evaluating and controlling forecasts.

FORECAST:
A statement about the future value of a variable of interest
such as demand.
Forecasting is used to make informed decisions

Match

supply to demand.

Two important aspects:

Level

of demand

Degree

of accuracy

Long-range plan the system (strategic)

Short-range plan to use the system (on-going operations)

Forecasts

Forecasts affect decisions and activities throughout an organization

Accounting

Cost/profit estimates

Finance

Cash flow and funding

Human Resources

Hiring/recruiting/training

Marketing

Pricing, promotion, strategy

MIS

IT/IS systems, services

Operations

Schedules, workloads

Product/service design

New products and services

Features of Forecasts

Assumes causal system

past ==> future

Forecasts are rarely perfect

Forecast accuracy decreases

as time horizon increases

Elements of a Good Forecast

Timely

Reliable

Accurate

Written

Cost Effective

Steps in the Forecasting Process

The forecast

Step 6: Monitor the forecast

Step 5: Make the forecast
Step 4: Obtain, clean and analyze data
Step 3: Select a forecasting technique
Step 2: Establish a time horizon
Step 1: Determine purpose of forecast

Forecasting Process
1. Identify the purpose of
forecast

2. Collect historical data

6. Check forecast accuracy

with one or more measures

7.
Is accuracy of
forecast acceptable?

5. Develop/compute forecast
for period of historical data

No

3. Plot data and identify

patterns

4. Select a forecast model

that seems appropriate for
data

8b. Select new forecast

model or adjust parameters
of existing model

Yes
8a. Forecast over planning
horizon

9. Adjust forecast based on

additional qualitative
information and insight

10. Monitor results and

measure forecast accuracy

Types of Forecasts

Judgmental - uses subjective inputs

Time series - uses historical data assuming the future

will be like the past

Associative models - uses explanatory variables to

predict the future

Judgmental Forecasts

Executive opinions

Sales force opinions

Consumer surveys

Outside opinion

Delphi method
Opinions

of managers and staff

Achieves

a consensus forecast

Time Series Forecasts

Trend - long-term movement in data

Seasonality - short-term regular variations in

data

Cycle wavelike variations of more than one

years duration

Irregular variations - caused by unusual

circumstances

Random variations - caused by chance

Forecast Variations
Irregular
variation

Trend

Cycles
90
89
88
Seasonal variations

Naive Forecasts

Uh, give me a minute....

We sold 250 wheels last
week.... Now, next week we should
sell....
The forecast for any period equals the
previous periods actual value.

Nave Forecasts

Simple to use

Virtually no cost

Quick and easy to prepare

Data analysis is nonexistent

Easily understandable

Cannot provide high accuracy

Can be a standard for accuracy

Techniques for Averaging

Moving average

Weighted moving average

Exponential smoothing

Moving Averages

Moving average A technique that averages a number of

recent actual values, updated as new values become available.

Ft = MAn=

At-n + At-2 + At-1

n

Weighted moving average More recent values in a series are

given more weight in computing the forecast.

Ft = WMAn=

wnAt-n + wn-1At-2 + w1At-1

Moving Average Example

Calculate a three-period moving average forecast for demand in period 6

If the actual demand in period 6 is 38, then the moving average forecast for period 7 is:

Simple Moving Average

Actual

MA5

47
45
43
41
39
37

MA3

35
1

Ft = MAn=

10

11

At-n + At-2 + At-1

n

12

Weighted Moving Average Example

Period

Demand

Weight

42

40

10%

43

20%

40

30%

41

40%

Exponential Smoothing

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

Premise--The most recent observations might have the highest

predictive value.

Therefore, we should give more weight to the more recent time periods
when forecasting.

Uses most recent periods actual and forecast data

Weighted averaging method based on previous forecast plus a

percentage of the forecast error
A-F is the error term, is the % feedback

Exponential Smoothing Example

F3 F2 ( A2 F2 )

0.10, F3 42 0.10(40 42) 42 0.10 ( 2) 42 0.2 41.8

F4 F3 ( A3 F3 )

0.10, F4 41.8 0.10(43 41.8) 41.8 0.10 1.2 41.8 0.12 41.92

Picking a Smoothing Constant

Actual

Demand

50

.4

45

.1

40
35
1

Period

10 11 12

Common Nonlinear Trends

Parabolic

Exponential

Growth

Linear Trend Equation

Ft

Ft = a + bt
0 1 2 3 4 5

Ft

= Forecast for period t

t = Specified number of time periods
a = Value of Ft at t = 0
b = Slope of the line

Calculating a and b

b =

n (ty) - t y
n t 2 - ( t) 2

a =

y - b t
n

Linear Trend Equation Example

t
W eek
1
2
3
4
5
t = 15
(t)2 = 225

t2
1
4
9
16
25
t2 = 55

y
Sales
150
157
162
166
177

ty
150
314
486
664
885

y = 812 ty = 2499

Linear Trend Calculation

b =

a =

5 (2499) - 15(812)
5(55) - 225

812

- 6.3(15)
5

12495 -12180
275 - 225

= 143.5

y = 143.5 + 6.3t

= 6.3

Associative Forecasting

Predictor variables - used to predict values of

variable interest

Regression - technique for fitting a line to a set of

points

Least squares line - minimizes sum of squared

deviations around the line

Regression Methods
Linear regression
mathematical technique that relates a
dependent variable to an independent variable
in the form of a linear equation
Primary method for Associative Forecasting
Correlation
a measure of the strength of the relationship
between independent and dependent variables

Linear Regression Assumptions

Variations around the line are random

Deviations around the line normally distributed

Predictions are being made only within the range of

observed values

For best results:

Always

Check
Small

plot the data to verify linearity

for data being time-dependent

correlation may imply that other variables are

important

Linear Model Seems Reasonable

X
7
2
6
4
14
15
16
12
14
20
15
7

Y
15
10
13
15
25
27
24
20
27
44
34
17

Computed
relationship
50
40
30
20
10
0
0

10

15

20

25

A straight line is fitted to a set of sample points.

Linear Regression
y = a + bx

a = y-bx
b =

xy - nxy
x2 - nx2

where
a = intercept
b = slope of the line
x =
y =

x
= mean of the x data
n
y
=n mean of the y data

Linear Regression Example

x
(WINS)

y
(ATTENDANCE)

xy

x2

4
6
6
8
6
7
5
7

36.3
40.1
41.2
53.0
44.0
45.6
39.0
47.5

145.2
240.6
247.2
424.0
264.0
319.2
195.0
332.5

16
36
36
64
36
49
25
49

49

346.7

2167.7

311

Linear Regression Example

x=
y=

49
= 6.125
8
346.9
= 43.36
8

xy - nxy
x2 - nx2

b=

(2,167.7) - (8)(6.125)(43.36)
(311) - (8)(6.125)2

= 4.06
a = y - bx
= 43.36 - (4.06)(6.125)
= 18.46

Linear Regression Example

60,000

Attendance, y

50,000
40,000

Linear regression line, y = 18.46

+ 4.06x

30,000

Attendance forecast for 7 wins

20,000

y = 18.46 + 4.06(7)
= 46.88, or 46,880

10,000
|
0

|
1

|
2

|
3

|
4

|
5

|
6

|
7

Wins, x

|
8

|
9

|
10

Correlation and Coefficient of

Determination

Correlation, r

Measure of strength of relationship between the

dependent variable (demand) and the
independent variable

Varies between -1.00 and +1.00

Coefficient of determination, r2

Percentage of variation in dependent variable

resulting from changes in the independent
variable

Computing Correlation
r=

r=

n xy - x y
[n x2 - ( x)2] [n y2 - ( y)2]
(8)(2,167.7) - (49)(346.9)

[(8)(311) - (49)2] [(8)(15,224.7) - (346.9)2]

r = 0.947
Coefficient of determination
r2 = (0.947)2 = 0.897

Forecast Accuracy

Error - difference between actual value and predicted value

Mean Absolute Deviation (MAD)

Average absolute error

Weights errors linearly.

Mean Squared Error (MSE)

Average of squared error

Gives more weight to larger errors, which typically cause more problems

Mean Absolute Percent Error (MAPE)

Average absolute percent error

MAPE should be used when there is a need to put errors in perspective. For
example, an error of 10 in a forecast of 15 is huge. Conversely, an error of 10 in
a forecast of 10,000 is insignificant. Hence, to put large errors in perspective,
MAPE would be used.

MAD, MSE, and MAPE

MAD

Actual

forecast
n

MSE

forecast)

( Actual

n -1

MAPE

Actual

forecast

/ Actual*100)

Forecast Accuracy Example

MAD, MSE, and MAPE

MAD easiest to compute, but weighs errors
linearly.
MSE Gives more weight to larger errors;
larger errors cause more problems.
MAPE Puts errors in perspective: e.g., error
of 10 in a forecast of 15 is huge, but error of
10 in a forecast of 10,000 is perhaps negligible.

Controlling the Forecast

Control chart
A

visual tool for monitoring forecast errors

Used

to detect non-randomness in errors

Forecasting errors are in control if

All
No

errors are within the control limits

patterns, such as trends or cycles, are

present

Tracking Signal
Tracking signal
Ratio of cumulative error to MAD

Tracking signal

(Actual - forecast)

MAD

Bias Persistent tendency for forecasts to be

Greater or less than actual values.

Forecast Control

Tracking signal
monitors the forecast to see if it is biased
high or low
1 MAD 0.8
Control limits of 2 to 5 MADs are used most
frequently

Tracking signal =

(Dt - Ft)
=
MAD

E
MAD

Tracking Signal Values

Tracking Signal Plot

Sources of Forecast errors

Model may be inadequate

Irregular variations

Incorrect use of forecasting technique

Choosing a Forecasting Technique

No single technique works in every situation
Two most important factors
Cost
Accuracy
Other factors include the availability of:
Historical data
Computers
Time needed to gather and analyze the data
Forecast horizon

Operations Strategy

Forecasts are the basis for many decisions

Work to improve short-term forecasts

Accurate short-term forecasts improve

Profits
Lower

inventory levels

Reduce

inventory shortages

Improve

customer service levels

Enhance

forecasting credibility

Supply Chain Forecasts

Sharing

forecasts with supply can

Improve forecast quality in the
supply chain
Lower costs
Shorter lead times