3-1 Forecasting

Operations Management

William J. Stevenson

8th edition
3-2 Forecasting

Forecasting
3-3 Forecasting

FORECAST:
 A statement about the future value of a variable of interest such
as demand.
 Forecasts affect decisions and activities throughout an
organization
 Accounting, finance
 Human resources
 Marketing
 MIS
 Operations
 Product / service design
3-4 Forecasting

Uses of Forecasts

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, MRP, workloads

Product/service design New products and services

3-5 Forecasting

Forecasting and Supply Chain Management

 Accurate forecasting determines how much inventory a company

must keep at various points along its supply chain
 Continuous replenishment
 supplier and customer share continuously updated data
 typically managed by the supplier
 reduces inventory for the company
 speeds customer delivery
 Variations of continuous replenishment
 quick response
 JIT (just-in-time)
 VMI (vendor-managed inventory)
 stockless inventory
3-6 Forecasting

 Assumes causal system

past ==> future
 Forecasts rarely perfect because of randomness
 Forecasts more accurate for
groups vs. individuals
 Forecast accuracy decreases
as time horizon increases
I see that you will
get an A this semester.
3-7 Forecasting

Elements of a Good Forecast

Timely

Reliable Accurate

l s e
g fu u
i n Written to
n s y
a
M
e Ea
3-8 Forecasting

Steps in the Forecasting Process

“The forecast”

Step 6 Monitor the forecast

Step 5 Prepare the forecast
Step 4 Gather and analyze data
Step 3 Select a forecasting technique
Step 2 Establish a time horizon
Step 1 Determine purpose of forecast
3-9 Forecasting

Forecasting Methods
 Qualitative
 use management judgment, expertise, and opinion
to predict future demand
 Time series
 statistical techniques that use historical demand data
to predict future demand
 Regression methods
 attempt to develop a mathematical relationship
between demand and factors that cause its behavior
3-10 Forecasting

Judgmental Forecasts
 Management, marketing, purchasing, and
engineering are sources for internal qualitative
forecasts
 Executive opinions
 Sales force opinions
 Consumer surveys
 Outside opinion
 Delphi method
 involves soliciting forecasts about technological
advances from experts
3-11 Forecasting

Demand Behaviour

 Trend - a gradual, long-term up or down

movement of demand
 Seasonality - short-term regular variations in
data
 Cycle – wavelike variations of more than one
year’s duration
 Random variations - movements in demand
that do not follow a pattern
3-12 Forecasting

Forecast Variations
Figure 3.1

Irregular
variation

Trend

Cycles

90
89
88
Seasonal variations
3-13 Forecasting

Time Series
 Assume that what has occurred in the past will
continue to occur in the future
 Relate the forecast to only one factor - time

 Include
 moving average
 exponential smoothing

 linear trend line

3-14 Forecasting

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 period’s actual value.
3-15 Forecasting

Naïve Approach

ORDERS
MONTH PER MONTH FORECAST

Jan 120 -
Feb 90 120
Mar 100 90
Apr 75 100
May 110 75
June 50 110
July 75 50
Aug 130 75
Sept 110 130
Oct 90 110
Nov - 90
3-16 Forecasting

Naïve 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

3-17 Forecasting

Techniques for Averaging

 Moving average - stable demand with no

pronounced behavioral patterns
 Weighted moving average - weights are
assigned to most recent data
3-18 Forecasting

Moving Averages

 Simple Moving average – A technique that averages

a number of recent actual values, updated as new
values become available.
n

 A i
MAn = i=1

n
3-19 Forecasting

Simple Moving Average

Actual
MA5
47
45
43
41
39
37
MA3
35
1 2 3 4 5 6 7 8 9 10 11 12
n

 Ai
MAn = i=1

n
3-20 Forecasting

Moving Average Example

Compute 3- and 5-month moving averages.

3-21 Forecasting
3-22 Forecasting

Smoothing Effects
3-23 Forecasting

Weighted Moving Average

 More recent values in a series are given more
weight in computing the forecast.
 Adjusts moving average method to more closely
reflect data fluctuations
3-24 Forecasting

Weighted Moving Average Example

MONTH WEIGHT DATA

August 17% 130
September 33% 110
October 50% 90

November Forecast

= (0.50)(90) + (0.33)(110) + (0.17)(130)

= 103.4 orders
3-25 Forecasting

Exponential Smoothing
 Averaging method
 Weights most recent data more strongly

 Reacts more to recent changes

 Widely used, accurate method

3-26 Forecasting

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.
3-27 Forecasting

Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

 Weighted averaging method based on previous
forecast plus a percentage of the forecast error
 A-F is the error term,  is the % feedback or the
smoothing constant
3-28 Forecasting

Exponential Smoothing (α=0.30)

PERIOD MONTH
DEMAND
1 Jan 37

2 Feb 40

3 Mar 41

4 Apr 37

5 May 45
What is F13 = ?
6 Jun 50

7 Jul 43
3-29 Forecasting

Exponential Smoothing (α=0.30)

F2 = 37
PERIOD MONTH
DEMAND F3 = F2 + α(A2 – F2)

1 Jan 37 = 37 + 0.3(40-37)
= 37.9
2 Feb 40

3 Mar 41 F4 = F3 + α(A3 – F3)

= 37.9 + 0.3(41-37.9)
4 Apr 37 = 38.83
.
5 May 45 .
.
6 Jun 50
F13 = ?
7 Jul 43
3-30 Forecasting

Exponential Smoothing (cont.)

FORECAST, Ft
PERIOD MONTH DEMAND ( = 0.3) ( = 0.5)
1 Jan 37 – –
2 Feb 40 37.00 37.00
3 Mar 41 37.90 38.50
4 Apr 37 38.83 39.75
5 May 45 38.28 38.37
6 Jun 50 40.29 41.68
7 Jul 43 43.20 45.84
8 Aug 47 43.14 44.42
9 Sep 56 44.30 45.71
10 Oct 52 47.81 50.85
11 Nov 55 49.06 51.42
12 Dec 54 50.84 53.21
13 Jan – 51.79 53.61
3-31 Forecasting

More Example - Exponential Smoothing

Period Actual Alpha = 0.1 Error Alpha = 0.4 Error

1 42
2 40 42 -2.00 42 -2
3 43 41.8 1.20 41.2 1.8
4 40 41.92 -1.92 41.92 -1.92
5 41 41.73 -0.73 41.15 -0.15
6 39 41.66 -2.66 41.09 -2.09
7 46 41.39 4.61 40.25 5.75
8 44 41.85 2.15 42.55 1.45
9 45 42.07 2.93 43.13 1.87
10 38 42.36 -4.36 43.88 -5.88
11 40 41.92 -1.92 41.53 -1.53
12 41.73 40.92
3-32 Forecasting

Picking a Smoothing Constant

Actual
50
.4
.1
45
Demand

40

35
1 2 3 4 5 6 7 8 9 10 11 12
Period
3-33 Forecasting

Common Nonlinear Trends

Figure 3.5

Parabolic

Exponential

Growth
3-34 Forecasting

Linear Trend Equation

Ft

Ft = a + bt

 Ft = Forecast for period t 0 1 2 3 4 5 t

 t = Specified number of time periods
 a = Value of Ft at t = 0
 b = Slope of the line
3-35 Forecasting

Calculating a and b

n  (ty) -  t  y
b =
n t 2 - (  t) 2

 y - b t
a =
n
3-36 Forecasting

Linear Trend Equation Example

t y
2
W eek t S a le s ty
1 1 150 150
2 4 157 314
3 9 162 486
4 16 166 664
5 25 177 885

2
 t = 15  t = 55  y = 812  ty = 2 4 9 9
2
(  t) = 2 2 5
3-37 Forecasting

Linear Trend Calculation

5 (2499) - 15(812) 12495-12180

b = = = 6.3
5(55) - 225 275 -225

812 - 6.3(15)
a = = 143.5
5

y = 143.5 + 6.3t
3-38 Forecasting

Linear Trend Example

t(PERIOD) y(DEMAND) ty t2
1 73 73 1
2 40 80 4
3 41 123 9
4 37 148 16
5 45 225 25
6 50 300 36
7 43 301 49
8 47 376 64
9 56 504 81
10 52 520 100
11 55 605 121
12 54 648 144
78 557 3867 650
3-39 Forecasting

Linear Trend Example (cont.)

78
t = = 6.5
12
557
y = = 46.42
12
nty - t  y 12(3867)- 78(557)
b = = =1.72
nt – ( t)
2 2
12(650) - (78)2

a = y - bt
= 46.42 - (1.72)(6.5) = 35.2
3-40 Forecasting

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
3-41 Forecasting

Linear Model Seems Reasonable

X Y Computed
7 15
relationship
2 10
6 13 50

4 15 40

14 25 30

15 27 20

16 24
10

0
12 20 0 5 10 15 20 25

14 27
20 44
15 34
7 17
A straight line is fitted to a set of sample points.
3-42 Forecasting

Standard Error
 Standard error of estimate
 A measure of the scatter of points around a
regression line
 If the standard error is relatively small, the
predictions using the linear equation will tend to be
more accurate than if the standard error is larger

Se 
 y  y c 
2

n2
where
Se  standard error of estimate
y  the value of each data point
n  number of data points
3-43 Forecasting

Goodness of Fit
 Refers to how well a regression line “fits” the data
 Determined by r2=coefficient of determination,
0<r2<1
where

n( xy)  ( x)( y )

r
n(  x )  (  x )  n(  y )  (  y )
2 2 2 2
3-44 Forecasting

Correlation
 The value of r varies between 1.00 and +1.00
 A value of +1.00 indicates a strong linear
relationship between the variables
 If r = 1.00, then an increase in the independent
variable will result in a corresponding linear
increase in the dependent variable.
 r = 1.00 shows an inverse relationship between
the variables
3-45 Forecasting

Linear Regression Example

3-46 Forecasting
3-47 Forecasting
3-48 Forecasting

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
3-49 Forecasting

Issues to Consider
 Always plot the line to verify that a linear
relationships 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
3-50 Forecasting

Other Forecasting Methods - Focus

 Focus Forecasting
 Some companies use forecasts based on a “best
current performance” basis
 Apply several forecasting methods to the last several
periods of historical data
 The method with the highest accuracy is used to
make the forecast for the following period
 This process is repeated each month
3-51 Forecasting

Other Forecasting Methods - Diffusion

 Diffusion Models
 Historical data on which to base a forecast are not
available for new products
 Predictions are based on rates of product adoption
and usage spread from other established products
 Take into account facts such as
 Market potential
 Attention from mass media
 Word-of-mouth
3-52 Forecasting

Forecast Accuracy and Control

 Forecasters want to minimize forecast errors
 It is nearly impossible to correctly forecast real-
world variable values on a regular basis
 So, 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 accuracy should be an important
forecasting technique selection criterion
3-53 Forecasting

Forecast Accuracy and Control (contd.)

 Forecast errors should be monitored

 Error = Actual – Forecast

et  At  Ft
 If errors fall beyond acceptable bounds, corrective
action may be necessary
3-54 Forecasting

Sources of Forecast errors

 Omission of important variable, model may

be inadequate
 A sudden change or shift in variable that the
model cannot deal with--irregular variations
 Incorrect use of forecasting technique

 Employing the wrong trend line

 Misinterpretation of results
3-55 Forecasting

Measurement of Errors
 Mean Absolute Deviation (MAD)
 Average absolute error
 MAD weights all errors evenly
 Mean Squared Error (MSE)
 Average of squared error
 MSE weights errors according to their squared values
 Mean Absolute Percent Error (MAPE)
 Average absolute percent error
 MAPE weights errors according to relative error
3-56 Forecasting

MAD, MSE, and MAPE

 Actual  forecast
MAD =
n
2
 ( Actual  forecast)
MSE =
n -1

 Actual  forecas / Actual)*100)

MAPE =
t
n
3-57 Forecasting

Example 1

Actual Forecast (A-F) [|

Period
(A) (F) Error |Error| Error2 Error|/Actual]x100
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%

3-58 Forecasting

Example 2
Forecast
Month Demand
Technique1 Technique2
1 492 488 495
2 470 484 482
3 485 480 478
4 493 490 488
5 498 497 492
6 492 493 493
3-59 Forecasting

Example 2
Solution:
Month Technique1 Technique2
e |e| e |e|
1 4 4 -3 3
2 -14 14 -12 12
3 5 5 7 7 e 28
4 3 3 5 5 MAD1    4.67
n 6
5 1 1 6 6  e 34
MAD2    5.67
6 -1 1 -1 1 n 6
∑ -2 28 2 34 Technique 1 is better
3-60 Forecasting

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 errors are within the control limits
 No patterns, such as trends or cycles, are
present
3-61 Forecasting

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.
3-62 Forecasting

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
3-63 Forecasting

Exponential Smoothing
3-64 Forecasting

Linear Trend Equation

3-65 Forecasting

Simple Linear Regression