Chapter 8 - Forecasting

Operations Management
by
R. Dan Reid & Nada R. Sanders
4th Edition © Wiley 2010

© Wiley 2010 1
Principles of Forecasting
Many types of forecasting models that
differ in complexity and amount of
data & way they generate forecasts:
1. Forecasts are rarely perfect
2. Forecasts are more accurate for
grouped data than for individual
items
3. Forecast are more accurate for
shorter than longer time periods
© Wiley 2010 2
Types of Forecasting
Methods
 Decide what needs to be forecast
 Level of detail, units of analysis & time
horizon required
 Evaluate and analyze appropriate data
 Identify needed data & whether it’s
available
 Select and test the forecasting model
 Cost, ease of use & accuracy
 Generate the forecast
 Monitor forecast accuracy over time
© Wiley 2010 3
Types of Forecasting
Methods
 Forecasting methods are classified
into two groups:

© Wiley 2010 4
 Types of Forecasting
Models
 Qualitative methods – judgmental
methods
 Forecasts generated subjectively by

the forecaster
 Educated guesses

 Quantitative methods – based on

mathematical modeling:
 Forecasts generated through

mathematical modeling
© Wiley 2010 5
 Qualitative Methods
Type Characteristics Strengths Weaknesses
Executive A group of managers Good for strategic or One person's opinion
opinion meet & come up with new-product can dominate the
a forecast forecasting forecast

Market Uses surveys & Good determinant of It can be difficult to

research interviews to identify customer preferences develop a good
customer preferences questionnaire

Delphi Seeks to develop a Excellent for Time consuming to

method consensus among a forecasting long-term develop
group of experts product demand,
technological
changes, and
© Wiley 2010 6
Quantitative Methods
 Time Series Models:
 Assumes information needed to generate a
forecast is contained in a time series of data
 Assumes the future will follow same patterns
as the past
 Causal Models or Associative Models
 Explores cause-and-effect relationships
 Uses leading indicators to predict the future
 Housing starts and appliance sales

© Wiley 2010 7
 Time Series Models
 Forecaster looks for data patterns as
 Data = historic pattern + random variation
 Historic pattern to be forecasted:
 Level (long-term average) – data fluctuates around a
constant mean
 Trend – data exhibits an increasing or decreasing pattern
 Seasonality – any pattern that regularly repeats itself
and is of a constant length
 Cycle – patterns created by economic fluctuations
 Random Variation cannot be predicted
© Wiley 2010 8
Time Series Patterns

© Wiley 2010 9
Time Series Models
 Naive: Ft 1  At

The forecast is equal to the actual value observed
during the last period – good for level patterns
 Simple Mean: Ft 1  A t / n

The average of all available data - good for level
patterns
 A t / n
 Moving Average:F t 1


The average value over a set time period
(e.g.: the last four weeks)

Each new forecast drops the oldest data point &
adds a new observation

More responsive to a trend but still lags behind
actual data

© Wiley 2010 10
Time Series Models con’t
 Weighted Moving Average: Ft 1  C t A t

 All weights must add to 100% or 1.00

e.g. Ct .5, Ct-1 .3, Ct-2 .2 (weights add to 1.0)

 Allows emphasizing one period over others; above

indicates more weight on recent data (Ct=.5)

 Differs from the simple moving average that

weighs all periods equally - more responsive to
trends
© Wiley 2010 11
Time Series Models con’t
 Exponential Smoothing: F αA  1  α F
t 1 t t  
Most frequently used time series method because
of ease of use and minimal amount of data
needed 

 Need just three pieces of data to start:

 Last period’s forecast (Ft)

 Last periods actual value (At) 
 Select value of smoothing coefficient, ,between 0 and
1.0
 If no last period forecast is available, average

the last few periods or use naive method
 Higher values (e.g. .7 or .8) may place too
much weight on last©period’s
Wiley 2010
random variation 12
Time Series Problem
 Determine forecast for Period Actual
periods 7 & 8 1 300
 2-period moving average 2 315
 4-period moving average
3 290
 2-period weighted moving
4 345
average with t-1 weighted
0.6 and t-2 weighted 0.4 5 320
 Exponential smoothing 6 360
with alpha=0.2 and the 7 375
period 6 forecast being 375 8
© Wiley 2010 13
Time Series Problem
Solution
Period Actual 2-Period 4-Period 2-Per.Wgted. Expon. Smooth.

1 300

2 315

3 290

4 345

5 320

6 360

7 375 340.0 328.8 344.0 372.0

8 367.5 350.0 369.0 372.6

© Wiley 2010 14
 Forecasting trend problem: a company uses exponential
smoothing with trend to forecast usage of its lawn care products.
At the end of July the company wishes to forecast sales for
August. July demand was 62. The trend through June has been 15
additional gallons of product sold per month. Average sales have
been 57 gallons per month. The company uses alpha+0.2 and
beta +0.10. Forecast for August.

 Smooth the level of the series:

S July αA t  (1  α)(S t  1  Tt  1 ) 0.262  0.857  15 70

 Smooth the trend:

TJuly β(St  St  1 )  (1  β)Tt  1 0.170  57  0.915 14.8

 Forecast including trend:

FITAugust S t  Tt 70  14.8 84.8 gallons

© Wiley 2010 15
 Linear Trend Line
A time series technique that computes a
forecast with trend by drawing a
straight line through a set of data using
this formula:
Y = a + bx where
Y = forecast for period X
X = the number of time periods from X = 0
A = value of y at X = 0 (Y intercept)
B = slope of the line
© Wiley 2010 16
Forecasting Trend
 Basic forecasting models for trends compensate for the
lagging that would otherwise occur
 One model, trend-adjusted exponential smoothing
uses a three step process
 Step 1 - Smoothing the level of the series

S t αA t  (1  α)(S t  1  Tt  1 )
 Step 2 – Smoothing the trend
Tt β(S t  S t  1 )  (1  β)Tt  1
 Forecast including the trend
FITt 1 S t  Tt
© Wiley 2010 17
Forecasting Seasonality
 Calculate the average demand per season
 E.g.: average quarterly demand
 Calculate a seasonal index for each season
of each year:
 Divide the actual demand of each season by
the average demand per season for that year
 Average the indexes by season
 E.g.: take the average of all Spring indexes,
then of all Summer indexes, ...

© Wiley 2010 18
Seasonality con’t
 Forecast demand for the next year &
divide by the number of seasons
 Use regular forecasting method & divide by
four for average quarterly demand
 Multiply next year’s average seasonal
demand by each average seasonal
index
 Result is a forecast of demand for each
season of next year

© Wiley 2010 19
 Seasonality problem: a university must develop forecasts
for the next year’s quarterly enrollments. It has collected
quarterly enrollments for the past two years. It has also
forecast total enrollment for next year to be 90,000
students. What is the forecast for each quarter of next
year?

Quarter Year Season Year Season Avg. Year3

1 al Index 2 al Index Inde
x
Fall 24000 1.2 26000 1.238 1.22 27450
Winter 23000 22000
Spring 19000 19000
Summe 14000 17000
r
Total 80000 84000 90000
Averag 2000 2100 22500
e 0 0
© Wiley 2010 20
Causal Models
 Often, leading indicators can help to predict
changes in future demand e.g. housing starts
 Causal models establish a cause-and-effect
relationship between independent and
dependent variables
 A common tool of causal modeling is linear
regression: Y a  bx
 Additional related variables may require
multiple regression modeling

© Wiley 2010 21
Linear Regression

Identify dependent (y)
and independent (x)
b
 XY  X  Y  variables
 X 2  X  X   Solve for the slope of the

lineb  XY  n X Y
2
X 2
 nX

 Solve for the y intercept

a Y  b X
 Develop your equation for
the trend line
Y=a + bX
© Wiley 2010 22
 Linear Regression Problem: A maker of golf shirts has
been tracking the relationship between sales and
advertising dollars. Use linear regression to find out what
sales might be if the company invested $53,000 in
advertising next year.

Sales $ Adv.$ XY X^ Y^2 b

 XY  n XY
2
(Y) (X) 2  X  nX 2

1 130 32 4160 230 16,90

4 0 28202  447.25147.25
b 1.15
9253  447.25
2

2 151 52 7852 270 22,80

4 1 a Y  b X 147.25  1.1547.25
a 92.9
3 150 50 7500 250 22,50
0 0 Y a  bX 92.9  1.15X
Y 92.9  1.1553 153.85
4 158 55 8690 302 24964
5
5 153.8 53
5
Tot 589 189 2820 925 ©87165
Wiley 2010 23
 Correlation Coefficient
How Good is the Fit?
 Correlation coefficient (r) measures the direction and strength of
the linear relationship between two variables. The closer the r value
is to 1.0 the better the regression line fits the data points.
n XY   X  Y 
r
 X   X * n Y  Y 
2 2
2 2
n
428,202  189589
r 2
.982
4(9253) - (189) * 487,165  589
2

r 2 .982 .964
2

2
 Coefficient of determination r ( ) measures the amount of variation
in the dependent
2
variable about its mean that is explained by the
regressionr line. Values of ( ) close to 1.0 are desirable.

© Wiley 2010 24
Multiple Regression
 An extension of linear regression
but:
 Multiple regression develops a
relationship between a dependent
variable and multiple independent
variables. The general formula is:

© Wiley 2010 25
Measuring Forecast Error
 Forecasts are never perfect
 Need to know how much we should
rely on our chosen forecasting
method
 Measuring forecast error:
E t  A t  Ft

 Note that over-forecasts = negative

errors and under-forecasts =
positive errors
© Wiley 2010 26
 Measuring Forecasting Accuracy
 Mean Absolute Deviation MAD 
 actual  forecast
(MAD) n

measures the total error in a
forecast without regard to sign
 Cumulative Forecast Error CFE  actual  forecast 
(CFE)

Measures any bias in the forecast
 actual - forecast 2

MSE 
n
 Mean Square Error (MSE)

Penalizes larger errors CFE
TS 
MAD
 Tracking Signal

Measures if your model is working

© Wiley 2010 27
 Accuracy & Tracking Signal Problem: A company is
comparing the accuracy of two forecasting methods. Forecasts
using both methods are shown below along with the actual values
for January through May. The company also uses a tracking signal
with ±4 limits to decide when a forecast should be reviewed.
Which forecasting method is best?

Method A Method B
Month Actu F’cas Error Cum. Trackin F’cas Error Cum. Tracking
al t Error g t Error Signal
sales Signal

Jan. 30 28 2 2 2 27 2 2 1

Feb. 26 25 1 3 3 25 1 3 1.5
Marc 32 32 0 3 3 29 3 6 3
h
April 29 30 -1 2 2 27 2 8 4
May 31 30 1 3 3 29 2 10 5

MAD 1 2
© Wiley 2010 28
MSE 1.4 4.4
Forecasting Software
 Spreadsheets
 Microsoft Excel, Quattro Pro, Lotus 1-2-3
 Limited statistical analysis of forecast data
 Statistical packages
 SPSS, SAS, NCSS, Minitab
 Forecasting plus statistical and graphics
 Specialty forecasting packages
 Forecast Master, Forecast Pro, Autobox, SCA

© Wiley 2010 29
 Forecasting Across the
Organization
 Forecasting is critical to management of
all organizational functional areas
 Marketing relies on forecasting to predict
demand and future sales
 Finance forecasts stock prices, financial
performance, capital investment needs..
 Information systems provides ability to share
databases and information
 Human resources forecasts future hiring
requirements

© Wiley 2010 30