Production and Operations

Management
Unit 4

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Unit 4 - Forecasting
•Introduction, The Strategic Importance of Forecasting, Benefits, Cost
implications and Decision making using forecasting, Classification of
Forecasting Process, Methods of Forecasting, Forecasting and Product Life
Cycle, Selection of the Forecasting Method, Qualitative Methods of
Forecasting, Quantitative Methods, Associative Models of Forecasting,
Accuracy of Forecasting.

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What is forecasting?

Forecasting is a tool used for predicting

future events e.g demand based on
past demand information.
Why is forecasting important?

Demand for products and services is usually uncertain.

Forecasting can be used for…
• Strategic planning (long range planning)
• Finance and accounting (budgets and cost controls)
• Marketing (future sales, new products)
• Production and operations
What is forecasting all about?

Demand for Mercedes E Class We try to predict the

future by looking back
at the past

Predicted
demand
looking
Time back six
Jan Feb Mar Apr May Jun Jul Aug months
Actual demand (past sales)
Predicted demand
 All forecasts have common elements

• Assumption that past continues into future

• Errors occur-- actual differs from predicted; presence of
randomness
• Forecasts of group of items (aggregate) tends to be more accurate
than individual items (i.e., departmental vs. whole hospital)
• Forecast accuracy decreases as time horizon increases

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 Characteristics of a Good Forecast

Timely

Reliable

Accurate – a good forecast will not deviate widely from the actual outcom

Meaningful units ($$’s, visits, discharges, patient days, etc.)

Easy to use

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 Steps in the Forecasting Process

Step 1 Identify the goal of the forecast

Step 2 Establish a time horizon

Step 3 Select a forecasting technique

Step 4 Conduct the forecast (analyze data)

Step 5 Determine its accuracy

Step 6 Monitor the forecast

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 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

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 Types of Forecasting Methods

• Forecasting methods are classified into two groups:

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 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

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 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
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 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
– E.g Housing statistics and appliance sales

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 The Delphi Method

• Method of obtaining opinions of managers and staff

• Involves circulating a series of questionnaires, each developed from
the previous one, to achieve a consensus on an issue (in this case, a
forecast)
• Useful for forecasting technological changes and their impacts

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 The Delphi Approach, cont.

• Advantages
Advantages
• More
More individuals
individuals may
may be
be engaged
engaged than can effectively
effectively interact
interact face-to-face
face-to-face
• ItIt is
is important
important to
to avoid
avoid bandwagon
bandwagon effect
effect
• Preserves
Preserves anonymity
anonymity ofof participants
participants
• Weaknesses
Weaknesses
• Questions
Questions may may be
be ambiguous
ambiguous leading
leading to
to false
false consensus
• Panel
Panel members may may change
change
• Studies
Studies do do not
not prove
prove that
that Delphi
Delphi forecasts
forecasts are
are highly
highly accurate
accurate
• Preserving
Preserving anonymity removes
removes accountability
accountability

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 Forecasting Approaches, cont.

• Time
Time series--
series-- identify
identify the
the behavior
behavior of
of the
the series
series byby using
using factors
factors such
such as
as trend,
trend, seasonality,
seasonality, cycles,
cycles,
irregular
irregular variations,
variations, and
and random
random variations
variations
• Techniques
Techniques for
for averaging
averaging
• Naive
Naive forecasts
forecasts
• Moving
Moving averages
averages (MA)
(MA)
• Exponential
Exponential smoothing
• Techniques
Techniques forfor trend
trend
• Linear
Linear equations
equations using
using regression
regression (ytt = aa ++ bx
bxtt))
• Trend
Trend adjusted
adjusted exponential
exponential smoothing
smoothing
• Techniques
Techniques forfor seasonality
seasonality
• Seasonal
Seasonal Variations
Variations
• Indices
Indices Technique
Technique

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Forecasting Approaches, cont.

• Associative Techniques
• Simple linear regression (y = a + bx)
• Scatter diagram-- plot data
• Correlations

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Example: Mercedes E-class vs. M-class Sales
Month E-class Sales M-class Sales
Jan 23,345 -
Feb 22,034 -
Mar 21,453 -
Apr 24,897 -
May 23,561 -
Jun 22,684 -
Jul ? ?

Question: Can we predict the new model M-class sales based on

the data in the the table?

Answer: Maybe... We need to consider how much the two

markets have in common
What should we consider when looking at
past demand data?

• Trends

• Seasonality

• Cyclical elements

• Autocorrelation

• Random variation
Some Important Questions

• What is the purpose of the forecast?

• Which systems will use the forecast?
• How important is the past in estimating the future?

Answers will help determine time horizons, techniques,

and level of detail for the forecast.
Qualitative forecasting methods
Grass Roots: deriving future demand by asking the person
closest to the customer.
Market Research: trying to identify customer habits; new
product ideas.
Panel Consensus: deriving future estimations from the
synergy of a panel of experts in the area.
Historical Analogy: identifying another similar market.
Delphi Method: similar to the panel consensus but with
concealed identities.
Quantitative forecasting methods

Time Series: models that predict future demand based

on past history trends
Causal Relationship: models that use statistical
techniques to establish relationships between various
items and demand
Simulation: models that can incorporate some
randomness and non-linear effects
Averaging Techniques
• Smooth out fluctuations in time serious because individual highs and
lows cancel each other out
So, would forecasts based on averages exhibit more or less
variability?

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Naive Forecasts

• A naive forecast for any period equals the previous period’s actual
value
• Low cost, easy to prepare, easy to understand, but less accurate
forecasts
• Can be applied to seasonal or trend data
Examples:
If last week’s demand was 50 units, the naive forecast
for the coming week is 50 units.

If seasonal pattern exists, the naive forecast for next January

would equal the actual demand for January of this year.
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How should we pick our forecasting model? i.e
qualitative or quantitative method!

1. Data availability
2. Time horizon for the forecast
3. Required accuracy
4. Required Resources
Time Series: Moving average

• The moving average model uses the last t periods in order to

predict demand in period t+1.
• There can be two types of moving average models: simple
moving average and weighted moving average
• The moving average model assumption is that the most
accurate prediction of future demand is a simple (linear)
combination of past demand.
Time series: simple moving average

In the simple moving average models the forecast value is

At + At-1 + … + At-n
Ft+1 =
n

t is the current period.

Ft+1 is the forecast for next period
n is the forecasting horizon (how far back we look),
A is the actual sales figure from each period.
Example: forecasting sales at Kroger

Kroger sells (among other stuff) bottled spring water

Month Bottles
Jan 1,325
Feb 1,353
Mar 1,305 What will
the sales be
Apr 1,275
for July?
May 1,210
Jun 1,195
Jul ?
What if we use a 3-month simple moving average?

AJun + AMay + AApr

FJul = = 1,227
3

What if we use a 5-month simple moving average?

AJun + AMay + AApr + AMar + AFeb

FJul = = 1,268
5
 1400
1350
1300
5-month
1250
MA forecast
1200 3-month
1150 MA forecast
1100
1050
1000
0 1 2 3 4 5 6 7 8

What do we observe?

5-month average smoothes data more;

3-month average more responsive
Example: Kroger sales of bottled water

Month Bottles
Jan 1,325
Feb 1,353
What will
Mar 1,305
be the sales
Apr 1,275 for July?
May 1,210
Jun 1,195
Jul ?
6-month simple moving average…

AJun + AMay + AApr + AMar + AFeb + AJan

FJul = = 1,277
6

In other words, because we used equal weights, a slight downward

trend that actually exists is not observed…
Linear regression in forecasting

Linear regression is based on

1. Fitting a straight line to data
2. Explaining the change in one variable through changes in
other variables.

dependent variable = a + b  (independent variable)

By using linear regression, we are trying to explore which

independent variables affect the dependent variable
Example: do people drink more when it’s cold?

Alcohol Sales

Which line best

fits the data?

Average Monthly
Temperature
The best line is the one that minimizes the error

The predicted line is …

Y  a  bX

So, the error is …

εi  y i - Yi

Where: ε is the error

y is the observed value
Y is the predicted value
Selecting the Right Forecasting Model

1. The amount & type of available data

 Some methods require more data than others
2. Degree of accuracy required
 Increasing accuracy means more data
3. Length of forecast horizon
 Different models for 3 month vs. 10 years
4. Presence of data patterns
 Lagging will occur when a forecasting model meant for a level pattern is
applied with a trend
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 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

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 Guidelines for Selecting Software

• Does the package have the features you want?

• What platform is the package available for?
• How easy is the package to learn and use?
• Is it possible to implement new methods?
• Do you require interactive or repetitive forecasting?
• Do you have any large data sets?
• Is there local support and training available?
• Does the package give the right answers?

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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

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