Operations Management: Sustainability

and Supply Chain Management

Fourth Canadian Edition

Chapter 4
Forecasting

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Outline (1 of 2)

• Global Company Profile: Forecasting Provides a

Competitive Advantage for Disney
• What Is Forecasting?
• The Strategic Importance of Forecasting
• Seven Steps in the Forecasting System
• Forecasting Approaches
• Time-Series Forecasting

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Outline (2 of 2)

• Associative Forecasting Methods: Regression and

Correlation Analysis
• Monitoring and Controlling Forecasts
• Forecasting in the Service Sector

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Learning Objectives (1 of 2)

When you complete this chapter, you should be

able to:
1. Understand the three-time horizons and which
models apply for each
2. Explain when to use each of the four qualitative
models
3. Apply the naive, moving average, exponential
smoothing, and trend methods

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Learning Objectives (2 of 2)

When you complete this chapter, you should be

able to:
4. Compute three measures of forecast accuracy
5. Develop seasonal indices
6. Conduct a regression and correlation analysis
7. Use a tracking signal

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Global Company Profile: Forecasting Provides
a Competitive Advantage for Disney (1 of 4)

• Global portfolio includes parks in Hong Kong, Paris,

Tokyo, Orlando, and Anaheim
• Revenues are derived from people – how many
visitors and how they spend their money
• Daily management report contains only the forecast
and actual attendance at each park

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Global Company Profile: Forecasting Provides
a Competitive Advantage for Disney (2 of 4)

• Disney generates daily, weekly, monthly, annual, and

five-year forecasts
• Forecast used by labour management, maintenance,
operations, finance, and park scheduling
• Forecast used to adjust opening times, rides, shows,
staffing levels, and guests admitted

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Global Company Profile: Forecasting Provides
a Competitive Advantage for Disney (3 of 4)

• 20% of customers come from outside the USA

• Economic model includes gross domestic product
(GDP), cross-exchange rates, arrivals into the USA
• A staff of 35 analysts and 70 field people survey 1
million park guests, employees, and travel
professionals each year

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Global Company Profile: Forecasting Provides
a Competitive Advantage for Disney (4 of 4)

• Inputs to the forecasting model include airline

specials, Federal Reserve policies, Wall Street trends,
vacation/holiday schedules for 3000 school districts
around the world
• Average forecast error for the five-year forecast is 5%
• Average forecast error for annual forecasts is between
0% and 3%

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What is Forecasting?

• Process of predicting a future event

• Underlying basis of all business decisions
– Production
– Inventory
– Personnel
– Facilities

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Forecasting Time Horizons
LO1: Understand the three-time horizons and which models apply for
each
• Short-range forecast
– Up to 1 year, generally less than 3 months
– Purchasing, job scheduling, workforce levels, job
assignments, production levels
• Medium-range forecast
– 3 months to 3 years
– Sales and production planning, budgeting
• Long-range forecast
– 3+ years
– New product planning, facility location, research and
development
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Distinguishing Differences

• Medium/long-range forecasts deal with more

comprehensive issues and support management
decisions regarding planning and products, plants and
processes
• Short-term forecasting usually employs different
methodologies than longer-term forecasting
• Short-term forecasts tend to be more accurate than
longer-term forecasts

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Influence of Product Life Cycle

Introduction – Growth – Maturity – Decline

• Introduction and growth require longer forecasts than

maturity and decline
• As product passes through life cycle, forecasts are
useful in projecting
– Staffing levels
– Inventory levels
– Factory capacity

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Types of Forecasts

• Economic forecasts
– Address business cycle – inflation rate, money supply,
housing starts, etc.
• Technological forecasts
– Predict rate of technological progress
– Impacts development of new products
• Demand forecasts
– Predict sales of existing products and services

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The Strategic Importance of
Forecasting
• Human Resources – Hiring, training, laying off
workers
• Capacity – Capacity shortages can result in
undependable delivery, loss of customers, loss of
market share
• Supply-Chain Management – Good supplier relations
and price advantages

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Seven Steps in the Forecasting
System
1. Determine the use of the forecast
2. Select the items to be forecasted
3. Determine the time horizon of the forecast
4. Select the forecasting model(s)
5. Gather the data
6. Make the forecast
7. Validate and implement results

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The Realities!

• Forecasts are seldom perfect

• Most techniques assume an underlying stability in the
system
• Product family and aggregated forecasts are more
accurate than individual product forecasts

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Forecasting Approaches (1 of 2)

Qualitative Methods
• Used when situation is vague and little data exist
– New products
– New technology
• Involves intuition, experience
– e.g., forecasting sales on internet

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Forecasting Approaches (2 of 2)

Quantitative Methods
• Used when situation is ‘stable’ and historical data
exist
– Existing products
– Current technology
• Involves mathematical techniques
– e.g., forecasting sales of colour televisions

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Overview of Qualitative Methods (1 of 2)

LO2: Explain when to use each of the four qualitative models

1. Jury of executive opinion

– Pool opinions of high-level experts, sometimes
augment by statistical models

2. Delphi method
– Panel of experts, queried iteratively

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Overview of Qualitative Methods (2 of 2)

3. Sales force composite

– Estimates from individual salespersons are reviewed
for reasonableness, then aggregated

4. Consumer Market Survey

– Ask the customer

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Overview of Quantitative Approaches

1. Naive approach
2. Moving averages
Time-series
3. Exponential
models
smoothing
4. Trend projection
Associative
5. Linear regression
model

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Time-Series Forecasting

• Set of evenly spaced numerical data

– Obtained by observing response variable at regular
time periods
• Forecast based only on past values, no other
variables important
– Assumes that factors influencing past, and present will
continue influence in future

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Components of Demand

Figure 4.1 Demand Charted Over Four Years with the Growth Trend and Seasonality Indicated

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Trend Component

• Persistent, overall upward or downward pattern

• Changes due to population, technology, age, culture,
etc.
• Typically, several years duration

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Seasonal Component

• Regular pattern of up and down fluctuations

• Due to weather, customs, etc.
• Occurs within a single year
Period of “Season” Number of “Seasons”
Pattern Length in Pattern
Week Day 7
Month Week 4–4
Month Day 28–31
Year Quarter 4
Year Month 12
Year Week 52

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Cyclical Component

• Repeating up and down movements

• Affected by business cycle, political, and economic
factors
• Multiple years duration
• Often causal or associative relationships

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Random Component

• Erratic, unsystematic, ‘residual’ fluctuations

• Due to random variation or unforeseen events
• Short duration and nonrepeating

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Naive Approach

LO3: Apply the naive, moving-average, exponential smoothing, and

trend methods

• Assumes demand in next period is the same as

demand in most recent period
– e.g., If January sales were 68, then February sales will
be 68
• Sometimes cost effective and efficient
• Can be good starting point

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Moving Average Method

• Moving Average is a series of arithmetic means

• Used if little or no trend
• Used often for smoothing
– Provides overall impression of data over time

 Demand in previous n periods

Moving average   4-1
n

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Graph of Moving Average

Figure 4.2 Actual Demand vs. Moving-Average and Weighted–Moving-Average Methods for Donna’s Garden Supply

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Weighted Moving Average

• Used when some trend might be present

– Older data usually less important
• Weights based on experience and intuition

  Weight for period n  Demand in period n 

Weighted moving average   4-2 
 Weights

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Potential Problems With Moving
Average
• Increasing n smooths the forecast but makes it less
sensitive to changes
• Does not forecast trends well
• Requires extensive historical data

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Exponential Smoothing

• Form of weighted moving average

– Weights decline exponentially
– Most recent data weighted most
• Requires smoothing constant (α)
– Ranges from 0 to 1
– Subjectively chosen
• Involves little record keeping of past data

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Three Common Measures of Error (1 of 2)

LO4: Compute three measures of forecast accuracy

1. Mean Absolute Deviation (MAD)

 Actual  Forecast
MAD   4-5
n

2. Mean Squared Error (MSE)

  Forecast errors 
2

MSE   4-6 
n

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Three Common Measures of Error (2 of 2)

3. Mean Absolute Percent Error (MAPE)

n
100 Actuali  Forecast i / Actuali
MAPE  i 1
 4-7 
n

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Determining the Mean Absolute
Deviation (MAD)
Actual Forecast Absolute Forecast Absolute
Tonnage with Deviation for with Deviation for
Quarter Unloaded α = 0.10 α = 0.10 α = 0.50 α = 0.50
1 180 175 5.00 175 5.00
2 168 175.50 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
Sum of absolute deviations: 82.45 98.62
10.31 12.33
MAD =

INSIGHT On the basis of this comparison of the two MADs, a smoothing constant of α = 0.10 is preferred to α = 0.50
because its MAD is smaller.
LEARNING EXERCISE If the smoothing constant is changed from α = 0.10 to α = 0.20, what is the new MAD?
[Answer: 10.21.]
RELATED PROBLEMS 4.5b, 4.8c, 4.9c, 4.14, 4.23, 4.37a
EXCEL OM Data File Ch04Ex4a.xlsx and Ch04Ex4b.xlsx can be found on MyLab Operations Management.
ACTIVE MODEL 4.2 This example is further illustrated in Active Model 4.2 on MyLab Operations Management.

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Determining the Mean Square Error
(MSE)
Actual Tonnage Forecast for
Quarter Unloaded α = 0.10 (Error)2
1 180 175 52 = 25
2 168 175.50 (−7.5)2 = 56.25
3 159 174.75 (− 15.75)2 = 248.06
4 175 173.18 (1.82)2 = 3.31
5 190 173.36 (16.64)2 = 276.89
6 205 175.02 (29.98)2 = 898.70
7 180 178.02 (1.98)2 = 3.92
8 182 178.22 (3.78)2 = 14.29
Sum of errors squared = 1,526.42

  Forecast errors 
2

MSE   1, 526.46 / 8  190.8

n
INSIGHT Is this MSE = 190.8 good or bad? It all depends on the MSEs for other forecasting approaches. A low MSE is
better because we want to minimize MSE. MSE exaggerates errors because it squares them.
LEARNING EXERCISE Find the MSE for α = 0.50. [Answer: MSE = 195.20. The result indicates that
α = 0.10 is a better choice because we seek a lower MSE. Coincidentally, this is the same conclusion we reached
using MAD in Example 4.]
RELATED PROBLEMS 4.8d, 4.14, 4.20

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Trend Projections (1 of 2)

Fitting a trend line to historical data points to project into

the medium to long-range
Linear trends can be found using the least- squares
technique
ŷ = a + bx
where ŷ = computed value of the variable to be
predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
x = independent variable
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Trend Projections (2 of 2)

Figure 4.4 The Least Squares Method for Finding the Best-Fitting Straight Line, Where the Asterisks Are the Locations of
the Seven Actual Observations or Data Points

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Least-Squares Requirements

1. We always plot the data to ensure a linear

relationship
2. We do not predict time periods far beyond the
database
3. Deviations around the least-squares line are
assumed to be random

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Seasonal Variations In Data

LO5: Develop seasonal indices

• The multiplicative seasonal model can adjust trend

data for seasonal variations in demand

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Seasonal Forecast Calculation

Steps in the process:

1. Find average historical demand for each season
2. Compute the average demand over all seasons
3. Compute a seasonal index for each season
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the number
of seasons, then multiply it by the seasonal index for
that season

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Associative Forecasting Methods:
Regression and Correlation Analysis
• Using several variables related to the quantity being
predicted
• More powerful than time-series methods
– Regression Analysis
– Correlation Analysis
• Most common technique is linear regression analysis

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Linear Regression
LO6: Conduct a regression and correlation analysis
Forecasting an outcome based on predictor variables
using the least-squares technique
ŷ = a + bx

where ŷ = computed value of the variable to

be predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
x = independent variable to predict the value
of the dependent variable

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Standard Error of the Estimate

• A forecast is just a point estimate of a future value

• This point is actually the mean of a probability
distribution

Figure 4.9 Distribution about the Point Estimate of $3.25 Million Sales

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Correlation

• How strong is the linear relationship between the

variables?
• Correlation does not necessarily imply causality!
• Coefficient of correlation, r, measures degree of
association
– Values range from −1 to +1

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Correlation Coefficient (1 of 2)

n  xy   x  y
r  4-16 
n  x2   x   n  y 2   y  
2 2
  

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Correlation Coefficient (2 of 2)

Figure 4.10 Four Values of the Correlation Coefficient

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Determining the Coefficient of
Correlation
• Coefficient of Determination, r2, measures the percent
of change in y predicted by the change in x
– Values range from 0 to 1
– Easy to interpret
• For the Nodel Construction example:
r = .901
r2 = .81

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Monitoring and Controlling
Forecasts (1 of 2)
LO7: Use a tracking signal
Tracking Signal
• Measures how well the forecast is predicting actual
values
• Ratio of cumulative forecast errors to mean absolute
deviation (MAD)
– Good tracking signal has low values
– If forecasts are continually high or low, the forecast has
a bias error

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Monitoring and Controlling
Forecasts (2 of 2)

Cumulative error
Tracking Signal  
MAD
  Actual demand in period i  Forecast demand in person i 
=
MAD
(4-18)
  Actual |  Forecast |
Where  MAD  
n

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Tracking Signal

Figure 4.11 A Plot of Tracking Signals

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Forecasting in the Service Sector

• Presents unusual challenges

– Special need for short-term records
– Needs differ greatly as function of industry and product
– Holidays and other calendar events
– Unusual events

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Fast Food Restaurant Forecast

Figure 4.12 Forecasts Are Unique: Note the Variations between (a) Hourly Sales at a Fast-Food Restaurant
SOURCE: Based on historical data: see Journal of Business Forecasting (Winter 1999–2000): 6–11.

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FedEx Call Centre Forecast

Figure 4.12 Forecasts Are Unique: Note the Variations between (b) Hourly Call Volume at FedEx
SOURCE: Based on historical data: see Journal of Business Forecasting (Winter 1999–2000): 6–11.

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Summary

• Forecasts are important for operations managers and

their planning
• However, it is difficult to predict the future. Two types
of forecasting:
– Qualitative
– Quantitative
• Qualitative forecasting is the most used methodology,
due to the mathematical complexities of the
quantitative methodology

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