CHAPTER

Forecasting
 What is 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
 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

 Common in all forecasts
 Assumes causal system
past ==> future
 Forecasts rarely perfect because of
randomness
 Forecasts more accurate for
groups vs. individuals I see that you will
get an A this semester.
 Forecast accuracy decreases
as time horizon increases
Elements of a Good Forecast

Timely

Reliable Accurate

Written
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
 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
 Time Series Forecasts

 Trend - long-term movement in data

 Seasonality - short-term regular variations in
data
 Cycle – wavelike variations of more than one
year’s duration
 Irregular variations - caused by unusual
circumstances
 Random variations - caused by chance
 Forecast Variations

Irregular
variatio
n
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 period’s actual value.
 Uses for Naive Forecasts

 Stable time series data

 F(t) = A(t-1)
 Seasonal variations
 F(t) = A(t-n)
 Data with trends
 F(t) = A(t-1) + (A(t-1) – A(t-2))
 Naive Forecasts

 Simple to use
 Virtually no cost

 Quick and easy to prepare

 Easily understandable

 Can be a standard for accuracy

 Cannot provide high 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. n

i=1
Ai
MAn =
n
 The demand for tires in a tire store in the past 5
weeks were as follows. Compute a three-period
moving average forecast for demand in week 6.
83 80 85 90 94
Moving average & Actual demand
 Moving Averages
 Weighted moving average – More recent values in a
series are given more weight in computing the
forecast.

Example:
 For the previous demand data, compute a weighted
average forecast using a weight of .40 for the most
recent period, .30 for the next most recent, .20 for the
next and .10 for the next.
 If the actual demand for week 6 is 91, forecast
demand for week 7 using the same weights.
 Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

• The most recent observations might have the
highest predictive value.
 Therefore, we should give more weight to the
more recent time periods when 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
Example - Exponential Smoothing

Period Actual 0.1 Error 0.4 Error

1 83
2 80 83 -3.00 83 -3
3 85 82.70 2.30 81.80 3.20
4 89 82.93 6.07 83.08 5.92
5 92 83.54 8.46 85.45 6.55
6 95 84.38 10.62 88.07 6.93
7 91 85.44 5.56 90.84 0.16
8 90 86.00 4.00 90.90 -0.90
9 88 86.40 1.60 90.54 -2.54
10 93 86.56 6.44 89.53 3.47
11 92 87.20 4.80 90.92 1.08
12 87.68 91.35
Picking a Smoothing Constant

Exponential Smoothing
Actual Alpha=0.10 Alpha=0.40
100

95

90
Demand

85

80

75

70
2 3 4 5 6 7 8 9 10 11
Period
 Problem 1
 National Mixer Inc. sells can openers.
Monthly sales for a seven-month period
were as follows: Month Sales
 Forecast September sales volume using (1000)
each of the following: Feb 19
 A five-month moving average Mar 18
 Exponential smoothing with a smoothing Apr 15
constant equal to .20, assuming a March May 20
forecast of 19. Jun 18
 The naive approach Jul 22
 A weighted average using .60 for August, Aug 20
.30 for July, and .10 for June.
 Problem 2
 A dry cleaner uses exponential smoothing to
forecast equipment usage at its main plant. August
usage was forecast to be 88% of capacity. Actual
usage was 89.6%. A smoothing constant of 0.1 is
used.
 Prepare a forecast for September
 Assuming actual September usage of 92%, prepare
a forecast of October usage
 Problem 3
An electrical contractor’s records during the last five
weeks indicate the number of job requests:
Week: 1 2 3 4 5
Requests: 20 22 18 21 22

Predict the number of requests for week 6 using each of

these methods:
 Naïve
 A four-period moving average
 Exponential smoothing with a smoothing constant of .30.
Use 20 for week 2 forecast.
 Review: forecast
 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
 Review: forecast
 Naïve technique
 Stable time series data
 Seasonal variations
 Data with trends

 Averaging
 Moving average
 Weighted moving average
 Exponential smoothing
 Techniques for Trend

• Develop an equation that will suitably describe

trend, when trend is present.

• The trend component may be linear or nonlinear

• We focus on linear trends

Common Nonlinear Trends

Parabolic

Exponential

Growth
 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

 Example: Ft =10+2t. Interpret 10 and 2. Plot F

 Example
 Sales for over the last 5 weeks are shown below:

Week: 1 2 3 4 5
Sales: 150 157 162 166 177

 Plot the data and visually check to see if a linear

trend line is appropriate.
 Determine the equation of the trend line
 Predict sales for weeks 6 and 7.
 Line chart

Sales

180
175
170
165
160
Sales

Sales
155
150
145
140
135
1 2 3 4 5
Week
Calculating a and b

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

 y - b t
a =
n
Linear Trend Equation Example
t y
2
Week t Sales ty
1 1 150 150
2 4 157 314
3 9 162 486
4 16 166 664
5 25 177 885

 t = 15 t = 55  y = 812  ty = 2499

2

(t)2 = 225
 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
 Linear Trend plot

Actual data Linear equation

180

175

170

165
160

155
150

145
140

135
1 2 3 4 5
 Recall: Problem 1
 National Mixer Inc. sells can openers.
Monthly sales for a seven-month period
were as follows: Month Sales
(1000)
 Plot the monthly data Feb 19
Mar 18
 Forecast September sales volume using
Apr 15
a line trend equation
May 20
 Which method of forecast seems least Jun 18
appropriate? Jul 22
 What does use of the term sales rather Aug 20
than demand presume?
 Line chart

Sales

20

0
F M A M J
J Month A S
 Problem 4
 A cosmetics manufacturer’s marketing department has
developed a linear trend equation that can be used to predict
annual sales of its popular Hand & Foot Cream:

Ft  80  15t
where
Ft  Annual sales (1000 bottles)
t  0 corresponds to 1990

 Are annual sales increasing or decreasing? By how much?

 Predict annual sales for the year 2006 using the equation.
 Techniques for Seasonality
 Seasonality may refer to regular annual variation. There
are two models:

 Additive: expressed as a quantity (e.g., 20 units), which is

added or subtracted from the series average

 Multiplicative: a percentage of the average or seasonal

relative (e.g., 1.10), which is used to multiply the value of a
series to incorporate seasonality.
Additive vs. multiplicative
 Example
 A furniture manufacturer wants to predict quarterly demand for a
certain loveseat for periods 15 and 16, which happen to be the
second and third quarters of a particular year. The series consists
of both trend and seasonality. The trend portion of demand is
projected using the equation

Ft  124  7.5t
 Quarter relatives are
Q1  1.20, Q2  1.10, Q3  0.75, Q4  0.95

 Use this information to predict demand for periods 15 and 16.

 Problem

 A manager is using the equation below to forecast quarterly

demand for a product:

Y(t) = 6,000 + 80t

where t = 0 at Q2 of last year

 Quarter relatives are Q1 = .6, Q2 = .9, Q3 = 1.3, and Q4 = 1.2.

 What forecasts are appropriate for the last quarter of this year and the
first quarter of next year?
 Problem
 A manager of store that sells and installs hot tubs
wants to prepare a forecast for January, February
and March of 2007. Her forecasts are a
combination of trend and seasonality. She uses the
following equation to estimate the trend component
of monthly demand:

Ft  70  5t
Where t=0 is June of 2005. Seasonal relatives are
1.10 for Jan, 1.02 for Feb, and .95 for March. What
demands should she predict?
 Computing seasonal relatives

120

100

80

60

40

20

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

If your data appears to have seasonality, how do you compute the

seasonal relatives?
 Computing seasonal relatives
 Calculate centered moving average for each
period.
 Obtain the ratio of the actual value of the period
over the centered moving average.
 Number of periods needed in a centered moving
average = Number of seasons involved:
 Monthly data: a 12-period moving average
 Quarterly data: a 4-period moving average
 Example
 The manager of a parking lot has computed the
number of cars per day in the lot for three weeks.
Using a seven-period centered moving average,
calculate the seasonal relatives.

 Note that a seven period centered moving average

is used because there are seven days (seasons) per
week. See seasonal relatives1.xls
 Problem 5

 Obtain estimates of quarter relatives for these data:

Year: 1 2 3 4
Quarter: 1 2 3 4 1 2 3 4 1 2 3 4 1
Demand: 14 18 35 46 28 36 60 71 45 54 84 88 58
 Problem

 The manager of a restaurant believes that her

restaurant does about 10% of its business on Sunday
through Wednesday, 15% on Thursday night, 25%
on Friday night, and 20% on Saturday night.

 What seasonal relatives would describe this

situation?
 Note:
 An alternative to deal with seasonality is to
deseasonalize data.
 Deseasonalize = Remove seasonal component
from data
 Gives clearer picture of the trend (nonseasonal
component)
 Deseasonalize can be done by dividing each data
point by its seasonal relative.
 Forecasts: review

 Judgmental - uses subjective inputs

 Time series - uses historical data assuming the
future will be like the past
 Naïve approach
 Averaging
 Techniques for trend
 Trend and seasonality
 Associative models - uses explanatory variables to
predict the future
 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
 LINEAR REGRESSION

Suppose that J&T has a new product called

“AppleGlo”, which is a household cleaner. This First-Year
AppleGlo Advertising First-Year
new product has been introduced into 14 sales
Expenditures Sales
regions over the last two years. The ($ millions) ($ millions)
Advertising expenditure vs. the first year sales Region x y
are shown in the table for each region. Maine 1.8 104
New Hampshire 1.2 68
Vermont 0.4 39
The company is considering introducing Massachusetts 0.5 43
AppleGlo into two new regions, with the Connecticut 2.5 127
advertising campaign of $2.0 and $1.5 Rhode Island 2.5 134
New York 1.5 87
million.
New Jersey 1.2 77
The company would like to predict what the Pennsylvania 1.6 102
Delaware 1.0 65
expected first year sales of AppleGlo would
Maryland 1.5 101
be in each region. West Virginia 0.7 46
Virginia 1.0 52
Ohio 0.8 33
 LINEAR REGRESSION

160
140
120
($Millions)

100
Sales

80
60
40
20
0
0 0.5 1 1.5 2 2.5
Advertising Expenditures ($Millions)

Questions: • How to relate advertising to sales?

• What is expected first-year sales if advertising expenditure is $1M?
• How confident are you in the estimate? How good is the fit?
 Correlation

The correlation coefficient is a quantitative

measure of the strength of the linear relationship
between two variables. The correlation ranges
from + 1.0 to - 1.0. A correlation of  1.0
indicates a perfect linear relationship, whereas a
correlation of 0 indicates no linear relationship.
An algebraic formula for correlation
coefficient

n xy   x y
r
[n( x )  ( x) ][n( y )  ( y) ]
2 2 2 2
 Simple Linear Regression

Simple linear regression analysis

analyzes the linear relationship that exists
between two variables.

y  a  bx
where:
y = Value of the dependent variable
x = Value of the independent variable
a = Population’s y-intercept
b = Slope of the population regression line
 Simple Linear Regression

The coefficients of the line are

n xy   x y
b
n x  ( x )
2 2

a
 y  b x
or n
a  y  bx
 Problem 7

 The manager of a seafood restaurant was Sold (y) Price (x)

asked to establish a pricing policy on 200 6.00
lobster dinners. Experimenting with 190 6.50
prices produced the following data: 188 6.75
180 7.00
 Create the scatter plot and determine if 170 7.25
a linear relationship is appropriate.
162 7.50
160 8.00
 Determine the correlation coefficient
and interpret it 155 8.25
156 8.50
 Obtain the regression line and interpret 148 8.75
its coefficients. 140 9.00
133 9.25
 Forecast Accuracy
 Source of forecast errors:
 Model may be inadequate
 Irregular variations
 Incorrect use of forecasting technique
 Random variation

 Key to validity is randomness

 Accurate models: random errors
 Invalid models: nonrandom errors

 Key question: How to determine if forecasting

errors are random?
 Error measures

 Error - difference between actual value and predicted

value
 Mean Absolute Deviation (MAD)
 Average absolute error
 Mean Squared Error (MSE)
 Average of squared error
 Mean Absolute Percent Error (MAPE)
 Average absolute percent error
 MAD, MSE, and MAPE

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

Actual  Forecast
 Actual
 100
MAPE 
n
 Example

Period Actual Forecast (A-F) |A-F| (A-F)^2 (|A-F|/Actual)*100

1 217 215 2 2 4 0.92
2 213 216 -3 3 9 1.41
3 216 215 1 1 1 0.46
4 210 214 -4 4 16 1.90
5 213 211 2 2 4 0.94
6 219 214 5 5 25 2.28
7 216 217 -1 1 1 0.46
8 212 216 -4 4 16 1.89
-2 22 76 10.26

MAD= 2.75
MSE= 10.86
MAPE= 1.28
 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

Controlling the forecast
 Control charts
 Control charts are based on the following
assumptions:
 when errors are random, they are Normally
distributed around a mean of zero.
 Standard deviation of error is MSE
 95.5% of data in a normal distribution is within 2
standard deviation of the mean
 99.7% of data in a normal distribution is within 3
standard deviation of the mean
 Upper and lower control limits are often determine
via
0  2 MSE or 0  3 MSE
 Example
 Compute 2s control limits for
forecast errors of previous
example and determine if the
forecast is accurate.
5.41

s  MSE  3.295 3.41

2s  6.59
1.41

-0.59 0 10

 Errors are all between -6.59 -2.59

and +6.59 -4.59

 No pattern is observed -6.59

 Therefore, according to control

chart criterion, forecast is
reliable
 Problem 8
Period Demand Predicted
 The manager of a travel agency has
been using a seasonally adjusted 1 1 29 1 24
forecast to predict demand for 2 1 94 200
packaged tours. The actual and 3 1 56 1 50
predicted values are 4 91 94
5 85 80
6 1 32 1 40
 Compute MAD, MSE, and MAPE.
7 1 26 1 28
8 1 26 1 24
 Determine if the forecast is working 9 95 1 00
using a control chart with 2s limits. Use
data from the first 8 periods to develop 10 1 49 1 50
the control chart, then evaluate the 11 98 94
remaining data with the control chart. 12 85 80
13 1 37 1 40
14 1 34 1 28
 Problem
 Given the following demand data, prepare a naïve
forecast for periods 2 through 10. Then determine each
forecast error, and use those values to obtain 2s control
limits. If demand in the next two periods turns out to be
125 and 130, can you conclude that the forecasts are in
control?

Period 1 2 3 4 5 6 7 8 9 10
Demand 118 117 120 119 126 122 117 123 121 124
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