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Chapter 3
Forecasting
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Forecast
OM is mostly proactive not reactive

It involves structured planning activities

Planning requires data pertaining to the feature

Forecast: A statement about the future
Not necessarily numerical
Weather forecasts
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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
Uses of Forecasts
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REMARKS
Assume a causal system
Future resembles the past
Forecasts rarely perfect because of randomness
Forecasts more accurate for groups vs. individuals.
Forecasting errors among items in a group usually have a canceling
effect.
Extremes in a group cancel each other
Ex. I can forecast the class average from the midterm better than
Mrs. Xs individual grade.
Sample variance of {-1,1,-1,1} is 1.
Sample variance of {(-1+1)/2, {(-1+1)/2} is 0.
Forecast accuracy decreases as time horizon for forecasts increases
Ex. I can forecast this years class average better than next years
class average
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Elements of a Good Forecast
Timely
Accurate
Reliable
Written
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Steps in the Forecasting Process
Step 1 Determine purpose of forecast
Step 2 Establish a time horizon
Step 3 Select a forecasting technique
Step 4 Gather and analyze data
Step 5 Prepare the forecast
Step 6 Monitor the forecast
The forecast
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Types of Forecasts
Judgmental - Subjective analysis of subjective inputs
Associative models Analyzes historical data to reveal
relationships between (easily or in advance) observable
quantities and forecast quantities. Uses this relationship to
make predictions.
Time series Objective analysis historical data assuming
the future will be like the past
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Judgmental Forecasts
Executive opinions (long-range planning)
There are factors hard to quantify
Ex: Effects of November 2004 election on new houses built in 2005
Sales force composite
Retailer forecasts for the manufacturer
Consumer surveys
The guy at the mall who asks if you like cherry flavor in your shampoo
Outside opinion
Financial and consulting gurus and companies
Opinions of managers and staff
Delphi method: A series of questionnaires developed sequentially
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Associative Forecasting
Based on identification of related variables that can be used
to predict values of the variable of interest.
Sales of mountain bikes in an area may be related to the percentage
of the young population living in that area.
Sales of Harley-Davidson motorbikes is related to mid-aged men
population. Average age of H-D owners is 46.
Ice cream sales can be related to temperature
Home depot bases sales forecasts on mortgage refinancing rates,
smaller rates imply higher sales.
Changes in Federal Reserve Boards interest rate leads to certain
business activities
House sales
Industrial investments
Increase in energy cost leads to price increases in products and
services

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Associative Forecasting
Find an association between the predictor and the
predicted
Predictor variables - used to predict values of variable
interest, sometimes called independent variables
Predicted variable = Dependent variable
Regression - technique for fitting a line to a set of
points
Linear regression is the most widely used form of
regression
The objective is to obtain an equation of a straight line that minimizes the
sum of squared vertical deviations of data points from the line.
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Linear Regression (cont.)
y = a + bx
Where
y = predicted (dependent) variable
x = predictor (independent) variable
b = slope of the line
a = value of y when x = 0 (the height of line
at the y intercept)
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Computing a and b
Given n data points, find the intercept a and the slope b to
2
1 1
2
1 1 1
|
.
|

\
|

=


= =
= = =
n
t
t
n
t
t
n
t
n
t
n
t
t t t t
x x n
y x y x n
b

=

=
=
n
t
t t
bx a y
1
2
) ( Minimize
line the from deviations of sum the Minimize
errors squared of sum the Minimize
n
x
b
n
y
a
n
t
t
n
t
t
= =
=
1 1
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Linear Model Seems Reasonable
0
10
20
30
40
50
0 5 10 15 20 25
X Y
7 15
2 10
6 13
4 15
14 25
15 27
16 24
12 20
14 27
20 44
15 34
7 17
Computed
relationship
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Another Linear Regression Example
Variables: Weeks and Sales
t y
Week t
2
Sales ty
1 1 150 150
2 4 157 314
3 9 162 486
4 16 166 664
5 25 177 885
E t = 15 E t
2
= 55 E y = 812 E ty = 2499
(E t)
2
= 225
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Linear Trend Calculation
y = 143.5 + 6.3 t
Sales in week t = 143.5 + 6.3 t
a =
812 - 6.3(15)
5
=
b =
5 (2499) - 15(812)
5(55) - 225
=
12495 - 12180
275 - 225
= 6.3
143.5
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Linear Trend Calculation
y = 143.5 + 6.3t
When t = 0, the value of y is 143.45 and the
slope of the line is 6.3. meaning that the
value of of y will increase by 6.3 units for
each time period. If t = 10, the forecast is
143.5 + 6.3(10) = 206.5
Excel example
regression.xls
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Linear Regression
Remember from Statistics
Correlation (r) between variables: The strength and
direction of relationships between two variables
1.00 means changes in one variable are always matched
by changes in the other, vice versa.
A correlation close to zero means little linear relationship
The square of the correlation coefficient provides a
measure of the percentage of variability in the values of y
that is explained by the independent variable.(80% or
more: the independent variable is a good predictor of the
values of dependent variable)
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Time series
Time-ordered sequence of observations taken at regular
intervals over a period of time
Future values of the series can be estimated from past values.

Types of Variations in Time Series Data
Trend - long-term movement in data
Seasonality - short-term regular variations in data
Cycles wavelike variations of long-term
Irregular variations - caused by unusual circumstances
Random variations - caused by chance
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Forecast Variations
Trend
Irregular
variation
Cycles
Seasonal variations
Year 01
00
99
Figure 3-1
Cyclical
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Uses a single previous value of a time series as the basis
of a forecast.
Virtually no cost
Data analysis is nonexistent
Easily understandable
Cannot provide high accuracy
If it were true, future will always be the same as the past

Some notation: Forecast at time t is F(t)
Actual observation at time t is A(t)
Today is temperature is 98 F, A(Today)=98
F(Tomorrow)=98
F(Day after)=98
Nave Forecasts
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Stable time series data
Forecast is the same as the last actual observation
F(t) = A(t-1)
Seasonal variations
Forecast is the same as the last actual observation when
we were in the same point in the cycle, where a cycle
lasts n periods.
F(t) = A(t-n)
Data with trends
There is constant trend, the change from (t-2) to (t-1)
will be exactly as the change from (t-1) to (t)
F(t) = A(t-1) + (A(t-1) A(t-2))
Uses for Nave Forecasts
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Naive Forecasts
Uh, give me a minute....
We sold 250 wheels last
week.... Now, next
week we should sell....
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Nave (Cont.)
Check if the resulting accuracy is acceptable
The higher the accuracy, often the higher the cost.
Do we really need our forecast that accurate? Is it
worth the additional resources?
Why do you need forecasts for? How critical they are
for operations?

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Time Series Models: Variations
What is random and what is not?
Historical data contain random variations or noise
Random variations are caused by relatively
unimportant factors.
What is random? Can we not study everything to negligible
detail? God does not roll dices A.E.
The objective is to remove all randomness and have
real variations.
Minor variations are random and large ones are real.
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Techniques for Averaging
Moving averages (MA)
Nave methods just trace the actual data with a lag of
one period, F(t)=A(t-1)
They dont smooth
MA uses a number of the most recent actual data to
smooth
Weighted moving averages

Exponential smoothing
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Simple Moving Average
Note the sensitivity of forecasts


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37
39
41
43
45
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1 2 3 4 5 6 7 8 9 10 11 12
Actual
MA(t,3)
MA(t,5)
ns observatio actual n using 1 - t period in made forecast MA :
,
,
1
,
n t
t
n t i
i
n t t
MA
n
A
MA F

=
= =
Averaging (over time) techniques are used to smooth variations in the data.
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Ex: Three period moving average forecast
Month Demand
1 42 MA(6,3) = (43 + 40 + 41) / 3
2 40 = 41.33.
3 43 If A(6) = 39, then
4 40 MA(7,3) = (40 + 41 + 39) / 3
5 41 = 40.00
6 39

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Weighted average
Moving Average
Advantage=Easy to compute and easy to
understand
Disadvantage=All values in the average are
weighted equally

Weighted Moving Average
Similar to moving average
It assigns more weight to the most recent values in
a time series
Idea: most recent observations must be better indicators
of the future than older observations
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Weighted average
Compute a weighted average forecast using a
weight of 0.4 for the most recent period, 0.3
for the next most recent, 0.2 for the next and
0.1 for the next.

Continuing with the data on the left
F(6) = .40(41)+.30(40)+.20(43)+.10(40)=41.0
If the actual demand for period 6 is 39,
F(7) = .40(39)+.30(41)+.20(40)+.10(43)=40.2

The weighted average is more reflective of
the most recent occurrences.
Month Demand
1 42
2 40
3 43
4 40
5 41
6 39

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Exponential Smoothing
Forecast today=Forecast yesterday+(alpha)*(Forecast error yesterday)
Each new forecast is equal to the previous forecast plus a percentage of
the previous error.
Todays forecast
Depends on yesterdays (time-wise dependence, strong memory)
But it has to be corrected by forecast error
Therefore, we should give more weight to the more recent time
periods when forecasting.
Alpha = smoothing constant = percentage of the forecast error.
) (
1 1 1
+ =
t t t t
F A F F o
Forecast error:=Actual Forecast =A(t-1)-F(t-1)
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Exponential Smoothing
as an Weighted Average
Idea--The most recent observations might have the
highest predictive value along with the most recent
forecast errors. Let us balance them:
1 1
) 1 (

+ =
t t t
F A F o o
1 t
A o
1
) 1 (

t
F o
t
F
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Period Actual Forecast withAlpha = 0.1 Error with Forecast withError with
1 42 Alpha=0.1 Alpha=0.1 Alpha=0.4 Alpha=0.4
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
Example of Exponential Smoothing
Forecasts made in a period and the period has the same color
1 1
) 1 (

+ =
t t t
F A F o o
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Picking a Smoothing Constant:
Responsiveness vs. Smoothing
The quickness of forecast adjustment to error is determined by the
smoothing constant.
The closer the alpha is to zero, the slower the forecast will be to
adjust to forecast errors.
Conversely, the closer the value of alpha is to 1.00, the greater the
responsiveness to the actual observations and the less the
smoothing
Select a smoothing constant that balances the benefits of
responding to real changes if and when they occur.
1 1 1 1 1
) 1 ( ) (

+ = + =
t t t t t t
F A F A F F o o o
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Picking a Smoothing Constant
Sensitivity of Forecasts
35
40
45
50
1 2 3 4 5 6 7 8 9 10 11 12
Period
D
e
m
a
n
d
o = 0.1
o = 0.4
Actual
Excel example
exponential-smoothing.xls
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Techniques for trend
Develop an equation that will describe trend
The trend component may be linear or it
may not
Linear trend:

Y
t
= a + bt
0 1 2 3 4 5
t
Y
b is similar to the slope.
However, since it is
calculated with the variability
of the data in mind, its
formulation is not as
straight-forward as our usual
notion of slope.
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Common Nonlinear Trends
Parabolic
Exponential
Growth
Figure 3-5
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Adjusting for Trend with Double
Exponential Smoothing
Simple exponential smoothing with no trend

Add forecasted trend

This time trend is also smoothed, note that
previous trend (of t-1) and current trend (of t)
appear in the smoothing formula:
See Table 3-2 for an exercise

{ } { }
t t t t
T F A F + + =
+
o o 1
1
t
T
{ } { }
1 1
1 ) (

+ =
t t t t
T F F T | |
1 1
and


t t t
F F T
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Techniques for seasonality
Regularly repeating upward or downward
movements in time series values
Seasonality: weather variations, vacations and
holidays
Seasonality: Expressed in terms of the amount
that actual values deviate from the average
value of the series
Seasonality is expressed as a percentage of the
average amount
seasonal percentages = seasonal relatives = seasonal indices
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Different models of seasonality
Seasonal relative = 1.45 for the quantity of television
sold in August at Circuit City, meaning that TV sales
for that month are 45% above the monthly average.
Seasonal factor=0.60 for the number of notebooks
sold at the UTD bookstore in April, meaning that
notebook sales are 40% below the monthly average.

Seasonal indices are your vehicle to travel between
the seasonal and deseasonal worlds.
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Use Seasonality Indices
to Deseasonalize and Seasonalize
Deseasonalize historical observations
Divide them by seasonal indices
Make the analysis = Generate forecasts
Seasonalize forecasts
Multiply them by seasonal indices
t t t
Inputs
Analyze Output
Excel example
seasonalforecast.xls
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Forecast Accuracy
Measurement is the first step to improve an
activity
What value of smoothing constant is good?
Accuracy measurement is a vital aspect of
forecasting
Impossible to correctly predict future values
Important to include an indication of how big the
forecast deviate from the actual values
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Forecast Accuracy
Error - difference between actual value and
predicted value
Mean absolute deviation (MAD)
Average absolute error (weights all errors evenly)
Mean squared error (MSE)
Average of squared error (weights errors according
to their squared values)
Tracking signal
Ratio of cumulative error and MAD
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MAD & MSE
error. forecast of variance for the estimator unbiased the is MSE : says Statistics
MSE s deviation standard error) (forecast of Estimate

) (
1
) (
| |

1
1
2
1
2
1
= =

=
=

=
= =
=
MAD
F A
Signal Tracking
n
F A
n
F A
MSE
n
F A
MAD
Forecast Actual error Forecast
n
t
t t
n
t
t t
n
t
t t
n
t
t t
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Use for MAD & MSE
Compare the accuracy of alternative
forecasting methods using MAD and MSE.
parameter (such as alpha) values used in forecasting
by using MAD and MSE
Determine which method yields the lowest MAD
or MSE for a given set of data.
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Controlling the quality of forecast
Necessary to monitor forecast to ensure that the
forecast is performing adequately
This is accomplished by comparing forecast errors to
predetermined values
Errors that fall within the limits are considered
acceptable
Errors outside either limit indicates that corrective
action is needed.
Tracking signal values are compared to predetermined limits (+4,-4) based
on judgment and experience
Upper and lower limits for individual forecast errors are calculated using
control chart techniques. We will learn about control charts in quality
chapters.
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Choosing a forecasting technique
No single technique works best in every situation
No single technique works best in every situation
The forecast horizon
Forecasting frequency
Forecasting is not free
Consider cost and accuracy
Weigh cost-accuracy trade-offs carefully
Forecast detail, part / product level?
Availability of
historical data
computers
able users / decision makers
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Choosing a forecasting technique (cont.)
Moving Averages and Exponential
Smoothing are short range techniques. They
produce forecast for the next period
Trend equations are used for much longer
time horizons.
More than one forecasting techniques might
be used to increase confidence.
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Summary
We studied the steps of forecasting
We examined three forecasting techniques:
Judgmental
Associative
Time Series
We learned about seasonality, trend, cyclical data
Discussed monitoring forecast accuracy