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Operations
Management
Topic 2 Forecasting
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What is Forecasting?
Process of predicting a
future event

Can be any or
combination of:
Mathematical model
Intuitive
Hmm. you
gonna get an A for
this subject
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Short-range forecast
Up to 1 year but generally less than 3 months
used for planning purchasing, job scheduling,
workforce levels, job assignments, production levels.
Medium-range forecast
Generally spans from 3 months to 3 years
useful for sales planning, production planning and
budgeting, cash budgeting, and analyzing various
operating plans.
Long-range forecast
Generally 3 years or more
used in planning for new products, capital
expenditures, facility location or expansion, and
R&D
Forecasting Time Horizons
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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
We can also forecast the economy or the technology.
But for OM, demand forecasting the most relevant.
The forecast is the only estimate of demand until actual
demand becomes known.



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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 advantage

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Seven Steps in Forecasting
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
Qualitative (subjective)
Forecast incorporates the decision makers
intuition, emotion, personal experiences, and
value system in reaching a forecast.
Quantitative
Forecast use a variety of mathematical models/
techniques that rely on historical data and/or
causal variables to forecast demand.
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Forecasting Approaches
Used when situation is vague and
little data exist
New products
New technology
e.g., forecasting sales on Internet
Qualitative Methods
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Forecasting Approaches
Used when situation is stable and
historical data exist
Existing products
Current technology
e.g., forecasting sales of color televisions
Quantitative Methods
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Qualitative methods
1. Jury of executive opinion uses the opinion of a
small group of high level managers to form a group estimate
of demand.
2. Delphi method using a group process that allows
experts to make forecasts.
3. Sales force composite based on salespersons
estimates of expected sales.
4. Consumer market survey solicits inputs from
customers or potential customers regarding future
purchasing plans.
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Quantitative Methods
1. Naive approach
2. Moving averages
3. Weighted Moving
Averages
4. Exponential
smoothing
5. Trend projection
6. Linear regression
Time-Series
Models
Associative Model
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uses a series of past data points to make a
forecast. It is based on a sequence of evenly
spaced (weekly, monthly, quarterly, etc) data
points.
Predict on the assumption that the future is a
function of the past.
Forecast based only on past values, no other
variables important
Look what happened over a period of time and use
a series of past data to make a forecast.
For example: to predict the sales of lawn mowers,
use the past sales to make the forecasts.


Time Series Models
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Associative Models
Incorporate variables or factors that might
influence the quantity being forecast.
For example: an associative model for lawn
mower sales might use factors such as new
housing starts, advertising budgets, and
competitors prices.
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Components of Demand
D
e
m
a
n
d

f
o
r

p
r
o
d
u
c
t

o
r

s
e
r
v
i
c
e

| | | |
1 2 3 4
Year
Average demand
over four years
Seasonal peaks
Trend
component
Actual
demand
Random
variation
Figure 4.1
Product demand charted over 4 years with
a Growth Trend and Seasonality added:
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Persistent, overall upward or
downward pattern
Changes due to population,
technology, age, culture, etc.
Typically several years duration
Trend Component
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Regular pattern of up and down
fluctuations
Due to weather, customs, etc.
Occurs within a single year
Seasonal Component
Number of
Period Length Seasons
Week Day 7
Month Week 4-4.5
Month Day 28-31
Year Quarter 4
Year Month 12
Year Week 52
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Repeating up and down movements
Affected by business cycle, political, and
economic factors
Multiple years duration
Often causal or
associative
relationships
Cyclical Component
0 5 10 15 20
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Erratic, unsystematic, residual
fluctuations
Due to random variation or unforeseen
events
Short duration and
nonrepeating
Random Component
M T W T F
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Naive Approach
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
Weighted moving average
Exponential smoothing
Techniques for Averaging
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Moving Average Method
Moving average =
demand in previous n periods

n
A forecasting method that uses an average of the n most recent
periods of data to forecast the next period. Useful if we can assume
that market demands will stay fairly steady over time.
e.g. a 4-month moving average is found by summing the demand during
the past 4 months and dividing by 4. This practice tends to smooth out
short term irregularities in the data series.
Where n is the number of periods in the moving average.

The above is used as an estimate of the next periods demand
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Moving Average Example
Storage shed sales at a Garden Supply shop are as shown in the following
Table.
Example 1:
Calculate the 3-month
moving average forecast.
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J anuary 10
February 12
March 13
April 16
May 19
J une 23
J uly 26

Actual 3-Month
Month Shed Sales Moving Average




(12 + 13 + 16)/3 = 13
2
/
3

(13 + 16 + 19)/3 = 16
(16 + 19 + 23)/3 = 19
1
/
3
Moving Average Example
10
12
13
(10 + 12 + 13)/3 = 11
2
/
3
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Moving Average Example
e.g. the forecast for December is 20.7
The forecast for coming January is
(18+16+14)/3=16.0
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Graph of Moving Average
| | | | | | | | | | | |
J F M A M J J A S O N D
S
h
e
d

S
a
l
e
s

30
28
26
24
22
20
18
16
14
12
10
Actual
Sales
Moving
Average
Forecast
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Weighted Moving Average
Weighted
moving average
=
(weight for period n)
x (demand in period n)
weights
When a detectable trend or pattern is present, weights can be used to place
more emphasis on recent values. This makes forecasting techniques more
responsive to changes because more recent periods may be more heavily
weighted.
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Weighted Moving Average Ex:
Example 2
The shop in Example 1 decides to forecast storage shed sales by weighting the past 3 months as
follows:
Period Weight applied
Last month 3
2 months ago 2
3 months ago 1
_____________________________
Solution:
(weights) = 6

Based on the weightings above, the forecast for any month
[(3 x Sales last month) + (2 x Sales 2 months ago) + (1 x Sales 3 months ago)]
= -------------------------------------------------------------------------------------------------
(weights)
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J anuary 10
February 12
March 13
April 16
May 19
J une 23
J uly 26

Actual 3-Month Weighted
Month Shed Sales Moving Average




[(3 x 16) + (2 x 13) + (12)]/6 = 14
1
/
3

[(3 x 19) + (2 x 16) + (13)]/6 = 17
[(3 x 23) + (2 x 19) + (16)]/6 = 20
1
/
2
Weighted Moving Average
10
12
13
[(3 x 13) + (2 x 12) + (10)]/6 = 12
1
/
6



Weights Applied Period
3 Last month
2 Two months ago
1 Three months ago
6 Sum of weights
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Weighted Moving Average Ex:
Note that in this situation more heavily weighting the latest month provides a much more
accurate projection.
Note also that moving averages are effective in smoothing out sudden fluctuations in the
demand pattern to provide stable estimates.
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Moving Average And
Weighted Moving Average
Note from the graph that both moving averages lag the actual demand. The
weighted moving average, however reacts more quickly to changes in
demand.
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Increasing n smooths the forecast but makes
it less sensitive to real changes in the data.
Cannot pick up trends very well. Because
they are averages, they will always stay
within past levels and will not predict
changes to either higher or lower levels.
Require extensive historical of past data.
Potential Problems With
Moving Average
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Exponential Smoothing
Is a weighted moving average forecasting technique
in which data points are weighted by an exponential
function.
This technique involves little record keeping of past
data.
Easy to use.
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Exponential Smoothing
New forecast = Last periods forecast
+ a (Last periods actual demand
Last periods forecast)
F
t
= F
t 1
+ a(A
t 1
- F
t 1
)
where F
t
= new forecast
F
t 1
= previous forecast
a = smoothing (or weighting)
constant (0 a 1)
Remember This!!!!!!!!
Basic exponential smoothing formula:
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Exponential Smoothing Example
Example 3

In January, a car dealer predicted February demand for 142 Ford Mustangs. Actual
February demand was 153. Using a smoothing constant chosen by management of =
0.20, forecast the March demand using the exponential smoothing model.

Solution:
Substituting into the formula above,
New forecast (for March demand),
F
Mac
= F
Feb
+ (A
Feb
F
Feb
)
= 142 + 0.20 (153 142)
= 144.2
Therefore the March demand forecast for Ford Mustang is 144.
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Measuring Forecast Error
Forecast error (or Deviation) = Actual demand Forecast demand
= A
t
- F
t
.
Several measures in use:
Mean absolute deviation (MAD)
Mean squared error (MSE)
Mean absolute percent error (MAPE)

| Actual - Forecast |
MAD = ------------------------------
n
(Forecast error)
2

MSE = ------------------------
n

n

100 | Actual
i
- Forecast
i
| / Actual
i

MAPE = -------
i=1
--------------------------------------------
n
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Trend Projection
A time-series forecasting method that fits a trend line to a
series of historical data points and then projects the line
into the future for forecasts.

It is usually for medium-to-long range forecasts.


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Forecast Error Example:
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Exponential Smoothing Example
2
Demand for the last four months was:
Predict demand for July using each of these methods:
(A)
1) A 3-period moving average
2) exponential smoothing with alpha equal to .20 (use nave to
begin).
(B)
3) If the naive approach had been used to predict demand for April
through June, what would MAD have been for those months?
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Exponential Smoothing Example 2
Month Demand Forecast
March 6 -
April 8 6
May 10 6 + 0.2(8 6) = 6.4
June 8 6.4 + 0.2(10 6.4) = 7.12
7.12 + 0.2(8 7.12) = 7.296
A) 1. (8+10+8)/3 = 8.33 (July Forecast)
2. Use nave to begin
B)
Month March April May June
Demand 6 8 10 8
Nave - 6 8 10
Error - +2 +2 -2
MAD 6/3 = 2.0
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Moving Average

Weekly sales of ten-grain bread at the local organic food market are in the
table below. Based on this data, forecast week 9 using a five-week moving
average.
Other Examples
Week 1 2 3 4 5 6 7 8
Sales 415 389 420 382 410 432 405 421
(382+410+432+405+421)= 410.0
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Exponential Smoothing & MAD
Jim's department at a local department store has tracked the sales of a product
over the last ten weeks. Forecast demand using exponential smoothing with
an alpha of 0.4, and an initial forecast of 28.0. Calculate MAD.
Other Examples
Period Demand
1 24
2 23
3 26
4 36
5 26
6 30
7
32
8 26
9 25
10 28
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Period Demand Forecast Error Absolute
1 24 28.00
2 23 26.40 -3.40 3.40
3 26 25.04 0.96 0.96
4 36 25.42 10.58 10.58
5 26 29.65 -3.65 3.65
6 30 28.19 1.81 1.81
7 32 28.92 3.08 3.08
8 26 30.15 -4.15 4.15
9 25 28.49 -3.49 3.49
10 28 27.09 0.91 0.91
Total 2.64 32.03
Average 0.29 3.56
Bias MAD
Other Examples
Exponential Smoothing
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Other Examples Problems: Forecasting
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QUIZ 1
The docking rate of ships at the Northport varies monthly and the operations
manager is attempting to test the use of exponential smoothing to determine the
effectiveness of the technique in forecasting. He begins the analysis in the
month of January and continues for an additional 5 months. The initial forecast
for January is 320. Actual data for the past 6 month are as follows:
The operation manager has decided on 2 values for a i.e. = 0.1 and a = 0.4.
Which of these alpha values will be more accurate? Explain why?