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Forecasting

Introduction
 What is a forecast?
 A statement about future values of a variable, in other
words forecasts are prediction of future
 Something that can be predicted in advance
• Better predictions lead to informed decisions
 Example of forecast
 Weather forecast
 Forecasting the demand of a product before it occurs
Manufacture according to the predicted demand
Companies that does demand forecasting: Wal-Mart,
JCPenney, Gap, P & G etc.
 Forecasting helps managers by reducing some of
the uncertainty, thereby allowing them to develop
meaningful plans.
Introduction
• Forecasts affects decisions in all the departments
in an organization
• Accounting – new product estimated cost, profit
projections
• Finance – replacement of equipment, amount of
funding/borrowing needs
• Human Resources – hiring activities, layoff planning
• Marketing – pricing and promotions etc.
• Operations – schedules, capacity planning, work
assignments, inventory planning, make-or-buy
decisions, outsourcing etc.
• Product/service design – timeline to design a new
product etc.
Forecasting Methods

• Depend on
• time frame
• demand behavior
Time frame
• Short- to mid-range forecast
• typically encompasses the immediate
future
• Examples: cash, inventories
• daily up to two years
• Examples: Purchasing Material, Worked
force, Inventories
• Long-range forecast
• usually encompasses a period of time
longer than two years
• Examples: New Product line, Capital fund
Demand Behavior
• Trend
• a gradual, long-term up or down movement
of demand
• Random variations
• movements in demand that do not follow a
pattern
• Cycle
• an up-and-down repetitive movement in
demand
• Seasonal pattern
• an up-and-down repetitive movement in
demand occurring periodically
Behaviors of a Time
Series Data
Irregula
r
variatio
n
Trend

Cycles

Seasonal variations
Forecasting Techniques
and Common Models
• Qualitative
• use management judgment, expertise, and
opinion to predict future demand
• Time series
• statistical techniques that use historical
demand data to predict future demand
• Regression methods
• attempt to develop a mathematical
relationship between demand and factors
that cause its behavior
Forecasting Techniques
and Common Models
• Qualitative: Subjective, Judgmental; based on estimates
and opinions
• Grass roots:
• build forecast from bottom
• Assumption is that person closest to the customer or customer
him/herself can predict data more accurately
• Market research :
• market surveys, customer interviews etc.
• Typically used to forecast long-range and new product line
• Panel consensus :
• Idea is that panel of a people from a variety of positions can
develop more reliable forecast
• Participants may be executive, sales people, customers, etc.
Forecasting Techniques
and Common Models
• Qualitative: Subjective, Judgmental; based on
estimates and opinions
• Historical analogy
• look at a closer analogy – similar product or
complementary products can be used

• Delphi method :
• Opinions of managers and staff
• Achieves a consensus forecast
Forecasting Techniques
and Common Models
• Time Series Analysis: Timely ordered sequence
of observation (hourly, daily, monthly, yearly
etc.)
• Simple moving average
• Weighted moving average
• Exponential smoothing
• Regression analysis
Simple Moving Averages
• A technique that averages a number of
recent actual values, updated as new
values become available.
At-n + … At-2 + At-1
Ft = MAn= n
Example Problems
• EXAMPLE 1
• Compute a three-period moving average forecast, given demand for
shopping carts for the last five periods.

• If actual demand in period 6 turns out to be 38, what would be


the moving average forecast for period 7 would be
Weighted Moving
Averages
• Weighted moving average – More recent
values in a series are given more weight
in computing the forecast. Sum of W’s =
1

Ft = wnAt-n + … wn-1 At-2 + w1At-


WMAn= 1
Example Problems
• EXAMPLE 2
• Given the following demand data,
• Part 1: 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.
• Part 2 If the actual demand for period 6 is 39,
forecast demand for period 7 using the same weights
as in part a.
Exponential Smoothing

Ft = Ft-1 + α (At-1 - Ft-1 )


• Premise--The most recent observations might have
the highest predictive value.
• Therefore, we should give more weight to the more recent
time periods when forecasting.
• Weighted averaging method based on previous
forecast plus a percentage of the forecast error
• A-F is the error term, α is the % feedback
• Value of α should be between 0 and 1
Effect of Smoothing
Constant

0.0 ≤ α ≤ 1.0
If α = 0.20, then Ft +1 = 0.20 Dt + 0.80 Ft

If α = 0, then Ft +1 = 0 Dt + 1 Ft 0 = Ft

Forecast does not reflect recent data


If α = 1, then Ft +1 = 1 Dt + 0 Ft = Dt

Forecast based only on most recent data


Example Problem
• For example, suppose the previous forecast was
42 units, actual demand was 40 units, and α = .
10. What is the new forecast value?

• Then, if the actual demand turns out to be 43,


the next forecast would be
Trend Effect in
Exponential Smoothing
• Upward or downward trend in data collected over a
sequence of one period causes the exponential forecast to
always lag behind.
• Correction requires in exponentially smoothed forecast by
adding trend adjustment
• FITt= Ft + Tt
• Ft = FITt-1 + α (At-1 - FITt-1 )
• Tt = Tt -1 + α δ (At-1 - FITt-1 )
• Ft = The exponentially smoothed forecast for period t
• Tt = The exponentially smoothed trend for period t
• FITt = The forecast including trend for period t
• FITt-1 = The forecast including trend made for prior period
• At-1 = The Actual demand for prior period
• δ = Trend Smoothing Constant Delta
Forecast Accuracy
• Forecast Error
• difference between forecast and actual
demand
• Sources of Error
• Failing to include the right variables
• Using wrong relationship among variables
• Mistakenly shifting the seasonal demand
from where it normally occurs
• Measurement of Error
• Mean Absolute Deviation
• Tracking Signal
Mean Absolute Deviation
(MAD)

Σ | Dt - Ft |
MAD = n
where
t = period number
Dt = demand in period t
Ft = forecast for period t
n = total number of periods
  = absolute value
MAD Example
PERIOD DEMAND, Dt Ft (α =0.3) (Dt - Ft) |Dt - Ft|
1 37 37.00 – –
2 40 37.00 3.00 3.00
3 41 37.90 3.10 3.10
4 37 38.83 -1.83 1.83
5 45 38.28 6.72 6.72
6 50 40.29 9.69 9.69
7 43 43.20 -0.20 0.20
8 47 43.14 3.86 3.86
9 56 44.30 11.70 11.70
10 52 47.81 4.19 4.19
11 55 49.06 5.94 5.94
12 54 50.84 3.15 3.15
557 49.31 53.39
MAD Example

Σ | Dt - Ft |
MAD = n
53.39
=
11
= 4.85
Forecast Control
• Tracking signal
• monitors the forecast to see if it is biased high or low

• MAD = Mean absolute Deviation


• RSEF = running sum of forecast errors, considering
the nature of the error

RSFE
Tracking signal =
MAD
Tracking Signal Values
DEMAND FORECAST, ERROR ∑E = TRACKING
PERIOD Dt Ft Dt - Ft ∑ (Dt - Ft) MAD SIGNAL

1 37 37.00 – – – –
2 40 37.00 3.00 3.00 3.00 1.00
3 41 37.90 3.10 6.10 3.05 2.00
4 37 38.83 -1.83 4.27 2.64 1.62
5 45 38.28 6.72 10.99 3.66 3.00
6 50 40.29 9.69 20.68 4.87 4.25
7 43 43.20 -0.20 20.48 4.09 5.01
8 47 43.14 3.86 24.34 4.06 6.00
9 56 44.30 11.70 36.04 5.01 7.19
10 52 47.81 4.19 40.23 4.92 8.18
11 55 49.06 5.94 46.17 5.02 9.20
12 54 50.84 3.15 49.32 4.85 10.17
Tracking Signal Values

Tracking signal for period 3

6.10
TS3 = = 2.00
3.05
Tracking Signal Plot
3σ –
Tracking signal (MAD)

2σ –
Exponential smoothing (α = 0.30)
1σ –

0σ –

-1σ –

-2σ –

-3σ – Linear trend line

| | | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12
Period
Regression Methods
• Linear regression
• a mathematical technique that relates a dependent
variable to an independent variable in the form of a
linear equation
• Correlation
• a measure of the strength of the relationship
between independent and dependent variables
Linear Regression

y = a + bx a =y - b x
Σ xy -
b =
nxy
where Σ x2 -
a = intercept
nx2
b = slope of the line
Σ x
x = = mean of the x data
n
Σ y
y = n = mean of the y data
Linear Regression Example
x y
(WINS) (ATTENDANCE) xy x2
4 36.3 145.2 16
6 40.1 240.6 36
6 41.2 247.2 36
8 53.0 424.0 64
6 44.0 264.0 36
7 45.6 319.2 49
5 39.0 195.0 25
7 47.5 332.5 49
49 346.7 2167.7 311
Linear Regression Example
(cont.)
49
x= = 6.125
8
346.9
y= = 43.36
8

∑xy - nxy
b=
∑x2 - nx2
(2,167.7) - (8)(6.125)(43.36)
=
(311) - (8)(6.125)2
= 4.06

a = y - bx
= 43.36 - (4.06)(6.125)
= 18.46
Linear Regression Example
(cont.)
Regression equationAttendance forecast for 7 wins
y = 18.46 + y = 18.46 + 4.06(7)
4.06x 60,000 – = 46.88, or 46,880

50,000 –

40,000 –
Attendance, y

30,000 –

20,000 –
Linear regression
10,000 –
line, y = 18.46 +
4.06x

| | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10
Wins, x
Multiple Regression
Study the relationship of demand to two or more independent
variables

y = β 0 + β 1x1 + β 2x2 … + β kxk


where
β 0 = the intercept
β 1, … , β k = parameters for the
independent variables
x1, … , xk = independent variables