Chapter 3

Forecasting

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Chapter 3: Learning Objectives

You should be able to:
List the elements of a good forecast Outline the steps in the forecasting process Describe qualitative forecasting techniques and their advantages and disadvantages Compare and contrast qualitative and quantitative approaches to forecasting Briefly describe averaging techniques, trend and seasonal techniques, and regression analysis, and solve typical problems Describe three measures of forecast accuracy Describe two ways of evaluating and controlling forecasts Identify the major factors to consider when choosing a forecasting technique
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Forecast
Forecast a statement about the future value of a variable of interest
We make forecasts about such things as weather, demand, and resource availability Forecasts are an important element in making informed decisions

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An Important Input to Decision Making

The primary goal operations and supply chain management is to match supply to demand
A demand forecast is essential for determining how much supply will be needed to match demand:
Budget preparation Capacity decisions (e.g., staff and equipment) Purchasing decisions

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Forecast Uses
Plan the system
Generally involves long-range plans related to: Types of products and services to offer Facility and equipment levels Facility location

Plan the use of the system

Generally involves short- and medium-range plans related to: Inventory management Workforce levels Purchasing Budgeting

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Elements of a Good Forecast

The forecast should be timely should be accurate should be reliable should be expressed in meaningful units should be in writing technique should be simple to understand and use should be cost effective

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Steps in the Forecasting Process

1. 2. 3. 4. 5. 6. Determine the purpose of the forecast Establish a time horizon Select a forecasting technique Obtain, clean, and analyze appropriate data Make the forecast Monitor the forecast

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Forecasting Approaches
Qualitative Forecasting Qualitative techniques permit the inclusion of soft information such as: Human factors Personal opinions Hunches These factors are difficult, or impossible, to quantify Quantitative Forecasting Quantitative techniques involve either the projection of historical data or the development of associative methods that attempt to use causal variables to make a forecast These techniques rely on hard data

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Judgemental Forecasting
Executive opinions Sales force opinion Consumer surveys Other approaches Delphi method

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Time-Series Behaviors

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Uses of Forecasts
Accounting Finance Cost/profit estimates Cash flow and funding

Human Resources Marketing

Operations Product/service design

Hiring/recruiting/training Pricing, promotion, strategy

Schedules, MRP, workloads New products and services

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Features of Forecasts
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
I see that you will get an A this semester.

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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 periods actual value.

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Nave Forecasts
Simple to use Quick and easy to prepare Easily understandable Cannot provide high accuracy

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Uses for Nave 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))

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Techniques for Averaging

Moving average Weighted moving average Exponential smoothing

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Muffins 30 34 32

Cinemon buns 18 17 19

Cupcakes 45 26 27

34
35 30 34 36 29 31

19
22 23 23 25 24 26

23
22 48 29 20 14 18

35
31 37 34 33

27
28 29 31 33

47
26 27 24 22
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Moving Averages
Moving average A technique that averages a number of recent actual values, updated as new values become available.

Ft = MAn=

At-n + At-2 + At-1 n

Weighted moving average More recent values in a series are given more weight in computing the forecast.

Ft = WMAn=

wnAt-n + wn-1At-2 + w1At-1

n
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Simple Moving Average

Actual
47 45 43 41 39 37 35 1 2 3 4 5 6 7 8 9 10 11 12

MA5

MA3

Ft = MAn=

At-n + At-2 + At-1

n
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Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

month Feb Mar Sales (000) 19 18 Apr 15 Premise--The most recent observations might have the highest predictive value. May 20

Therefore, we should give more weight to the more June 18 recent time periods when forecasting.
Jul aug 22 20

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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

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Picking a Smoothing Constant

50
Demand

Actu al

.4

45 40 35 1 2 3 4 5 6 7 8

.1

9 10 11 12

Period

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Linear Trend Equation

Ft

Ft = a + bt
Ft = Forecast for period t t = Specified number of time periods a = Value of Ft at t = 0 b = Slope of the line
0 1 2 3 4 5 t

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Calculating a and b
n (ty) - t y b = 2 - ( t) 2 n t

y - b t a = n

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Linear Trend Equation Example

t Week 1 2 3 4 5 t2 1 4 9 16 25 y Sales 150 157 162 166 177 ty 150 314 486 664 885

t = 15 t2 = 55 2 ( t) = 225

y = 812 ty = 2499

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Linear Trend Calculation

b = 5 (2499) - 15(812) 5(55) - 225 = 12495 -12180 275 -225 = 6.3

812 - 6.3(15) a = = 143.5 5

y = 143.5 + 6.3t
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Techniques for Seasonality

Seasonal variations
Regularly repeating movements in series values that can be tied to recurring events.

Seasonal relative
Percentage of average or trend

Centered moving average

A moving average positioned at the center of the data that were used to compute it.

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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

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Linear Model Seems Reasonable

X 7 2 6 4 14 15 16 12 14 20 15 7 Y 15 10 13 15 25 27 24 20 27 44 34 17

Computed relationship
50 40 30 20 10 0 0 5 10 15 20 25

A straight line is fitted to a set of sample points.

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Forecast Accuracy
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

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MAD, MSE, and MAPE

MAD = Actual forecast

n
MSE = ( Actual forecast)
2

n -1
( Actual forecast n
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MAPE =

/ Actual*100)

MAD, MSE and MAPE

MAD
Easy to compute Weights errors linearly

MSE
Squares error More weight to large errors

MAPE
Puts errors in perspective

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Example 10
Period 1 2 3 4 5 6 7 8 Actual 217 213 216 210 213 219 216 212 Forecast 215 216 215 214 211 214 217 216 (A-F) 2 -3 1 -4 2 5 -1 -4 -2 |A-F| 2 3 1 4 2 5 1 4 22 (A-F)^2 4 9 1 16 4 25 1 16 76 (|A-F|/Actual)*100 0.92 1.41 0.46 1.90 0.94 2.28 0.46 1.89 10.26

MAD= MSE= MAPE=

2.75 10.86 1.28

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Controlling the Forecast

Control chart
A visual tool for monitoring forecast errors Forecasting errors are in control if All errors are within the control limits No patterns, such as trends or cycles, are present

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Sources of Forecast errors

Model may be inadequate Irregular variations Incorrect use of forecasting technique

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Tracking Signal
Tracking signal
Ratio of cumulative error to MAD

(Actual -forecast) Tracking signal =

MAD
Bias Persistent tendency for forecasts to be Greater or less than actual values.

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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

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Operations Strategy
Forecasts are the basis for many decisions Work to improve short-term forecasts Accurate short-term forecasts improve
Profits Lower inventory levels Reduce inventory shortages Improve customer service levels Enhance forecasting credibility

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Supply Chain Forecasts

Sharing forecasts with supply can
Improve forecast quality in the supply chain Lower costs Shorter lead times

Gazing at the Crystal Ball (reading in text)

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Exponential Smoothing

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Linear Trend Equation

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Simple Linear Regression

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Time-Series Forecasting - Averaging

These Techniques work best when a series tends to vary about an average
Averaging techniques smooth variations in the data They can handle step changes or gradual changes in the level of a series Techniques
Moving average Weighted moving average Exponential smoothing

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Simple Linear Regression

Regression - a technique for fitting a line to a set of data points
Simple linear regression - the simplest form of regression that involves a linear relationship between two variables
The object of simple linear regression is to obtain an equation of a straight line that minimizes the sum of squared vertical deviations from the line (i.e., the least squares criterion)

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Monitoring the Forecast

Tracking forecast errors and analyzing them can provide useful insight into whether forecasts are performing satisfactorily Sources of forecast errors
The model may be inadequate Irregular variations may have occurred The forecasting technique has been incorrectly applied Random error

Control charts are useful for identifying the presence of nonrandom error in forecasts Tracking signals can be used to detect forecast bias

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Choosing a Forecasting Technique

Factors to consider
Cost Accuracy Availability of historical data Availability of forecasting software Time needed to gather and analyze data and prepare a forecast Forecast horizon

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Using Forecast Information

Reactive approach
View forecasts as probable future demand React to meet that demand

Proactive approach
Seeks to actively influence demand Advertising Pricing Product/service modifications Generally requires either and explanatory model or a subjective assessment of the influence on demand

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Operations Strategy
The better forecasts are, the more able organizations will be to take advantage of future opportunities and reduce potential risks
A worthwhile strategy is to work to improve short-term forecasts Accurate up-to-date information can have a significant effect on forecast accuracy:
Prices Demand Other important variables

Reduce the time horizon forecasts have to cover Sharing forecasts or demand data through the supply chain can improve forecast quality

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