What is Forecasting?

Process of predicting a future event Underlying basis of all business decisions

Production Inventory Personnel Facilities

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15-2

Demand Management

Independent Demand: Finished Goods Dependent Demand: Raw Materials, Component parts, Sub-assemblies, etc.
C(2)

B(4)

D(2)

E(1)

D(3)

F(2)

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15-3

Independent Demand: What a firm can do to manage it?

Can take an active role to influence demand

Can take a passive role and simply respond to demand

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Forecasting Time Horizons

Short-range forecast
Up to 1 year, generally less than 3 months Purchasing, job scheduling, workforce levels, job assignments, production levels

Medium-range forecast
3 months to 3 years Sales and production planning, budgeting

Long-range forecast
3+ years New product planning, facility location, research and development

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Distinguishing Differences
Medium/long range forecasts deal with more comprehensive issues and support management decisions regarding planning and products, plants and processes Short-term forecasting usually employs different methodologies than longer-term forecasting Short-term forecasts tend to be more accurate than longer-term forecasts

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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

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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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Simple Moving Average Ft = At

1

+ At

+ At 3+ .. At

n
Ft = Forecast for the coming period At 1 = Actual value in period t 1 n = Number of periods to be averaged At 2, At 3 , At n Actual occurrences two periods ago ,three periods ago and so on up to n periods ago

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Moving Average Example

Month January February March April May June July Actual Shed Sales 10 12 13 16 19 23 26 3-Month Moving Average

(10 + 12 + 13)/3 = 11 2/3 13)/3 (12 + 13 + 16)/3 = 13 2/3 (13 + 16 + 19)/3 = 16 (16 + 19 + 23)/3 = 19 1/3

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Three period Moving Average

If actual demand in period 6 turns out to be 38, the moving average forecast for period 7 would be

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Three Period Moving Average

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Weighted Moving Average

The formula for a weighted moving average Ft = w At 1 + w At 2+ .. + wn At n w = weight to be given to actual occurrence for the period t-1 w = weight to be given to actual occurrence for the period t-2 wn = weight to be given to actual occurrence for the period t-n n =Total Number of Periods in the forecast .
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Weighted Moving Average

Although many periods may be ignored (that is their weights are zero ) and the weighting scheme may be in any order (for e.g. more distant data may have greater weights than more recent data) the sum of all the weights must be equal to 1. Choosing Weights ---Experience and trial and error are the simplest ways to choose weights .As a general rule ,the most recent past is the most important indicator of what to expect in the future and therefore it should get a higher weighting .
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Illustration
Given the following demand data, a) 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. b)If the actual demand for period 6 is 39, forecast demand for period 7 using the same weights as in part a. Period 1 2 3 4 5 Demand 42 40 43 40 41 Solution: --F6 = .10(40) + .20(43) + .30(40) + .40(41) = 41.0 F7 = .10(43) + .20(40) + .30(41) + .40(39) = 40.2
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Moving Average And Weighted Moving Average

30 25 Sales demand 20 15 10 5 | J | F | M | A | M | J | J | A | S | O | N | D Moving average Actual sales Weighted moving average

Exponential Smoothing
Form of weighted moving average Weights decline exponentially Most recent data weighted most Requires smoothing constant (E) Ranges from 0 to 1 Subjectively chosen Involves little record keeping of past data

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Illustration
A department store may find that in a four month period the best forecast is derived using 40percent of the actual sales for the most recent month ,30 percent of two months ago ,20 percent of three month ago and 10 percent of four month ago .If actual sales experience was Month 1 Month2 Month3 Month4 100 90 105 95 ? The forecast for month 5 would be F5=0.40 (95)+0.30(105)+0.20(90)+ .10(100)= =38+31.5+18+10 =97.5
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Exponential dependencies.

Many processes in nature have exponential dependencies .The decay with time of the amplitude of a pendulum swinging in air ,the decrease in time of the temperature of an object that is initially warmer than its surroundings and the growth in time of an initially small bacterial colony are all processes that are well modelled exponential relationships .

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Y=exp(x)
.

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Exponential Smoothing -1

Ft = Ft Ft Ft 1 At 1

(At

- Ft 1)

= Exponentially smoothed forecast for Period t = Exponentially smoothed forecast for Period t-1 = Smoothing constant , = Actual demand in the prior period

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Exponential Smoothing -2
The smoothing constant represents a percentage of the forecast error. Each new forecast is equal to the previous forecast plus a percentage of the previous error. For example, suppose the previous forecast was 42 units, actual demand was 40 units, and = .10. The new forecast would be computed as follows: Ft =42+0.10(40-42)=41.8 Then, if the actual demand turns out to be 43, the next forecast would be Ft = 41.8 +0.10(43-41.8)=41.92
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Illustration
The long run demand for the product under study is relatively stable and a smoothing constant (alpha) of 0.05 is considered appropriate .If the exponential method were used as a continuing policy a forecast would have been made for last month .Assume that last month s forecast Ft 1 was 1050 units .If 1000 actually were demanded rather than 1050 ,what would be the the forecast for this month ? Ft = Ft 1 + (At 1 - Ft 1) =1050+0.05(1000-1050) =1050+0.05(-50) =1047.5 units
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Exponential Smoothing -3

Higher the value of alpha ,the more closely the forecast follows the actual . Single exponential smoothing has the shortcoming of lagging changes in demand . To more closely track actual demand ,a trend factor may be added .Adjusting the value of alpha also helps .

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Impact of Different Alpha

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Forecast Accuracy

Three commonly used measures for summarizing historical errors are; 1. The mean absolute deviation (MAD) 2. The mean squared error (MSE) 3. The mean absolute percent error (MAPE). The formulas used to compute MAD, MSE, and MAPE are as follows:

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Common Measures of Error Mean Absolute Deviation (MAD) MAD)

MAD = |Actual - Forecast| n

Mean Squared Error (MSE) MSE)

MSE = (Forecast Errors)2 Errors) n
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Common Measures of Error

Mean Absolute Percent Error (MAPE) MAPE)

n

100|Actual 100|Actuali - Forecasti|/Actuali MAPE =

i=1

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Measuring Forecast Accuracy

Mean Squared Error (MSE) represents the variance of errors in a forecast. This criterion is most useful if you want to minimize the occurrence of a major error(s).

n n 2 ( A t - F t ) et2 MSE = t = 1 = t =1 n n
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Measuring Forecast Accuracy

Mean Absolute Deviation (MAD) measures the average absolute error of a forecast. A sign of an error, which represents over- or underestimation, is really not important in most cases; we are rather concerned with the value of deviation.
n n t

| A
MAD =
t =1

- Ft | =

| e
t =1

where: At = actual value in period t, Ft = forecasted value in period t, et = forecast error in period t, n = number of periods.
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Accuracy and Control of Forecasts

Forecast error: is the difference between the value that occurs and the value that was predicted for a given time period. Error = Actual Forecast

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Illustration
Compute MAD, MSE, and MAPE for the following data, showing actual and predicted numbers of accounts serviced.

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MAD/MAPE/MSE

MSE =

(e) = 76/8=9.5 n

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