DBH3

Forecasts
To make forecasts people uses two kinds of information: (i) Current factors or conditions (ii) Past experience in a similar situation * Forecasts are t e !asis for !ud"etin"# plannin" capacit$# sales# production and in%entor$# personnel# purc asin" and more& * Forecasts pla$ an important role in t e plannin" process !ecause t e$ ena!le a mana"er to anticipate t e future so e can plan accordin"l$& Example: (i) 'ccountin": (ew product cost estimates# profit pro)ections# cas mana"ement etc& (ii) Human resources: Hirin" acti%ities# recruitment# trainin" etc& (iii) *perations: +c edulin"# work assi"nment# in%entor$ plannin" etc& T ere are two uses of forecasts& (i) To elp mana"ers plan t e s$stem (ii) To elp t em plan t e use of t e s$stem& Planning systems involves lon",term plans a!out t e t$pes of products to offer# w at facilities and e-uipments to a%e# w ere to locate etc& Planning the use of systems refers to s ort,term and intermediate,term plannin" w ic in%ol%es plannin" in%entor$ and work force# plannin" purc asin" and production# !ud"etin" and sc edulin"&

Common features to all forecasts

' wide %ariet$ of forecastin" tec ni-ues are in use& .n man$ respects# t e$ are -uite different from eac ot er& But some features are common to all& (i) (ii) (iii) (i%) Forecastin" tec ni-ues "enerall$ assume t at t e same underl$in" casual s$stem t at existed in t e past will continue to exist in t e future& Forecasts are rarel$ perfect/ actual results usuall$ differ from predicted %alues& Forecasts for "roups of items tend to !e more accurate t an forecasts for indi%idual items& Because forecastin" errors amon" items in a "roup usuall$ as a cancellin" effect& Forecast accurac$ decreases as t e time ori0on increases& + ort term forecasts a%e lower uncertainties t an t e lon",term forecasts&

DBH3

Elements of a good forecast

' properl$ prepared forecast s ould fulfill certain re-uirements& T e forecasts s ould !e (i) (ii) (iii) (i%) (%) (%i) timely: T e forecastin" must co%er t e time necessar$ to implement possi!le c an"es& accurate: T is ena!les users to plan for possi!le errors and pro%ides a !asis for comparin" alternati%es reliable: ' tec ni-ue t at sometimes pro%ide "ood forecasts and sometimes poor one lea%es users wit t e uneas$ feelin"s& in meaningful units: Financial planner needs to know ow man$ dollars will !e needed2 +c edulers s ould know w at mac ines and skills will !e re-uired2 in writing: ' written forecast permits an o!)ecti%e !asis for e%aluatin" t e forecast once actual results are in& simple to understand: +imple forecastin" tec ni-ues en)o$ wide spread popularit$ !ecause users are more comforta!le workin" wit t em&

Steps in the forecasting process:

T ere are six !asic steps in t e forecastin" process: (i) Determining the purpose of the forecast: How will it !e used and w en will it !e needed2 .t will pro%ide an indication of t e le%el of detail re-uired in t e forecast and t e le%el of t e accurac$ necessar$& (ii) Establish a time horizon: T e forecasts must indicate a time inter%al# keepin" in mind t at accurac$ decreases as t e time ori0on increases& iii! Select a forecast techni"ue (i%) #ather and analyze relevant data: .t elps in identif$in" an$ assumptions t at are made in con)unction wit preparin" and usin" forecast& v! $a%e the forecast& (%i) $onitor the forecast: .t determines w et er it is performed in a satisfactor$ manner& .f it is not# reexamine t e met od& T ere are two "eneral approac es fore forecastin"& 3it er or !ot approac es mi" t !e used to de%elop forecasts& (i) 'ualitative method: .t in%ol%es su!)ecti%e inputs# numerical description& .t includes soft information ( uman factor# personal opinion etc) in t e forecastin" process& (ii) 'uantitative method: .t in%ol%es eit er t e pro)ection of istorical data or t e de%elopment of associati%e met ods w ic utili0e explanator$ %aria!les to make forecasts& T is met od mainl$ anal$0es data&

DBH3

We classify the forecasting techniques as

(i) (ii) (iii) (i) (ii) (iii) 5ud"mental Time series 'ssociati%e& (udgmental forecast: 5ud"mental forecasts rel$ on anal$sis of su!)ecti%e inputs o!tained from %arious sources suc as opinion from consumer sur%e$s# sales staff# mana"ers and executi%es and experts& )ime series forecasts: Forecasts t at pro)ect patterns identified in recent time series o!ser%ations& .t pro)ect past experience into t e future& *ssociative model: Forecastin" tec ni-ue t at uses explanator$ %aria!les to predict future demand& For example# demand for paint mi" t !e related to %aria!les suc as t e price per "allon and t e amount spent on ad%ertisin" and dr$in" time# ease of cleanup etc&

Forecasts based on (udgment and +pinion

.n some situations# forecasts rel$ solel$ on )ud"ment and opinion& For instances# (i) .f t e mana"ement must a%e a forecast -uickl$# t ere ma$ not !e enou" time to "at er and anal$0e -uantitati%e data& (ii) at anot er time# especiall$ w en political and economic conditions are c an"in"# a%aila!le data ma$ !e out of date and more up,to,date information mi" t not $et !e a%aila!le& .n suc instances forecasts are !ased on executi%e opinions# sales force opinions# consumer sur%e$s# etc& Executive opinions: 6arketin" mana"er# financial mana"er and operations mana"er ma$ meet and collecti%el$ de%elop a forecast& T is approac is used for lon",term plannin" and new product de%elopment& Sales force opinions: T e sales staff or t e customer ser%ice staff is often a "ood source of information !ecause of t eir direct contact wit customers& T e$ are often aware of an$ plans t e customers ma$ !e considerin" for t e future& *ne of t e draw!acks of t is approac is t at t e$ ma$ !e una!le to distin"uis !etween w at customers would like to do and w at t e$ actuall$ will do& Consumer surveys: +ince consumers determine demand# it is !etter to collect information from t em& .f possi!le e%er$ customer or potential customer can !e contacted& Howe%er# it is not all time possi!le to identif$ all t e customer or potential customers& +o# mana"ers often rel$ on sample consumer opinions&

DBH3

Forecasts based on Time series:

' time series is a time,oriented se-uence of o!ser%ations taken at re"ular inter%als ( ourl$# weekl$# dail$# etc)& T e data ma$ !e measurements of demand# earnin"s# profits etc& T ese tec ni-ues are !ased on t e assumption t at future %alues of t e series can !e estimated from t e past %alues& 'nal$sis of time series data can !e accomplis ed !$ plottin" t e data in an$ of t e followin" patterns: (i) )rend: .t refers to a lon",term upward or downward mo%ement in t e data& 3xample: Population s ifts# c an"in" incomes etc&

Trends

(ii) Seasonality: .t refers to s ort,term re"ular %ariations related to calendar or time of a da$& 3xample: 7estaurants# supermarkets experiences weekl$ or dail$ seasonalit$&

+easonalit$ (iii) Cycles: C$cles are wa%elike %ariations lastin" more t an one $ear& 3xample: 3conomic# political and a"ricultural conditions&

C$cles

DBH3 (i%) ,rregular variations: .t caused !$ unusual circumstances# not relati%e of t$pical !e a%ior& T ese need to !e identified and remo%e from t e data&

.rre"ular Trends

(%) -andom variations: 7andom %ariations are residual %ariations t at remains after all ot er !e a%iors a%e !een accounted for& T e small !umps in t e fi"ures are random %ariation&

Approaches involving time series data

.aive $ethods: .t is simple !ut widel$ used met od& T is is t e forecast for an$ period e-uals t e pre%ious period9s actual %alue& For example# if t e demand for a product last week was :; <=s# t e forecast for t is week is :; <=s& T is met od as se%eral ad%anta"es: it as no cost# it is -uick and eas$# and it is easil$ understanda!le& )echni"ues for *veraging: '%era"in" tec ni-ues smoot fluctuations in a time series !ecause t e indi%idual i" s and lows in t e data offset eac ot er w en t e$ are com!ined into an a%era"e& ' forecast !ased on an a%era"e t us tends to ex i!it less %aria!ilit$ t an t e ori"inal data& T e minor %ariations are treated as random %ariation and lar"er %ariations are %iewed as real c an"es& T e followin" t ree tec ni-ues widel$ used for a%era"in"& (i) 6o%in" a%era"e (ii) >ei" ted mo%in" a%era"e (iii) 3xponential smoot in" $oving average: Tec ni-ue t at a%era"es a num!er of recent actual data %alues# updated as new %alues !ecome a%aila!le is known as mo%in" a%era"e forecast& T e mo%in" a%era"e forecast can !e computed usin" t e followin" formula

Ft = MAn =

A
i =1

t i

w ere

i ? 'n index t at corresponds to time period n ? (o& of period in t e mo%in" a%era"e Ai ? 'ctual %alue in period t-i MA ? 6o%in" a%era"e Ft ? Forecast for time period t

DBH3

For example# MA3 implies a t ree,period mo%in" a%era"e forecast# and MA: implies a fi%e,period mo%in" a%era"e forecast& Example: Compute a 3,period mo%in" a%era"e forecast "i%en demand for s oppin" carts for t e last fi%e periods& Period Demand 1 84 4 8; 3 83 8 8; : 81 Solution: i ? 'n index t at corresponds to time period n ?3? (o& of period in t e mo%in" a%era"e Ai ? 'ctual %alue in period t-i MA ? 6o%in" a%era"e Ft ? Forecast for time period t

83 + 8; + 81 = 81&33 3 3 .f t e actual demand in period @ turns out to !e 3A# t e mo%in" a%era"e forecast for
T e mo%in" a%era"e for period @ is#

F@ = MA3 =

A
i =1

t i

period B would !e

FB = MA3 =

A
i =1

t i

& 8; + 81 + 3A = 3C&@B 3

DBH3

50

40 Demand 30 20 0 2 4 Period 6 8 10

' 3 and :,period mo%in" a%era"e forecast a"ainst actual demand for 1; periods& (ote: T e more periods in a mo%in" a%era"e# t e "reater t e forecast will la" c an"es in t e data& * T is tec ni-ue is eas$ to compute and eas$ to understand& * ' possi!le disad%anta"e is t at all %alues in t e a%era"e are wei" ted e-uall$& For example# in a 1;,period mo%in" a%era"e# eac %alue as wei" t of 1D1;& Hence# t e oldest %alue as t e same wei" t as t e most recent %alue& Decreasin" t e num!er of %alues in t e a%era"e increases in wei" t of more recent %alues& Example /: =i%en t e followin" data: Period (o& of complaints 1 @; 4 @: 3 :: 8 :A : @8 (a) Ese nai%e approac to make t e forecast for t e next period& (!) Compute a 3,period mo%in" a%era"e forecast& 0eighted moving average: ' wei" ted a%era"e is similar to t e mo%in" a%era"e# except t at it assi"ns more wei" t to t e most recent %alues in a time series& For example# t e most recent %alue mi" t !e assi"ned a %alue of ;&8# t e next most recent %alue a wei" t of ;&3# t e next after t at a wei" t of ;&4# and t e next after t at a wei" t of ;&1& (ote t at t e sum of t e wei" ts is 1&;& T e wei" ted mo%in" a%era"e can !e computed !$ t e followin" formula
Ft = wn At n + wn 1 At ( n 1) + wn 4 At ( n 4 ) +&&&&&&w4 At 4 + w1 At 1

DBH3 T e ad%anta"e of a wei" ted a%era"e o%er a simple mo%in" a%era"e is t at t e wei" ted a%era"e is more reflecti%e of t e most recent occurrences& Howe%er# t e c oice of t e wei" t is somew at ar!itrar$ and "enerall$ in%ol%es t e use of trial and error to find a suita!le wei" tin" sc eme& Example 1: =i%en t e demand for s Period 1 4 3 8 : oppin" carts for t e last fi%e periods& Demand 84 8; 83 8; 81

(a) Compute a wei" ted mo%in" a%era"e forecast usin" a wei" t of ;&8 for t e most recent period# ;&3 for t e next most recent# ;&4 for t e next# and t e next after t at a wei" t of ;&1& (!) .f t e actual demand for period @ is 3C# forecast demand for period B usin" t e same wei" ts as in part (a)& Solution: a!

Ft = wn At n + wn 1 At ( n 1) + wn 4 At ( n 4 ) +&&&&&&w4 At 4 + w1 At 1 ;&1 * 8; + ;&4 * 83 + ;&3 * 8; + ;&8 * 81 = 81&;

F@ = w8 At 8 + w3 At 3 + w4 At 4 + w1 At 1 =

b!

Ft = wn At n + wn 1 At ( n 1) + wn 4 At ( n 4 ) +&&&&&&w4 At 4 + w1 At 1 FB = w8 At 8 + w3 At 3 + w4 At 4 + w1 At 1 = ;&1 * 83 +;&4 * 8; +;&3 * 81 +;&8 * 3C = 8;&4

Example /: =i%en t e followin" data: Period (o& of complaints 1 @; 4 @: 3 :: 8 :A : @8 (a) Compute a wei" ted mo%in" a%era"e forecast usin" a wei" t of ;&8 for t e most recent period# ;&3 for t e next most recent# ;&4 for t e next# and t e next after t at a wei" t of ;&1& (!) .f t e actual demand for period @ is :C# forecast demand for period B usin" t e same wei" ts as in part (a)& Exponential smoothing:

DBH3 >ei" ted a%era"in" met od !ased on pre%ious forecast plus a percenta"e of t e forecast error& .t is sop isticated wei" ted a%era"e met od t at is still relati%el$ eas$ to use and understand& (ext forecast ? Pre%ious forecast F (actual G pre%ious forecast) T at is# Ft = Ft 1 + ( At 1 Ft 1 ) w ere

? T e smoot in" constant ? I of t e error

At 1 ? 'ctual %alue in t e pre%ious period Ft ? Forecast for time period t Ft 1 ? Forecast for t e pre%ious time period

Commonl$ used %alue of ran"es from ;&;: to ;&:& How %alues are used w en t e a%era"e tends to !e sta!le& Hi" er %alues of are used w en t e a%era"e is not sta!le&

Example 1: =i%en t e followin" data: Period (o& of complaints 1 @; 4 @: 3 :: 8 :A : @8 Ese exponential smoot in" approac wit a smoot in" constant of ;&8 to make t e forecast for t e next period& Solution: Period 1 4 3 8 : @ (o& of complaints @; @: :: :A @8 Forecast Calculations @; is t e initial forecast @; @; F ;&8(@:,@;) ? @4 @4 @4 F ;&8(::,@4) ? :C&4 :C&4 :C&4 F ;&8(:A,:C&4) ? :A&B4 :A&B4 :A&B4 F ;&8(@8,:A&B4) ? @;&A3 @;&A3

DBH3 Example /: =i%en t e demand for s Period 1 4 3 8 : Ese exponential smoot in" approac forecast for t e next period& oppin" carts for t e last fi%e periods& Demand 84 8; 83 8; 81 wit a smoot in" constant of ;&3 to make t e

1;

DBH3 )echni"ues for )rends: 'nal$sis of trends in%ol%es de%elopin" an e-uation t at will suita!l$ descri!e t e trend& .t ma$ !e linear or ma$ not !e& Hinear trends are fairl$ common& T ere are two tec ni-ues t at can !e used to de%elop forecasts w en trend is present& (i) Ese of a trend e-uation (ii) 'n extension of exponential smoot in"& )rend E"uation: ' linear trend e-uation as t e form Ft = a + b t w ere

t ? +pecified no& of time periods from t ? ;

a ? Jalue of

Ft at t ? ;

b ? +lope of t e line
Ft ? Forecast for time period t

Ft = a + bt
a

y b =

y t
t

T e coefficients of t e line a and ! can !e computed from t e istorical data usin" t e formulas:
b= nty t y nt ( t )
4 4

and a =

y bt n

= y bt w ere n is t e num!er of periods

and $ is t e time series&

11

DBH3 Example: Cell p one for a firm o%er t e last 1; weeks are s own as follows& >ould a linear trend line !e appropriate2 Determine t e e-uation of t e trend line and predict sales for weeks 11 and 14& >eek Enit +ales
780 770 760 750 Sales 740 730 720 710 700 690 0 2 4 Weeks 6 8 10

1 B;;

4 B48

3 B4;

8 B4A

: @ B8; B84

B B:A

A B:;
t 1 2 3 4 5 6 7 8 9 10

C BB;
y 700 724 720 728 740 742 758 750 770 775 7407

1; BB:
ty 700 1448 2160 2912 3700 4452 5306 6000 6930 7750 41358

T is plot su""ests t at a linear trend is appropriate& =i%en n = 1;#

b=

t = ::# t
4

= 3A:

nty t y nt ( t )
4

1; 81#3:A :: B#8;B = B&:1 1; 3A: :: ::

a=

y bt = B#8;B B&:1 :: = @CC&8

n 1;

T e trend line is Ft = a + b t = @CC&8 + B&:1t w ere t ? ; for period ;& T e forecast for period 11 is F11 = a + b t = @CC&8 + B&:1 11 = BA4&;1 T e forecast for period 14 is F11 = a + b t = @CC&8 + B&:1 14 = BAC&:4
800 790 780 770 760 Sales 750 740 730 720 710 700 690 -3 2 We e k s 7 12

14

DBH3 Example/: Plot t e followin" data on a "rap and %erif$ %isuall$ t at a linear trend line is appropriate& De%elop a line trend e-uation& T en use t e e-uation to predict t e next two %alues of t e series& Period 1 Demand 88 4 :4 3 :; 8 :8 : :: @ :: B @; A :@ C @4

*ssociative forecasting techni"ues: T e essence of associati%e tec ni-ues is t e de%elopment of an e-uation t at summari0es t e effects of predictor %aria!les (w ic is used to predict %alues of t e %aria!le of interest)& Hinear re"ression met od is used for t is anal$sis& 2inear regression method: Tec ni-ue for fittin" a line to a set of points& T e o!)ecti%e in linear re"ression is to o!tain an e-uation of a strai" t line t at minimi0es t e sum of s-uared %ertical de%iations of data points from t e line& T e least s-uares line as t e e-uation y c = a + bx

x ? predictor or independent %aria!le a ? Jalue of y c at x ? ;

b ? +lope of t e line
y c ? Predicted or dependent %aria!le

yc = a + bx
a

y b =

y x
x

T e line intersect t e $ axis w ere $ ? a& T e slope of t e line is !& T e coefficients of t e line a and ! can !e computed from t e formulas:
b= nxy x y n x ( x )
4 4

and a =

y b x n

= y bx w ere n is t e num!er of

periods and $ is t e time series&

13

DBH3 Example: Healt $ am!ur"er as a c ain of 14 stores in California& +ales fi"ures and profits for t e stores "i%en !elow& *!tain a re"ression line for t e data and predict for a store assumin" sales of K1; million&

Enit sales B x K million Profit $ y ;&1: x K million 7 .15

2 6 4 14 15 16 12 14 20 15 7 0.10 0.13 0.15 0.25 0.27 0.24 0.20 0.27 0.44 0.34 0.17

4 ;&1;

@ ;&13

18

1:

1@ ;&48

14 ;&4

18 ;&4B

4; ;&88

1: ;&3 8

B ;&1B

Forecasts 0.1621124 0.0824612 0.1461822 0.1143217 0.273624 0.2895543 0.3054845 0.2417636 0.273624 0.3692054 0.2895543 0.1621124

&1: &4: ;&4 B

Solution: Step1: Plot t e data and decide if a linear model is reasona!le& Step/: b =
a=

n xy x y n x ( x )
4 4

14 3:4C 134 4B1 = ;&;1:C 14 1BC@ 134 134

14 *!tain t e re"ression y c = ;&;:;@ + ;&;1:C x & For example# for sale of x ? B# estimated profit is y c = ;&;:;@ + ;&;1:C B = ;&1@41148 or K1@4#1148&
y 50 45 40 35 30 25 20 15 10 5 0 0 5 10 15 20 25

y b x = 4B1 ;&;1:C 134 = ;&;:;@

n

18

DBH3 Example: T e owner of a ardware store as noted a sales pattern for window locks t at seems to !e parallel t e num!er of !reak,ins reported eac week in t e newspaper& T e data are: sales 8@ 1A 4; 44 4B 38 18 3B 3; Break,ins 3 3 3 : 8 B 4 @ 8 (a) (!) (c) Plot t e data to see t e t$pe of t e "rap *!tain a re"ression e-uation for t e data& 3stimate sales w en t e num!er of !reak,ins is :&

Comments on the use of linear regression: 1& Jariations around t e line are random& 4& De%iations around t e line s ould !e narrowl$ distri!uted& 3& Predictions are made wit in t e ran"e of t e o!ser%ed %alues& Forecast accuracy: Forecastin" accurac$ is a si"nificant factor w en decidin" amon" forecastin" alternati%es& 'ccurac$ is !ased on t e istorical error performance of a forecast& T ree common met ods for measurin" istorical errors are: A Ft (i) 6ean a!solute de%iation (6'D): '%era"e a!solute error& 6'D ? t n ( At Ft ) 4 (ii) 6ean s-uared error (6+3): '%era"e of s-uared errors& 6+3 ? n 1 (iii) 6ean a!solute percent error (6'P3): '%era"e a!solute percent error& At Ft 1;;I 6'P3 ? At
n 3xample: Compute 6'D# 6+3# and 6'P3 for t e followin" data&

Period 1 4 3 8 : @ B A

'ctual 41B 413 41@ 41; 413 41C 41@ 414

Forecast 41: 41@ 41: 418 411 418 41B 41@

3rror (',F) 4 ,3 1 ,8 4 : ,1 ,8 ,4

Error

Error 4

( Error
;&C4I 1&81 ;&8@ 1&C ;&C8 4&4A ;&8@ 1&AC 1;&4@I

Actual ) 1;;

4 3 1 8 4 : 1 8 44
t

8 C 1 1@ 8 4: 1 1@ B@
= 44 = 4&B: A

(i) 6ean a!solute de%iation (6'D) ?

Ft

1:

DBH3

(ii) 6ean s-uared error (6+3) ?

( A

Ft )

n 1

(iii) 6ean a!solute percent error (6'P3) ?

B@ = 1;&A@ A 1 At Ft 1;;I At 1;&4@I = = 1&4AI n A

Example /: Calculate 6'D# 6+3 and 6'P3 for t e followin" data and compare t em& 6ont 1 4 3 8 : @ Demand 8C4 8B; 8A: 8C3 8CA 8C4 Tec 8AA 8A8 8A; 8C; 8CB 8C3 Forecast ni-ue 1 Tec ni-ue 4 8C: 8A4 8BA 8AA 8C4 8C3

Control forecast3 $onitor forecast: )rac%ing signal method: Trackin" si"nal met od is used to monitor a forecast& T is met od is an older met od w ic is t e ratio of t e cumulati%e forecast error to t e correspondin" %alue of 6'D& Trackin" si"nalt ?

MADt Example: For a!o%e example# ( At Ft ) = 4 = ;&B Trackin" si"nalt ? MADt 4&B:

( A

Ft )

1@