3

Forecasting

McGraw-Hill/Irwin

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives

List the elements of a good forecast.

Outline the steps in the forecasting process.
Describe at least three qualitative
forecasting techniques and the advantages
and disadvantages of each.
Compare and contrast qualitative and
quantitative approaches to forecasting.

3-2

Learning Objectives

Briefly describe averaging techniques, trend

and seasonal techniques, and regression
analysis, and solve typical problems.
Describe two measures of forecast
accuracy.
Describe two ways of evaluating and
controlling forecasts.
Identify the major factors to consider when
choosing a forecasting technique.
3-3

FORECAST:
A statement about the future value of a
variable of interest such as demand.
Forecasting is used to make informed
decisions.
Long-range
Short-range

3-4

Forecasts
Forecasts affect decisions and activities
throughout an organization
Accounting, finance
Human resources
Marketing
MIS
Operations
Product / service design

3-5

Uses of Forecasts
Accounting

Cost/profit estimates

Finance

Cash flow and funding

Human Resources

Hiring/recruiting/training

Marketing

Pricing, promotion, strategy

MIS

IT/IS systems, services

Operations

Schedules, MRP, workloads

Product/service design

New products and services

3-6

Features of Forecasts
Assumes causal system
past ==> future
Forecasts rarely perfect because of
randomness
Forecasts more accurate for
groups vs. individuals

I see that you will

get an A this semester.

Forecast accuracy decreases

as time horizon increases

3-7

Elements of a Good Forecast

Timely

Reliable

Accurate

Written

3-8

Steps in the Forecasting Process

The forecast

Step 6 Monitor the forecast

Step 5 Make the forecast

Step 4 Obtain, clean and analyze data
Step 3 Select a forecasting technique
Step 2 Establish a time horizon
Step 1 Determine purpose of forecast

3-9

Types of Forecasts
Judgmental - uses subjective inputs
Time series - uses historical data
assuming the future will be like the
past
Associative models - uses
explanatory variables to predict the
future

3-10

Judgmental Forecasts
Executive opinions
Sales force opinions
Consumer surveys
Outside opinion

Delphi method
Opinions of managers and staff
Achieves a consensus forecast

3-11

Time Series Forecasts

Trend - long-term movement in data
Seasonality - short-term regular
variations in data
Cycle wavelike variations of more than
one years duration
Irregular variations - caused by unusual
circumstances
Random variations - caused by chance

3-12

Forecast Variations
Figure 3.1
Irregular
variatio
n

Trend

Cycles
90
89
88
Seasonal variations

3-13

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.

3-14

Nave Forecasts

Simple to use
Virtually no cost
Quick and easy to prepare
Data analysis is nonexistent
Easily understandable
Cannot provide high accuracy
Can be a standard for accuracy

3-15

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))

3-16

Techniques for Averaging

Moving average
Weighted moving average
Exponential smoothing

3-17

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
3-18

Simple Moving Average

Actual

MA5

47
45
43
41
39
37

MA3

35
1

Ft = MAn=

10 11 12

At-n + At-2 + At-1

n
3-19

Exponential Smoothing

Ft = Ft-1 + (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.

3-20

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

3-21

Example 3 - Exponential Smoothing

Period

Actual
1
2
3
4
5
6
7
8
9
10
11
12

Alpha = 0.1 Error

42
40
43
40
41
39
46
44
45
38
40

42
41.8
41.92
41.73
41.66
41.39
41.85
42.07
42.36
41.92
41.73

Alpha = 0.4 Error

-2.00
1.20
-1.92
-0.73
-2.66
4.61
2.15
2.93
-4.36
-1.92

42
41.2
41.92
41.15
41.09
40.25
42.55
43.13
43.88
41.53
40.92

-2
1.8
-1.92
-0.15
-2.09
5.75
1.45
1.87
-5.88
-1.53

3-22

Picking a Smoothing Constant

Actual

Demand

50

.4

45

.1

40
35
1

9 10 11 12

Period

3-23

Common Nonlinear Trends

Figure 3.5

Parabolic

Exponential

Growth

3-24

Linear Trend Equation

Ft

Ft = a + bt
0 1 2 3 4 5

Ft = Forecast for period t

t = Specified number of time periods
a = Value of Ft at t = 0
b = Slope of the line

3-25

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

y - b t
a =
n

3-26

Linear Trend Equation Example

t
Week
1
2
3
4
5

t2
1
4
9
16
25

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

y
Sales
150
157
162
166
177

ty
150
314
486
664
885

y = 812 ty = 2499

3-27

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
3-28

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.

3-29

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

3-30

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

10

15

20

25

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

3-31

Linear Regression Assumptions

Variations around the line are random
Deviations around the line normally
distributed
Predictions are being made only within the
range of observed values
For best results:
Always plot the data to verify linearity
Check for data being time-dependent
Small correlation may imply that other variables
are important
3-32

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

3-33

MAD, MSE, and MAPE

MAD

Actual

forecast

n
MSE

( Actual

forecast)

n -1

MAPE =

( Actual

forecas
t
n

/ Actual*100)

3-34

MAD, MSE and MAPE

MAD
Easy to compute
Weights errors linearly

MSE
Squares error
More weight to large errors

MAPE
Puts errors in perspective

3-35

Example 10
Period
1
2
3
4
5
6
7
8

MAD=
MSE=
MAPE=

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

2.75
10.86
1.28

3-36

Controlling the Forecast

Control chart
A visual tool for monitoring forecast errors
Used to detect non-randomness in errors

Forecasting errors are in control if

All errors are within the control limits
No patterns, such as trends or cycles, are
present

3-37

Sources of Forecast errors

Model may be inadequate
Irregular variations
Incorrect use of forecasting technique

3-38

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.

3-39

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
3-40

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

3-41

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)

3-42

Exponential Smoothing

3-43

Linear Trend Equation

3-44

Simple Linear Regression

3-45