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# FORECASTING FUNDAMENTALS

## Forecast: A prediction, projection, or estimate of some future activity, event, or

occurrence.
Types of Forecasts
- Economic forecasts
o Predict a variety of economic indicators, like money supply, inflation
rates, interest rates, etc.
- Technological forecasts
o Predict rates of technological progress and innovation.
- Demand forecasts
o Predict the future demand for a companys products or services.
Since virtually all the operations management decisions (in both the strategic
category and the tactical category) require as input a good estimate of future
demand, this is the type of forecasting that is emphasized in our textbook and in
this course.
TYPES OF FORECASTING METHODS
Qualitative methods: These types of forecasting methods are based on judgments,
opinions, intuition, emotions, or personal experiences and are subjective in nature.
They do not rely on any rigorous mathematical computations.
Quantitative methods: These types of forecasting methods are based on
mathematical (quantitative) models, and are objective in nature. They rely heavily
on mathematical computations.

Model

Description

Nave

## Uses an average of a specified number of the most

recent observations, with each observation receiving the
same emphasis (weight)

## Uses an average of a specified number of the most

recent observations, with each observation receiving a
different emphasis (weight)

Exponential Smoothing

## A weighted average procedure with weights declining

exponentially as data become older

Trend Projection

## Technique that uses the least squares method to fit a

straight line to the data

Seasonal Indexes

## A mechanism for adjusting the forecast to accommodate

any seasonal patterns inherent in the data

## DECOMPOSITION OF A TIME SERIES

Patterns that may be present in a time series
Trend: Data exhibit a steady growth or decline over time.
Seasonality: Data exhibit upward and downward swings in a short to intermediate time frame
(most notably during a year).
Cycles: Data exhibit upward and downward swings in over a very long time frame.
Random variations: Erratic and unpredictable variation in the data over time with no
discernable pattern.

## EXPONENTIAL SMOOTHING METHOD

Exponential smoothing method: The new forecast for next period (period t) will be calculated
as follows:
New forecast = Last periods forecast + (Last periods actual demand Last periods forecast)
(this box contains all you need to know to apply exponential smoothing)
Ft = Ft-1 + (At-1 Ft-1) (equation 1)
Ft = At-1 + (1-)Ft-1

## Where is a smoothing coefficient whose value is between 0 and 1.

The exponential smoothing method only requires that you dig up two pieces of data to apply it
(the most recent actual demand and the most recent forecast).
An attractive feature of this method is that forecasts made with this model will include a portion
of every piece of historical demand. Furthermore, there will be different weights placed on these
historical demand values, with older data receiving lower weights. At first glance this may not be
obvious, however, this property is illustrated on the following page.
Mean Absolute Deviation (MAD): To eliminate the problem of positive errors canceling
negative errors, a simple measure is one that looks at the absolute value of the error (size of the
deviation, regardless of sign). When we disregard the sign and only consider the size of the error,
we refer to this deviation as the absolute deviation. If we accumulate these absolute deviations
over time and find the average value of these absolute deviations, we refer to this measure as the
mean absolute deviation (MAD). For our hypothetical two forecasting methods, the absolute
deviations can be calculated for each year and an average can be obtained for these yearly
absolute deviations, as follows
Mean Squared Error (MSE): Another way to eliminate the problem of positive errors
canceling negative errors is to square the forecast error. Regardless of whether the forecast error
has a positive or negative sign, the squared error will always have a positive sign. If we
accumulate these squared errors over time and find the average value of these squared errors, we
refer to this measure as the mean squared error (MSE). For our hypothetical two forecasting
methods, the squared errors can be calculated for each year and an average can be obtained for
these yearly squared errors, as follows:

Mean Absolute Percent Error (MAPE): A problem with both the MAD and MSE is that their
values depend on the magnitude of the item being forecast. If the forecast item is measured in
thousands or millions, the MAD and MSE values can be very large. To avoid this problem, we

can use the MAPE. MAPE is computed as the average of the absolute difference between the
forecasted and actual values, expressed as a percentage of the actual values. In essence, we look
at how large the miss was relative to the size of the actual value. For our hypothetical two
forecasting methods, the absolute percentage error can be calculated for each year and an
average can be obtained for these yearly values, yielding the MAPE, as follows