You are on page 1of 69

# CHAPTER

2

Forecasting

What is Forecasting?
FORECAST:
 A statement about the future value of a variable of
interest such as demand.
 Forecasts affect decisions and activities throughout
an organization
 Accounting, finance
 Human resources
 Marketing
 MIS
 Operations
 Product / service design

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

Product/service design New products and services

individuals I see that you will get an A this semester. Common in all forecasts  Assumes causal system past ==> future  Forecasts rarely perfect because of randomness  Forecasts more accurate for groups vs.  Forecast accuracy decreases as time horizon increases .

Elements of a Good Forecast Timely Reliable Accurate Written .

Steps in the Forecasting Process “The forecast” Step 6 Monitor the forecast Step 5 Prepare the forecast Step 4 Gather and analyze data Step 3 Select a forecasting technique Step 2 Establish a time horizon Step 1 Determine purpose of forecast .

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

Judgmental Forecasts  Executive opinions  Sales force opinions  Consumer surveys  Outside opinion .

caused by unusual circumstances  Random variations .caused by chance .long-term movement in data  Seasonality .short-term regular variations in data  Cycle – wavelike variations of more than one year’s duration  Irregular variations . Time Series Forecasts  Trend .

Forecast Variations Irregular variatio n Trend Cycles 90 89 88 Seasonal variations .

. Now.. The forecast for any period equals the previous period’s actual value.. . next week we should sell.. We sold 250 wheels last week.... give me a minute..Naive Forecasts Uh..

Uses for Naive 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)) .

Naive Forecasts  Simple to use  Virtually no cost  Quick and easy to prepare  Easily understandable  Can be a standard for accuracy  Cannot provide high accuracy .

Techniques for Averaging  Moving average  Weighted moving average  Exponential smoothing .

Compute a three-period moving average forecast for demand in week 6. 83 80 85 90 94 . Moving Averages  Moving average – A technique that averages a number of recent actual values. updated as new values become available. n  i=1 Ai MAn = n  The demand for tires in a tire store in the past 5 weeks were as follows.

Moving average & Actual demand .

20 for the next and . .  If the actual demand for week 6 is 91. Moving Averages  Weighted moving average – More recent values in a series are given more weight in computing the forecast. compute a weighted average forecast using a weight of . Example:  For the previous demand data. forecast demand for week 7 using the same weights. .40 for the most recent period. .10 for the next.30 for the next most recent.

we should give more weight to the more recent time periods when forecasting.Ft-1) • The most recent observations might have the highest predictive value. Exponential Smoothing Ft = Ft-1 + (At-1 . .  Therefore.

Ft-1)  Weighted averaging method based on previous forecast plus a percentage of the forecast error  A-F is the error term. Exponential Smoothing Ft = Ft-1 + (At-1 .  is the % feedback .

16 8 90 86.07 83.60 90.84 0.44 89.92 1.70 2.35 .54 8.20 4 89 82.68 91.00 83 -3 3 85 82.90 9 88 86.93 7 91 85.4 Error 1 83 2 80 83 -3.08 12 87.54 -2.20 4.07 6.45 6.46 85.56 90.56 6.00 90.1 Error 0.40 1.55 6 95 84.08 5.93 6.92 5 92 83.80 90.62 88.80 3.Example .Exponential Smoothing Period Actual 0.44 5.53 3.90 -0.30 81.54 10 93 86.38 10.00 4.47 11 92 87.

Picking a Smoothing Constant Exponential Smoothing Actual Alpha=0.40 100 95 90 Demand 85 80 75 70 2 3 4 5 6 7 8 9 10 11 Period .10 Alpha=0.

30 for July.10 for June. .60 for August.20. Aug 20 . Problem 1  National Mixer Inc. Jun 18  The naive approach Jul 22  A weighted average using . Monthly sales for a seven-month period were as follows: Month Sales  Forecast September sales volume using (1000) each of the following: Feb 19  A five-month moving average Mar 18  Exponential smoothing with a smoothing Apr 15 constant equal to . and . assuming a March May 20 forecast of 19. sells can openers.

Problem 2  A dry cleaner uses exponential smoothing to forecast equipment usage at its main plant. A smoothing constant of 0. prepare a forecast of October usage .6%. August usage was forecast to be 88% of capacity. Actual usage was 89.  Prepare a forecast for September  Assuming actual September usage of 92%.1 is used.

30. . Use 20 for week 2 forecast. Problem 3 An electrical contractor’s records during the last five weeks indicate the number of job requests: Week: 1 2 3 4 5 Requests: 20 22 18 21 22 Predict the number of requests for week 6 using each of these methods:  Naïve  A four-period moving average  Exponential smoothing with a smoothing constant of .

individuals  Forecast accuracy decreases as time horizon increases . Review: forecast  Assumes causal system past ==> future  Forecasts rarely perfect because of randomness  Forecasts more accurate for groups vs.

Review: forecast  Naïve technique  Stable time series data  Seasonal variations  Data with trends  Averaging  Moving average  Weighted moving average  Exponential smoothing .

when trend is present. • The trend component may be linear or nonlinear • We focus on linear trends . Techniques for Trend • Develop an equation that will suitably describe trend.

Common Nonlinear Trends Parabolic Exponential Growth .

Interpret 10 and 2. Linear Trend Equation Ft Ft = a + bt  Ft = Forecast for period t 0 1 2 3 4 5 t  t = Specified number of time periods  a = Value of Ft at t = 0  b = Slope of the line  Example: Ft =10+2t. Plot F .

Example  Sales for over the last 5 weeks are shown below: Week: 1 2 3 4 5 Sales: 150 157 162 166 177  Plot the data and visually check to see if a linear trend line is appropriate.  Determine the equation of the trend line  Predict sales for weeks 6 and 7. .

Line chart Sales 180 175 170 165 160 Sales Sales 155 150 145 140 135 1 2 3 4 5 Week .

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

Linear Trend Equation Example t y 2 Week t Sales ty 1 1 150 150 2 4 157 314 3 9 162 486 4 16 166 664 5 25 177 885  t = 15 t = 55  y = 812  ty = 2499 2 (t)2 = 225 .

3 5(55) . Linear Trend Calculation 5 (2499) .5 + 6.3(15) a = = 143.15(812) 12495-12180 b = = = 6.6.225 275 -225 812 .3t .5 5 y = 143.

Linear Trend plot Actual data Linear equation 180 175 170 165 160 155 150 145 140 135 1 2 3 4 5 .

Monthly sales for a seven-month period were as follows: Month Sales (1000)  Plot the monthly data Feb 19 Mar 18  Forecast September sales volume using Apr 15 a line trend equation May 20  Which method of forecast seems least Jun 18 appropriate? Jul 22  What does use of the term sales rather Aug 20 than demand presume? . sells can openers. Recall: Problem 1  National Mixer Inc.

Line chart Sales 20 0 F M A M J J Month A S .

. Problem 4  A cosmetics manufacturer’s marketing department has developed a linear trend equation that can be used to predict annual sales of its popular Hand & Foot Cream: Ft  80  15t where Ft  Annual sales (1000 bottles) t  0 corresponds to 1990  Are annual sales increasing or decreasing? By how much?  Predict annual sales for the year 2006 using the equation.

g.10). which is used to multiply the value of a series to incorporate seasonality.. There are two models:  Additive: expressed as a quantity (e. 20 units). which is added or subtracted from the series average  Multiplicative: a percentage of the average or seasonal relative (e..g. 1. . Techniques for Seasonality  Seasonality may refer to regular annual variation.

10. Q2  1.20. Example  A furniture manufacturer wants to predict quarterly demand for a certain loveseat for periods 15 and 16. Q3  0.5t  Quarter relatives are Q1  1. which happen to be the second and third quarters of a particular year. Q4  0.75. . The trend portion of demand is projected using the equation Ft  124  7. The series consists of both trend and seasonality.95  Use this information to predict demand for periods 15 and 16.

Problem  A manager is using the equation below to forecast quarterly demand for a product: Y(t) = 6.6.9.2.000 + 80t where t = 0 at Q2 of last year  Quarter relatives are Q1 = .3. Q3 = 1. and Q4 = 1. Q2 = .  What forecasts are appropriate for the last quarter of this year and the first quarter of next year? .

and .10 for Jan. She uses the following equation to estimate the trend component of monthly demand: Ft  70  5t Where t=0 is June of 2005. 1. Problem  A manager of store that sells and installs hot tubs wants to prepare a forecast for January.02 for Feb. Her forecasts are a combination of trend and seasonality. Seasonal relatives are 1. What demands should she predict? .95 for March. February and March of 2007.

Computing seasonal relatives 120 100 80 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 If your data appears to have seasonality. how do you compute the seasonal relatives? .

 Obtain the ratio of the actual value of the period over the centered moving average. Computing seasonal relatives  Calculate centered moving average for each period.  Number of periods needed in a centered moving average = Number of seasons involved:  Monthly data: a 12-period moving average  Quarterly data: a 4-period moving average .

calculate the seasonal relatives.  Note that a seven period centered moving average is used because there are seven days (seasons) per week. Example  The manager of a parking lot has computed the number of cars per day in the lot for three weeks. See seasonal relatives1. Using a seven-period centered moving average.xls .

Problem 5  Obtain estimates of quarter relatives for these data: Year: 1 2 3 4 Quarter: 1 2 3 4 1 2 3 4 1 2 3 4 1 Demand: 14 18 35 46 28 36 60 71 45 54 84 88 58 .

Problem  The manager of a restaurant believes that her restaurant does about 10% of its business on Sunday through Wednesday. and 20% on Saturday night. 25% on Friday night.  What seasonal relatives would describe this situation? . 15% on Thursday night.

Note:  An alternative to deal with seasonality is to deseasonalize data. .  Deseasonalize = Remove seasonal component from data  Gives clearer picture of the trend (nonseasonal component)  Deseasonalize can be done by dividing each data point by its seasonal relative.

uses subjective inputs  Time series . Forecasts: review  Judgmental .uses explanatory variables to predict the future .uses historical data assuming the future will be like the past  Naïve approach  Averaging  Techniques for trend  Trend and seasonality  Associative models .

Associative Forecasting  Predictor variables .minimizes sum of squared deviations around the line .used to predict values of variable interest  Regression .technique for fitting a line to a set of points  Least squares line .

This First-Year AppleGlo Advertising First-Year new product has been introduced into 14 sales Expenditures Sales regions over the last two years.8 33 .2 77 The company would like to predict what the Pennsylvania 1.0 52 Ohio 0.5 43 AppleGlo into two new regions. The (\$ millions) (\$ millions) Advertising expenditure vs.6 102 Delaware 1. West Virginia 0.2 68 Vermont 0.0 and \$1.7 46 Virginia 1. LINEAR REGRESSION Suppose that J&T has a new product called “AppleGlo”. which is a household cleaner. New Jersey 1. the first year sales Region x y are shown in the table for each region. with the Connecticut 2.5 134 New York 1. Maine 1.8 104 New Hampshire 1.5 101 be in each region.5 Rhode Island 2.5 127 advertising campaign of \$2.4 39 The company is considering introducing Massachusetts 0.5 87 million.0 65 expected first year sales of AppleGlo would Maryland 1.

5 1 1.5 Advertising Expenditures (\$Millions) Questions: • How to relate advertising to sales? • What is expected first-year sales if advertising expenditure is \$1M? • How confident are you in the estimate? How good is the fit? . LINEAR REGRESSION 160 140 120 (\$Millions) 100 Sales 80 60 40 20 0 0 0.5 2 2.

0 to . Correlation The correlation coefficient is a quantitative measure of the strength of the linear relationship between two variables. whereas a correlation of 0 indicates no linear relationship.0 indicates a perfect linear relationship.0. A correlation of  1.1. The correlation ranges from + 1. .

An algebraic formula for correlation coefficient n xy   x y r [n( x )  ( x) ][n( y )  ( y) ] 2 2 2 2 .

y  a  bx where: y = Value of the dependent variable x = Value of the independent variable a = Population’s y-intercept b = Slope of the population regression line . Simple Linear Regression Simple linear regression analysis analyzes the linear relationship that exists between two variables.

Simple Linear Regression The coefficients of the line are n xy   x y b n x  ( x ) 2 2 a  y  b x or n a  y  bx .

Problem 7

 The manager of a seafood restaurant was Sold (y) Price (x)
asked to establish a pricing policy on 200 6.00
lobster dinners. Experimenting with 190 6.50
prices produced the following data: 188 6.75
180 7.00
 Create the scatter plot and determine if 170 7.25
a linear relationship is appropriate.
162 7.50
160 8.00
 Determine the correlation coefficient
and interpret it 155 8.25
156 8.50
 Obtain the regression line and interpret 148 8.75
its coefficients. 140 9.00
133 9.25

Forecast Accuracy
 Source of forecast errors:
 Irregular variations
 Incorrect use of forecasting technique
 Random variation

 Key to validity is randomness
 Accurate models: random errors
 Invalid models: nonrandom errors

 Key question: How to determine if forecasting
errors are random?

Error measures

 Error - difference between actual value and predicted
value
 Average absolute error
 Mean Squared Error (MSE)
 Average of squared error
 Mean Absolute Percent Error (MAPE)
 Average absolute percent error

and MAPE  Actual  forecast MAD = n 2  ( Actual  forecast) MSE = n -1 Actual  Forecast  Actual  100 MAPE  n . MAD. MSE.

86 MAPE= 1.28 .46 8 212 216 -4 4 16 1.89 -2 22 76 10.75 MSE= 10.41 3 216 215 1 1 1 0.90 5 213 211 2 2 4 0.94 6 219 214 5 5 25 2. Example Period Actual Forecast (A-F) |A-F| (A-F)^2 (|A-F|/Actual)*100 1 217 215 2 2 4 0.28 7 216 217 -1 1 1 0.92 2 213 216 -3 3 9 1.46 4 210 214 -4 4 16 1.26 MAD= 2.

such as trends or cycles. are present . 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.

Controlling the forecast .

Control charts  Control charts are based on the following assumptions:  when errors are random. they are Normally distributed around a mean of zero.5% of data in a normal distribution is within 2 standard deviation of the mean  99.7% of data in a normal distribution is within 3 standard deviation of the mean  Upper and lower control limits are often determine via 0  2 MSE or 0  3 MSE .  Standard deviation of error is MSE  95.

295 3.41 -0.41 s  MSE  3.59 and +6. Example  Compute 2s control limits for forecast errors of previous example and determine if the forecast is accurate.59 0 10  Errors are all between -6. forecast is reliable .59  Therefore. 5.41 2s  6.59 1.59 -2.59 -4. according to control chart criterion.59  No pattern is observed -6.

then evaluate the 11 98 94 remaining data with the control chart. Use data from the first 8 periods to develop 10 1 49 1 50 the control chart. The actual and 3 1 56 1 50 predicted values are 4 91 94 5 85 80 6 1 32 1 40  Compute MAD. 12 85 80 13 1 37 1 40 14 1 34 1 28 . MSE. Problem 8 Period Demand Predicted  The manager of a travel agency has been using a seasonally adjusted 1 1 29 1 24 forecast to predict demand for 2 1 94 200 packaged tours. 7 1 26 1 28 8 1 26 1 24  Determine if the forecast is working 9 95 1 00 using a control chart with 2s limits. and MAPE.

If demand in the next two periods turns out to be 125 and 130. can you conclude that the forecasts are in control? Period 1 2 3 4 5 6 7 8 9 10 Demand 118 117 120 119 126 122 117 123 121 124 . Then determine each forecast error. prepare a naïve forecast for periods 2 through 10. and use those values to obtain 2s control limits. Problem  Given the following demand data.

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 .