AMBO UNIVERSITY INISTITUTE OF

TECHNOLOGY

Industrial Management & Engineering Economy

(IEng 5241)

FOR
DEPARTMENT OF MECHANICAL ENGINEERING
5th Year
By Begna Ch.
1
Chapter Two

Forecasting

2
Outline

 What is forecasting?
 Types of forecasts
 Time-Series forecasting
 Naïve
 Moving Average
 Exponential Smoothing
 Regression
 Good forecasts

3
Forecasting

 Predict the next number in the pattern:

a) 3.7, 3.7, 3.7, 3.7, 3.7, ?

b) 2.5, 4.5, 6.5, 8.5, 10.5, ?

c) 5.0, 7.5, 6.0, 4.5, 7.0, 9.5, 8.0, 6.5, ?

4
Forecasting

 Predict the next number in the pattern:

a) 3.7, 3.7, 3.7, 3.7, 3.7, 3.7

b) 2.5, 4.5, 6.5, 8.5, 10.5, 12.5

c) 5.0, 7.5, 6.0, 4.5, 7.0, 9.5, 8.0, 6.5, 9.0

5
 What is Forecasting?

 Process of predicting a future event based on

historical data
 Educated Guessing
 Underlying basis of all business decisions
 Production
 Inventory
 Personnel
 Facilities

6
 Why do we need to forecast?

 In general, forecasts are almost always wrong. So,

 Throughout the day we forecast very different
things such as weather, traffic, stock market,
state of our company from different
perspectives.
 Virtually every business attempt is based on
forecasting. Not all of them are derived from
sophisticated methods. However, “Best"
educated guesses about future are more
valuable for purpose of Planning than no
forecasts and hence no planning. 7
Importance of Forecasting in OM
 Departments throughout the organization depend
on forecasts to formulate and execute their plans.

 Finance needs forecasts to project cash flows

and capital requirements.

 Human resources need forecasts to anticipate

hiring needs.

 Production needs forecasts to plan production

levels, workforce, material requirements,
inventories, etc. 8
Importance of Forecasting in OM

 Demand is not the only variable of interest to

forecasters.

 Manufacturers also forecast worker

absenteeism, machine availability, material
costs, transportation and production lead times,
etc.

 Besides demand, service providers are also

interested in forecasts of population, of other
demographic variables, of weather, etc. 9
Types of Forecasts by Time Horizon
Quantitative
 Short-range forecast methods

 Usually < 3 months

 Job scheduling, worker assignments Detailed
use of
 Medium-range forecast system

 3 months to 2 years
 Sales/production planning

 Long-range forecast
 > 2 years Design
of system
 New product planning Qualitative
10

Methods
Qualitative Forecasting Methods

Qualitative
Forecasting

Models
Sales Delphi
Executive Market
Force Method
Judgement Research/
Composite
Survey

Smoothing

11
 Qualitative Methods

Briefly, the qualitative methods are:

 Executive Judgment: Opinion of a group of high level experts or

managers is pooled

 Sales Force Composite: Each regional salesperson provides

his/her sales estimates. Those forecasts are then reviewed to
make sure they are realistic. All regional forecasts are then pooled
at the district and national levels to obtain an overall forecast.

 Market Research/Survey: Solicits input from customers pertaining

to their future purchasing plans. It involves the use of
questionnaires, consumer panels and tests of new products and
services.

12

.
 Qualitative Methods
 Delphi Method: As opposed to regular panels where the
individuals involved are in direct communication, this method
eliminates the effects of group potential dominance of the most
vocal members. The group involves individuals from inside as well
as outside the organization.

Typically, the procedure consists of the following steps:

 Each expert in the group makes his/her own forecasts in form
of statements
 The coordinator collects all group statements and summarizes
them
 The coordinator provides this summary and gives another set
of questions to each group member including feedback as to
the input of other experts.
 The above steps are repeated until a consensus is reached.
13
.
Quantitative Forecasting Methods

Quantitative
Forecasting

Time Series Regression

Models Models

2. Moving 3. Exponential
1. Naive
Average Smoothing
a) simple a) level
b) weighted b) trend
c) seasonality
14
Quantitative Forecasting Methods

Quantitative
Forecasting

Time Series Regression

Models Models

2. Moving 3. Exponential
1. Naive
Average Smoothing
a) simple a) level
b) weighted b) trend
c) seasonality
15
Time Series Models

 Try to predict the future based on past

data

 Assume that factors influencing the past will

continue to influence the future

16
Time Series Models: Components

Random Trend

Seasonal Composite

17
Product Demand over Time
Trend component
Seasonal peaks
Demand for product or service

Actual
Random demand line
variation
Year Year Year Year
1 2 3 4
18
Now let’s look at some time series approaches to forecasting…
Quantitative Forecasting Methods

Quantitative
Time Series
Models

Models

2. Moving 3. Exponential
1. Naive
Average Smoothing
a) simple a) level
b) weighted b) trend
c) seasonality

19
1. Naive Approach

 Demand in next period is the same as

demand in most recent period
 May sales = 48 → June forecast = 48

 Usually not good

20
2a. Simple Moving Average

 Assumes an average is a good estimator of

future behavior
 Used if little or no trend
 Used for smoothing

A t + A t -1 + A t -2 + ... + A t -n 1
Ft 1 =
n

Ft+1 = Forecast for the upcoming period, t+1

n = Number of periods to be averaged
At = Actual occurrence in period t
21
 A t + A t -1 + A t -2 + ... + A t -n 1
Ft 1 =
n
2a. Simple Moving Average
You’re manager in Amazon’s electronics
department. You want to forecast ipod sales for
months 4-6 using a 3-period moving average.
Sales
Month (000)
1 4
2 6
3 5
4 ?
5 ?
6 ?
22
 A t + A t -1 + A t -2 + ... + A t -n 1
Ft 1 =
n
2a. Simple Moving Average
You’re manager in Amazon’s electronics
department. You want to forecast ipod sales for
months 4-6 using a 3-period moving average.
Sales Moving Average
Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 ? (4+6+5)/3=5
5 ?
6 ?
23
2a. Simple Moving Average

What if ipod sales were actually 3 in month 4

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3? 5
5 ?
6 ? 24
2a. Simple Moving Average

Forecast for Month 5?

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3 5
5 ? (6+5+3)/3=4.667
6 ? 25
2a. Simple Moving Average

Actual Demand for Month 5 = 7

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3 5
5 ?7 4.667
6 ? 26
2a. Simple Moving Average

Forecast for Month 6?

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3 5
5 7 4.667
6 ? (5+3+7)/3=5 27
2b. Weighted Moving Average
Gives more emphasis to recent data
Ft 1 = w1At + w 2At -1 + w3At -2 + ... + w n At -n 1

Weights
decrease for older data
sum to 1.0 Simple moving
average models
weight all previous
periods equally
28
 Ft 1 = w1At + w 2At -1 + w3At -2 + ... + w n At -n 1
2b. Weighted Moving Average: 3/6, 2/6, 1/6

Month Sales Weighted

(000) Moving
Average
1 4 NA
2 6 NA
3 5 NA
4 ? 31/6 = 5.167
5 ?
6 ?
29
 Ft 1 = w1At + w 2At -1 + w3At -2 + ... + w n At -n 1
2b. Weighted Moving Average: 3/6, 2/6, 1/6

Month Sales Weighted

(000) Moving
Average
1 4 NA
2 6 NA
3 5 NA
4 3 31/6 = 5.167
5 7 25/6 = 4.167
6 32/6 = 5.333
30
3a. Exponential Smoothing

 Assumes the most recent observations have

the highest predictive value
 gives more weight to recent time periods

Ft+1 = Ft + a(At - Ft)

et

Ft+1 = Forecast value for time t+1 Need initial

At = Actual value at time t forecast Ft
a = Smoothing constant to start.

31
3a. Exponential Smoothing – Example 1
Ft+1 = Ft + a(At - Ft)
i Ai

Week Demand
1 820 Given the weekly demand
2 775 data what are the exponential
3 680 smoothing forecasts for
4 655 periods 2-10 using a=0.10?
5 750
6 802 Assume F1=D1
7 798
8 689
9 775
32
10
3a. Exponential Smoothing – Example 1
Ft+1 = Ft + a(At - Ft)
i Ai Fi

Week Demand a = 0.1 0.6

1 820 820.00 820.00
2 775 820.00 820.00
3 = F1+ a(A793.00
680 F2815.50 1–F1) =820+.1(820–820)
4 655 801.95 725.20=820
5 750 787.26 683.08
6 802 783.53 723.23
7 798 785.38 770.49
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28 33
3a. Exponential Smoothing – Example 1
Ft+1 = Ft + a(At - Ft)
i Ai Fi

Week Demand a = 0.1 0.6

1 820 820.00 820.00
2 775 820.00 820.00
3 680 815.50 793.00
F3 = F2+ a(A2–F2) =820+.1(775–820)
4 655 801.95 725.20
5 750 787.26 683.08=815.5
6 802 783.53 723.23
7 798 785.38 770.49
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28 34
3a. Exponential Smoothing – Example 1
Ft+1 = Ft + a(At - Ft)
i Ai Fi

Week Demand a = 0.1 0.6

1 820 820.00 820.00
2 775 820.00 820.00
3 680 815.50 793.00
4 655 801.95 725.20
5 750 787.26 683.08
This process
6 802 783.53 723.23
continues
7 798 785.38 770.49
through week
8 689 786.64 787.00
10
9 775 776.88 728.20
10 776.69 756.28 35
3a. Exponential Smoothing – Example 1
Ft+1 = Ft + a(At - Ft)
i Ai Fi

Week Demand a = 0.1 a = 0.6

1 820 820.00 820.00
2 775 820.00 820.00
3 680 815.50 793.00
4 655 801.95 725.20
5 750 787.26 683.08 What if the
6 802 783.53 723.23 a constant
7 798 785.38 770.49 equals 0.6
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28 36
3a. Exponential Smoothing – Example 2
Ft+1 = Ft + a(At - Ft)
i Ai Fi

Month Demand a = 0.3 a = 0.6

January 120 100.00 100.00
February 90 106.00 112.00
March 101 101.20 98.80
April 91 101.14 100.12
May 115 98.10 94.65 What if the
June 83 103.17 106.86 a constant
July 97.12 92.54 equals 0.6
August
September
37
 3a. Exponential Smoothing – Example 3

Company A, a personal computer producer

purchases generic parts and assembles them to
final product. Even though most of the orders
require customization, they have many common
components. Thus, managers of Company A need
a good forecast of demand so that they can
purchase computer parts accordingly to minimize
inventory cost while meeting acceptable service
level. Demand data for its computers for the past 5
months is given in the following table. 38
3a. Exponential Smoothing – Example 3
Ft+1 = Ft + a(At - Ft)
i Ai Fi

Month Demand a = 0.3 a = 0.5

January 80 84.00 84.00
February 84 82.80 82.00
March 82 83.16 83.00
April 85 82.81 82.50
May 89 83.47 83.75 What if the
June 85.13 86.38 a constant
July ?? ?? equals 0.5

39
3a. Exponential Smoothing

How to choose α
depends on the emphasis you want to place
on the most recent data

Increasing α makes forecast more

sensitive to recent data

40
Forecast Effects of Smoothing Constant a
Ft+1 = Ft + a (At - Ft)
or Ft+1 = a At + a(1- a) At - 1 + a(1- a)2At - 2 + ...
w1 w2 w3

Weights
a= Prior Period 2 periods ago 3 periods ago
a a(1 - a) a(1 - a)2

a= 0.10
10% 9% 8.1%
a= 0.90 90% 9% 0.9%
41
To Use a Forecasting Method

 Collect historical data

 Select a model
 Moving average methods
 Select n (number of periods)
 For weighted moving average: select weights
 Exponential smoothing
 Select a

 Selections should produce a good forecast

…but what is a good forecast? 42
A Good Forecast

 Has a small error

 Error = Demand - Forecast

43
Measures of Forecast Error
et
n

a. MAD = Mean Absolute Deviation A

t=1
t - Ft
MAD =
n

b. MSE = Mean Squared Error 

 t t
A - F 2

t =1
MSE =
n

c. RMSE = Root Mean Squared Error RMSE = MSE

44

 Ideal values =0 (i.e., no forecasting error)

 n

MAD Example A
t=1
t - Ft = 40 =10
MAD = 4
n

What is the MAD value given the

forecast values in the table below?
At Ft
Month Sales Forecast |At – Ft|
1 220 n/a
2 250 255 5
3 210 205 5
4 300 320 20
5 325 315 10
45

= 40
 n

 t t
A - F 2

t =1 = 550 =137.5
MSE/RMSE Example MSE =
n 4

What is the MSE value? RMSE = √137.5

=11.73
At Ft
Month Sales Forecast |At – Ft| (At – Ft)2
1 220 n/a
2 250 255 5 25
3 210 205 5 25
4 300 320 20 400
5 325 315 10 100
46

= 550
 Measures of Error
1. Mean Absolute Deviation
(MAD)
n
t At Ft et |et| et2 e
MAD  1
t
84 = 14
Jan 120 100 20 20 400 n
6
16
Feb 90 106 -16 256 2a. Mean Squared Error
(MSE)
Mar 101 102 n

 t 
-1 1 2
1 e
April 91 101 MSE  1 1,446
-10 10 100
n = 241
May 115 98 6
17 17 289
2b. Root Mean Squared Error
June 83 103 -20 20 400 (RMSE)

84 RMSE  MSE
-10 1,446
= SQRT(241)
47
=15.52
 An accurate forecasting system will have
small MAD, MSE and RMSE; ideally equal to
zero. A large error may indicate that either
the forecasting method used or the
parameters such as α used in the method
are wrong.
Note: In the above, n is the number of periods,
which is 6 in our example

48
Forecast Bias

 How can we tell if a forecast has a positive or

negative bias?

 TS = Tracking Signal
Good tracking signal has low values

RSFE  (actual  forecast )

t t
TS = = t
MAD Mean absolute
MADdeviation
49

30
Quantitative Forecasting Methods

Quantitative
Forecasting

Time Series Regression

Models Models

2. Moving 3. Exponential
1. Naive
Average Smoothing
a) simple a) level
b) weighted b) trend
c) seasonality
50
Exponential Smoothing (continued)

 We looked at using exponential

smoothing to forecast demand with
only random variations
Ft+1 = Ft + a (At - Ft)
Ft+1 = Ft + a At – a Ft
Ft+1 = a At + (1-a) Ft

51
Exponential Smoothing (continued)

 We looked at using exponential

smoothing to forecast demand with only
random variations
 What if demand varies due to
randomness and trend?

 What if we have trend and seasonality in

the data?

52
 Regression Analysis as a Method for
Forecasting
Regression analysis takes advantage
of the relationship between two
variables. Demand is then
forecasted based on the
knowledge of this relationship and
for the given value of the related
variable.

Ex: Sale of Tires (Y), Sale of Autos (X)

are obviously related

If we analyze the past data of these

two variables and establish a
relationship between them, we may
use that relationship to forecast the
sales of tires given the sales of
automobiles.

The simplest form of the relationship

is, of course, linear, hence it is Sales of Autos (100,000)
referred to as a regression line. 53
 Formulas

y=a+bx

where,

 xy  n x y
x

y
b
 x  nx
2 2

x
y
a  y  bx
54
Regression – Example
y = a+ b X b
 xy  n x y a  y  bx
 x  nx
2 2

MonthAdvertising Sales X 2 XY
January 3 1 9.00 3.00
February 4 2 16.00 8.00
March 2 1 4.00 2.00
April 5 3 25.00 15.00
May 4 2 16.00 8.00
June 2 1 4.00 2.00
July

TOTAL 20 10 74 38
55
 General Guiding Principles for
Forecasting

1. Forecasts are more accurate for larger groups of items.

2. Forecasts are more accurate for shorter periods of time.
3. Every forecast should include an estimate of error.
4. Before applying any forecasting method, the total system
should be understood.
5. Before applying any forecasting method, the method
should be tested and evaluated.
6. Be aware of people; they can prove you wrong very easily
in forecasting

56
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