Chapter 4

Forecasting
 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, ?

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

Decisions that Need Forecasts

 Which markets to pursue?

 What products to produce?
 How many people to hire?
 How many units to purchase?
 How many units to produce?
 And so on……
 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
 Forecasting
 The use of historic data to determine the direction of future trends.
Forecasting is used by companies to determine how to allocate
their budgets for an upcoming period of time. This is typically based
on demand for the goods and services it offers, compared to the
cost of producing them. Investors utilize forecasting to determine if
events affecting a company, such as sales expectations, will
increase or decrease the price of shares in that company.
Forecasting also provides an important benchmark for firms which
have a long-term perspective of operations.
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
Importance of Forecasting
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.
Importance of Forecasting

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.
 At this point, it may be useful to point out the “time horizons” considered by different industries. For example,
some colleges and universities look 30 to fifty years ahead, industries engaged in long distance transportation
(steam ship, railroad) or provision of basic power (electrical and gas utilities, etc.) also look far ahead (20 to 100
years). Ask them to give examples of industries having much shorter long-range horizons.

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
Methods
Forecasting Techniques

 1. Qualitative(technological) forecasting
is based on judgements expressed by
individual or group.
 Forecasts generated subjectively by the
forecaster
 2. Quantitative(statistical) forecasting
utilizes significant amount of data and
equations.
 Forecasts generated through mathematical
modeling.
Qualitative Forecasting Methods

Qualitative
Forecasting

Models
Executive Delphi
Market
Judgement Method
Research/
Survey

Smoothing
A point you may wish to make here is that only in the case of linear
regression are we assuming that we know “why” something happened.
General time-series models are based exclusively on “what” happened in
the past; not at all on “why.” Does operating in a time of drastic change
imply limitations on our ability to use time series models?
 Qualitative Methods
Briefly, the qualitative methods are:

1.Executive Judgment: Opinion of a group of high level

experts or managers is pooled

2.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.

3. The Delphi method: a form of expert opinion forecasting

that uses a series of questions and answers to obtain a
consensus forecast, where expert do no meet.
 Qualitative Methods

3. The Delphi method:

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.

.
Qualitative Method
Quantitative Forecasting Methods

Quantitative
Forecasting

Time Series Regression

Models Models

A point you may wish to make

here is that only in the case of
linear regression are we

2. Moving 3. Exponential
assuming that we know “why”

1. Naive something happened. General

Average Smoothing
time-series models are based
exclusively on “what” happened
in the past; not at all on “why.”
a) simple a) level Does operating in a time of
drastic change imply limitations
b) weighted b) trend on our ability to use time series
models?

c) seasonality
Time Series Models

 Try to predict the future based on past

data

 Assume that factors influencing the past will

continue to influence the future
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
A point you may wish to make here is that only in the case of linear
regression are we assuming that we know “why” something happened.
General time-series models are based exclusively on “what” happened in
the past; not at all on “why.” Does operating in a time of drastic change
imply limitations on our ability to use time series models?
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

Naïve Forecasting

Next period forecast = Last Period’s

actual:
2.Moving Average

Next period’s forecast = simple

average of the last N periods
2a. Simple Moving Average

 Assumes an average is a good estimator of

future behavior
 Used if little or no trend
 Used for smoothing
 Next period’s forecast = simple average of the last n
periods

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

n = Number of periods to be averaged
At = Actual occurrence in period t
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 ?
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 ?
2a. Simple Moving Average

What if ipod sales were actually 3 in month 4

(Sales (F)Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3? 5
5 ?
6 ?
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 ?
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 ?
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
2b. Weighted Moving Average
Gives more emphasis to recent data

Weights
decrease for older data
W1+W2+…..Wn=1 Simple moving
sum to 1.0 average models
weight all previous
periods equally
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 ?
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
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.
3a. Exponential Smoothing – Example 1
Ft+1 = Ft + a(At - Ft)
i Ai

Given the weekly demand

data what are the exponential
smoothing forecasts for
periods 2-10 using a=0.10?

Assume F1=D1
3a. Exponential Smoothing – Example 1
Ft+1 = Ft + a(At - Ft)
i Ai Fi
a=

F2 = F1+ a(A1–F1) =820+.1(820–820)

=820
3a. Exponential Smoothing – Example 1
Ft+1 = Ft + a(At - Ft)
i Ai Fi
a=

F3 = F2+ a(A2–F2) =820+.1(775–820)

=815.5
3a. Exponential Smoothing – Example 1
Ft+1 = Ft + a(At - Ft)
i Ai Fi
a=

This process
continues
through week
10
3a. Exponential Smoothing – Example 1
Ft+1 = Ft + a(At - Ft)
i Ai Fi
a= a=

What if
the
a
constant
equals 0.6
A Good Forecast

 Has a small error

 Error = Demand - Forecast
Forecast Accuracy

 Forecasts are rarely perfect

 Need to know how much we should rely on
our chosen forecasting method
 Measuring forecast error:

 Note that over-forecasts = negative errors

and under-forecasts = positive errors
 This slide illustrates the equations for two measures of forecast error.
Students might be asked if there is an occasion when one method might
be preferred over the other.

Measures of Forecast Error

et

a. MAD = Mean Absolute Deviation

b. MSE = Mean Squared Error

c. RMSE = Root Mean Squared Error

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

 = 40 =10
MAD Example 4

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
= 40
 = 550 =137.5
MSE/RMSE Example 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
= 550
 Measures of Error
1. Mean Absolute Deviation
(MAD)
t At Ft et |et| e t2
84 = 14
Jan 120 100 20 20 400
6
-16 16
Feb 90 106 256 2a. Mean Squared Error
-1 1 1 (MSE)
Mar 101 102
-10 10 100
April 91 101 1,446
17 17 289 = 241
May 115 98 6
-20 20 400
2b. Root Mean Squared Error
June 83 103 (RMSE)
-10 84 1,446
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
= SQRT(241)
method are wrong.
Note: In the above, n is the number of periods, which is 6 in our example =15.52