Forecasting

Chapter 6
FORECASTING
‘If your actions inspire others to dream more, learn more, do more
and become more, you are a leader.’
Industrial Engineering and Management, BME III/II
Course outline
 Forecasting techniques
 Qualitative techniques
 Quantitative techniques
 Casual quantitative
techniques
 Forecast errors

By: Khem Gyanwali, Thapathali Campus, IOE,TU 2
Forecasting
Forecasting is an interference of what is likely to happen in
the future. It is not absolutely certain prophesy but is
fundamental to management.
Underlying basis of all business decisions
– Production
– Inventory
– Personnel
– Facilities
It involves a study of the present and past data with a view to
estimate the future activities. It often examines historical data
to determine relationships between key variables in a
problem and uses those relationships to make statement
about the future.
Industrial Engineering and Management, BME III/I

By: Khem Gyanwali, Thapathali Campus, IOE,TU
3
Forecasting
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.
4
Forecasting
Requirements of forecasting for operations.

• For long-range, strategic decisions and
shorter- range decisions in day to day
operations as an important input.
• To meet the level of demand of the company
so that they can have optimum amount of
goods, services and employees.
• Provide a basis for co-ordination of plans for
activities in various parts of a company.
5
Forecasting
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.
• 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.

6
1. Forecasting techniques
Quantitative
Forecasting horizon methods
• Short-range forecast
– 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
Design
– > 2 years of system
• New product planning
Qualitative
Methods
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Forecasting during the life cycle
Introduction Growth Maturity Decline
Qualitative models Quantitative models

- Executive judgment
- Time series analysis
- Market research
- Regression analysis
-Survey of sales force
-Delphi method
Sales
Time
8
The basic forecasting techniques are
I. Qualitative techniques
a. The Delphi method.
b. Market survey.
c. Sales force composite.
d. Executive judgment.
II. Quantitative (time series models) techniques
a. Naive
b. Moving average
c. Exponential smoothing
III. Casual quantitative techniques
a. Regression analysis.
b. Correlation analysis.

9
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.

10
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.

11
II. Quantitative techniques
Quantitative
Forecasting
Time Series Regression models

Models Correlation Models
1. Naive 2. Moving 3. Exponential

Average Smoothing
a) simple a) level
b) weighted b) trend
c) seasonality

12
• Quantitative methods are based on an analysis of historical
data concerning one or more time series.
• A time series is a set of observations measured at successive
points in time or over successive periods of time.
• If the historical data used are restricted to past values of the
series that we are trying to forecast, the procedure is called a
time series method.
• If the historical data used involve other time series that are
believed to be related to the time series that we are trying to
forecast, the procedure is called a causal method.
• Quantitative approaches are generally preferred.

13
Demand for product or service
Product demand over time
Year Year Year Year

1 2 3 4

14
Product demand over time
Trend component
Seasonal peaks
Demand for product or service
Actual demand
Random line
variation
Year Year Year Year
1 2 3 4
Now let’s look at some time series approaches to forecasting…
15
A. Naive
• Demand in next period
is the same as demand
in most recent period
– May sales = 48 → June
forecast = 48
• Usually not good

16
B. 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

17
Example: Simple Moving Average
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

18
C. Weighted Moving Average
• Gives more emphasis to recent data
Ft 1 = w1A t + w 2 A t -1 + w 3A t -2 + ... + w n A t -n 1
• Weights
– decrease for older data Simple moving
– sum to 1.0 average models
weight all previous
periods equally

19
Example: Weighted Moving Average
Weights: 3/6, 2/6, 1/6
Ft 1 = w1A t + w 2 A t -1 + w 3A t -2 + ... + w n A t -n 1
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
By: Khem Gyanwali, Thapathali Campus, IOE,TU 20
D. Basic Exponential Smoothing
Assumes the most recent observations have the highest
predictive value
– gives more weight to recent time periods
Ft+1 = Ft + (At - Ft)

Ft+1 = Forecast value for time t+1 Need initial
et
At = Actual value at time t forecast Ft
 = Smoothing constant
to start.
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
21
Example: Basic Exponential Smoothing
Ft+1 = Ft + (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 =0.10?
5 750
6 802 Assume F1=D1
7 798
8 689
9 775
10
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Example:
Basic Exponential Smoothing
Ft+1 = Ft + (At - Ft)
i Ai Fi
Week Demand  = 0.1 F2 = F1+ (A1–F1)

= 820+.1(820–820)
1 820 820.00
= 820
2 775 820.00 F3 = F2+ (A2–F2)
3 680 815.50 = 820+.1(775–820)
4 655 = 815.5
5 750
6 802
7 798 This process
8 689 continues
9 775 through week 10
10
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Example:
Basic Exponential Smoothing
Ft+1 = Ft + (At - Ft)
i Ai Fi
Week Demand  = 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
6 802 783.53 723.23 What if the
7 798 785.38 770.49  constant
equals 0.6
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28

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E. Exponential Smoothing with trend correction
Basic smoothing is equivalent to moving average, only the
weights given are decreasing exponentially. So, this method
does not satisfactorily predict the future demand when there
is trend pattern in the demand. e.g. an increasing or
decreasing trend.
Step 1: Base for period t is calculated as;
St = αDt + (1- α)(St-1 + Tt-1)
Step 2: Trend correction factor is calculated as;
Tt = β(St – St-1) + (1- β)Tt-1
Step 3: Forecast for period (t+1) is given by:
Ft+1 = St + Tt

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Regression Analysis:
It is similar to trend analysis, except the independent
variable is not restricted to time.
Instead of letting time represent our independent
variable, we could forecast sales based upon the price of
the product. Since products often go on sale, we could
collect data over several months collecting the weekly
price and number of items sold for the week.
For this model, we would find the regression equation in
the same manner in which we found the trend line
except we would call the independent variable x, instead
of t.
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Using the method of least squares, the formula for the regression line is:
Y = b0 + b1x.
where: Y= dependent variable which depends on the value of x

b1 = slope of the regression line
b0 = regression line projection for x= 0
b1 = n XiYi - Xi Yi

nXi2 - (Xi)2
where: Yt = observed value of the time series at time period t
= average of the observed values for Yt

= average time period for the n observations

27
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 referred to as a
regression line. Sales of Autos (100,000)

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Example:
Regression
Month Advertising(x) Sales(y) x2 xy

3.00 b  
xy  n x y
January 3 1 9.00
 x  nx
2 2
February 4 2 16.00 8.00
March 2 1 4.00 2.00
April 5 3 25.00 15.00 a  y  bx
May 4 2 16.00 8.00
June 2 1 4.00 2.00 y = a + bx
July
TOTAL 20 10 74 38

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2. Forecast errors
n
MAD = Mean Absolute Deviation 

t =1
A t - Ft
MAD =
n
MSE = Mean Squared Error n
 A t - Ft 
2
t =1
MSE =
n
RMSE = Root Mean Squared Error

RMSE = MSE
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.

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2. Forecast errors
1. Mean Absolute Deviation
t At Ft et |et| et2 (MAD)
Jan 120 100 20 20 400 n
e t
MAD  1
= 84/6 = 14
Feb 90 106 -16 16 256 n
2. Mean Squared Error
Mar 101 102 -1 1 1 (MSE)
n
April 91 101 -10 10 100

 te  2
= 1446/6
May 115 98 17 17 289
MSE  1
n = 241
2. Root Mean Squared Error
June 83 103 -20 20 400
(RMSE)
-10 84 1446
RMSE  MSE
= 15.52

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2. Forecast errors
• How can we tell if a forecast has a positive or
negative bias?
• TS = Tracking Signal
– Good tracking signal has low values
RSFE t  (actual  forecast )

t
TS = = t
MAD Mean absolute deviation

32
Industrial Engineering and Management, BME III/II 33

Forecasting

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Chapter 6

Industrial Engineering and Management, BME III/II

Industrial Engineering and Management, BME III/I

Why do we need to forecast?

Requirements of forecasting for operations.

Industrial Engineering and Management, BME III/II

Qualitative models Quantitative models

Industrial Engineering and Management, BME III/II

Sales Force Composite: Each regional salesperson provides

Market Research/Survey: Solicits input from customers

Industrial Engineering and Management, BME III/II

Typically, the procedure consists of the following steps:

Industrial Engineering and Management, BME III/II

Time Series Regression models

1. Naive 2. Moving 3. Exponential

Industrial Engineering and Management, BME III/II

Industrial Engineering and Management, BME III/II

Year Year Year Year

Industrial Engineering and Management, BME III/II

Industrial Engineering and Management, BME III/II

Industrial Engineering and Management, BME III/II

Sales Moving Average

Industrial Engineering and Management, BME III/II

Industrial Engineering and Management, BME III/II

Ft+1 = Ft + (At - Ft)

Ft+1 = Ft + (At - Ft)

Week Demand  = 0.1 F2 = F1+ (A1–F1)

Industrial Engineering and Management, BME III/II

Industrial Engineering and Management, BME III/II

where: Y= dependent variable which depends on the value of x

b1 = n XiYi - Xi Yi

= average of the observed values for Yt

Industrial Engineering and Management, BME III/II

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

If we analyze the past data of

The simplest form of the

Industrial Engineering and Management, BME III/II

Month Advertising(x) Sales(y) x2 xy

Industrial Engineering and Management, BME III/II

MAD = Mean Absolute Deviation 

MSE = Mean Squared Error n

RMSE = Root Mean Squared Error

Industrial Engineering and Management, BME III/II

Industrial Engineering and Management, BME III/II

RSFE t  (actual  forecast )

Industrial Engineering and Management, BME III/II

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