CHAPTER - 3

FORECASTING

4-1
 Outline
 What Is Forecasting?
 Forecasting Time Horizons
 The Strategic Importance of Forecasting
 Forecasting Approaches
Qualitative Methods
Quantitative Methods

4-2
 Outline – Continued
 Time-Series Forecasting
 Decomposition of a Time Series
 Naive Approach
 Moving Averages
 Exponential Smoothing
 Exponential Smoothing with Trend
Adjustment
 Trend Projections
 Seasonal Variations in Data
 Cyclical Variations in Data
4-3
 Outline – Continued
 Associative Forecasting Methods:
Regression and Correlation
Analysis
 Monitoring and Controlling
Forecasts
 Adaptive Smoothing
 Focus Forecasting
 Forecasting in the Service Sector

4-4
 What is Forecasting?
 Process of predicting
a future event
 Underlying basis
of all business
??
decisions
 Production
 Inventory
 Personnel
 Facilities

4-5
 The Realities!

 Forecasts are seldom perfect

 Most techniques assume an
underlying stability in the system
 Product family and aggregated
forecasts are more accurate than
individual product forecasts

4-6
 Forecasting Time Horizons
 Short-range forecast
 Up to 1 year, generally less than 3 months
 Purchasing, job scheduling, workforce
levels, job assignments, production levels
 Medium-range forecast
 3 months to 3 years
 Sales and production planning, budgeting
 Long-range forecast
 3+ years
 New product planning, facility location,
research and development
4-7
 Influence of Product Life
Cycle
Introduction – Growth – Maturity – Decline

 Introduction and growth require longer

forecasts than maturity and decline
 As product passes through life cycle,
forecasts are useful in projecting
 Staffing levels
 Inventory levels
 Factory capacity

4-8
 Product Life Cycle
Introduction Growth Maturity Decline
Product design Forecasting Standardization Little product
and critical Fewer product differentiation
development Product and changes, more Cost
OM Strategy/Issues

critical process minor changes minimization

Frequent reliability Optimum Overcapacity
product and Competitive capacity in the
process design product industry
changes Increasing
improvements stability of Prune line to
Short production and options process eliminate
runs Increase capacity items not
Long production
High production Shift toward runs returning
costs product focus good margin
Product
Limited models Enhance improvement Reduce
Attention to distribution and cost cutting capacity
quality

Figure 2.5
4-9
Forecasting Approaches
Qualitative Methods
 Used when little data exist
 New products
 New technology
 Involves perception, experience
 e.g., forecasting sales on
Internet

4 - 10
 Qualitative Methods

1. Jury of executive opinion (Pool opinions of

high-level experts, sometimes augment by
statistical models)
2. Delphi method (Panel of experts, queried
iteratively until consensus is reached)
3. Sales force composite (Estimates from
individual salespersons are reviewed for
reasonableness, then aggregated)
4. Consumer Market Survey (Ask the customer)

4 - 11
 Quantitative Approaches
 Used when situation is ‘stable’ and
historical data exist
 Existing products
 Current technology
 Involves mathematical techniques
 e.g., forecasting sales of LCD
televisions

4 - 12
 Quantitative Approaches

1. Naive approach
2. Moving averages
time-series
3. Exponential models
smoothing
4. Trend projection
5. Linear regression associative
model

4 - 13
 Time Series Forecasting

 Set of evenly spaced numerical data

 Obtained by observing response
variable at regular time periods
 Forecast based only on past values,
no other variables important
 Assumes that factors influencing
past and present will continue
influence in future

4 - 14
Time Series Components

Trend Cyclical

Seasonal Random

4 - 15
 Components of Demand
Trend
component
Demand for product or service

Seasonal peaks

Actual demand
line

Average demand
over 4 years

Random variation
| | | |
1 2 3 4
Time (years)
Figure 4.1
4 - 16
 Trend Component
 Persistent, overall upward or
downward pattern
 Changes due to population,
technology, age, culture, etc.
 Typically several years
duration

4 - 17
 Seasonal Component
 Regular pattern of up and
down fluctuations
 Due to weather, customs, etc.
 Occurs within a single year
Number of
Period Length Seasons
Week Day 7
Month Week 4-4.5
Month Day 28-31
Year Quarter 4
Year Month 12
Year Week 52

4 - 18
 Cyclical Component
 Repeating up and down movements
 Affected by business cycle,
political, and economic factors
 Multiple years duration

0 5 10 15 20
4 - 19
 Random Component
 Erratic, unsystematic, ‘residual’
fluctuations
 Due to random variation or unforeseen
events
 Short duration
and nonrepeating

M T W T F
4 - 20
 Naive Approach
 Assumes demand in next
period is the same as
demand in most recent period
 e.g., If January sales were 68, then
February sales will be 68
 Sometimes cost effective and
efficient
 Can be good starting point

4 - 21
 Moving Average Method

 MA is a series of arithmetic means

 Used if little or no trend
 Used often for smoothing
 Provides overall impression of data
over time

∑ demand in previous n periods

Moving average = n

4 - 22
 Moving Average Example
Actual 3-Month
Month Shed Sales Moving Average
January 10
February 12
March 13
April 16 (10 + 12 + 13)/3 = 11 2/3
May 19 (12 + 13 + 16)/3 = 13 2/3
June 23 (13 + 16 + 19)/3 = 16
July 26 (16 + 19 + 23)/3 = 19 1/3

4 - 23
 Graph of Moving Average
Moving
30 –
Average
28 –
Forecast
26 – Actual
24 – Sales
Shed Sales

22 –
20 –
18 –
16 –
14 –
12 –
10 –
| | | | | | | | | | | |
J F M A M J J A S O N D

4 - 24
Moving Average Example

4 - 25
Weighted Moving Average
 Used when some trend might be
present
 Older data usually less important
 Weights based on experience and
intuition
∑ [(weight for period n)
Weighted x (demand in period n)]
moving average = ∑ weights

4 - 26
 Weights Applied Period
Weighted Moving
3 Average
Last month
2 Two months ago
1 Three months ago
6 Sum of weights

Actual 3-Month Weighted

Month Shed Sales Moving Average
January 10
February 12
March 13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 = 121/6
May 19 [(3 x 16) + (2 x 13) + (12)]/6 = 141/3
June 23 [(3 x 19) + (2 x 16) + (13)]/6 = 17
July 26 [(3 x 23) + (2 x 19) + (16)]/6 = 201/2

4 - 27
 Potential Problems With
Moving Average
 Increasing n smooths the forecast
but makes it less sensitive to
changes
 Do not forecast trends well
 Require extensive historical data

4 - 28
 Moving Average And
Weighted Moving Average
Weighted
30 – moving
average
25 –
Sales demand

20 – Actual
sales
15 –
Moving
10 – average

5 –
| | | | | | | | | | | |
J F M A M J J A S O N D
Figure 4.2
4 - 29
 Exponential Smoothing
 Form of weighted moving average
 Weights decline exponentially
 Most recent data weighted most
 Requires smoothing constant ()
 Ranges from 0 to 1
 Subjectively chosen
 Involves little record keeping of past
data
4 - 30
 Exponential Smoothing
New forecast = Last period’s forecast
+  (Last period’s actual demand
– Last period’s forecast)

Ft = Ft – 1 + (At – 1 - Ft – 1)

Ft =  At – 1 + (1-)Ft – 1)
where Ft = new forecast
Ft – 1 = previous forecast
 = smoothing (or weighting)
constant (0 ≤  ≤ 1)
4 - 31
 Exponential Smoothing
Example
Predicted demand(t-1) = 142 Ford Mustangs
Actual demand (t-1)= 153
Smoothing constant  = .20

4 - 32
 Exponential Smoothing
Example
Predicted demand (t-1)= 142 Ford Mustangs
Actual demand = (t-1)153
Smoothing constant  = .20

New forecast (t) = 142 + .2(153 – 142)

4 - 33
 Exponential Smoothing
Example
Predicted demand = 142 Ford Mustangs
Actual demand = 153
Smoothing constant  = .20

New forecast = 142 + .2(153 – 142)

= 142 + 2.2
= 144.2 ≈ 144 cars

4 - 34
 Impact of Different 
225 –

Actual  = .5
200 – demand
Demand

175 –

 = .1
150 – | | | | | | | | |
1 2 3 4 5 6 7 8 9
Quarter

4 - 35
 Impact of Different 
225 –

Actual  = .5
200
Chose
– high values
demandof 
Demand

when underlying average

is likely to change
–
175
Choose low values of 
when underlying average  = .1
is stable|
150 – | | | | | | | |
1 2 3 4 5 6 7 8 9
Quarter

4 - 36
.

4 - 37
.

4 - 38
 Choosing 

The objective is to obtain the most

accurate forecast no matter the
technique
We generally do this by selecting the
model that gives us the lowest forecast
error

Forecast error = Actual demand - Forecast value

= At - Ft

4 - 39
Common Measures of Error

Mean Absolute Deviation (MAD)

∑ |Actual - Forecast|
MAD =
n

Mean Squared Error (MSE)

∑ (Forecast Errors)2
MSE =
n

4 - 40
Common Measures of Error

Mean Absolute Percent Error (MAPE)

n
∑100|Actuali - Forecasti|/Actuali
MAPE = i=1
n

4 - 41
 Example 4
• During the past 8 quarters, the Port of
Baltimore has unloaded large quantities of
grain from ships. The Port’s Operations
Manager wants to test the forecasting
method exponential smoothing to see how
well the this method works in predicting
tonnage unloaded.
• He guesses that the forecast of grain
unloaded in the first quarter was 175 tons.

4 - 42
 Comparison of Forecast
Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded  = .10  = .10  = .50  = .50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62

4 - 43
 Comparison of Forecast
Error
∑ |deviations|
Rounded Absolute Rounded Absolute
MADActual
= Forecast Deviation Forecast Deviation
Tonnage n
with for with for
Quarter Unloaded  = .10  = .10  = .50  = .50
1
For 180
= .10 175 5.00 175 5.00
2 168 = 82.45/8
175.5 = 10.31
7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 For 175
= .50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 = 98.62/8
175.02 = 12.33
29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62

4 - 44
 Comparison of Forecast
Error2
∑ (forecast errors)
Rounded Absolute Rounded Absolute
MSE = Actual Forecast Deviation Forecast Deviation
Tonnage
n
with for with for
Quarter Unloaded  = .10  = .10  = .50  = .50
1
For 180
= .10 175 5.00 175 5.00
2 = 1,526.54/8
168 175.5 = 190.82
7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 For 175
= .50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 = 1,561.91/8
205 175.02 = 195.24
29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33

4 - 45
 Comparison of Forecast
n Error
∑100|deviation |/actual i i
Rounded Absolute Rounded Absolute
MAPE = i=1
Actual Forecast Deviation Forecast Deviation
Tonnage with n for with for
Quarter Unloaded  = .10  = .10  = .50  = .50
1
 = .10 175
For 180 5.00 175 5.00
2 168 = 44.75/8
175.5 = 7.50
5.59% 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 =
For 175 .50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 = 54.05/8
175.02 =29.98
6.76% 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 190.82 195.24
4 - 46
 Comparison of Forecast
Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded  = .10  = .10  = .50  = .50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 190.82 195.24
MAPE 5.59% 6.76%
4 - 47
 Exponential Smoothing with
Trend Adjustment
When a trend is present, exponential
smoothing must be modified to respond
to trend
Forecast Exponentially Exponentially
including (FITt) = smoothed (Ft) + smoothed (Tt)
trend forecast trend

4 - 48
Exponential Smoothing with
Trend Adjustment

Ft = (At - 1) + (1 - )(Ft - 1 + Tt - 1)

Tt = b(Ft - Ft - 1) + (1 - b)Tt - 1

Step 1: Compute Ft
Step 2: Compute Tt
Step 3: Calculate the forecast FITt = Ft + Tt

4 - 49
 EXAMPLE

• A Portland manufacturer wants to

forecast the demand for a pollution-
control equipment.
• Past data shows that there is an
increasing trend.
• The company assumes the initial forecast
for month 1 was 11 units and the trend
over that period was 2 units.
• α = 0.2 β =0.4
4 - 50
 Exponential Smoothing with
Trend Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17
3 20
4 19
5 24
6 21
7 31
8 28
9 36
10

Table 4.1
4 - 51
 Exponential Smoothing with
Trend Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17
3 20
4 19
5 24 Step 1: Forecast for Month 2
6 21
7 31 F2 = A1 + (1 - )(F1 + T1)
8 28 F2 = (.2)(12) + (1 - .2)(11 + 2)
9 36
10 = 2.4 + 10.4 = 12.8 units
Table 4.1
4 - 52
 Exponential Smoothing with
Trend Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80
3 20
4 19
5 24 Step 2: Trend for Month 2
6 21
7 31 T2 = b(F2 - F1) + (1 - b)T1
8 28 T2 = (.4)(12.8 - 11) + (1 - .4)(2)
9 36
10 = .72 + 1.2 = 1.92 units
Table 4.1
4 - 53
 Exponential Smoothing with
Trend Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80 1.92
3 20
4 19
5 24 Step 3: Calculate FIT for Month 2
6 21
7 31 FIT2 = F2 + T2
8 28 FIT2 = 12.8 + 1.92
9 36
10 = 14.72 units
Table 4.1
4 - 54
 Exponential Smoothing with
Trend Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80 1.92 14.72
3 20 15.18 2.10 17.28
4 19 17.82 2.32 20.14
5 24 19.91 2.23 22.14
6 21 22.51 2.38 24.89
7 31 24.11 2.07 26.18
8 28 27.14 2.45 29.59
9 36 29.28 2.32 31.60
10 32.48 2.68 35.16

Table 4.1
4 - 55
Exponential Smoothing with
Trend Adjustment Example
35 –

30 – Actual demand (At)

Product demand

25 –

20 –

15 –

10 – Forecast including trend (FITt)

with  = .2 and b = .4
5 –

0 – | | | | | | | | |
1 2 3 4 5 6 7 8 9
Figure 4.3
Time (month)
4 - 56
 Trend Projections
Fitting a trend line to historical data points
to project into the medium to long-range
Linear trends can be found using the least
squares technique

y^ = a + bx
^ = computed value of the variable to
where y
be predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable

4 - 57
Values of Dependent Variable Least Squares Method

Actual observation Deviation7

(y-value)

Deviation5 Deviation6

Deviation3

Deviation4

Deviation1
(error) Deviation2
Trend line, y^ = a + bx

Time period Figure 4.4

4 - 58
Values of Dependent Variable Least Squares Method

Actual observation Deviation7

(y-value)

Deviation5 Deviation6

Deviation3 Least squares method

minimizes the sum of the
Deviation
squared errors (deviations)
4

Deviation1
(error) Deviation2
Trend line, y^ = a + bx

Time period Figure 4.4

4 - 59
 Least Squares Method
Equations to calculate the regression variables

y^ = a + bx

Sxy - nxy
b=
Sx2 - nx2

a = y - bx

4 - 60
 Least Squares Example
Time Electrical Power
Year Period (x) Demand (megawatt) x2 xy
2006 1 74 1 74
2007 2 79 4 158
2008 3 80 9 240
2009 4 90 16 360
2010 5 105 25 525
2011 6 142 36 852
2012 7 122 49 854
∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063
x=4 y = 98.86

∑xy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
∑x - nx
2 2 140 - (7)(4 2)

a = y - bx = 98.86 - 10.54(4) = 56.70

4 - 61
 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
2003 1 74 1 74
2004 2 79 4 158
2005The trend
3 line is 80 9 240
2006 4 90 16 360
2007 y^ 5= 56.70 + 10.54x
105 25 525
2008 6 142 36 852
2009 7 122 49 854
∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063
x=4 y = 98.86

∑xy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
∑x - nx
2 2 140 - (7)(4 2)

a = y - bx = 98.86 - 10.54(4) = 56.70

4 - 62
 Least Squares Example
160 –
Trend line,
150 – y^ = 56.70 + 10.54x
140 –
Power demand

130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
50 –
| | | | | | | | |
2006 2007 2008 2009 2010 2011 2012 2013 2014
Year
4 - 63
Seasonal Variations In Data

The multiplicative
seasonal model
can adjust trend
data for seasonal
variations in
demand (jet skis,
snow mobiles)

4 - 65
Seasonal Variations In Data
Steps in the process:
1. Find average historical demand for each season
2. Compute the average demand over all seasons
3. Compute a seasonal index for each season
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the
number of seasons, then multiply it by the
seasonal index for that season

4 - 66
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012 Monthly Index
Jan 80 85 105 90 94
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Apr 90 95 115 100 94
May 113 125 131 123 94
Jun 110 115 120 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
4 - 67
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94
Mar 80 93 Average
82 85 monthly 94
2010-2012 demand
Seasonal90index95= 115Average monthly
Apr 100 demand94
May 113 125 131 123 94
= 90/94 = .957
Jun 110 115 120 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
4 - 68
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90 95 115 100 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 115 94 1.223
Jul 100 102 113 105 94 1.117
Aug 88 102 110 100 94 1.064
Sept 85 90 95 90 94 0.957
Oct 77 78 85 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
4 - 69
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012
MonthlyIndex
Jan 80 85 105 90 94 0.957
Feb 70 85 Forecast
85 for802013 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90Expected
95 115 annual demand
100 = 1,200
94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 1,200 115 94 1.223
Jul 100 102Jan 113 x .957 = 96 94
105 1.117
12
Aug 88 102 110 100 94 1.064
1,200
Sept 85 90
Feb 95 x90
.851 = 85 94 0.957
Oct 77 78 85 12 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
4 - 70
 Seasonal Index Example
2013 Forecast
140 – 2012 Demand
130 – 2011 Demand
2010 Demand
120 –
Demand

110 –
100 –
90 –
80 –
70 –
| | | | | | | | | | | |
J F M A M J J A S O N D
Time
4 - 71
 Associative Forecasting
Used when changes in one or more
independent variables can be used to predict
the changes in the dependent variable

Most common technique is linear

regression analysis

We apply this technique just as we did

in the time series example

4 - 72
 Associative Forecasting
Forecasting an outcome based on
predictor variables using the least squares
technique
y^ = a + bx
^
where y = computed value of the variable to
be predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable though to
predict the value of the dependent
variable
4 - 73
 Associative Forecasting
Example
Sales Area Payroll
($ millions), y ($ billions), x
2.0 1
3.0 3
2.5 4 4.0 –
2.0 2
2.0 1 3.0 –
3.5 7 Sales
2.0 –

1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
4 - 74
 Associative Forecasting
Example
Sales, y Payroll, x x2 xy
2.0 1 1 2.0
3.0 3 9 9.0
2.5 4 16 10.0
2.0 2 4 4.0
2.0 1 1 2.0
3.5 7 49 24.5
∑y = 15.0 ∑x = 18 ∑x2 = 80 ∑xy = 51.5

∑xy - nxy 51.5 - (6)(3)(2.5)

x = ∑x/6 = 18/6 = 3 b=
∑x2 - nx2
= 80 - (6)(32) = .25

y = ∑y/6 = 15/6 = 2.5 a = y - bx = 2.5 - (.25)(3) = 1.75

4 - 75
 Associative Forecasting
Example
y^ = 1.75 + .25x Sales = 1.75 + .25(payroll)

If payroll next year

4.0 –
is estimated to be
$6 billion, then: 3.25
3.0 –
Nodel’s sales
2.0 –
Sales = 1.75 + .25(6)
Sales = $3,250,000 1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll

4 - 76
 Standard Error of the
Estimate
 A forecast is just a point estimate of a
future value
 This point is 4.0 –
actually the 3.25
mean of a 3.0 –
Nodel’s sales
probability 2.0 –
distribution
1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
Figure 4.9

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 Standard Error of the
Estimate

∑y2 - a∑y - b∑xy

Sy,x =
n-2

We use the standard error to set up

prediction intervals around the
point estimate

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 Standard Error of the
Estimate
∑y2 - a∑y - b∑xy 39.5 - 1.75(15) - .25(51.5)
Sy,x = =
n-2 6-2

Sy,x = .306 4.0 –

3.25
3.0 –
Nodel’s sales
The standard error
2.0 –
of the estimate is
$306,000 in sales 1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll

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 Prediction Intervals
The ranges or limits of a forecast are estimated by:
Upper limit = Y + t*Sy,x
Lower limit = Y - t*Sy,x
where:
Y = forecasted value (point estimate)
t = number of standard deviations from
the mean of the distribution to provide a given
probability of exceeding the limits through chance
syx = standard error of the forecast

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 Prediction Intervals
Estimate the confidence interval for annual
sales of next year (remember payroll next
year is estimated to be $6 billion) so that the
probability that the actual sales exceeding
these limits will be approximately equal to
0.05.
Sales = 1.75 + .25(6)
Sales = $3,250,000

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 Prediction Intervals
Step 1: Compute the standard error of the
forecasts, syx.
Step 2: Determine the appropriate value for
t.
n = 6, so degrees of freedom = n – 2 = 4
level of significance = =.05
The Student’s t Distribution Table shows:
(tα/2=0.025) ) =2.78

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 Prediction Intervals
Step 3: Compute upper and lower limits.
Upper limit = $3,250,000 + 2.78 * $306,000
=$4,100,680
Lower limit = $3,250,000 - 2.78 * $306,000
= $2,399,320
We are 95% confident the actual sales for
next year will be between $2,399,320 and
$4,100,680.

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 Correlation
 How strong is the linear
relationship between the variables?
 Correlation does not necessarily
imply causality!
 Coefficient of correlation, r,
measures degree of association
 Values range from -1 to +1

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Correlation Coefficient
nSxy - SxSy
r=
[nSx2 - (Sx)2][nSy2 - (Sy)2]

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y y
Correlation Coefficient
nSxy - SxSy
r=
[nSx 2 - (Sx)2][nSy2 - (Sy)2]
(a) Perfect positive x (b) Positive x
correlation: correlation:
r = +1 0<r<1

y y

(c) No correlation: x (d) Perfect negative x

r=0 correlation:
r = -1 4 - 86
 Correlation
 Coefficient of Determination, r2,
measures the percent of change in
y predicted by the change in x
 Values range from 0 to 1
 Easy to interpret

For the Nodel Construction example:

r = .901
r2 = .81
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 Multiple Regression
Analysis
If more than one independent variable is to be
used in the model, linear regression can be
extended to multiple regression to
accommodate several independent variables

y^ = a + b1x1 + b2x2 …

Computationally, this is quite

complex and generally done on the
computer
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 Multiple Regression
Analysis
In the Nodel example, including interest rates in
the model gives the new equation:

y^ = 1.80 + .30x1 - 5.0x2

An improved correlation coefficient of r = .96

means this model does a better job of predicting
the change in construction sales

Sales = 1.80 + .30(6) - 5.0(.12) = 3.00

Sales = $3,000,000
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 Monitoring and Controlling
Forecasts
Tracking Signal
 Measures how well the forecast is
predicting actual values
 Ratio of cumulative forecast errors to
mean absolute deviation (MAD)
 Good tracking signal has low values
 If forecasts are continually high or low, the
forecast has a bias error

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Monitoring and Controlling
Forecasts

Tracking Cumulative error

signal =
MAD

∑(Actual demand in
period i -
Forecast demand
Tracking in period i)
signal = (∑|Actual - Forecast|/n)

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 Tracking Signal

Signal exceeding limit

Tracking signal
Upper control limit
+

0 MADs Acceptable
range

–
Lower control limit

Time

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 Tracking Signal Example
Cumulative
Absolute Absolute
Actual Forecast Cumm Forecast Forecast
Qtr Demand Demand Error Error Error Error MAD

1 90 100 -10 -10 10 10 10.0

2 95 100 -5 -15 5 15 7.5
3 115 100 +15 0 15 30 10.0
4 100 110 -10 -10 10 40 10.0
5 125 110 +15 +5 15 55 11.0
6 140 110 +30 +35 30 85 14.2

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 Tracking Signal Example
Tracking Cumulative
Absolute Absolute
Actual Signal
Forecast Cumm Forecast Forecast
Qtr (CummDemand
Demand Error/MAD)
Error Error Error Error MAD

1 90-10/10
100= -1 -10 -10 10 10 10.0
2 95
-15/7.5
100= -2 -5 -15 5 15 7.5
3 115 0/10
100
= 0 +15 0 15 30 10.0
4 100-10/10
110= -1 -10 -10 10 40 10.0
5 125
+5/11110
= +0.5+15 +5 15 55 11.0
6 140
+35/14.2
110= +2.5
+30 +35 30 85 14.2

The variation of the tracking signal

between -2.0 and +2.5 is within acceptable
limits
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 One Company’s Rules for Changing
the Smoothing Constant (α )

Limits Do not Increase Increase Increase

for change α by 0.1 α by 0.3 α by 0.5
Absolute
Tracking
Signal
0 - 2.4 *
2.5 - 2.9 *
3.0 - 3.9 *
Over 4 *

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Forecasting in the Service
Sector
 Presents unusual challenges
 Special need for short term records
 Needs differ greatly as function of
industry and product
 Holidays and other calendar events
 Unusual events

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