You are on page 1of 59

BBn

Current factors or conditions

Past experience in a similar situation

Forecasts are the basis for budgeting,


planning capacity, sales, production
and inventory, personnel, purchasing
and more.

Forecasts play an important role in the


planning process because they enable
a manager to anticipate the future so
he can plan accordingly.

Accounting: New product cost estimates,


profit projections, cash management etc.

Human resources: Hiring activities,


recruitment, training etc.

Operations: Scheduling, work assignment,


inventory planning etc.

To help managers plan the system

To help them plan the use of the system

Forecasting techniques generally assume that the same


underlying casual system that existed in the past will
continue to exist in the future.

Forecasts are rarely perfect; actual results usually differ


from predicted values.

Forecasts for groups of items tend to be more accurate


than forecasts for individual items. Because forecasting
errors among items in a group usually has a cancelling
effect.

Forecast accuracy decreases as the time horizon


increases. Short term forecasts have lower uncertainties
than the long-term forecasts.

A properly prepared forecast should fulfill certain


requirements. The forecasts should be:

timely: The forecasting must cover the time


necessary to implement possible changes.

accurate: This enables users to plan for


possible errors and provides a basis for
comparing alternatives

reliable: A technique that sometimes provide


good forecasts and sometimes poor one leaves
users with the uneasy feelings.

in meaningful units: Financial planner needs


to know how many dollars will be needed?
Schedulers should know what machines and
skills will be required?

in writing: A written forecast permits an


objective basis for evaluating the forecast once
actual results are in.

simple to understand: Simple forecasting


techniques enjoy wide spread popularity because
users are more comfortable working with them.

There are six basic steps in the forecasting process:

Determining the purpose of the forecast:


How will it be used and when will it be needed?
It will provide an indication of the level of detail
required in the forecast and the level of the
accuracy necessary.

Establish a time horizon: The forecasts must


indicate a time interval, keeping in mind that
accuracy decreases as the time horizon
increases.

Select a forecast technique

Gather and analyze relevant data: It helps in


identifying any assumptions that are made in
conjunction with preparing and using forecast.

Make the forecast.

Monitor the forecast: It determines whether it is


performed in a satisfactory manner. If it is not,
reexamine the method.

Either or both approaches might be used to


develop forecasts.

Qualitative method: It involves subjective


inputs, numerical description. It includes soft
information (human factor, personal opinion
etc) in the forecasting process.

Quantitative method: It involves either the


projection of historical data or the development
of associative methods which utilize
explanatory variables to make forecasts. This
method mainly analyzes data.

Judgmental

Time series

Associative

Judgmental forecasts rely on analysis of


subjective inputs obtained from various
sources such as opinion from consumer
surveys, sales staff, managers and
executives and experts

Forecasts that project patterns identified in


recent time series observations. It project
past experience into the future

Forecasting technique that uses explanatory


variables to predict future demand. For
example, demand for paint might be related
to variables such as the price per gallon and
the amount spent on advertising and drying
time, ease of cleanup etc.

In some situations, forecasts rely solely on


judgment and opinion. For instances,
If the management must have a forecast quickly,
there may not be enough time to gather and
analyze quantitative data.
At another time, especially when political and
economic conditions are changing, available data
may be out of date and more up-to-date information
might not yet be available.
In such instances forecasts are based on executive
opinions, sales force opinions, consumer surveys, etc.

Marketing manager, financial manager and


operations manager may meet and
collectively develop a forecast. This
approach is used for long-term planning and
new product development.

The sales staff or the customer service staff


is often a good source of information
because of their direct contact with
customers. They are often aware of any
plans the customers may be considering for
the future. One of the drawbacks of this
approach is that they may be unable to
distinguish between what customers would
like to do and what they actually will do.

Since consumers determine demand, it is


better to collect information from them. If
possible every customer or potential
customer can be contacted. However, it is
not all time possible to identify all the
customer or potential customers. So,
managers often rely on sample consumer
opinions.

A time series is a time-oriented sequence of


observations taken at regular intervals
(hourly, weekly, daily, etc). The data may
be measurements of demand, earnings,
profits etc. These techniques are based on
the assumption that future values of the
series can be estimated from the past
values.

Analysis of time series data can be


accomplished by plotting the data in any of
the following patterns:
i.
ii.
iii.
iv.
v.

Trend
Seasonality
Cycles
Irregular variations
Random variations

Trends

Trend: It refers to a long-term upward or


downward movement in the data.
Example: Population shifts, changing incomes
etc.

Seasonality

Seasonality: It refers to short-term regular


variations related to calendar or time of a day.
Example: Restaurants, supermarkets
experiences weekly or daily seasonality.

Cycles

Cycles: Cycles are wavelike variations


lasting more than one year.
Example: Economic, political and
agricultural conditions.

Irregular Trends

Irregular variations: It caused by unusual


circumstances, not relative of typical
behavior. These need to be identified and
remove from the data.

Random variations: Random variations are


residual variations that remains after all other
behaviors have been accounted for. The small
bumps in the figures are random variation.

Naive Methods: It is simple but widely used


method. This is the forecast for any period
equals the previous periods actual value. For
example, if the demand for a product last
week was 50 KGs, the forecast for this week
is 50 KGs. This method has several
advantages: it has no cost, it is quick and
easy, and it is easily understandable.

Techniques for Averaging:


Averaging techniques smooth fluctuations in
a time series because the individual highs
and lows in the data offset each other when
they are combined into an average. A
forecast based on an average thus tends to
exhibit less variability than the original
data. The minor variations are treated as
random variation and larger variations are
viewed as real changes.

The following three techniques widely used


for averaging.
i. Moving average
ii. Weighted moving average
iii. Exponential smoothing

Moving average: Technique that averages a


number of recent actual data values, updated as
new values become available is known as moving
average forecast. The moving average forecast
can be computed using the following formula:
n

Ft MAn

i 1

At i
n

i = An index that corresponds to time period


n = No. of period in the moving average
At= Actual value in period t-i
MA = Moving average
Ft= Forecast for time period t

For example, MA3 implies a three period


moving average forecast,and MA5 implies a
fiveperiod moving average forecast.
Example: Compute a 3-period moving
average forecast given demand for
shopping carts for the last five periods.

Period

Demand

42

40

43

40

41

i = An index that corresponds to time period


n =3= No. of period in the moving average
Ai= Actual value in period t-i
MA = Moving average
Ft= Forecast for time period t

The moving average for period 6 is, F6 MA3

t i

i 1

43 40 41
41.33
3

the actual demand in period 6 turns out to be 38, the moving average
forecast for period 7 would be :

F7 MA3

t i

i 1

40 41 38

39.67
3

A 3 and 5-period moving average forecast against actual


demand for 10 periods.

Note: The more periods in a moving average, the greater the


forecast will lag changes in the data.
* This technique is easy to compute and easy to understand.
* A possible disadvantage is that all values in the average are
weighted equally. For example, in a 10-period moving average,
each value has weight of 1/10. Hence, the oldest value has the
same weight as the most recent value. Decreasing the number of
values in the average increases in weight of more recent values.

Example 2: Given the following data:


Period No. of
complaints
1
60
2

65

55

58

64

(i)Use naive approach to make the forecast for the


next period.
(ii)Compute a 3-period moving average forecast.

Weighted moving average:


A weighted average is similar to
the moving average, except that it
assigns more weight to the most
recent values in a time series. For
example, the most recent value
might be assigned a value of 0.4,
the next most recent value a
weight of 0.3, the next after that a
weight of 0.2, and the next after
that a weight of 0.1. Note that the
sum of the weights is 1.0.

The weighted moving average can be computed by the following


formula:

Ft wn At n wn 1 At ( n 1) wn 2 At ( n 2) ......w2 At 2 w1 At 1
The advantage of a weighted average over a simple
moving average is that the weighted average is more
reflective of the most recent occurrences. However, the
choice of the weight is somewhat arbitrary and
generally involves the use of trial and error to find a
suitable weighting scheme.

Example 1: Given the demand for


shopping carts for the last five periods.
Period

Demand

42

40

43

40

41

(a) Compute a weighted moving average forecast using a


weight of 0.4 for the most recent period, 0.3 for the next
most recent, 0.2 for the next, and the next after that a
weight of 0.1.
(b) If the actual demand for period 6 is 39, forecast
demand for period 7 using the same weights as in part (a).

Solution: (a)

Ft wn At n wn 1 At ( n 1) wn 2 At ( n 2) ......w2 At 2 w1 At 1
F6 w4 At 4 w3 At 3 w2 At 2 w1 At 1
0.1 * 40 0.2 * 43 0.3 * 40 0.4 * 41 41.0
Solution: (b)

Ft wn At n wn1 At ( n 1) wn2 At ( n 2) ......w2 At 2 w1 At 1


F7 w4 At 4 w3 At 3 w2 At 2 w1 At 1
0.1 * 43 0.2 * 40 0.3 * 41 0.4 * 39 40.2

Example 2: Given the following data:

Period

No. of complaints

60

65

55

58

64

(a) Compute a weighted moving average forecast using a


weight of 0.4 for the most recent period, 0.3 for the next
most recent, 0.2 for the next, and the next after that a
weight of 0.1.
(b) If the actual demand for period 6 is 59, forecast demand
for period 7 using the same weights as in part (a).

Exponential smoothing:
Weighted averaging method based on previous forecast plus a
percentage of the forecast error.
It is sophisticated weighted average method that is still relatively easy
to use and understand.
Next forecast = Previous forecast +

(actual previous forecast)


That is,

Ft Ft 1 At 1 Ft 1
= The smoothing constant = % of the error

At 1 = Actual value in the previous period


Ft = Forecast for time period t
Ft 1 = Forecast for the previous time period

Commonly used value of ranges from 0.05 to 0.5. Low values are used when the average tends to be stable. Higher values of

are used when the average is not stable.

Example 1: Given the following data:


Period

No. of complaints

60

65

55

58

64

Use exponential smoothing approach with a smoothing constant of 0.4 to make the forecast for the next period.

Solution:

Period

No. of complaints

60

65

60

60 + 0.4(65-60) = 62

55

62

62 + 0.4(55-62) = 59.2

58

59.2

59.2 + 0.4(58-59.2) = 58.72

64

58.72

58.72 + 0.4(64-58.72) = 60.83

Forecast

Calculations
60 is the initial forecast

60.83

Example 2: Given the demand for shopping


carts for the last five periods.

Period

Demand

42

40

43

40

41

Use exponential smoothing approach with a


smoothing constant of 0.3 to make the forecast
for the next period.

Example: Cell phone for a firm over the last 10 weeks are shown as follows. Would a linear
trend line be appropriate? Determine the equation of the trend line and predict sales for
weeks 11 and 12.
Week

10

Unit Sales

700

724

720

728

740

742

758

750

770

775

This plot suggests that a linear trend is appropriate.

ty

700

700

724

1448

720

2160

728

2912

740

3700

742

4452

758

5306

750

6000

770

6930

10

775

7750

7407

41358

Given
n 10,

55,

n ty t y
n t t
2

385

10 41,358 55 7,407

7.51
10 385 55 55

y b t 7,407 7.51 55

699.4
n

10

The trend line is

Ft a b t 699.4 7.51t
where t = 0 for period 0.

The forecast for period 11 is

F11 a b t 699.4 7.51 11 782.01

The forecast for period 12 is

F11 a b t 699.4 7.51 12 789.52

Example2: Plot the following data on a graph and verify visually


that a linear trend line is appropriate. Develop a line trend
equation. Then use the equation to predict the next two values of
the series.
Period

Demand

44

52

50

54

55

55

60

56

62

Associative forecasting techniques


The essence of associative techniques is the
development of an equation that summarizes the effects
of predictor variables (which is used to predict values of
the variable of interest). Linear regression method is used
for this analysis.

Linear regression method


Technique for fitting a line to a set of points. The objective
in linear regression is to obtain an equation of a straight
y c a bx
line that minimizes
the sum of squared vertical deviations
of data points from the line. The least squares line has
the equation

x = predictor or independent variable


a= Value of at x = 0
b= Slope of the line
yc= Predicted or dependent variable
The line intersect the y axis where y =
a. The slope of the line is b.
The coefficients of the line a and b can
be computed from the formulas:

y
y c a bx
y

x
a

y
x

n xy
n x 2

x y
x
2

and

y b x

a
y bx
n

where n is the number of periods and y is the


time series.

Example: Healthy hamburger has a chain of 12 stores in California. Sales figures and profits for the
stores given below. Obtain a regression line for the data and predict for a store assuming sales of
$10 million.
Unit sales x $
million

14

15

16

12

14

20

15

Profit y
$ million

0.15

0.10

0.13

.15

.25

0.27

0.24

0.2

0.27

0.44

0.34

0.17

Solution:
Step1: Plot the data and decide if a linear model is
reasonable.
x
y
Forecasts
7

.15

0.1621124

0.10

0.0824612

0.13

0.1461822

0.15

0.1143217

14

0.25

0.273624

15

0.27

0.2895543

16

0.24

0.3054845

12

0.20

0.2417636

14

0.27

0.273624

20

0.44

0.3692054

15

0.34

0.2895543

0.17

0.1621124

Step2:

n xy x y
n x 2 x

12 3529 132 271


0.0159
12 1796 132 132

y b x 271 0.0159 132

0.0506
n

12

Obtain the regression yc 0.0506 0.0159 x


For example, for sale of x = 7, estimated profit is

y c 0.0506 0.0159 7 0.1621124

or $162,1124

Example: The owner of a hardware store has noted a sales pattern for window locks that
seems to be parallel the number of break-ins reported each week in the newspaper. The
data are:
sales

46

18

20

22

27

34

14

37

30

Break-ins

c.

a. Plot the data to see the type of the graph


b. Obtain a regression equation for the data.
Estimate sales when the number of break-ins is 5.

Comments on the use of


linear regression:

Variations around the line are random.

Deviations around the line should be


narrowly distributed.

Predictions are made within the range of the


observed values.

Forecast accuracy:
Forecasting accuracy is a significant factor when deciding among forecasting
alternatives. Accuracy is based on the historical error performance of a forecast.
Three common methods for measuring historical errors are:
(i) Mean absolute deviation (MAD): Average absolute error. MAD =

(ii) Mean squared error (MSE): Average of squared errors. MSE =

At Ft
n
t

n 1

(iii) Mean absolute percent error (MAPE): Average absolute percent error.

MAPE =

Ft

At
n

100%

Ft

Example: Compute MAD, MSE, and MAPE for the following


data.

Error Actual 100

Error 2

Error

Period

Actual

Forecast

Error (A-F)

217

215

0.92%

213

216

-3

1.41

216

215

0.46

210

214

-4

16

1.9

213

211

0.94

219

214

25

2.28

216

217

-1

0.46

212

216

-4

16

1.89

-2

22

76

10.26%

(i) Mean absolute deviation (MAD) =

(ii) Mean squared error (MSE) =

Ft

Ft

n 1

76
10.86
8 1

(iii) Mean absolute percent error (MAPE) =

22
2.75
8

Ft

At
n

100%

10.26%
1.28%
8

Example 2: Calculate MAD, MSE and MAPE for the following data and
compare them
Month

Demand

Forecast
Technique 1

Technique 2

492

488

495

470

484

482

485

480

478

493

490

488

498

497

492

492

493

493

Control forecast/ Monitor


forecast:

Tracking signal method:


Tracking signal method is used to monitor a
forecast. This method is an older method which is
the ratio of the cumulative forecast error to the
corresponding value of MAD.
Tracking signalt =

Ft

MADt

Example: For last slide example Tracking signalt =

A F
t

MADt

2
0.7
2.75

The End