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Oskoorouchi

Summer 2006

CHAPTER

3

Forecasting

What is Forecasting?

FORECAST:

• •

A statement about the future value of a variable of interest such as demand. Forecasts affect decisions and activities throughout an organization • Accounting, finance • Human resources • Marketing • MIS • Operations • Product / service design

strategy IT/IS systems. MRP. workloads New products and services .Uses of Forecasts Accounting Finance Human Resources Marketing MIS Operations Product/service design Cost/profit estimates Cash flow and funding Hiring/recruiting/training Pricing. services Schedules. promotion.

individuals Forecast accuracy decreases as time horizon increases I see that you will get an A this semester.Common in all forecasts • Assumes causal system past ==> future Forecasts rarely perfect because of randomness Forecasts more accurate for groups vs. • • • .

Elements of a Good Forecast Timely Reliable l fu Accurate se u M g in an e Written sy Ea to .

Steps in the Forecasting Process “The forecast” Step 6 Monitor the forecast Step 5 Prepare the forecast Step 4 Gather and analyze data Step 3 Select a forecasting technique Step 2 Establish a time horizon Step 1 Determine purpose of forecast .

uses explanatory variables to predict the future • .uses historical data assuming the future will be like the past Associative models .Types of Forecasts • • Judgmental .uses subjective inputs Time series .

Judgmental Forecasts • Executive opinions Sales force opinions Consumer surveys Outside opinion • • • .

Time Series Forecasts • Trend .caused by chance .long-term movement in data • Seasonality .short-term regular variations in data • Cycle – wavelike variations of more than one year’s duration • Irregular variations .caused by unusual circumstances • Random variations .

Forecast Variations Irregular variation Trend Cycles 90 89 88 Seasonal variations .

Now. next week we should sell..... The forecast for any period equals the previous period’s actual value.. give me a minute..Naive Forecasts Uh.. We sold 250 wheels last week... .

Uses for Naive Forecasts • Stable time series data • F(t) = A(t-1) F(t) = A(t-n) F(t) = A(t-1) + (A(t-1) – A(t-2)) • Seasonal variations • • Data with trends • .

Naive Forecasts • Simple to use • Virtually no cost • Quick and easy to prepare • Easily understandable • Can be a standard for accuracy • Cannot provide high accuracy .

Techniques for Averaging • • • Moving average Weighted moving average Exponential smoothing .

Moving Averages • Moving average – A technique that averages a number of recent actual values. 83 80 85 90 94 MA = ∑1 Ai i= n n . • The demand for tires in a tire store in the past 5 weeks were as n follows. updated as new values become available. Compute a three-period moving average forecast for demand in week 6.

Moving average & Actual demand .

Moving Averages

•

Weighted moving average – More recent values in a series are given more weight in computing the forecast.

Example:

•

•

For the previous demand data, compute a weighted average forecast using a weight of .40 for the most recent period, .30 for the next most recent, .20 for the next and .10 for the next. If the actual demand for week 6 is 91, forecast demand for week 7 using the same weights.

Exponential Smoothing

Ft = Ft-1 + α (At-1 - Ft-1 )

• The most recent observations might have the highest predictive value.

•

Therefore, we should give more weight to the more recent time periods when forecasting.

Exponential Smoothing

Ft = Ft-1 + α (At-1 - Ft-1 )

•

Weighted averaging method based on previous forecast plus a percentage of the forecast error • A-F is the error term, α is the % feedback

Example .54 84.07 90.4 83 81.20 87.08 .92 6.53 90.35 Error -3 3.54 89.00 86.92 91.93 0.93 83.70 82.68 Error -3.56 87.47 1.08 85.56 4.90 90.1 83 82.46 10.20 5.44 86.80 83.45 88.Exponential Smoothing Period Actual 1 83 2 80 3 85 4 89 5 92 6 95 7 91 8 90 9 88 10 93 11 92 12 0.54 3.62 5.84 90.00 1.60 6.80 0.55 6.40 86.00 2.38 85.07 8.16 -0.30 6.90 -2.44 4.

10 Alpha=0.40 100 95 Demand 90 85 80 75 70 2 3 4 5 6 7 8 9 10 11 Period .Picking a Smoothing Constant Exponential Smoothing Actual Alpha=0.

. The naive approach A weighted average using . and . .Problem 1 • National Mixer Inc.10 for June.20.30 for July. sells can openers. Monthly sales for a seven-month period were as follows: • Forecast September sales volume using each of the following: • • Month Feb Mar Apr May Jun Jul Aug Sales (1000) 19 18 15 20 18 22 20 • • A five-month moving average Exponential smoothing with a smoothing constant equal to . assuming a March forecast of 19.60 for August.

Actual usage was 89.1 is used. A smoothing constant of 0. August usage was forecast to be 88% of capacity.Problem 2 • A dry cleaner uses exponential smoothing to forecast equipment usage at its main plant.6%. • Prepare a forecast for September • Assuming actual September usage of 92%. prepare a forecast of October usage .

Use 20 for week 2 forecast.30.Problem 3 • An electrical contractor’s records during the last five weeks indicate the number of job requests: Week: 1 2 3 4 5 Requests: 20 22 18 21 22 Predict the number of requests for week 6 using each of these methods: • • • Naïve A four-period moving average Exponential smoothing with a smoothing constant of . .

Review: forecast • Assumes causal system past ==> future Forecasts rarely perfect because of randomness Forecasts more accurate for groups vs. individuals Forecast accuracy decreases as time horizon increases • • • .

Review: forecast • Naïve technique • Stable time series data • Seasonal variations • Data with trends • Averaging • Moving average • Weighted moving average • Exponential smoothing .

• The trend component may be linear or nonlinear • We focus on linear trends . when trend is present.Techniques for Trend • Develop an equation that will suitably describe trend.

Common Nonlinear Trends Parabolic Exponential Growth .

Plot F .Linear Trend Equation Ft Ft = a + bt • • • • • Ft = Forecast for period t 0 1 t = Specified number of time periods a = Value of Ft at t = 0 b = Slope of the line 2 3 4 5 t Example: Ft =10+2t. Interpret 10 and 2.

Example • Sales for over the last 5 weeks are shown below: 1 150 2 157 3 162 4 166 5 177 Week: Sales: • Plot the data and visually check to see if a linear trend line is appropriate. • Determine the equation of the trend line • Predict sales for weeks 6 and 7. .

Line chart Sales 180 175 170 165 Sales 160 155 150 145 140 135 1 2 3 Week 4 5 Sales .

Calculating a and b n ∑ (ty) .( ∑ t) 2 ∑ y .b∑ t a = n .∑ t ∑ y b = n∑ t 2 .

Linear Trend Equation Example t W 1 2 3 4 5 Σ t 2 (Σ t ) = = 2 e e k t 1 4 9 1 6 2 5 2 y S 1 1 1 1 1 5 Σ 5y a 5 5 6 6 7 = le s t y 0 1 5 0 7 3 1 4 2 4 8 6 6 6 6 4 7 8 8 5 8Σ 1 y 2 = t 2 4 9 1 Σ 5t = 2 2 5 .

5 + 6.3(15) a = = 143.3t .3 5(55) .Linear Trend Calculation 5 (2499) .15(812) 12495-12180 b = = = 6.225 275 -225 812 .5 5 y = 143.6.

Linear Trend plot Actual data 180 175 170 165 160 155 150 145 140 135 1 2 3 4 5 Linear equation .

sells can openers. Monthly sales for a seven-month period were as follows: • • • • Month Feb Mar Apr May Jun Jul Aug Sales (1000) 19 18 15 20 18 22 20 Plot the monthly data Forecast September sales volume using a line trend equation Which method of forecast seems least appropriate? What does use of the term sales rather than demand presume? .Recall: Problem 1 • National Mixer Inc.

Line chart Sales 20 0 F M J A Month A M S J .

.Problem 4 • A cosmetics manufacturer’s marketing department has developed a linear trend equation that can be used to predict annual sales of its popular Hand & Foot Cream: Ft = 80 + 15t where Ft = Annual sales (1000 bottles) t = 0 corresponds to 1990 • • Are annual sales increasing or decreasing? By how much? Predict annual sales for the year 2006 using the equation.

20 units).Techniques for Seasonality • Seasonality may refer to regular annual variation.g. which is added or subtracted from the series average Multiplicative: a percentage of the average or seasonal relative (e. There are two models: • Additive: expressed as a quantity (e.. which is used to multiply the value of a series to incorporate seasonality.10). • .. 1.g.

Additive vs. multiplicative .

Q4 = 0.95 • Use this information to predict demand for periods 15 and 16. which happen to be the second and third quarters of a particular year.Example • A furniture manufacturer wants to predict quarterly demand for a certain loveseat for periods 15 and 16.75.5t • Quarter relatives are Q1 = 1. Q3 = 0. .10. The series consists of both trend and seasonality. Q2 = 1.20. The trend portion of demand is projected using the equation Ft = 124 + 7.

2. and Q4 = 1. Q3 = 1.000 + 80t where t = 0 at Q2 of last year • Quarter relatives are Q1 = .Problem • A manager is using the equation below to forecast quarterly demand for a product: Y(t) = 6. • What forecasts are appropriate for the last quarter of this year and the first quarter of next year? . Q2 = .9.3.6.

and .95 for March.Problem • A manager of store that sells and installs hot tubs wants to prepare a forecast for January.02 for Feb.10 for Jan. Her forecasts are a combination of trend and seasonality. February and March of 2007. What demands should she predict? . Seasonal relatives are 1. 1. She uses the following equation to estimate the trend component of monthly demand: Ft = 70 + 5t Where t=0 is June of 2005.

Computing seasonal relatives 120 100 80 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 If your data appears to have seasonality. how do you compute the seasonal relatives? .

Computing seasonal relatives • Calculate centered moving average for each period. • Number of periods needed in a centered moving average = Number of seasons involved: • Monthly data: a 12-period moving average • Quarterly data: a 4-period moving average . • Obtain the ratio of the actual value of the period over the centered moving average.

Using a seven-period centered moving average.xls • .Example • The manager of a parking lot has computed the number of cars per day in the lot for three weeks. See seasonal relatives1. Note that a seven period centered moving average is used because there are seven days (seasons) per week. calculate the seasonal relatives.

Problem 5 • Obtain estimates of quarter relatives for these data: Year: 1 2 3 1 2 3 4 45 54 84 88 4 1 58 Quarter: 1 2 3 4 1 2 3 4 Demand: 14 18 35 46 28 36 60 71 .

25% on Friday night. and 20% on Saturday night.Problem • The manager of a restaurant believes that her restaurant does about 10% of its business on Sunday through Wednesday. 15% on Thursday night. • What seasonal relatives would describe this situation? .

. • Deseasonalize = Remove seasonal component from data • Gives clearer picture of the trend (nonseasonal component) • Deseasonalize can be done by dividing each data point by its seasonal relative.Note: • An alternative to deal with seasonality is to deseasonalize data.

uses subjective inputs Time series .uses historical data assuming the future will be like the past • • • • Naïve approach Averaging Techniques for trend Trend and seasonality • Associative models .uses explanatory variables to predict the future .Forecasts: review • • Judgmental .

minimizes sum of squared deviations around the line • • .Associative Forecasting • Predictor variables .used to predict values of variable interest Regression .technique for fitting a line to a set of points Least squares line .

with the advertising campaign of $2.LINEAR REGRESSION LINEAR REGRESSION Suppose that J&T has a new product called “AppleGlo”. the first year sales are shown in the table for each region.0 52 O h io 0 .5 101 W e s t V ir g in ia 0 .0 and $1. The company would like to predict what the expected first year sales of AppleGlo would be in each region. which is a household cleaner. F irs tY e a r A p p le G lo A d v e rtis in g F irs tY e a r E x p e n d itu re s S a le s ($ m illio n s ) ($ m illio n s ) R e g io n x y M a in e 1 .7 46 V irg in ia 1 .0 65 M a ry la n d 1 .5 43 C o n n e c tic u t 2 .5 134 N e w Y o r k 1 .5 127 R h o d e Isla n d 2 .6 102 D e la w a re 1 .2 77 P e n n s y lv a n ia 1 .5 million.8 104 N e w H a m p s h ir e 1 .2 68 V e rm o n t 0 . The company is considering introducing AppleGlo into two new regions.8 33 . The Advertising expenditure vs. This new product has been introduced into 14 sales regions over the last two years.5 87 N e w Je rs e y 1 .4 39 M a s s a c h u s e tts 0 .

5 Advertising Expenditures ($Millions) Questions: • • • How to relate advertising to sales? What is expected first-year sales if advertising expenditure is $1M? How confident are you in the estimate? How good is the fit? .5 1 1.5 2 2.LINEAR REGRESSION LINEAR REGRESSION 160 140 120 Sales ($Millions) 100 80 60 40 20 0 0 0.

Correlation The correlation coefficient is a quantitative measure of the strength of the linear relationship between two variables.0 to .0 indicates a perfect linear relationship.0. . whereas a correlation of 0 indicates no linear relationship. A correlation of ± 1. The correlation ranges from + 1.1.

An algebraic formula for correlation coefficient r= [n(∑ x ) − (∑ x) ][n(∑ y ) − (∑ y ) ] 2 2 2 2 n∑ xy − ∑ x ∑ y .

y = a + bx where: y = Value of the dependent variable x = Value of the independent variable a = Population’s y-intercept b = Slope of the population regression line .Simple Linear Regression Simple linear regression analysis analyzes the linear relationship that exists between two variables.

Simple Linear Regression The coefficients of the line are b= n∑ xy − ∑ x ∑ y n∑ x − (∑ x ) 2 2 or ∑ y − b∑ x a= n a = y − bx .

50 6. Determine the correlation coefficient and interpret it Obtain the regression line and interpret its coefficients.50 8.00 9.75 9.50 8.25 8.25 7.00 8.75 7. Experimenting with prices produced the following data: • Sold (y) 200 190 188 180 170 162 160 155 156 148 140 133 Price (x) 6. • • .00 6.Problem 7 • The manager of a seafood restaurant was asked to establish a pricing policy on lobster dinners.00 7.25 Create the scatter plot and determine if a linear relationship is appropriate.

Forecast Accuracy • Source of forecast errors: • • • • Model may be inadequate Irregular variations Incorrect use of forecasting technique Random variation • Key to validity is randomness • • Accurate models: random errors Invalid models: nonrandom errors • Key question: How to determine if forecasting errors are random? .

Error measures • Error .difference between actual value and predicted value Mean Absolute Deviation (MAD) • • Average absolute error Average of squared error Average absolute percent error • Mean Squared Error (MSE) • • Mean Absolute Percent Error (MAPE) • .

and MAPE MAD = ∑ Actual − forecast n MSE = ∑ ( Actual − forecast) n -1 2 MAPE = ∑ Actual − Forecast × 100 Actual n . MSE.MAD.

28 .9 9 1.8 76 10.Example Period 1 2 3 4 5 6 7 8 Actual 217 213 216 210 213 219 216 212 Fore cast 215 216 215 214 211 214 217 216 (A-F) 2 -3 1 -4 2 5 -1 -4 -2 |A-F| 2 3 1 4 2 5 1 4 22 (A-F)^2 (|A-F|/Actual)*1 4 0.4 16 1.86 1.4 1 0.9 25 2.2 1 0.4 16 1.2 MAD= MSE= MAPE= 2.75 10.9 4 0.

are present . such as trends or cycles.Controlling the Forecast • Control chart • A visual tool for monitoring forecast errors • Used to detect non-randomness in errors • Forecasting errors are in control if • All errors are within the control limits • No patterns.

Controlling the forecast .

• Standard deviation of error is MSE • 95. they are Normally distributed around a mean of zero.Control charts • Control charts are based on the following assumptions: • when errors are random.5% of data in a normal distribution is within 2 standard deviation of the mean • 99.7% of data in a normal distribution is within 3 standard deviation of the mean • Upper and lower control limits are often determine via 0 ±2 MSE or0 3 MSE ± .

295 2 s = 6.Example • Compute 2s control limits for forecast errors of previous example and determine if the forecast is accurate.41 -0. forecast is reliable 10 .59 -6. 5.59 -4. according to control chart criterion.41 s = MSE = 3.41 1.59 Errors are all between -6.59 0 -2.59 • • • 3.59 and +6.59 No pattern is observed Therefore.

• 1 2 3 4 5 6 7 8 9 10 11 12 13 1 29 1 94 156 91 85 1 32 1 26 1 26 95 1 49 98 85 137 1 24 20 0 150 94 80 1 40 1 28 1 24 100 150 94 80 1 40 .Problem 8 • The manager of a travel agency has been using a seasonally adjusted forecast to predict demand for packaged tours. then evaluate the remaining data with the control chart. The actual and predicted values are • Pe rio d De m a nd Predic te d Compute MAD. MSE. Determine if the forecast is working using a control chart with 2s limits. Use data from the first 8 periods to develop the control chart. and MAPE.

Problem • Given the following demand data. and use those values to obtain 2s control limits. Then determine each forecast error. prepare a naïve forecast for periods 2 through 10. can you conclude that the forecasts are in control? Period Demand 1 2 3 4 5 6 7 8 9 10 118 117 120 119 126 122 117 123 121 124 . If demand in the next two periods turns out to be 125 and 130.

Choosing a Forecasting Technique • No single technique works in every situation • Two most important factors • Cost • Accuracy • Other factors include the availability of: • Historical data • Computers • Time needed to gather and analyze the data • Forecast horizon .

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