Chapter 3

Forecasting

McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 3: Learning Objectives

 You should be able to:

1. List the elements of a good forecast
2. Outline the steps in the forecasting process
3. Describe at least three qualitative forecasting techniques and
the advantages and disadvantages of each
4. Compare and contrast qualitative and quantitative approaches
to forecasting
5. Describe averaging techniques, trend and seasonal techniques,
and regression analysis, and solve typical problems
6. Explain three measures of forecast accuracy
7. Compare two ways of evaluating and controlling forecasts
8. Assess the major factors and trade-offs to consider when
choosing a forecasting technique

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Forecast

Forecast – a statement about the future value of a

variable of interest
 We make forecasts about such things as weather,
demand, and resource availability
 Forecasts are an important element in making informed
decisions
I see that you will
get an “A” this semester

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Two Important Aspects of Forecasts

Expected level of demand

 The level of demand may be a function of some
structural variation such as trend or seasonal variation
Accuracy
 Related to the potential size of forecast error

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 Features Common to All Forecasts

1. Techniques assume some underlying causal system that

existed in the past will persist into the future
2. Forecasts are not perfect
3. Forecasts for groups of items are more accurate than
those for individual items
4. Forecast accuracy decreases as the forecasting horizon
increases

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 Elements of a Good Forecast

The forecast
 should be timely
 should be accurate
 should be reliable
 should be expressed in meaningful units
 should be in writing
 technique should be simple to understand and use
 should be cost effective

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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
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Forecast Accuracy and Control
Forecasters want to minimize forecast errors
It is nearly impossible to correctly forecast real-
world variable values on a regular basis
So, it is important to provide an indication of
the extent to which the forecast might deviate
from the value of the variable that actually
occurs
Forecast accuracy should be an important
forecasting technique selection criterion
Error = Actual – Forecast
If errors fall beyond acceptable bounds,
corrective action may be necessary
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 Forecast Accuracy Metrics

MAD
MAD 
 Actual t  Forecast t
 Easy to compute
n  Weights errors linearly
MSE
  Actual t  Forecast t 
2

MSE   Squares error

n 1  More weight to large errors
MAPE
Actual t  Forecast t
 Actual t
100  Puts errors in perspective
MAPE 
n

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 Forecast Error Calculation

Actual Forecast (A-F)

Period
(A) (F) Error |Error| Error2 [|Error|/Actual]x100
1 107 110 -3 3 9 2.80%

2 125 121 4 4 16 3.20%

3 115 112 3 3 9 2.61%

4 118 120 -2 2 4 1.69%

5 108 109 1 1 1 0.93%

Sum 13 39 11.23%

n=5 n-1 = 4 n=5

MAD MSE MAPE

= 2.6 = 9.75 = 2.25%

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Forecasting Approaches
Qualitative Forecasting
 Qualitative techniques permit the inclusion of soft
information such as:
Human factors
Personal opinions
Hunches
 These factors are difficult, or impossible, to quantify
Quantitative Forecasting
 Quantitative techniques involve either the projection
of historical data or the development of associative
methods that attempt to use causal variables to make a
forecast
 These techniques rely on hard data
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Time-Series Forecasts

Forecasts that project patterns identified in

recent time-series observations
Time-series - a time-ordered sequence
of observations taken at regular time
intervals
Assume that future values of the time-series
can be estimated from past values of the
time-series

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Time-Series Behaviors

Trend
Seasonality
Cycles
Irregular variations
Random variation

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Time-Series Behaviors

Irregular
variation
Random
Trend variations

Cycles

14
15
16
Seasonal variations

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Time-Series Forecasting - Naïve Forecast
Naïve Forecast
 Uses a single previous value of a time series as the basis
for a forecast
The forecast for a time period is equal to the previous
time period’s value
 Can be used with
a stable time series Uh, give me a minute.. We sold 250
seasonal variations wheels last week.... Now, next week
trend we should sell....

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Naïve Forecasts
Data with trends Example

Week Sales F (t) = A(t-1) + (A(t-1) – A(t-2))

(t) y F (6) = A (5) + (A(5) – A (4))
1 150 F (6) = 177 + (177 – 166)
2 157 F (6) = 177 + 11
3 162 F (6) = 188
4 166
5 177
6 ?

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Time-Series Forecasting - Averaging

These Techniques work best when a series

tends to vary about an average
Averaging techniques smooth variations in
the data
They can handle step changes or gradual
changes in the level of a series
Techniques
1. Moving average
2. Weighted moving average
3. Exponential smoothing

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Moving Average

Technique that averages a number of the most

recent actual values in generating a forecast
n

A t i
Ft  MA n  i 1
n
where
Ft  Forecast for time period t
MA n  n period moving average
At 1  Actual value in period t  1
n  Number of periods in the moving average
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Moving Average

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 Moving Average
As new data become available, the forecast is
updated by adding the newest value and dropping
the oldest and then re-computing the average
The number of data points included in the
average determines the model’s sensitivity
Fewer data points used-- more responsive
More data points used-- less responsive MA5

MA3

Actual

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Weighted Moving Average
The most recent values in a time series are given
more weight in computing a forecast
The choice of weights, w, is somewhat arbitrary
and involves some trial and error
Ft 1  wt ( At )  wt 1 ( At 1 )  ...  wt  n ( At  n )
where
wt  weight for period t ,
wt 1  weight for period t  1, etc.
At  the actual value for period t ,
At 1  the actual value for period t  1, etc.
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Example 2

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 Exponential Smoothing

A weighted averaging method that is based

on the previous forecast plus a percentage of
the forecast error
Ft  Ft 1   ( At 1  Ft 1 )
where
Ft  Forecast for period t
Ft 1  Forecast for the previous period
 = Smoothing constant
At 1  Actual demand or sales from the previous period
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Example 3

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 Solution
a) The values are stable (i.e., no trend or cycles).
Therefore, the most recent value of the series
becomes the next forecast: 64

b)

c)

d)

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Picking a Smoothing Constant
Period Actual Alpha = 0.1 Error Alpha = 0.4 Error
1 42
2 40 42 -2.00 42 -2
3 43 41.8 1.20 41.2 1.8
4 40 41.92 -1.92 41.92 -1.92
5 41 41.73 -0.73 41.15 -0.15
6 39 41.66 -2.66 41.09 -2.09
7 46 41.39 4.61 40.25 5.75
8 44 41.85 2.15 42.55 1.45
9 45 42.07 2.93 43.13 1.87
10 38 42.36 -4.36 43.88 -5.88
11 40 41.92 -1.92 41.53 -1.53
12 41.73 40.92

50 Actual .4
 .1
D e m a nd

45

40

35
1 2 3 4 5 6 7 8 9 10 11 12
Period 3-26
Linear Trend

A simple data plot can reveal the existence

and nature of a trend
Linear trend equation

Ft  a  bt
where
Ft  Forecast for period t
a  Value of Ft at t  0
b  Slope of the line
t  Specified number of time periods from t  0
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 Estimating slope and intercept

Slope and intercept can be estimated from historical

data
n ty   t  y
b
n t 2    t 
2

a
 y  b t
or y  bt
n

where
n  Number of periods
y  Value of the time series

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Example
Calculate the Linear trend Equation for the
following set of sales data

Week Sales t 2 y ty
t
t y Week Sales
1 150 1 1 150 150
2 157 2 4 157 314
3 162
4 166
3 9 162 486
5 177 4 16 166 664
5 25 177 885

S t = 15 S t2 = 55 S y = 812 Sty = 2499

2
(S t) = 225

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Linear Trend Calculation

5 (2499) - 15(812) 12495 -12180

b = = = 6.3
5(55) - 225 275 - 225

812 - 6.3(15)
a = = 143.5
5

y = 143.5 + 6.3t
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Associative Forecasting Techniques

Associative techniques are based on the

development of an equation that summarizes
the effects of predictor variables
Predictor variables - variables that can be used to
predict values of the variable of interest
House prices may be related to such factors as home and
property size, location, number of bedrooms, and number
of bathrooms

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 Simple Linear Regression

Regression - a technique for fitting a line to a set of

data points
 Simple linear regression - the simplest form of
regression that involves a linear relationship between
two variables
The object of simple linear regression is to obtain an
equation of a straight line that minimizes the sum of
squared vertical deviations from the line (i.e., the least
squares criterion)

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 Least Squares Line
minimizes sum of squared deviations around the line
yc  a  bx
where
yc  Predicted (dependent) variable
x  Predictor (independe nt) variable
b  Slope of the line
a  Value of yc when x  0 (i.e., the height of the line at the y intercept)
and
n  xy     x   y 
b
 
n  x2   x
2

a
 y  b x
or y  b x
n
where
n  Number of paired observatio ns
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Simple Linear Regression

X Y
7 15 Computed
2 10
6 13 relationship
4 15 50
14 25 40

15 27 30

16 24 20

12 20 10

14 27 0
0 5 10 15 20 25

20 44
15 34 A straight line is fitted to a set of sample points.
7 17

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 Formulas
n (x.y) -  x  y
x y
b = (wins) (attendance, 1,000s) xy x2
 2 2
n x - (  x) 4
6
36.3
40.1
145.2 16
240.6 36
6 41.2 247.2 36
8 53.0 424.0 64

 y - bx 6
7
44.0
45.6
264.0 36
319.2 49
a= 5 39.0 195.0 25
n 7 47.5 332.5 49
49 346.7 2,167.7 311

Yx = a + bx
y 18.46  4.06x

Attendance forecast for x  7 wins is :

y 18.46  4.06(7)  46.88 or 46,880

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Choosing a Forecasting Technique

Factors to consider
Cost
Accuracy
Availability of historical data
Availability of forecasting software
Time needed to gather and analyze data
and prepare a forecast
Forecast horizon

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Using Forecast Information
Reactive approach
View forecasts as probable future demand
React to meet that demand
Proactive approach
Seeks to actively influence demand
Advertising
Pricing
Product/service modifications
Generally requires either an explanatory model
or a subjective assessment of the influence on
demand

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Operations Strategy
The better forecasts are, the more able
organizations will be to take advantage of future
opportunities and reduce potential risks
 A worthwhile strategy is to work to improve short-term
forecasts
Accurate up-to-date information can have a
significant effect on forecast accuracy:
 Prices
 Demand
 Other important variables
 Reduce the time horizon forecasts have to cover
 Sharing forecasts or demand data through the
supply chain can improve forecast quality
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