Slides Prepared by John Loucks

Slides prepared
by John Loucks
 2002 South-Western/Thomson Learning TM 1 1

Chapter
Chapter 33
Demand Forecasting
2
Overview

Introduction

Qualitative Forecasting Methods

Quantitative Forecasting Models

How to Have a Successful Forecasting System

Computer Software for Forecasting

Forecasting in Small Businesses and Start-Up
Ventures

Wrap-Up: What World-Class Producers Do
3
Introduction

Demand estimates for products and services are the
starting point for all the other planning in operations
management.

Management teams develop sales forecasts based in
part on demand estimates.

The sales forecasts become inputs to both business
strategy and production resource forecasts.
4
Forecasting is an Integral Part
of Business Planning
Inputs: Forecast Demand

Market, Method(s) Estimates
Economic,
Other
Sales Management
Forecast Team
Business Production Resource

Strategy Forecasts
5
Some Reasons Why
Forecasting is Essential in OM

New Facility Planning – It can take 5 years to design
and build a new factory or design and implement a
new production process.

Production Planning – Demand for products vary
from month to month and it can take several months
to change the capacities of production processes.

Workforce Scheduling – Demand for services (and
the necessary staffing) can vary from hour to hour
and employees weekly work schedules must be
developed in advance.
6
Examples of Production Resource Forecasts
Forecast Time Item Being Unit of

Horizon Span Forecasted Measure
Long Product Lines, Dollars,
Years
Range Factory Capacities Tons
Medium Product Groups, Units,
Months
Range Depart. Capacities Pounds
Short Days, Specific Products, Units,
Range Weeks Machine Capacities Hours
7
Forecasting Methods

Qualitative Approaches

Quantitative Approaches
8
Qualitative Approaches

Usually based on judgments about causal factors that
underlie the demand of particular products or services

Do not require a demand history for the product or
service, therefore are useful for new products/services

Approaches vary in sophistication from scientifically
conducted surveys to intuitive hunches about future
events

The approach/method that is appropriate depends on
a product’s life cycle stage
9
Qualitative Methods

Educated guess intuitive hunches

Executive committee consensus

Delphi method

Survey of sales force

Survey of customers

Historical analogy

Market research scientifically conducted surveys
10
Quantitative Forecasting Approaches

Based on the assumption that the “forces” that
generated the past demand will generate the future
demand, i.e., history will tend to repeat itself

Analysis of the past demand pattern provides a good
basis for forecasting future demand

Majority of quantitative approaches fall in the
category of time series analysis
11
Time
Time Series
Series Analysis
Analysis

A time series is a set of numbers where the order or
sequence of the numbers is important, e.g., historical
demand

Analysis of the time series identifies patterns

Once the patterns are identified, they can be used to
develop a forecast
12
Components of a Time Series

Trends are noted by an upward or downward sloping
line.

Cycle is a data pattern that may cover several years
before it repeats itself.

Seasonality is a data pattern that repeats itself over
the period of one year or less.

Random fluctuation (noise) results from random
variation or unexplained causes.
13
Seasonal Patterns
Length of Time Number of

Before Pattern Length of Seasons
Is Repeated Season in Pattern
Year Quarter 4
Year Month 12
Year Week 52
Month Day 28-31
Week Day 7
14
Quantitative Forecasting Approaches

Linear Regression

Simple Moving Average

Weighted Moving Average

Exponential Smoothing (exponentially weighted
moving average)

Exponential Smoothing with Trend (double
exponential smoothing)
15
Long-Range
Long-Range Forecasts
Forecasts

Time spans usually greater than one year

Necessary to support strategic decisions about
planning products, processes, and facilities
16
Simple Linear Regression

Linear regression analysis establishes a relationship
between a dependent variable and one or more
independent variables.

In simple linear regression analysis there is only one
independent variable.

If the data is a time series, the independent variable is
the time period.

The dependent variable is whatever we wish to
forecast.
17

Regression Equation
This model is of the form:
Y = a + bX
Y = dependent variable
X = independent variable
a = y-axis intercept
b = slope of regression line
18

Constants a and b
The constants a and b are computed using the
following equations:
a=
  y- x xy
x 2
n  x 2 -(  x)2
n xy-  x y
b=
n  x 2 -(  x)2
19

Once the a and b values are computed, a future value
of X can be entered into the regression equation and a
corresponding value of Y (the forecast) can be
calculated.
20
Example: College Enrollment

At a small regional college enrollments have grown
steadily over the past six years, as evidenced below.
Use time series regression to forecast the student
enrollments for the next three years.
Students Students
Year Enrolled (1000s) Year Enrolled (1000s)
1 2.5 4 3.2
2 2.8 5 3.3
3 2.9 6 3.4
21

x y x2 xy
1 2.5 1 2.5
2 2.8 4 5.6
3 2.9 9 8.7
4 3.2 16 12.8
5 3.3 25 16.5
6 3.4 36 20.4
x=21 y=18.1 x2=91 xy=66.5
22

91(18.1)  21(66.5)
a  2.387
6(91)  (21) 2
6(66.5)  21(18.1)
b  0.180
105
Y = 2.387 + 0.180X
23

Y7 = 2.387 + 0.180(7) = 3.65 or 3,650 students
Y8 = 2.387 + 0.180(8) = 3.83 or 3,830 students
Y9 = 2.387 + 0.180(9) = 4.01 or 4,010 students
Note: Enrollment is expected to increase by 180

students per year.
24

Simple linear regression can also be used when the
independent variable X represents a variable other
than time.

In this case, linear regression is representative of a
class of forecasting models called causal forecasting
models.
25
Example: Railroad Products Co.

Simple Linear Regression – Causal Model
The manager of RPC wants to project the firm’s
sales for the next 3 years. He knows that RPC’s long-
range sales are tied very closely to national freight car
loadings. On the next slide are 7 years of relevant
historical data.
Develop a simple linear regression model
between RPC sales and national freight car loadings.
Forecast RPC sales for the next 3 years, given that the
rail industry estimates car loadings of 250, 270, and
300 million.
26

RPC Sales Car Loadings
Year ($millions) (millions)
1 9.5 120
2 11.0 135
3 12.0 130
4 12.5 150
5 14.0 170
6 16.0 190
7 18.0 220
27

x y x2 xy
120 9.5 14,400 1,140
135 11.0 18,225 1,485
130 12.0 16,900 1,560
150 12.5 22,500 1,875
170 14.0 28,900 2,380
190 16.0 36,100 3,040
220 18.0 48,400 3,960
1,115 93.0 185,425 15,440
28

185, 425(93)  1,115(15, 440)

a  0.528
7(185, 425)  (1,115) 2
7(15, 440)  1,115(93)

b  0.0801
7(185, 425)  (1,115) 2
Y = 0.528 + 0.0801X
29

Y8 = 0.528 + 0.0801(250) = $20.55 million
Y9 = 0.528 + 0.0801(270) = $22.16 million
Y10 = 0.528 + 0.0801(300) = $24.56 million
Note: RPC sales are expected to increase by

$80,100 for each additional million national freight
car loadings.
30
Multiple
Multiple Regression
Regression Analysis
Analysis

Multiple regression analysis is used when there are
two or more independent variables.

An example of a multiple regression equation is:
Y = 50.0 + 0.05X1 + 0.10X2 – 0.03X3
where: Y = firm’s annual sales ($millions)

X1 = industry sales ($millions)
X2 = regional per capita income ($thousands)
X3 = regional per capita debt ($thousands)
31
Coefficient of Correlation (r)

The coefficient of correlation, r, explains the relative
importance of the relationship between x and y.

The sign of r shows the direction of the relationship.

The absolute value of r shows the strength of the
relationship.

The sign of r is always the same as the sign of b.

r can take on any value between –1 and +1.
32

Meanings of several values of r:
-1 a perfect negative relationship (as x goes up, y
goes down by one unit, and vice versa)
+1 a perfect positive relationship (as x goes up, y
goes up by one unit, and vice versa)
0 no relationship exists between x and y
+0.3 a weak positive relationship
-0.8 a strong negative relationship
33

r is computed by:
n xy   x  y
r
n x 2  (  x )2   n y 2  ( y )2 
34
Coefficient of Determination (r2)

The coefficient of determination, r2, is the square of
the coefficient of correlation.

The modification of r to r2 allows us to shift from
subjective measures of relationship to a more specific
measure.

r2 is determined by the ratio of explained variation to
total variation:
r2 
 (Y  y ) 2
 ( y  y ) 2
35

Coefficient of Correlation
x y x2 xy y2
120 9.5 14,400 1,140 90.25
135 11.0 18,225 1,485 121.00
130 12.0 16,900 1,560 144.00
150 12.5 22,500 1,875 156.25
170 14.0 28,900 2,380 196.00
190 16.0 36,100 3,040 256.00
220 18.0 48,400 3,960 324.00
1,115 93.0 185,425 15,440 1,287.50
36

Coefficient of Correlation
7(15, 440)  1,115(93)
r
7(185, 425)  (1,115)  7(1, 287.5)  (93) 
2 2
r = .9829
37

Coefficient of Determination
r2 = (.9829)2 = .966
96.6% of the variation in RPC sales is explained by
national freight car loadings.
38
Ranging Forecasts

Forecasts for future periods are only estimates and are
subject to error.

One way to deal with uncertainty is to develop best-
estimate forecasts and the ranges within which the
actual data are likely to fall.

The ranges of a forecast are defined by the upper and
lower limits of a confidence interval.
39
Ranging Forecasts

The ranges or limits of a forecast are estimated by:
Upper limit = Y + t(syx)
Lower limit = Y - t(syx)
where:
Y = best-estimate forecast
t = number of standard deviations from the mean
of the distribution to provide a given proba-
bility of exceeding the limits through chance
syx = standard error of the forecast
40
Ranging Forecasts

The standard error (deviation) of the forecast is
computed as:
s yx =
 - a y - b xy
y 2
n-2
41

Ranging Forecasts
Recall that linear regression analysis provided a
forecast of annual sales for RPC in year 8 equal to
$20.55 million.
Set the limits (ranges) of the forecast so that there
is only a 5 percent probability of exceeding the limits
by chance.
42

Ranging Forecasts

Step 1: Compute the standard error of the
forecasts, syx.
1287.5  .528(93)  .0801(15, 440)
syx   .5748
72

Step 2: Determine the appropriate value for t.
n = 7, so degrees of freedom = n – 2 = 5.
Area in upper tail = .05/2 = .025
Appendix B, Table 2 shows t = 2.571.
43

Ranging Forecasts

Step 3: Compute upper and lower limits.
Upper limit = 20.55 + 2.571(.5748)
= 20.55 + 1.478
= 22.028
Lower limit = 20.55 - 2.571(.5748)
= 20.55 - 1.478
= 19.072
We are 95% confident the actual sales for year 8
will be between $19.072 and $22.028 million.
44
Seasonalized Time Series Regression Analysis

Select a representative historical data set.

Develop a seasonal index for each season.

Use the seasonal indexes to deseasonalize the data.

Perform lin. regr. analysis on the deseasonalized data.

Use the regression equation to compute the forecasts.

Use the seas. indexes to reapply the seasonal patterns
to the forecasts.
45
Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis
An analyst at CPC wants to develop next year’s
quarterly forecasts of sales revenue for CPC’s line of
Epsilon Computers. She believes that the most recent
8 quarters of sales (shown on the next slide) are
representative of next year’s sales.
46


Representative Historical Data Set
Year Qtr. ($mil.) Year Qtr. ($mil.)
1 1 7.4 2 1 8.3
1 2 6.5 2 2 7.4
1 3 4.9 2 3 5.4
1 4 16.1 2 4 18.0
47


Compute the Seasonal Indexes
Quarterly Sales
Year Q1 Q2 Q3 Q4 Total
1 7.4 6.5 4.9 16.1 34.9
2 8.3 7.4 5.4 18.0 39.1
Totals 15.7 13.9 10.3 34.1 74.0
Qtr. Avg. 7.85 6.95 5.15 17.05 9.25
Seas.Ind. .849 .751 .557 1.843 4.000
48


Deseasonalize the Data
Quarterly Sales
Year Q1 Q2 Q3 Q4
1 8.72 8.66 8.80 8.74
2 9.78 9.85 9.69 9.77
49


Perform Regression on Deseasonalized Data
Yr. Qtr. x y x2 xy
1 1 1 8.72 1 8.72
1 2 2 8.66 4 17.32
1 3 3 8.80 9 26.40
1 4 4 8.74 16 34.96
2 1 5 9.78 25 48.90
2 2 6 9.85 36 59.10
2 3 7 9.69 49 67.83
2 4 8 9.77 64 78.16
Totals 36 74.01 204 341.39
50


Perform Regression on Deseasonalized Data
204(74.01)  36(341.39)
a  8.357
8(204)  (36) 2
8(341.39)  36(74.01)
b  0.199
8(204)  (36) 2
Y = 8.357 + 0.199X
51


Compute the Deseasonalized Forecasts
Y9 = 8.357 + 0.199(9) = 10.148

Y10 = 8.357 + 0.199(10) = 10.347
Y11 = 8.357 + 0.199(11) = 10.546
Y12 = 8.357 + 0.199(12) = 10.745
Note: Average sales are expected to increase by
.199 million (about $200,000) per quarter.
52


Seasonalize the Forecasts
Seas. Deseas. Seas.
Yr. Qtr. Index Forecast Forecast
3 1 .849 10.148 8.62
3 2 .751 10.347 7.77
3 3 .557 10.546 5.87
3 4 1.843 10.745 19.80
53
Short-Range Forecasts

Time spans ranging from a few days to a few weeks

Cycles, seasonality, and trend may have little effect

Random fluctuation is main data component
54
Evaluating Forecast-Model Performance
Short-range forecasting models are evaluated on the

basis of three characteristics:

Impulse response

Noise-dampening ability

Accuracy
55

Impulse Response and Noise-Dampening Ability

If forecasts have little period-to-period fluctuation,
they are said to be noise dampening.

Forecasts that respond quickly to changes in data
are said to have a high impulse response.

A forecast system that responds quickly to data
changes necessarily picks up a great deal of
random fluctuation (noise).

Hence, there is a trade-off between high impulse
response and high noise dampening.
56

Accuracy

Accuracy is the typical criterion for judging the
performance of a forecasting approach

Accuracy is how well the forecasted values match
the actual values
57
Monitoring Accuracy

Accuracy of a forecasting approach needs to be
monitored to assess the confidence you can have in
its forecasts and changes in the market may require
reevaluation of the approach

Accuracy can be measured in several ways

Standard error of the forecast (covered earlier)

Mean absolute deviation (MAD)

Mean squared error (MSE)
58
Monitoring Accuracy

Mean Absolute Deviation (MAD)
Sum of absolute deviation for n periods
MAD =
n
n
 Actual demand -Forecast demand

i i
MAD = i=1
59
Monitoring Accuracy

Mean Squared Error (MSE)
MSE = (Syx)2
A small value for Syx means data points are

tightly grouped around the line and error range is
small.
When the forecast errors are normally
distributed, the values of MAD and syx are related:
MSE = 1.25(MAD)
60
Short-Range Forecasting Methods

(Simple) Moving Average


Exponential Smoothing

Exponential Smoothing with Trend
61

An averaging period (AP) is given or selected

The forecast for the next period is the arithmetic
average of the AP most recent actual demands

It is called a “simple” average because each period
used to compute the average is equally weighted

. . . more
62

It is called “moving” because as new demand data
becomes available, the oldest data is not used

By increasing the AP, the forecast is less responsive
to fluctuations in demand (low impulse response and
high noise dampening)

By decreasing the AP, the forecast is more responsive
to fluctuations in demand (high impulse response and
low noise dampening)
63

This is a variation on the simple moving average
where the weights used to compute the average are
not equal.

This allows more recent demand data to have a
greater effect on the moving average, therefore the
forecast.

. . . more
64

The weights must add to 1.0 and generally decrease
in value with the age of the data.

The distribution of the weights determine the impulse
response of the forecast.
65

The weights used to compute the forecast (moving
average) are exponentially distributed.

The forecast is the sum of the old forecast and a
portion () of the forecast error (A t-1-Ft-1).
Ft = Ft-1 + (A t-1-Ft-1)


. . . more
66

The smoothing constant, , must be between 0.0 and
1.0.

A large  provides a high impulse response forecast.

A small  provides a low impulse response forecast.
67
Example:
Example: Central
Central Call
Call Center
Center

Moving Average
CCC wishes to forecast the number of incoming
calls it receives in a day from the customers of one of
its clients, BMI. CCC schedules the appropriate
number of telephone operators based on projected
call volumes.
CCC believes that the most recent 12 days of call
volumes (shown on the next slide) are representative
of the near future call volumes.
68
Example:
Example: Central
Central Call
Call Center
Center

Moving Average

Representative Historical Data
Day Calls Day Calls

1 159 7 203
2 217 8 195
3 186 9 188
4 161 10 168
5 173 11 198
6 157 12 159
69
Example:
Example: Central
Central Call
Call Center
Center

Moving Average
Use the moving average method with an AP = 3
days to develop a forecast of the call volume in Day
13.
F13 = (168 + 198 + 159)/3 = 175.0 calls
70
Example:
Example: Central
Central Call
Call Center
Center

Use the weighted moving average method with an
AP = 3 days and weights of .1 (for oldest datum), .3,
and .6 to develop a forecast of the call volume in Day
13.
F13 = .1(168) + .3(198) + .6(159) = 171.6 calls
Note: The WMA forecast is lower than the MA
forecast because Day 13’s relatively low call volume
carries almost twice as much weight in the WMA
(.60) as it does in the MA (.33).
71
Example:
Example: Central
Central Call
Call Center
Center

If a smoothing constant value of .25 is used and
the exponential smoothing forecast for Day 11 was
180.76 calls, what is the exponential smoothing
forecast for Day 13?
F12 = 180.76 + .25(198 – 180.76) = 185.07
F13 = 185.07 + .25(159 – 185.07) = 178.55
72
Example: Central Call Center

Forecast Accuracy - MAD
Which forecasting method (the AP = 3 moving
average or the  = .25 exponential smoothing) is
preferred, based on the MAD over the most recent 9
days? (Assume that the exponential smoothing
forecast for Day 3 is the same as the actual call
volume.)
73
Example: Central Call Center
AP = 3  = .25
Day Calls Forec. |Error| Forec. |Error|
4 161 187.3 26.3 186.0 25.0
5 173 188.0 15.0 179.8 6.8
6 157 173.3 16.3 178.1 21.1
7 203 163.7 39.3 172.8 30.2
8 195 177.7 17.3 180.4 14.6
9 188 185.0 3.0 184.0 4.0
10 168 195.3 27.3 185.0 17.0
11 198 183.7 14.3 180.8 17.2
12 159 184.7 25.7 185.1 26.1
MAD 20.5 18.0
74

As we move toward medium-range forecasts, trend
becomes more important.

Incorporating a trend component into exponentially
smoothed forecasts is called double exponential
smoothing.

The estimate for the average and the estimate for the
trend are both smoothed.
75

Model Form
FTt = St-1 + Tt-1
where:
FTt = forecast with trend in period t
St-1 = smoothed forecast (average) in period t-1
Tt-1 = smoothed trend estimate in period t-1
76

Smoothing the Average
St = FTt + (At – FTt)

Smoothing the Trend
Tt = Tt-1 + (FTt – FTt-1 - Tt-1)
where:  = smoothing constant for the average

 = smoothing constant for the trend
77
Criteria for Selecting
a Forecasting Method

Cost

Accuracy

Data available

Time span

Nature of products and services

Impulse response and noise dampening
78

Cost and Accuracy

There is a trade-off between cost and accuracy;
generally, more forecast accuracy can be obtained
at a cost.

High-accuracy approaches have disadvantages:

Use more data

Data are ordinarily more difficult to obtain

The models are more costly to design,
implement, and operate

Take longer to use
79

Cost and Accuracy

Low/Moderate-Cost Approaches – statistical
models, historical analogies, executive-committee
consensus

High-Cost Approaches – complex econometric
models, Delphi, and market research
80

Data Available

Is the necessary data available or can it be
economically obtained?

If the need is to forecast sales of a new product,
then a customer survey may not be practical;
instead, historical analogy or market research may
have to be used.
81

Time Span

What operations resource is being forecast and for
what purpose?

Short-term staffing needs might best be forecast
with moving average or exponential smoothing
models.

Long-term factory capacity needs might best be
predicted with regression or executive-committee
consensus methods.
82

Nature of Products and Services

Is the product/service high cost or high volume?

Where is the product/service in its life cycle?

Does the product/service have seasonal demand
fluctuations?
83

Impulse Response and Noise Dampening

An appropriate balance must be achieved between:
How responsive we want the forecasting model

to be to changes in the actual demand data

Our desire to suppress undesirable chance

variation or noise in the demand data
84
Reasons for Ineffective Forecasting

Not involving a broad cross section of people

Not recognizing that forecasting is integral to
business planning

Not recognizing that forecasts will always be wrong

Not forecasting the right things

Not selecting an appropriate forecasting method

Not tracking the accuracy of the forecasting models
85
Monitoring and Controlling
a Forecasting Model

Tracking Signal (TS)

The TS measures the cumulative forecast error
over n periods in terms of MAD
nn
 (Actual
i
(Actual demand
demand ii -- Forecast
Forecast demand
demandii ))
TS i11
TS ==
MAD
MAD

If the forecasting model is performing well, the TS
should be around zero

The TS indicates the direction of the forecasting
error; if the TS is positive -- increase the forecasts,
if the TS is negative -- decrease the forecasts.
86
Monitoring and Controlling
a Forecasting Model

Tracking Signal

The value of the TS can be used to automatically
trigger new parameter values of a model, thereby
correcting model performance.

If the limits are set too narrow, the parameter
values will be changed too often.

If the limits are set too wide, the parameter values
will not be changed often enough and accuracy
will suffer.
87
Computer Software for Forecasting

Examples of computer software with forecasting
capabilities

Forecast Pro
Primarily for

Autobox
forecasting

SmartForecasts for Windows

SAS

SPSS Have
Forecasting

SAP
modules

POM Software Libary
88
Forecasting in Small Businesses
and Start-Up Ventures

Forecasting for these businesses can be difficult for
the following reasons:

Not enough personnel with the time to forecast

Personnel lack the necessary skills to develop good
forecasts

Such businesses are not data-rich environments

Forecasting for new products/services is always
difficult, even for the experienced forecaster
89
Sources of Forecasting Data and Help

Government agencies at the local, regional, state, and
federal levels

Industry associations

Consulting companies
90
Some Specific Forecasting Data

Consumer Confidence Index

Consumer Price Index (CPI)

Gross Domestic Product (GDP)

Housing Starts

Index of Leading Economic Indicators

Personal Income and Consumption

Producer Price Index (PPI)

Purchasing Manager’s Index

Retail Sales
91
Wrap-Up: World-Class Practice

Predisposed to have effective methods of forecasting
because they have exceptional long-range business
planning

Formal forecasting effort

Develop methods to monitor the performance of their
forecasting models

Do not overlook the short run.... excellent short range
forecasts as well
92
End
End of
of Chapter
Chapter 33
93

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 2002 South-Western/Thomson Learning TM 1 1

Inputs: Forecast Demand

Business Production Resource

Forecast Time Item Being Unit of

Length of Time Number of

Note: Enrollment is expected to increase by 180

185, 425(93)  1,115(15, 440)

7(15, 440)  1,115(93)

Note: RPC sales are expected to increase by

where: Y = firm’s annual sales ($millions)

Y9 = 8.357 + 0.199(9) = 10.148

Short-range forecasting models are evaluated on the

 Actual demand -Forecast demand

A small value for Syx means data points are

Ft = Ft-1 + (A t-1-Ft-1)

Day Calls Day Calls

F13 = (168 + 198 + 159)/3 = 175.0 calls

where:  = smoothing constant for the average

to be to changes in the actual demand data

variation or noise in the demand data

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