Forecasting

Forecasting
•Forecasts are a basic input in the decision processes of operations management because
they provide information on future demand.
•The primary goal of operations management is to match supply to demand.
•Having a forecast of demand is essential for determining how much capacity or supply
will be needed to meet demand.
•For instance, operations needs to know what capacity will be needed to make staffing
and equipment decisions, budgets must be prepared, purchasing needs information for
ordering from suppliers, and supply chain partners need to make their plans
•Many businesses, most or all of anticipated demand is derived from forecasts.
Forecasting
•Two aspects of forecasts are important.
 One is the expected level of demand.
 The degree of accuracy that can be assigned to a forecast.
•The expected level of demand can be a function of some structural variation, such as a
trend or seasonal variation.
•Forecast accuracy is a function of the ability of forecasters to correctly model demand,
random variation, and sometimes unforeseen events.
•Forecasts are made with reference to a specific time horizon.
Components of Forecasting Demand
•The type of forecasting method to use depends on several factors, including
• The time frame of the forecast (i.e. how far in the future is being forecasted).
• The behavior of demand and the possible existence of patterns (trends, seasonality,
cycle)
• The causes of demand behavior.
Time Frame:-
• Forecasts are either short-to-mid-range, or long-range.
•Short-range (to mid-range) forecasts are typically for daily, weekly, or monthly sales
demand for up to approximately two years into the future.
•They are primarily used to determine production and delivery schedules and to establish
inventory levels.
Components of Forecasting Demand
•A long-range forecast is usually for a period longer than two years into the future.
•A long-range forecast is normally used for strategic planning—to establish long-term goals,
plan new products for changing markets, enter new markets, develop new facilities, develop
technology, design the supply chain, and implement strategic programs.
 Demand Behavior:-
•Demand exhibits predictable behavior, with trends or repetitive patterns, which the forecast
may reflect.
•The four types of demand behavior are trends, cycles, seasonal patterns, and random
•A trend is a gradual, long-term up or down movement of demand.
◦ For example, the demand for houses has followed an upward trend during the past few decades
Components of Forecasting Demand
•Random variations are movements that are not predictable and follow no pattern (and
thus are virtually unpredictable). They are routine variations that have no “assignable”
cause.
•A seasonal pattern is an oscillating movement in demand that occurs periodically (in
the short run) and is repetitive. Seasonality is often weather-related.
For example, every winter the demand for sweaters and Jackets increases, demand of
firecrackers increase during Diwali.
•A cycle is an up-and-down movement in demand that repeats itself over a lengthy time
span (i.e., more than a year).
◦ For example, The demand for winter sports equipment increases every four years
before and after the Winter Olympics.
Components of Forecasting Demand
Demand Charted over 4 Years, with a Growth Trend
and Seasonality Indicated
Forecasting Process
1. Identify the purpose of 2. Collect historical data 3. Plot data and identify
forecast patterns

6. Check forecast accuracy 5. Develop/compute 4. Select a forecast model

with one or more measures forecast for period of that seems appropriate for
historical data data

7.
Is accuracy of No 8b. Select new forecast
forecast model or adjust parameters
acceptable? of existing model

Yes
9. Adjust forecast based on 10. Monitor results and
8a. Forecast over planning
additional qualitative measure forecast accuracy
horizon
information and insight
Sources of Data
•Forecasting is often only as good as the quality and quantity of data available.
•Therefore, it is important to know the type of data required and the normal sources
through which such data could be collected.
 Sales-force Estimates-
•For every organization, one of the most valuable sources of data is the sales force that
operates in the field.
•The sales force spans the entire geographical range of operation, they have access to data
on the actual consumption and the changing patterns in consumption.
•Using this data, organizations can make an end-use analysis to project emerging
scenarios in market demand
Sources of Data
 Point of Sales (POS) Data System-
•Advances in information technology have enabled organizations to capture data at the
point of sale using POS systems.
•Using POS technology, as a customer buys a unit of an organization’s product at a retail
counter, the information is captured and instantaneously transferred to a common
database
•Giant retail chains such as Wal-Mart is attributed to the use of POS systems. You may
find similar systems in use in Indian retail chains such as Big Bazaar, More, and
Reliance Mart
Sources of Data
Forecasts from supply chain partners:-
• Organizations often have to rely on their supply chain partners to obtain data on actual
sales during a period.
•Moreover, supply chain partners provide vital information on market trends, competitor
performance, and overall market sentiments and projections. These estimates are crucial
for accurate forecasting of future demand, particularly during annual planning exercises.
Trade/Industry Association Journal
Economic surveys and Indicators- Economic research agencies such as the Central
Statistical Organization (CSO) and the Centre for Monitoring Indian Economy (CMIE)
provide useful data to model these situations and estimate the emerging demand for such
products.
Forecasting Methods
•Three basic types of forecasting: Time series methods, Causal methods, and Qualitative
methods.
 Time Series Forecasting: -
•Time series methods are statistical techniques that make use of historical data accumulated
over a period of time.
•Time series methods assume that what has occurred in the past will continue to occur in the
future.
•These methods assume that identifiable historical patterns or trends for demand over time will
repeat themselves.
•These methods relate the forecast to only one factor—time.
•They include the moving average, exponential smoothing, and linear trend line; and they are
among the most popular methods
Simple Moving Average
•The simple moving average method uses several demand values during the recent past
to develop a forecast.
•The simple moving average is useful for forecasting demand that is stable and does not
display any pronounced demand behavior, such as a trend or seasonal pattern.
•Moving averages are computed for specific periods, such as three months or five
months, depending on how much the forecaster desires to “smooth” the demand data.
•The formula for computing the simple moving average is:

Where, is the demand in period i and n is the number of period.

Three months Moving Average
ORDERS MOVING
AVERAGE 3
MONTH
Jan PER 120  Di
MONTH MA3 = i=1
Feb 90 3

Mar 100

Apr 75

May 110

June 50

July 75
Three months Moving Average
ORDERS MOVING
AVERAGE 3
MONTH
Jan
PER MONTH
120 –  Di
i=1
– MA3 =
Feb 90 – 3
103.3
Mar 100 88.3 90 + 110 + 130
95.0
= 3
Apr 75 78.3
78.3
= 110 orders for Nov
May 110 85.0
105.0
June 50 110.0

July 75
Five Months Moving Average
ORDERS MOVING
AVERAGE 5
MONTH
Jan
PER MONTH
120  Di
i=1
MA5 =
Feb 90 5

Mar 100

Apr 75

May 110

June 50

July 75
Five Months Moving Average
ORDERS MOVING
AVERAGE 5
MONTH
Jan
PER MONTH
120 –  Di
i=1
– MA5 =
Feb 90 – 5
–
Mar 100 – 90 + 110 + 130+75+50
= 5
99.0
Apr 75 85.0
82.0 = 91 orders for Nov
May 110 88.0
95.0
June 50 91.0

July 75

Aug 130
Smoothing Effects
3-Months Moving Average
Weighted Moving Average
• Used when some trend might be present
– Older data usually less important
Weights based on experience and intuition

Weighted
moving    Weight for period n Demand in period n 
average  Weights
Weighted Moving Average
Weighted Moving Average
Moving Average Vs Weighted Moving Average
Actual Demand vs. Moving-Average and Weighted-Moving-Average Methods
Exponential Smoothing
•Exponential smoothing is also an averaging method that weights the most recent data
more strongly.
•The forecast will react more to recent changes in demand.
•This is useful if the recent changes in the data are significant and unpredictable instead
of just random fluctuations (for which a simple moving average forecast would suffice).
•Exponential smoothing is one of the more popular and frequently used forecasting
techniques.
Exponential Smoothing
•Each new forecast is based on the previous forecast plus a percentage of the difference
between the forecast and the actual value.

Ft +1 = Dt + Ft
where:
Ft +1 = forecast for next period
Dt = actual demand for present period
Ft = previously determined forecast for present period
= weighting factor, smoothing constant
Effect of Smoothing Factor
• The quickness of forecast adjustment to error is determined by the smoothing
constant
• The closer the value of is to zero, the slower the forecast will be to adjust to
forecast error (i.e. greater the smoothing).
• The closer the value of is to 1, the greater the responsiveness and less the
smoothing.
0.0  1.0
If = 0.20, then Ft +1 = 0.20Dt + 0.80 Ft

If = 0, then Ft +1 = 0Dt + 1 Ft = Ft

Forecast does not reflect recent data

If = 1, then Ft +1 = 1Dt + 0 Ft =Dt

Forecast based only on most recent data

Example of Exponential Smoothing (
PERIOD MONTH DEMAND F2 = D1 + (1 - )F1

1 Jan 37

2 Feb 40
F3 = D2 + (1 - )F2
3 Mar 41

4 Apr 37
F13 = D12 + (1 - )F12
5 May 45

6 Jun 50

7 Jul 43
PERIOD MONTH DEMAND F2 = D1 + (1 - )F1
= (0.30)(37) + (0.70)(37)
1 Jan 37
= 37
2 Feb 40
F3 = D2 + (1 - )F2
3 Mar 41 = (0.30)(40) + (0.70)(37)
= 37.9
4 Apr 37
F13 = D12 + (1 - )F12
5 May 45 = (0.30)(54) + (0.70)(50.84)
= 51.79
6 Jun 50

7 Jul 43

8 Aug 47
 FORECAST, Ft + 1
PERIOD MONTH DEMAND ( = 0.3) ( = 0.5)
1 Jan 37 – –
2 Feb 40
3 Mar 41
4 Apr 37
5 May 45
6 Jun 50
7 Jul 43
8 Aug 47
9 Sep 56
10 Oct 52
11 Nov 55
12 Dec 54
13 Jan –
 FORECAST, Ft + 1
PERIOD MONTH DEMAND ( = 0.3) ( = 0.5)
1 Jan 37 – –
2 Feb 40 37.00 37.00
3 Mar 41 37.90 38.50
4 Apr 37 38.83 39.75
5 May 45 38.28 38.37
6 Jun 50 40.29 41.68
7 Jul 43 43.20 45.84
8 Aug 47 43.14 44.42
9 Sep 56 44.30 45.71
10 Oct 52 47.81 50.85
11 Nov 55 49.06 51.42
12 Dec 54 50.84 53.21
13 Jan – 51.79 53.61
Linear Trend Projection
• 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
• A linear trend line relates a dependent variable, which for our purposes is demand, to
one independent variable, time, in the form of a linear equation:
Λ
y  a  bx
Λ
where y  computed value of the variable to be
predicted (dependent variable)
Least Square Method
The Least-Squares Method for Finding the Best-
Fitting Straight Line, Where the Asterisks Are the
Locations of the Actual Observations or Data Points

Least squares method minimizes the sum of the

squared errors (deviations)
Least Square Method
•The coefficients of the line, a and b, are based on the following two equations:-
Linear Trend
• Cell phone sales for a California-based firm over the last 10 weeks are shown in the following
table. Plot the data, and visually check to see if a linear trend line would be appropriate. Then
determine the equation of the trend line, and predict sales for weeks 11 and 12.
Week Unit Sales Unit Sales (y)
1 700 800

2 724 780

3 720 760

4 728 740
5 740
720
6 742
7 758 700

8 750 680

9 770 660
0 2 4 6 8 10 12
10 775
Linear Trend
•The coefficients of the line, a and b, are based on the following two equations:-
Week(x) Unit Sales (y) xy x^2
1 700 700 1
2 724 1448 4
3 720 2160 9 • Y =699.4 + 7.51 X
4 728 2912 16 • Substituting values of t into this
5 740 3700 25 equation, the forecasts for the next two
6 742 4452 36 periods (i.e., t = 11 and t = 12) are:
7 758 5306 49
8 750 6000 64
9 770 6930 81
10 775 7750 100
55 7407 41358 385
5.5 740.7
Linear Trend Example
Electrical Electrical
Year Power Demand Year Power Demand
1 74 5 105
2 79 6 142
3 80 7 122
4 90 Blank Blank
Linear Trend Analysis
Seasonal Variation
Steps in the process for monthly seasons:
1. Find average historical demand for each month
2. Compute the average demand over all months
3. Compute a seasonal index for each month
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the number of months, then multiply it by
the seasonal index for that month
Seasonal Index Calculation
Seasonal Index Calculation
Seasonal Index calculation

Average monthly demand for past 3 years

Seasonal index 
Average monthly demand
Seasonal Index Calculation
Seasonal Index Calculation
Seasonal forecast for Year 4
Month Demand Month Demand
Jan July
1,200 over 12, end fraction, times 0.957 = 96 1,200 over 12, end fraction, times 1.117 = 112

1,200 1,200
1,200  .957  96  1.117  112
12  .957  96 12
12
Feb Aug
1,200 over 12, end fraction, times 0.851 = 85 1,200 over 12, end fraction, times 1.064 = 106

1,200
1,200 1,200
12 .851
.851 85
85  1.064  106
12 12
Mar Sept
1,200 over 12, end fraction, times 0.904 = 90 1,200 over 12, end fraction, times 0.957 = 96

1,200
1,200 1,200
.904
.904  90
90  .957  96
12
12 12
Apr Oct
1,200 over 12, end fraction, times 1.064 = 106 1,200 over 12, end fraction, times 0.851 = 85

1,200
1,200 1,200
1.064
1.064 106
106  .851  85
12
12 12

May Nov
1,200 over 12, end fraction, times 1.309 = 131 1,200 over 12, end fraction, times0.851 = 85

1,200
1,200 1,200
1.309
1.309 131
131  .851  85
12
12 12

June Dec
1,200 over 12, end fraction, times 1.223 = 122 1,200 over 12, end fraction, times0.851 = 85

1,200
1,200  1.223  122 1,200
 1.223  122  .851  85
12
12 12
Decomposition using Least Square
Regression
• When the demand contains both seasonal and trend effects at the same time, the
question is how they relate to each other.
• Decomposition of a time series means identifying and separating the time series data
into these components.
•Two approaches
•The seasonal amount is a constant no matter what the trend or average amount.
•The seasonal variation increases as the trend increase because its size depends on the
trend
Decomposition using Least Square
Regression
Step 1: Determine the seasonal factor (or Index)
Step 2: Deseasonalize the original factor.
Step 3: Develop a Least Squares regression line for the deseasonalised data.
Step 4: Project the regression line through the period to be forecast.
Step 5: Create the final forecast by adjusting the regression line by the seasonal factor.
Decomposition Example
Quarter Year1 Year2 Year3 Actual Demand
6000
I 600 2400 3800
II 1550 3100 4500 5000

III 1500 2600 4000 4000

IV 1500 2900 4900 3000

2000

1000

0
0 2 4 6 8 10 12 14
Forecast Accuracy
A forecast is never completely accurate; forecasts will always deviate from the actual
demand.
This difference between the forecast and the actual is the forecast error.
The objective of forecasting is that it be as slight as possible.
A large degree of error may indicate that either the forecasting technique is the wrong
one or it needs to be adjusted by changing its parameters (for example, in the
exponential smoothing forecast).
Mean Absolute Deviation
•The mean absolute deviation, or MAD, is one of the most popular and simplest to use
measures of forecast error.
• MAD is an average of the difference between the forecast and actual demand, as
computed by the following formula
Mean Absolute Percent Error
•The mean absolute percent error (MAPE) measures the absolute error as a percentage
of demand rather than per period.
•As a result, it eliminates the problem of interpreting the measure of accuracy relative to
the magnitude of the demand and forecast values, as MAD does.
•The mean absolute percent deviation is computed according to the following formula:

1 ∑ |𝐷𝑡 − 𝐹 𝑡|
𝑀𝐴𝑃𝐸= × × 100
𝑛 ∑ 𝐷𝑡
Cumulative Error and Bias
•Cumulative error (Sum of Error) is computed simply by summing the forecast errors,
as shown in the following formula

 A large positive value indicates that the forecast is probably consistently lower than
the actual demand, or is biased low.
 A large negative value implies that the forecast is consistently higher than actual
demand, or is biased high.
 A measure closely related to cumulative error is the average error, or bias. It is
computed by averaging the cumulative error over the number of time periods:
          3-month 5-month
Absolute Absolute
Period Demand Naïve 3-month 5-month Error Error Error Error
January 37 -            
February 40 37           
March 41 40           
April 37 41 39.33   -2.33 2.33    
May 45 37 39.33   5.67 5.67    
June 50 45 41.00 40 9.00 9.00 10 10
July 43 50 44.00 42.6 -1.00 1.00 0.4 0.4
August 47 43 46.00 43.2 1.00 1.00 3.8 3.8
September 56 47 46.67 44.4 9.33 9.33 11.6 11.6
October 52 56 48.67 48.2 3.33 3.33 3.8 3.8
November 55 52 51.67 49.6 3.33 3.33 5.4 5.4
December 54 55 54.33 50.6 -0.33 0.33 3.4 3.4
January 54 53.67 52.8        
557 28.00 35.33 38.40 38.40

3-month 5-month
MAD 3.93 5.49
MAPE 0.08 0.11
E 28.0 38.40
3.11 5.49
 Input: No. of demand periods 12
Alpha 0.30 0.5

Absolute Absolute
Period Demand Forecast (0.3) Error Error Forecast (0.5) Error Error
January 37
February 40 37.00 3.00 3.00 37.00 3.00 3.00
March 41 37.90 3.10 3.10 38.50 2.50 2.50
April 37 38.83 -1.83 1.83 39.75 -2.75 2.75
May 45 38.28 6.72 6.72 38.38 6.63 6.63
June 50 40.30 9.70 9.70 41.69 8.31 8.31
MAD 4.85 4.04
July 43 43.21 -0.21 0.21 45.84 -2.84 2.84
MAPE 0.10 0.09
August 47 43.15 3.85 3.85 44.42 2.58 2.58 E 33.21 33.21
September 56 44.30 11.70 11.70 45.71 10.29 10.29 4.48 3.02
October 52 47.81 4.19 4.19 50.86 1.14 1.14
November 55 49.07 5.93 5.93 51.43 3.57 3.57
December 54 50.85 3.15 3.15 53.21 0.79 0.79
January 51.79 53.61
Aggregate Forecast Improves Accuracy
The case is related to power distribution through State Electricity Boards (SEB).
Every state in India had to meet the demand of electricity for the three categories of consumers:
domestic, commercial, and industrial.
In a particular state, the electricity planning department used to come up with forecast for
electricity requirement from its directorates, which were individually responsible for one
category of consumers.
Based on the forecast, the Central planning unit (CPU) used to plan the electricity purchase
from other SEBs , NTPC etc.
The CPU of the state always complained that the forecasts of the three different types of
consumers had huge error due to vast difference with between forecast and actual requirements.
Aggregate Forecast Improves Accuracy
Domestic Commercial Industrial
1997-98 3020 1000 1866
1998-99 2000 500 2424
1999-00 1234 7000 2292
2000-01 2456 1292 200
2001-02 3963 120 3035
2002-03 5004 1919 100
2003-04 678 2312 1681
2004-05 5994 190 2161
2005-06 2000 3251 2383
2006-07 6825 3730 200