Chapter 3

Forecasting
Learning Objectives
 List the elements of a good forecast.
 Outline the steps in the forecasting process.
 Basic measure(s) of forecast accuracy.
 Compare and contrast qualitative and quantitative approaches to
forecasting.
 Basic forecasting techniques: averaging, trend and seasonal, and
associative.
 Evaluating and controlling forecasts.
 Businesses make plans for future operations based on anticipated

future demand.

 Anticipated demand is derived from two possible sources, actual

customer orders and forecasts. For businesses where customer orders

make up most or all of anticipated demand, planning is straightforward,

and little or no forecasting is needed. However, for many businesses,

most or all of anticipated demand is derived from forecasts.

 What is a Forecast?
https://www.youtube.com/watch?v=KJJCoHWi7Uc

Forecast is a statement about the future value of a variable of interest such as

demand.
Forecasts are a basic input in the decision processes of operations management
because they provide information on future demand.
Since 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.
Aspects of forecasts
Two aspects of forecasts are important:

i. Expected level of demand: can be a function of some structural

variation, such as a trend or seasonal variation

ii. Degree of accuracy: it is the potential size of forecast error.

Forecast accuracy is a function of the ability of forecasters to
correctly model demand, random variation, and sometimes
unforeseen events.
Time consideration
Forecasts are made with reference to a specific time horizon.

i. Short-term forecasts pertain to ongoing operations.

ii. Long-term forecasts pertain to new products or services, new equipment, new

facilities, or something else that will require a somewhat long lead time to

develop, construct, or otherwise implement.

Therefore,

Short-range – plan to use the system (on-going operations)

Long-range – plan the system (strategic)

Forecasts affect decisions and activities throughout
an organization

Accounting Cost/profit estimates

Finance Cash flow and funding

Human Resources Hiring/recruiting/training

Marketing Pricing, promotion, strategy

MIS IT/IS systems, services

Operations Schedules, workloads

Product/service design New products and services

Elements of a Good Forecast

Timely

Reliable Accurate

l se
f u u
i ng Written y
to
n s
ea Ea
M
Cost Effective
 Elements of a Good Forecast
The forecast should be timely. Usually, a certain amount of time is needed
to respond to the information contained in a forecast.
The forecast should be as accurate as possible, and the degree of accuracy
should be stated.
The forecast should be reliable; it should work consistently.

The forecast should be expressed in meaningful units. Financial planners

need to know how many dollars will be needed, production planners need to
know how many units will be needed, and schedulers need to know what
machines and skills will be required.
 Elements of a Good Forecast
The forecast should be in writing. Although this will not guarantee that all
concerned are using the same information, it will at least increase the
likelihood of it.
The forecasting technique should be simple to understand and use.
The forecast should be cost-effective: The benefits should outweigh the
costs.
Steps in the Forecasting Process

“The forecast”
Forecast

Step 6- Monitor the forecast

Step 5- Make the forecast
Step 4- Obtain, clean and analyze data
Step 3- Select a forecasting technique
Step 2- Establish a time horizon
Step 1- Determine purpose of forecast
 Steps in the Forecasting Process

There are six basic steps in the forecasting process:

1. Determine the purpose of the forecast- How will it be used and
when will it be needed? This step will provide an indication of the level of
detail required in the forecast, the amount of resources (personnel,
computer time, dollars) that can be justified, and the level of accuracy
necessary.
2. Establish a time horizon- The forecast must indicate a time interval,
keeping in mind that accuracy decreases as the time horizon increases.
3. Obtain, clean, and analyze appropriate data- Obtaining the data
can involve significant effort. Once obtained, the data may need to be
“cleaned” to get rid of outliers and obviously incorrect data before
analysis.
 Steps in the Forecasting Process
4. Select a forecasting technique- Time series analysis,
Exponential smoothing, Regression analysis, etc.

5. Make the forecast

6. Monitor the forecast errors- The forecast errors should be
monitored to determine if the forecast is performing in a satisfactory
manner. If it is not, reexamine the method, assumptions, validity of
data, and so on; modify as needed; and prepare a revised forecast.
 Forecasting Process
1. Identify the 2. Collect historical 3. Plot data and
purpose of forecast data identify patterns

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

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

7.
Is accuracy of No 8b. Select new
forecast forecast model or
acceptable? adjust parameters of
existing model
Yes
9. Adjust forecast based on 10. Monitor results
8a. Forecast over
additional qualitative and measure forecast
planning horizon
information and insight accuracy
 Forecasting Techniques
1. Judgmental forecasts rely on analysis of subjective inputs obtained
from various sources, such as consumer surveys, the sales staff,
managers and executives, and panels of experts.
2. Time-series forecasts simply attempt to project past experience into
the future. These techniques use historical data with the assumption
that the future will be like the past.

3. Associative models use equations that consist of one or more

explanatory variables that can be used to predict demand. For
example, demand for paint might be related to variables such as the
price per gallon and the amount spent on advertising, as well as to
specific characteristics of the paint (e.g., drying time, ease of cleanup).
 Judgmental Forecasts
 Expert Opinion- industry specialists, economists, or other knowledgeable individuals
provide their opinions and insights about future trends and events.

 Market Research- Surveys, focus groups, and other market research techniques are
used to gather opinions and expectations from potential customers or target
audiences.

 Delphi Method- involves a series of questionnaires or rounds of discussion with a

panel of experts. The responses are collected, summarized, and then fed back to the
experts for further input, with the process repeated until a consensus is reached.

Judgmental forecasting can be useful when there is a lack of historical data, when the
future environment is uncertain or rapidly changing, or when human insights and
perceptions play a crucial role in decision-making.

However it can be subject to biases, errors, and personal opinions, and it may not
always be as accurate as quantitative forecasting methods, especially when dealing with
complex and uncertain situations.
 Time Series Forecasts
A time series is a time-ordered sequence of observations taken at regular intervals (e.g., hourly, daily,
weekly, monthly, quarterly, annually).

 Assumes that future values of the series can be estimated from past values.

 Involves plotting the data and visually examining the plot.

 Trend - long-term movement in data. Example- Land price

 Seasonality - short-term regular variations in data. Example- Demand for seasonal fruits

 Cycle – wavelike variations of more than one year’s duration. Example- Gold price

 Irregular variations - caused by unusual circumstances. Example- Disaster /pandemic

 Random variations - caused by chance. Example- Stock prices (award news, change in
management)

If the fluctuations are not of fixed period then they are cyclic; if the period is unchanging and
associated with some aspect of the calendar, then the pattern is seasonal.
Forecast Variations

Irregular
variation

Trend

Cycles

90
89
88
Seasonal variations
 Naive Forecasts

We sold 250 wheels last

week.... Now, next week
we should sell....

The forecast for any period equals

the previous period’s actual value.
 Naïve Forecasts
Pros:
 Simple to use

 Virtually no cost

 Quick and easy to prepare

 Data analysis is nonexistent

 Easily understandable

However,
 Cannot provide high accuracy

The naive forecast can be effective for stable and unchanging time series
data. If historical data points exhibit little to no variation, the naive forecast
might actually perform reasonably well.

Example- Salary, daily grocery expense, rent, transportation cost

Forecasting Techniques
 Moving average
 Weighted moving average
 Exponential smoothing
 Moving Averages
Moving average – A technique that averages a number of recent actual
values, updated as new values become available.

At-n + … At-2 + At-1

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

wnAt-n + … wn-1At-2 + w1At-1

Ft = WMAn= n
 Moving Average Example
Calculate a three-period moving average forecast for demand in period 6

If the actual demand in period 6 is 38, then the moving average forecast for
period 7 is:
 Simple Moving Average

Actual
MA5
47
45
43
41
39
37 MA3
35
1 2 3 4 5 6 7 8 9 10 11 12

Takeaways:
• Fewer data points (e.g., the 3 month moving average) is more
sensitive to real life and is a more dynamic forecast.
• Larger data points (e.g., the 5 month moving average) is
smoother (less reactionary)
 Weighted Moving Average Example

Period Demand Weight

1 42

2 40 10%

3 43 20%

4 40 30%

5 41 40%

Takeaways:
• Choice of weights must add up to 100%
• Choice of weights are often based on trial and error, and
forecaster’s experience.
 Forecast Accuracy
 Why is forecast accuracy necessary?

It is important to include an indication of the extent to which the forecast

might deviate from the value of the variable that actually occurs. This will
provide the forecast user with a better perspective on how far off a forecast
might be.
 What happens if forecasts are inaccurate?

If the forecasts are inaccurate, schedules will be generated that may

provide for too few or too many resources, too little or too much output, the
wrong output, or the wrong timing of output, all of which can lead to
additional costs, dissatisfied customers, and headaches for managers.
FORECAST ACCURACY
Positive errors result when the forecast is too low
Negative errors when the forecast is too high.

For example,
if actual demand for a week is 100 units
forecast demand was 90 units

the error is 100 - 90 = 10 (Positive)

Therefore, the forecast was too low
Forecast errors influence decisions in two different ways. One is in
making a choice between various forecasting alternatives, and the
other is in evaluating the success or failure of a technique in use.
 Forecast Accuracy
 Mean Absolute Deviation (MAD)
 Average absolute error

 Easiest to compute

 Weights errors linearly.

 Mean Squared Error (MSE)

 Average of squared error

 Gives more weight to larger errors, which typically cause more problems

 Mean Absolute Percent Error (MAPE)

 Average absolute percent error

 MAPE should be used when there is a need to put errors in perspective. For example, an
error of 10 in a forecast of 15 is huge. Conversely, an error of 10 in a forecast of 10,000 is
insignificant. Hence, to put large errors in perspective, MAPE would be used.
 MAD, MSE, and MAPE

 Actual  forecast
MAD =
n
2
 ( Actual  forecast)
MSE =
n -1
Forecast Accuracy Example
 Forecast Accuracy Example
In the 8th period:
THE END