Forecasting

Session 7-8
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 Forecast
Forecast
 A statement about the future value of a
variable of interest.

•Forecasting is the process of

projecting the values of one or more
variables into the future.

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Forecast of the demand helps operations management
people in determining the capacity or supply to meet
demand

Forecasts are the basis for budgeting, planning

capacity, sales, production and inventory,
personnel, purchasing, and more

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 Important aspect of forecasting

 Expected level of demand

 Degree of accuracy (i.e., 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.

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 Categorization of forecast
 Short-term forecasts (e.g., an hour, day, week,
or month)
 Pertain to ongoing operations

 Long-term forecasts (e.g., the next six months,

the next year, the next five years)
 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
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Dependency of various departments on forecasting

Accounting.
 New product/process cost estimates, profit
projections, cash management.

Finance.
 Equipment/equipment replacement needs, timing
and amount of funding/ borrowing needs.

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Human resources.
 Hiring activities, including recruitment,
interviewing, and training; layoff planning,
including outplacement counseling.

Marketing.
 Pricing and promotion, e-business strategies,
global competition strategies.

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Management Information System
 New/revised information systems, Internet services.

Operations.
 Schedules, capacity planning, work assignments and
workloads, inventory planning, make-or-buy
decisions, outsourcing, project management.

Product/service design.
 Revision of current features, design of new products
or services.

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In most of these uses of forecasts, decisions in one area
have consequences in other areas. Therefore, it is very
important for all affected areas to agree on a common
forecast
For example,
 Salespeople, by their very nature, may be overly optimistic
with their forecasts, and may want to “reserve” capacity for
their customers. This can result in excess costs for operations
and inventory storage.
 Conversely, if demand exceeds forecasts, operations and the
supply chain may not be able to meet demand, which would
mean lost business and dissatisfied customers.

Forecasting is also an important component of yield

management, which relates to the percentage of
capacity being used. 1-10
 Characteristics of Forecasts
• Forecasts are always wrong. Should include
expected value and measure of error.

• Long-term forecasts are less accurate than

short-term forecasts (forecast horizon is
important)

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 Uses of forecasts

 Help managers plan the system

 It generally involves long-range plans about
the types of products and services to offer,
what facilities and equipment to have, where
to locate, and so on

 Help managers to plan the use of the

system
 It involve tasks such as planning inventory
and workforce levels, planning purchasing
and production, budgeting, and scheduling
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 Facts about forecasting
In spite of its use of computers and
sophisticated mathematical models,
forecasting is not an exact science

Instead, successful forecasting often requires a

skillful blending of science and intuition.
Experience, judgment, and technical expertise all
play a role in developing useful forecasts

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1. Forecasting techniques generally assume that the same
underlying causal system that existed in the past will continue
to exist in the future.
2. Forecasts are not perfect; actual results usually differ from
predicted values; the presence of randomness precludes a
perfect forecast.
3. Forecasts for groups of items tend to be more accurate than
forecasts for individual items because forecasting errors
among items in a group usually have a canceling effect.
Opportunities for grouping may arise if parts or raw materials
are used for multiple products or if a product or service is
demanded by a number of independent sources.
4. Forecast accuracy decreases as the time period covered by the
forecast (the time horizon) increases. Generally speaking,
short-range forecasts must contend with fewer uncertainties
than longer-range forecasts, so they tend to be more accurate.
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 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.
For example
• Capacity cannot be expanded overnight,
• Inventory levels cannot be changed immediately.

The forecast should be accurate, and the degree of accuracy

should be stated.
• This will enable users to plan for possible errors and will
provide a basis for comparing alternative forecasts.

The forecast should be reliable.

• It should work consistently

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Elements of a good forecast
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
• Schedulers need to know what machines and skills will be
required
The forecast should be in writing.
• It will help in evaluating the forecast once actual results are
in.
The forecasting technique should be simple to understand
and use.
The forecast should be cost-effective
• The benefits should outweigh the costs.
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Forecasting and Supply Chain

Accurate forecasts are very important for the supply

chain.
 Forecasting less than the exact value will lead
towards the shortage of materials, parts, and
services
 Which can lead to missed deliveries, work
disruption, and poor customer service
 Overly optimistic forecasts can lead to
excesses of materials and/or capacity
 Which increase cost involved
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Steps in the forecasting process??

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Steps in the forecasting process
Determine the purpose of the forecast
• How will it be used and when will it be needed?
Establish a time horizon
• Accuracy decreases as the time horizon increases
Obtain, clean, and analyze appropriate data
• Cleaning means to get rid of outliers and obviously
incorrect data before analysis
Select a forecasting technique and make the forecast
Monitor the forecast errors.
• It tests if forecasting is working in satisfactory manner
• If it is not, reexamine the method, assumptions, validity
of data, and so on

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Forecast Error
Forecast error is the difference between the value that occurs
and the value that was predicted for a given time period
Errort  ActualDemand t  ForcastedDemand t

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Forecast accuracy measures
 Mean absolute deviation (MAD)

MAD 
 Actual t  Forcastedt
n
 Mean squared error (MSE)

 Mean absolute percent error (MAPE)

Actualt  Forcastedt
 Actualt
100
MAPE 
n

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 Classification of Forecasting
 Qualitative
 Depends upon subjective inputs

 Quantitative
 Depends on projection of historical data or the
development of associative models

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Classification of Forecasting

It can also be categorised as

 Judgmental forecasts
 It rely on analysis of subjective inputs obtained
from various sources, such as consumer
surveys, the sales staff, managers and
executives, and panels of experts.
 Quite frequently, these sources provide insights
that are not otherwise available.

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 Time-series forecasts
 It attempts to project past experience into the future.
 These techniques use historical data with the
assumption that the future will be like the past.
 Here pattern in data is captured without trying to
identify causes of the patterns.

 Associative models
 Use equations that consist of one or more
explanatory variables
 For example, demand of movie tickets depend the
stars, languages it is released, number of theaters it
is exhibited etc.
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Qualitative forecasts
 When data is either unavailable or very expensive to
obtain or no time to collect the quantitative data
 When political and economic conditions are changing,
available data may be obsolete
 Introduction of new products and the redesign of existing
products

In such cases forecasting is usually done through

executive opinions, consumer surveys, opinions of
the sales staff, and opinions of experts

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 Forecasting Methods
• Qualitative: primarily subjective; rely on judgment
and opinion
• Time Series: use historical demand only
• Static
• Adaptive
• Causal: use the relationship between demand and
some other factor to develop forecast
• Simulation
• Imitate consumer choices that give rise to demand
• Can combine time series and causal methods

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 Components of an Observation
Observed demand (O) =
Systematic component (S) + Random component (R)

Level (current deseasonalized demand)

Trend (growth or decline in demand)

Seasonality (predictable seasonal fluctuation)

• Systematic component: Expected value of demand
• Random component: The part of the forecast that deviates
from the systematic component
• Forecast error: difference between forecast and actual demand
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 Time Series Forecasting
Quarter Demand Dt
II, 1998 8000
III, 1998 13000 Forecast demand for the
IV, 1998 23000 next four quarters.
I, 1999 34000
II, 1999 10000
III, 1999 18000
IV, 1999 23000
I, 2000 38000
II, 2000 12000
III, 2000 13000
IV, 2000 32000
I, 2001 41000 1-28
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 Forecasting Methods

• Static Forecasting

• A static method assumes that the estimates of

level, trend, and seasonality within the
systematic component do not vary as new
demand is observed.

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 Adaptive Forecasting

• The estimates of level, trend, and seasonality are

adjusted after each demand observation
• General steps in adaptive forecasting
• Moving average
• Simple exponential smoothing
• Trend-corrected exponential smoothing (Holt’s
model)
• Trend- and seasonality-corrected exponential
smoothing (Winter’s model)

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 Delphi method
An iterative process in which managers and
staff complete a series of questionnaires, each
developed from the previous one, to achieve a
consensus forecast

• As a forecasting tool, the Delphi method is

useful for technological forecasting, that is, for
assessing changes in technology and their
impact on an organization.

• For example, when vaccine for a disease might

be developed and ready for mass distribution. 1-31
Time Series Forecasting
A time series is a time-ordered sequence of
observations taken at regular intervals (e.g.,
hourly, daily, weekly, monthly, quarterly,
annually).
• Forecasting techniques based on time-series data
are made on the assumption that future values of
the series can be estimated from past values.

• No attempt is made to identify variables that

influence the series

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Common Patterns in Time series data
Trend
• Long-term upward or downward movement in the
data.
• Population shifts, changing incomes, and cultural
changes often account for such movements.
Seasonality
• Short-term, fairly regular variations generally
related to factors such as the calendar or time
of day
Cycles
• Wavelike variations of more than one year’s
duration.
• These are often related to a variety of
economic, political, and even agricultural
conditions.
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Stevenson, W. J. (2015). Operations management. McGraw-hill.
Common Patterns in Time series data

Irregular variations
• These are due to unusual circumstances such as severe
weather conditions, strikes, or a major change in a
product or service.
• They do not reflect typical behavior, and their
inclusion in the series can distort the overall picture.
Whenever possible, these should be identified and
removed from the data.
Random variations
• These are residual variations that remain after all other
behaviors have been accounted for
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Time series forecasting methods
Naive Methods
• A forecast for any period that equals the previous
period’s actual value.
• The naive approach can be used with a stable
series (variations around an average), with
seasonal variations, or with trend.
• With a stable series, the last data point becomes
the forecast for the next period.
• With seasonal variations, the forecast for this
“season” is equal to the value of the series last
“season.”

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Averaging techniques
Averaging techniques smooth variations in the
data

• Moving average
• Weighted moving average
• Exponential smoothing

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Moving average
n

A i 1
At  n  ...  At  2  At 1
Ft  MAn  i 1

n n
Where
Ft  Forecast for time period t
MAn  n period moving average
At i  Actual value in period t-i
n  Number of periods in moving average

Note: In a moving average, as each new actual value becomes

available, the forecast is updated by adding the newest value and
dropping the oldest and then recomputing the average.
Consequently, the forecast “moves” by reflecting only the most
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recent values.
Month Demand 3-month
Moving
Average
1 650
2 700
3 810
4 800
5 900
6 700
7

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Number of data points to be added
The moving average can incorporate as many data points as desired.
• Number of data points in the average determines its sensitivity to
each new data point:
• The fewer the data points in an average, the more sensitive
(responsive) the average tends to be.
• Conversely, moving averages based on more data points will
be more smooth but be less responsive to “real” changes.

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Stevenson, W. J. (2015). Operations management. McGraw-hill.
Advantages and disadvantages of MA
Advantages
• Easy to compute and easy to understand
Disadvantage
• All values in the average are weighted equally
• The oldest value has the same weight as the most recent
value.
• If a change occurs in the series, a moving average forecast
can be slow to react, especially if there are a large number of
values in the average.

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Weighted Moving Average
A weighted average is similar to a moving average, except that
it typically assigns more weight to the most recent values in a
time series
Ft  wt 1 ( At  n )  ...  wt  2 ( At  2 )  wt 1 ( At 1 )

Where
wt 1  Weight for period t  1, etc.
At 1  Actual value for period t  1, etc.

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Example
Given the following demand data,
Compute
1. 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.

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• The advantage of a weighted average over a simple
moving average is that the weighted average is more
reflective of the most recent occurrences.

• However, the choice of weights is somewhat

arbitrary and generally involves the use of trial and
error to find a suitable weighting scheme.

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Exponential Smoothing
In Exponential smoothing, each new forecast is
based on the previous forecast plus a percentage
of the difference between that forecast and the
actual value of the series at that point. That is:

Ft  Ft 1   ( At 1  Ft 1 )

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 Acknowledgement

The content is taken from-

Stevenson, W. J. (2015). Operations
management. McGraw-hill.

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