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Chapter three Forecasting

Outline
What is forecasting?
Types of forecasts
Qualitative
quantitative

Time-Series forecasting
Nave
Moving Average
Exponential Smoothing
Regression

Good forecasts

What is Forecasting?
Forecasts are estimates of occurrence, timing
, or magnitude of uncertain future events.
It is the process of predicting a future event
based on historical data
Forecasting is Educated Guessing
Underlying basis of all business decisions
v
v
v
v

Production
Inventory
Personnel
Facilities

The purpose of forecasting


The purpose of forecasting is to use
the best available information to guide
future activities toward organizational
goals.
Forecasting is the basis for all planning
and budgeting efforts.

Why do we need to forecast?


In general, forecasts are almost always wrong. So,
Throughout the day we forecast very different
things such as weather, traffic, stock market, state
of our company from different perspectives.
Virtually every business attempt is based on
forecasting. Not all of them are derived from
sophisticated methods. However, Best" educated
guesses about future are more valuable for
purpose of Planning than no forecasts and hence
no planning.

Importance of Forecasting in OM
Departments throughout the organization depend on
forecasts to formulate and execute their plans.
Finance needs forecasts to project cash flows and
capital requirements.
Human resources need forecasts to anticipate hiring
needs.
Production needs forecasts to plan production
levels,
workforce,
material
requirements,
inventories, etc.

Importance of Forecasting in OM
Demand is not the only variable of interest to
forecasters.
Manufacturers also forecast worker absenteeism,
machine availability, material costs, transportation
and production lead times, etc.
Besides demand, service providers are also
interested in forecasts of population, of other
demographic variables, of weather, etc.

Types of Forecasts by Time


Horizon
Quantitativ

Short-range forecast

e
methods

Usually < 3 months


Job scheduling, worker assignments
Detaile
d
use of
system
months to 2 years

Medium-range forecast
3

Sales/production planning

Long-range forecast
> 2 years
New product planning

Design
of system
Qualitative
Methods

Forecasting During the Life


Cycle
Introduction

Qualitative models
- Executive judgment
- Market research
-Survey of sales force
-Delphi method
Sales

Growth

Maturity

Quantitative models
- Time series analysis
- Regression analysis

Time

Decline

Types of forecasting
techniques

Forecasting depends on having enough


historical data to be able to describe the
record in statistical terms. predication ,
on the other hand , is integrating a great
deal
of
subjective
and
objective
information to form the best estimates of
the future. There are basically two broad
categories of forecasting techniques.
Qualitative methods
Quantitative methods

I.

Qualitative Methods

1.Delphi Method: The delphi method was


originally developed by Rand Corporation in
1969 to forecast military events, and has
become useful tool in other areas also.
The technique draws on a panel of experts ,
which can be formed in various ways that
eliminate the possible dominance of the
most verbal or prestigious person. Each
panel member is an expert on some aspect
of the problem. The objective is to gain the
benefit of expert opinion in the form of
consensus instead of compromise .

Typically, the procedure consists of the following


steps:
a. A coordinator poses a question , in writing , to
each expert on a panel , and each expert
makes brief statements of pridictions.
b. The coordinator brings the written preditions
together, edits and clarifies them.
c. A series of written questions are provided by
the coordinator to the experts that combine
the feedback , supplied by the other
experts. These are answered in writing .
d. Steps a to c are repeated for several
rounds until the coordinator is satisfied with
the overall prediction synthesized from the
experts.
As opposed to regular panels where the individuals
involved are in direct communication, this method
eliminates the effects of group potential dominance of
the most vocal members. The group involves individuals
from inside as well as outside the organization.

2.Jury of Executive opinion : Opinion of a


group of high level experts or managers is
pooled. For e.g, the managers of various
divisions could be asked about the profitability
of introducing a new product .
Opinions could be taken on an individual
basis or there could be a brainstorming group
session in which all members participate in
generating new ideas that can later be
evaluated for their feasibility and profitability.
This method is fast , less expensive and does
not depend upon any elaborative statistics
and brings in specialized viewpoints.
Its disadvantage is it is subjective opinions

3.Market Research/Survey: Solicits input


from customers pertaining to their future
purchasing plans. It involves the use of
questionnaires, consumer panels and
tests of new products and services. The
purpose of the survey is to identify the
nature of consumer consumption. A
forecast is developed after determining
how general sales vary with differences
in marketing location , buyer occupation ,
commodity prices , quantity , quality ,
consumer income and other factors.

4.Opinions of salesperson: This approach


involves the opinions of the sales force
and these opinions are primarily taken
into consideration for forecasting future
sales. The sales people, being closer to
the consumers, can estimate future
sales in their own territories more
accurately. These forecasts are good for
short range planning since sales people
are not sufficiently sophisticated to
predict long-term trends.

5.Historical analogy and life cycle


analysis:
market survey can be
supplemented by reference to the
performance of an ancestor of the
product or service by applying product
life cycle analysis. Most products pass
through stages of introduction , growth,
maturity and decline.
Not all products follow the same pattern
. For instance fashion items , food
stuffs, building materials and some
goods do not seem to decline at all.

II. Quantitative Forecasting


Methods
Quantitative
Forecasting
Regression
Models

Time Series
Models

1. Naive

2. Moving
Average
a) simple
b) weighted

3. Exponential
Smoothing
a) level
b) trend
c) seasonality

Time Series Models


Try to predict the future based on
past data

Assume that factors influencing the


past will continue to influence the
future

Time Series Models:


Components
Random

Trend

Seasonal

cyclical

Product Demand over Time


Demand for product or service
Year
1

Year
2

Year
3

Year
4

Product Demand over Time


Trend component
Seasonal peaks

Demand for product or service

Random
variation
Year
1

Year
2

Actual demand
line
Year
3

Year
4

Now lets look at some time series approaches to forecasting


Borrowed from Heizer/Render - Principles of Operations Management, 5e, and Operations Management, 7e

Trend Component
Persistent, overall upward or
downward pattern
Changes due to population,
technology, age, culture, etc.
Typically several years duration

Seasonal Component
Regular pattern of up and
down fluctuations
Due to weather, customs, etc.
Occurs within a single year
Period

Length

Number of
Seasons

Week
Month
Month
Year
Year
Year

Day
Week
Day
Quarter
Month
Week

7
4-4.5
28-31
4
12
52

Cyclical Component
Repeating up and down movements
Affected by business cycle, political,
and economic factors
Multiple years duration
Often causal or
associative
relationships
0

10

15

20

Random Component
Erratic, unsystematic, residual
fluctuations
Due to random variation or
unforeseen events
Short duration and
nonrepeating

M
F

Quantitative Forecasting
Methods
Quantitative
Time Series
Models
Models
1. Naive

2. Moving
Average
a) simple
b) weighted

3. Exponential
Smoothing
a) level
b) trend
c) seasonality

1.

Naive Approach

Demand in next period is the same as


demand in most recent period
May sales = 48June
forecast = 48

n
Usually not good

2. Simple Moving Average


Assumes an average is a good estimator
of future behavior
Used if little or no trend
Used for smoothing
AAt t ++AAt -t1-1++AAt -t 2-2 ++...
++AAt -t n-n11
...
FFt t 11 ==
nn
Ft+1
= Forecast for the upcoming period, t+1
n = Number of periods to be averaged
A t = Actual occurrence in period t

2. Simple Moving
Average
A + A + A + ... + A
FF == A + A + A + ... + A
t t 11

tt

t -t1-1

t -t2- 2

nn

t -tn- n11

Youre manager in Amazons electronics


department. You want to forecast ipod sales
for months 4-6 using a 3-period moving
average. Sales

Month
1
2
3
4
5
6

(000)
4
6
5
?
?
?

AAt ++AAt -1 ++AAt -2 ++......++AAt -n 1


t -1
t -2
t - n 1
FFt 1 == t
t 1
nn

2. Simple Moving Average

Youre manager in Amazons electronics


department. You want to forecast ipod sales for
months 4-6 using a 3-period moving average.

Month
1
2
3
4
5
6

Sales
(000)
4
6
5
?
?
?

Moving Average
(n=3)
NA
NA
NA
(4+6+5)/3=5

2. Simple Moving Average

What if ipod sales were actually 3


in month 4
Month
1
2
3
4
5
6

Sales
(000)
4
6
5
3?
?
?

Moving Average
(n=3)
NA
NA
NA
5

2a. Simple Moving Average

Forecast for Month 5?

Month
1
2
3
4
5
6

Sales
(000)
4
6
5
3
?
?

Moving Average
(n=3)
NA
NA
NA
5
(6+5+3)/3=4.667

2a. Simple Moving Average

Actual Demand for Month


5=7
Month
1
2
3
4
5
6

Sales
(000)
4
6
5
3
?7
?

Moving Average
(n=3)
NA
NA
NA
5
4.667

2a. Simple Moving Average

Forecast for Month 6?

Month
1
2
3
4
5
6

Sales
(000)
4
6
5
3
7
?

Moving Average
(n=3)
NA
NA
NA
5
4.667
(5+3+7)/3=5

2b. Weighted Moving


Average
Gives more emphasis to recent data
F = w A + w A + w A + ... + w A
Ftt11 = w11Att + w22 Att-1-1 + w33 Att--22 + ... + wnn Att--nn11

Weights
decrease for older data
sum to 1.0
Simple
Simplemoving
moving
average
averagemodels
models
weight
weightall
allprevious
previous
periods
periodsequally
equally

2b. Weighted Moving Average:


3/6, 2/6, 1/6
Month
1
2
3
4
5
6

Sales
(000)
4
6
5
?
?
?

Weighted
Moving
Average
NA
NA
NA
31/6 = 5.167

FFt t 11 ==ww11AAt t ++ww22AAt -t1-1++ww33AAt -t2-2++......++wwnnAAt -tn-n11

2b. Weighted Moving Average:


3/6, 2/6, 1/6
Month
1
2
3
4
5
6

Sales
(000)
4
6
5
3
7

Weighted
Moving
Average
NA
NA
NA
31/6 = 5.167
25/6 = 4.167
32/6 = 5.333

FFt t 11 ==ww11AAt t ++ww22AAt -t1-1++ww33AAt -t2-2++......++wwnnAAt -tn-n11

3. Exponential Smoothing
Assumes the most recent observations
have the highest predictive value
gives more weight to recent time periods

FFt+1
=
F
+
(A
F
)
=
F
+
(A
F
t
t
t
t+1
t
t
t)
et
Ft+1
At

= Forecast value for time t+1 Need initial


= Actual value at time t
= Smoothing constant

Need initial
forecast
forecastFFt t
totostart.
start.

3. Exponential Smoothing
1
FF == FFExample
++ (A
F
(A - F ))
t+1
t+1

tt

tt

tt

Ai

Given
Given the
the weekly
weekly demand
demand
data
data what
what are
are the
the
exponential
exponential
smoothing
smoothing forecasts
forecasts for
for
periods
periods 2-10
2-10 using
using =0.10?
=0.10?
Assume
Assume FF11=D
=D11

3. Exponential Smoothing
1
FF == FFExample
++ (A
F
(A - F ))
t+1
t+1

tt

Ai

tt

tt

Fi

F2 = F1+ (A1F1)

=820+(820820)
=820

3. Exponential Smoothing
1
FF == FFExample
++ (A
F
(A - F ))
t+1
t+1

tt

Ai

tt

tt

Fi

F3 = F2+ (A2F2)

=820+(775820)
=815.5

3. Exponential Smoothing
1
FF == FFExample
++ (A
F
(A - F ))
t+1
t+1

tt

Ai

tt

Fi

tt

3. Exponential Smoothing
1
FF == FFExample
++ (A
F
(A - F ))
t+1
t+1

tt

Ai

tt

tt

Fi

3. Exponential Smoothing
2
FF == FFExample
++ (A
F
(A - F ))
t+1
t+1

tt

Ai

tt

tt

Fi

What if the
constant
equals 0.6

3. Exponential Smoothing
Example 3

Company
Company A,
A, aa personal
personal computer
computer producer
producer
purchases
purchases generic
generic parts
parts and
and assembles
assembles them
them to
to
final
final product.
product. Even
Even though
though most
most of
of the
the orders
orders
require
require customization,
customization, they
they have
have many
many common
common
components.
components. Thus,
Thus, managers
managers of
of Company
Company A
A need
need
aa good
good forecast
forecast of
of demand
demand so
so that
that they
they can
can
purchase
purchase computer
computer parts
parts accordingly
accordingly to
to minimize
minimize
inventory
inventory cost
cost while
while meeting
meeting acceptable
acceptable service
service
level.
level. Demand
Demand data
data for
for its
its computers
computers for
for the
the past
past 55
months
months isis given
given in
in the
the following
following table
table..

3a. Exponential Smoothing


3
FF == FFExample
++ (A
F
(A - F ))
t+1
t+1

tt

Ai

tt

tt

Fi

What if the
constant
equals 0.5

3. Exponential
Smoothing
How to choose
depends on the emphasis you want to
place on the most recent data

Increasing makes forecast more


sensitive to recent data

Forecast Effects of
Smoothing Constant
Ft+1 = F + (At - Ft)
Ft+1 = At + (1- ) At - 1 + (1- )2At - 2 + ...
t

or

w1

w2

w3
Weights

Prior Period

2 periods ago

3 periods ago

(1 - )

(1 - )2

= 0.10

10%

9%

8.1%

= 0.90

90%

9%

0.9%

Regression analysis
/Trend Projections
Fitting a trend line to historical data
points to project into the medium-tolong-range
Linear trends can be found using the
least squares technique
^

y = a + bx
^

where y = computed value of the variable to be


predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable

Values of Dependent Variable

Least Squares Method


Actual observation
(y value)

Deviation7

Deviation5

Deviation6

Deviation3
Deviation4
Deviation1

Deviation2

Trend line, ^
y = a + bx

Time period

Figure 4.4

Values of Dependent Variable

Least Squares Method


Actual observation
(y value)

Deviation7

Deviation5
Deviation3

Deviation6

Least squares method minimizes


the sum of the squared errors
(deviations)
Deviation
4

Deviation1

Deviation2

Trend line, ^
y = a + bx

Time period

Figure 4.4

Least Squares Method


Equations to calculate the regression variables
^

y = a + bx
xy - nxy
b=
x2 - nx2
a = y - bx

Least Squares Example


Year
1999
2000
2001
2002
2003
2004
2005

Time
Period (x)
1
2
3
4
5
6
7
x = 28
x=4

Electrical Power
Demand
74
79
80
90
105
142
122
y = 692
y = 98.86

x2

xy

1
4
9
16
25
36
49
x2 = 140

74
158
240
360
525
852
854
xy = 3,063

xy - nxy 3,063 - (7)(4)(98.86)


b=
= 140 - (7)(42)
x2 - nx2
a = y - bx = 98.86 - 10.54(4) = 56.70

= 10.54

Least Squares Example


Time
Period (x)

Electrical Power
Demand

x2

xy

1999
1
74
1
2000
2
79
4
line is 80
2001The trend
3
9
2002
4
90
16
^
2003
y 5= 56.70 +10510.54x 25
2004
6
142
36
2005
7
122
49
x = 28
y = 692
x2 = 140
x=4
y = 98.86

74
158
240
360
525
852
854
xy = 3,063

Year

xy nx y 3,063 - (7)(4)(98.86)
b=
= - (7)(42)
140
x2 - nx2
a = y - bx = 98.86 - 10.54(4) = 56.70

Least Squares Example


Power demand

160
150
140
130
120
110
100
90
80
70
60
50

Trend line,
y^= 56.70 + 10.54x

|
1999

|
2000

|
2001

|
2002

|
2003
Year

|
2004

|
2005

|
2006

|
2007

Formulas
yy== aa++bbxx
where,
where,
x

xy n x y

b
x nx
2

x
y

a y bx

Regression Example 2

yy == aa ++ bb X
X

xy n x y

b
x nx
2

a y bx

To Use a Forecasting
Method
Collect historical data
Select a model
Moving average methods

Select n (number of periods)


For weighted moving average: select weights

Exponential smoothing
Select

Selections should produce a good forecast

but what is a good forecast?

A Good Forecast
Has a small error
Error = Demand - Forecast

Measures of Forecast
Error
a. MAD = Mean Absolute Deviation

b. MSE = Mean Squared Error


c. RMSE = Root Mean Squared Error

et
nn

MAD
MAD==

AA --FF
t=1
t=1

tt

tt

nn

nn

22

A
F

At t - Ft t

t=
t =11
MSE
=
MSE =

nn

RMSE
RMSE == MSE
MSE

n Ideal values =0 (i.e., no forecasting error)

nn

MAD

A --FF

Example
MAD
MAD==

t=1
t=1

tt

tt

nn

What
What isis the
the MAD
MAD value
value given
given the
the forecast
forecast
values
values in
in the
the table
table below?
below?
At

Month
1
2
3
4
5

Ft

Sales Forecast |At Ft|


220
n/a
5
250
255
5
210
205
20
300
320
325
315
10
= 40

= 40=10
4

nn

22

A
F

At t - Ft t

= 550=137.5
4

MSE/RMSE Example
nn
t=
t =11
MSE
=
MSE =

What
What isis the
the MSE
MSE value?
value?

RMSE = 137.5

=11.73
At

Month
1
2
3
4
5

Ft

Sales Forecast
220
n/a
250
255
210
205
300
320
325
315

|At Ft| (At Ft)2


5
5
20
10

25
25
400
100

= 550

Measures of Error
1. Mean Absolute Deviation
(MAD)
n

MAD
-16

16

-1

-10

84
6

= 14

2a. Mean Squared Error


(MSE)
n

10

100

17

17

289

-20

20

400

-10

84

1,446

MSE

2
e

t
1

1,446
= 241
6

2b. Root Mean Squared Error


(RMSE)

An accurate forecasting system will have small MAD, MSE


and RMSE; ideally equal to zero. A large error may indicate
that either the forecasting method used or the parameters
such as used in the method are wrong.
Note: In the above, n is the number of periods, which is 6 in

RMSE MSE
= SQRT(241)
=15.52

Forecast Bias
How can we tell if a forecast has a
positive or negative bias?

TS = Tracking Signal
Good tracking signal has low values

(actual

forecastt )

RSFE
TS =
= t
MAD
MAD Mean absolute
deviation
30

General Guiding Principles for


Forecasting
1.

Forecasts are more accurate for larger groups of


items.
2.
Forecasts are more accurate for shorter periods
of time.
3.
Every forecast should include an estimate of
error.
4. Before applying any forecasting method, the total
system should be understood.
5. Before applying any forecasting method, the method
should be tested and evaluated.
6.
Be aware of people; they can prove you wrong
very easily in forecasting

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