Forecasting

Module 2
 What is Forecasting?

 Process of predicting a future

event based on historical data
 Importance of forecasting

• 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
Quantitative
• Short-range forecast methods
–Usually < 3 months
• Job scheduling, worker assignments
Detailed
• Medium-range forecast use of
system
–3 months to 2 years
• Sales/production planning

• Long-range forecast
–> 2 years
• New product planning Design
of system
• New Market
Qualitative
Methods
 Forecasting During the Life Cycle

Introduction Growth Maturity Decline

Qualitative models Quantitative models

- Executive judgment
- Time series analysis
- Market research
- Regression analysis
-Survey of sales force
-Delphi method
Sales

Time
 Qualitative Forecasting Methods

Qualitative
Forecasting

Models
Sales Delphi
Executive Market
Force Method
Judgment Research/
Composite
Survey

Smoothing
 Qualitative Methods

• Executive Judgment: Opinion of a group of high level experts or

managers is pooled

• Sales Force Composite: Each regional salesperson provides

his/her sales estimates. Those forecasts are then reviewed to
make sure they are realistic. All regional forecasts are then
pooled to obtain an overall forecast.

• 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.

.
 Qualitative Methods
Delphi Method
Typically, the procedure consists of the following steps:
Each expert in the group makes his/her own forecasts in form
of statements

• The coordinator collects all group statements and

summarizes them
• The coordinator provides this summary and gives
another set of questions to each group member
including feedback as to the input of other experts.
• The above steps are repeated until a consensus is
reached.
.
 Quantitative Forecasting Methods

Quantitative
Forecasting

Time Series Regression

Models Models

2. Moving 3. Exponential
1. Naive
Average Smoothing
a) simple a) level
b) weighted b) trend
c) seasonality
 Time Series Model

• Try to predict the future based on past data

–Assume that factors influencing the past will continue to

influence the future
Time Series Patterns
 Product Demand over Time

Trend component
Seasonal peaks
Demand for product or service

Actual
Random demand line
variation
Year Year Year Year
1 2 3 4
 1. Naive Approach

 Demand in next period is the same as demand

in most recent period
June forecast = 48
 May sales = 48 →

 Usually not good

 2.a. Simple Moving Average

• Assumes an average is a good estimator of future

behavior
–Used if little trend
–Used for smoothing

A t + A t -1 + A t -2 + ... + A t -n 1
Ft 1 =
n
Ft+1 = Forecast for the upcoming period, t+1
n = Number of periods to be averaged
At = Actual occurrence in period t
 2a. Simple Moving Average

You’re manager in Amazon’s electronics department. You want

to forecast iPod sales for months 4-6 using a 3-period moving
average.
Sales Ft 1 =
A t + A t -1 + A t -2 + ... + A t -n 1
n
Month (000)
1 4
2 6
3 5
4 ?
5 ?
6 ?
 2a. Simple Moving Average
You’re manager in Amazon’s electronics department. You want
to forecast iPod sales for months 4-6 using a 3-period moving
average. A t + A t -1 + A t -2 + ... + A t -n 1
Ft 1 =
n
Sales Moving Average
Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 ? (4+6+5)/3=5
5 ?
6 ?
 2a. Simple Moving Average
• What if iPod sales were actually 3 in month 4?

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3? 5
5 ?
6 ?
 2a. Simple Moving Average
Forecast for Month 5?

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3 5
5 ? (6+5+3)/3=4.667
6 ?
 2a. Simple Moving Average
• Actual Demand for Month 5 = 7

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3 5
5 ?7 4.667
6 ?
 2a. Simple Moving Average
• Forecast for Month 6?

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3 5
5 7 4.667
6 ? (5+3+7)/3=5
 2b. Weighted Moving Average

• Gives more emphasis to recent data

Ft 1 = w1At + w 2At -1 + w 3At -2 + ... + w n At -n 1

• Weights
– decrease for older data
– sum to 1.0 Simple moving
average models
weight all previous
periods equally
2b. Weighted Moving Average: 0.5, 0.3,
0.2

Month Sales Weighted

(000) Moving
Average
1 4 NA
2 6 NA
Ft 1 = w1At + w 2 At -1 + w 3At -2 + ... + w n At -n 1

3 5 NA
4 ? 5.1
5 ?
6 ?
2b. Weighted Moving Average: 0.5, 0.3, 0.2

Ft 1 = w1At + w 2At -1 + w 3At -2 + ... + w n At -n 1

Month Sales Weighted

(000) Moving
Average
1 4 NA
2 6 NA
3 5 NA
4 3 5.1
5 7 4.2
6 5.4
 3a. Exponential Smoothing
• Assumes the most recent observations have the
highest predictive value

Ft+1 = Ft + a(At - Ft)

et

Ft+1 = Forecast value for time t+1 Need initial

At = Actual value at time t forecast Ft
a = Smoothing constant to start.
 3a. Exponential Smoothing – Example 1
Given the weekly demand
datai what areAi the exponential Week Demand
smoothing forecasts for 1 820
periods 2-10 using a=0.10? 2 775
3 680
Assume F1=D1 4 655
5 750
6 802
7 798

Ft+1 = Ft + a(At - Ft)

8 689
9 775
10
3a. Exponential Smoothing – Example 1

Ft+1 = Ft + a(At - Ft)

i Ai Fi
a=
Week Demand 0.1 0.6
1 820 820.00 820.00
2 775 820.00 820.00
3 = F1+ a(A793.00
680 F2815.50 1–F1)=820+.1(820–820)
4 655 801.95 725.20=820
5 750 787.26 683.08
6 802 783.53 723.23
7 798 785.38 770.49
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28
3a. Exponential Smoothing – Example 1

Ft+1 = Ft + a(At - Ft)

i Ai Fi

Week Demand a = 0.1 0.6

1 820 820.00 820.00
2 775 820.00 820.00
3 680 815.50 793.00
F3 = F2+ a(A2–F2)=820+.1(775–820)
4 655 801.95 725.20
5 750 787.26 683.08=815.5
6 802 783.53 723.23
7 798 785.38 770.49
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28
3a. Exponential Smoothing – Example 1

Ft+1 = Ft + a(At - Ft)

i Ai Fi

Week Demand a = 0.1 0.6

1 820 820.00 820.00
2 775 820.00 820.00
3 680 815.50 793.00
4 655 801.95 725.20
5 750 787.26 683.08
6 802 783.53 723.23 This process
7 798 785.38 770.49 continues
8 689 786.64 787.00through week 10
9 775 776.88 728.20
10 776.69 756.28
3a. Exponential Smoothing – Example 1

Ft+1 = Ft + a(At - Ft)

i Ai Fi

Week Demand a = 0.1 a = 0.6

1 820 820.00 820.00
2 775 820.00 820.00
3 680 815.50 793.00
4 655 801.95 725.20
5 750 787.26 683.08 What if the
6 802 783.53 723.23 a constant
7 798 785.38 770.49 equals 0.6
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28
 3a. Exponential Smoothing – Example 2

Ft+1 = Ft + a(At - Ft)

i Ai Fi

Month Demand a =0.3 a = 0.6

January 120 100.00 100.00
February 90 106.00 112.00
March 101 101.20 98.80
April 91 101.14 100.12
May 115 98.10 94.65 What if the
June 83 103.17 106.86 a constant
July 97.12 92.54 equals 0.6
August
September
 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 a

• Selections should produce a good forecast

…but what is a good forecast?
A Good Forecast Has a small error
Error = Demand - Forecast
Regression Analysis as a Method for
Forecasting
Linear Regression
 Linear Regression Problem

• A maker of golf shirts has been tracking the

relationship between sales and advertising dollars.
Use linear regression to find out what sales might
be if the company invested $53,000 in advertising
next year.
 Linear Regression Problem

Sales $ Adv.$ XY X^2 Y^2

(Y) (X)
1 130 32 4160 2304 16,900
b
 XY  n XY
2 151 52 7852 2704 22,801
 X  nX 2 2

3 150 50 7500 2500 22,500

28202  447.25147.25
4 158 55 8690 3025 24964 b  1.15
9253  447.25
2

5 153.85 53 a  Y  b X  147.25  1.1547.25

a  92.9
T 589 189 28202 9253 87165
o Y  a  bX  92.9  1.15X
t Y  92.9  1.1553  153.85

A 147.25 47.25
v
g
 Correlation Coefficient
How Good is the Fit?

• Correlation coefficient (r) measures the direction and strength of the linear
relationship between two variables. The closer the r value is to 1.0 the better
the regression line fits the data points.

n  XY    X  Y 
r
   
n  X 2   X  * n  Y 2  Y 
2 2

428,202  189589
r  .982
4(9253) - (189) * 487,165  589
2 2
 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