Forecasting
1-1
What Is Forecasting?
• Process of predicting a
future event
• Underlying basis of all
business decisions
– Production
– Inventory
– Personnel
– Facilities
Forecasting Time Horizons
1. Short-range forecast
– Up to 1 year, generally less than 3 months
– Purchasing, job scheduling, workforce levels, job assignments,
production levels
2. Medium-range forecast
– 3 months to 3 years
– Sales and production planning, budgeting
3. Long-range forecast
– 3+ years
– New product planning, facility location, research and
development
Distinguishing Differences
1. Medium/long range forecasts deal with more
comprehensive issues and support management decisions
regarding planning and products, plants and processes
2. Short-term forecasting usually employs different
methodologies than longer-term forecasting
3. Short-term forecasts tend to be more accurate than longer-
term forecasts
Types of Forecasts
1. Economic forecasts
– Address business cycle – inflation rate, money supply,
housing starts, etc.
2. Technological forecasts
– Predict rate of technological progress
– Impacts development of new products
3. Demand forecasts
– Predict sales of existing products and services
Strategic Importance of
Forecasting
• Supply-Chain Management – Good supplier relations,
advantages in product innovation, cost and speed to market
• Human Resources – Hiring, training, laying off workers
• Capacity – Capacity shortages can result in undependable
delivery, loss of customers, loss of market share
The Effect of Inaccurate Forecasting
12-7
Seven Steps in Forecasting
1. Determine the use of the forecast
2. Select the items to be forecasted
3. Determine the time horizon of the forecast
4. Select the forecasting model(s)
5. Gather the data needed to make the forecast
6. Make the forecast
7. Validate and implement the results
Forecasting Approaches
Qualitative Methods
Used when situation is vague and little data exist
– New products
– New technology
Involves intuition, experience
Forecasting Approaches
Quantitative Methods
Used when situation is ‘stable’ and historical data exist
– Existing products
– Current technology
Involves mathematical techniques
– e.g., forecasting sales of color televisions
Overview of Qualitative Methods
1. Jury of executive opinion
– Pool opinions of high-level experts, sometimes augmented by
statistical models
2. Delphi method
– Panel of experts, queried iteratively
Overview of Qualitative Methods
3. Sales force composite
– Estimates from individual salespersons are reviewed
for reasonableness, then aggregated
4. Market Survey
– Ask the customer
Jury of Executive Opinion
• Involves small group of high-level experts and managers
• Group estimates demand by working together
• Combines managerial experience with statistical models
• Relatively quick
Delphi Method
• Iterative group process,
continues until consensus is
reached
• Three types of participants
– Decision makers
– Staff
– Respondents
Sales Force Composite
• Each salesperson projects his or her sales
• Combined at district and national levels
• Sales reps know customers’ wants
• May be overly optimistic
Market Survey
• Ask customers about purchasing plans
• Useful for demand and product design and planning
• What consumers say and what they actually do may be
different
• May be overly optimistic
Overview of Quantitative Approaches
1. Naive approach
2. Moving averages
3. Exponential smoothing
4. Trend projection
5. Linear regression
Time-Series Forecasting
• Set of evenly spaced numerical data
– Obtained by observing response variable at regular
time periods
• Forecast based only on past values, no other variables
important
– Assumes that factors influencing past and present will
continue influence in future
Time-Series Components
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 “Season” Length Number Of “Seasons” In Pattern
Week Day 7
Month Week 4 – 4.5
Month Day 28 – 31
Year Quarter 4
Year Month 12
Year Week 52
Cyclical Component
• Repeating up and down
movements
• Affected by business cycle,
political, and economic
factors
• Multiple years duration
Random Component
• Erratic, unsystematic, ‘residual’ fluctuations
• Due to random variation or unforeseen events
• Short duration and nonrepeating
Components of Demand
Demand Charted over 4 Years, with a Growth Trend and Seasonality
Indicated
Naive Approach
• Assumes demand in next period is
the same as demand in most recent
period
– e.g., If January sales were 68,
then February sales will be 68
• Can be good starting point
Moving Averages
• MA is a series of arithmetic means
• Used if little or no trend
• Provides overall impression of data over time
Moving average
demand in previous n periods
n
Moving Average Example
Moving Average Example
Moving Average Example
Weighted Moving Average
• Used when some trend might be present
– Older data usually less important
• Weights based on experience and intuition
Weighted
Weight for period n Demand in period n
moving
average
Weights
Weighted Moving Average
Potential Problems with Moving
Average
1. Increasing n makes it less sensitive to changes
2. Does not forecast trends well. Always a lag.
3. Requires extensive historical data
Graph of Moving Averages
Actual Demand vs. Moving-Average and Weighted-Moving-Average Methods
Exponential Smoothing
New forecast = Last period’s forecast + α (Last period’s
actual demand − Last period’s forecast)
Ft Ft 1 + A t 1 Ft 1
where Ft = new forecast
Ft – 1 = previous period’s forecast
α= 0 1
smoothing (or weighting) constant
At – 1 = previous period’s actual demand
Exponential Smoothing
• Form of weighted moving average
– Weights decline exponentially
– Most recent data weighted most
Requires smoothing constant (α)
– Ranges from 0 to 1
– Subjectively chosen
• Involves little record keeping of past data
Effect of Smoothing Constants
• Smoothing constant generally .05 α .50
As α increases, older values become less significant
Exponential Smoothing Example
Predicted demand = 142 Ford Mustangs
Actual demand = 153
Smoothing constant α = .20
Exponential Smoothing Example
Predicted demand = 142 Ford Mustangs
Actual demand = 153
Smoothing constant α = .20
New forecast 142 .2(153 142)
142 2.2
144.2 144 cars
Impact of Different
Forecasting Errors
• Mean Absolute Deviation (MAD)
• Mean Squared Error (MSE)
• Mean Absolute Percent Error (MAPE)
Common Measures of Error
Mean Absolute Deviation (MAD)
MAD
| Actual Forecast
n
Determining the MAD
Actual
Tonnage Forecast With
Quarter Unloaded Forecast With a = .10 a = .50
1 180 175 175
2 168 175.50 = 175.00 + .10(180 − 175) 177.50
3 159 174.75 = 175.50 + .10(168 − 175.50) 172.75
4 175 173.18 = 174.75 + .10(159 − 174.75) 165.88
5 190 173.36 = 173.18 + .10(175 − 173.18) 170.44
6 205 175.02 = 173.36 + .10(190 − 173.36) 180.22
7 180 178.02 = 175.02 + .10(205 − 175.02) 192.61
8 182 178.22 = 178.02 + .10(180 − 178.02) 186.30
9 ? 178.59 = 178.22 + .10(182 − 178.22) 184.15
Determining the MAD
Actual
Tonnage Forecast With
Quarter Unloaded Forecast With a = .10 a = .50
1 180 175 175
2 168 175.50 = 175.00 + .10(180 − 175) 177.50
3 159 174.75 = 175.50 + .10(168 − 175.50) 172.75
4 175 173.18 = 174.75 + .10(159 − 174.75) 165.88
5 190 173.36 = 173.18 + .10(175 − 173.18) 170.44
6 205 175.02 = 173.36 + .10(190 − 173.36) 180.22
7 180 178.02 = 175.02 + .10(205 − 175.02) 192.61
8 182 178.22 = 178.02 + .10(180 − 178.02) 186.30
9 ? 178.59 = 178.22 + .10(182 − 178.22) 184.15
Determining the MAD
Common Measures of Error
Mean Squared Error (MS)
Forecast errors
2
MSE
n
Determining the MSE
Determining the MSE
Forecast errors
2
MSE= 1,526.52 8 190.8
n
Common Measures of Error
Mean Absolute Percent Error (MAPE)
100 Actual i Forecast i Actuali
MAPE= i =1
n
Determining the MAPE
Determining the MAPE
MAPE=
absolute percent error 44.75%
5.59%
n 8
Trend Projections
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
Λ
y a bx
Λ
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
Least Squares Method
The Least-Squares Method for Finding the Best-Fitting Straight Line,
Where the Asterisks Are the Locations of the Seven Actual Observations
or Data Points
Least squares method minimizes the sum of the squared errors (deviations)
Least Squares Method
Equations to calculate the regression variables
Least Squares 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
Least Squares Example
Electrical Power
Year (x) x2 xy
Demand (y)
1 74 1 74
2 79 4 158
3 80 9 240
4 90 16 360
5 105 25 525
6 142 36 852
7 122 49 854
sum
x of x28 sum of y = 692. sum of x squared = 140. sumofxy
xy =3,063
3,063
= 28 y 692 x 140
2
Least Squares Example
Electrical Power
Year (x) x2 xy
Demand (y)
1 74 1 74
2 79 4 158
3 80 9 240
4 90 16 360
5 105 25 525
6 142 36 852
7 122 49 854
sum
x of x28
= 28 sum of y = 692.
y 692
sum of x squared
2 = 140.
x 140 sumofxy
xy =3,063
3,063
x
x 28 4 y
y 692 98.86
n 7 n 7
Least Squares Example
b
xy nxy 3,063 7 4 98.86 295
10.54
x nx 140 7 4
2 2
2 28
a y bx 98.86 10.54 4 56.70
Thus, y 56.70 10.54 x
Demand in year 8 = 56.70 + 10.54(8)
= 141.02, or 141 megawatts
Seasonal Variations in Data
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 Example
Seasonal Index Example
1,128
Average monthly demand = = 94
12 months
Seasonal Index Example
Average monthly demand for past 3 years
Seasonal index
Average monthly demand
Seasonal Index Example
Seasonal Index Example
Seasonal forecast for Year 4
Month Demand Month Demand
1,200 over 12, end fraction, times 0.957 = 96 1,200 over 12, end fraction, times 1.117 = 112
Jan 1,200
.957 96
July 1,200
1.117 112
12 12
1,200 over 12, end fraction, times 0.851 = 85 1,200 over 12, end fraction, times 1.064 = 106
Feb 1,200
.851 85 Aug 1,200
1.064 106
12 12
1,200 over 12, end fraction, times 0.904 = 90 1,200 over 12, end fraction, times 0.957 = 96
Mar 1,200 Sept 1,200
.904 90 .957 96
12 12
1,200 over 12, end fraction, times 1.064 = 106 1,200 over 12, end fraction, times 0.851 = 85
Apr 1,200 Oct 1,200
1.064 106 .851 85
12 12
1,200 over 12, end fraction, times 1.309 = 131 1,200 over 12, end fraction, times0.851 = 85
May 1,200
1.309 131
Nov 1,200
.851 85
12 12
1,200 over 12, end fraction, times 1.223 = 122 1,200 over 12, end fraction, times0.851 = 85
June 1,200
1.223 122 Dec 1,200
.851 85
12 12
Seasonal Index Example
Seasonality Plus Trend
San Diego Hospital
Trend Data for San Diego Hospital
San Diego Hospital
Seasonality Indices for Adult Inpatient at San Diego Hospital
Month Seasonality Index Month Seasonality Index
January 1.04 July 1.03
February 0.97 August 1.04
March 1.02 September 0.97
April 1.01 October 1.00
May 0.99 November 0.96
June 0.99 December 0.98
San Diego Hospital
Seasonal Index for San Diego Hospital
San Diego Hospital
Period 67 68 69 70 71 72
Month Jan Feb Mar Apr May June
Forecast with 9,911 9,265 9,764 9,691 9,520 9,542
Trend &
Seasonality
Period 73 74 75 76 77 78
Month July Aug Sept Oct Nov Dec
Forecast with 9,949 10,068 9,411 9,724 9,355 9,572
Trend &
Seasonality
San Diego Hospital
Combined Trend and Seasonal Forecast
Associative Forecasting
Used when changes in one or more independent
variables can be used to predict the changes in the
dependent variable
Most common technique is linear-regression analysis
We apply this technique just as we did in the time-series
example
Associative Forecasting
Forecasting an outcome based on predictor variables using the
least squares technique
Λ
y a bx
Λ
where y value of the dependent variable (in our example,
sales)
a = y-axis intercept
b = slope of the regression
line
x = the independent variable
Associative Forecasting Example
Nodel’s Sales Area Payroll Nodel’s Sales Area Payroll
(In $ Millions), y (In $ Billions), x (In $ Millions), y (In $ Billions), x
2.0 1 2.0 2
3.0 3 2.0 1
2.5 4 3.5 7
Associative Forecasting Example
Nodel’s Sales Area Payroll Nodel’s Sales Area Payroll
(In $ Millions), y (In $ Billions), x (In $ Millions), y (In $ Billions), x
2.0 1 2.0 2
3.0 3 2.0 1
2.5 4 3.5 7
Associative Forecasting Example
Sales, y Payroll, x x2 xy
2.0 1 1 2.0
3.0 3 9 9.0
2.5 4 16 10.0
2.0 2 4 4.0
2.0 1 1 2.0
3.5 7 49 24.5
the sum of Y= 15.0 the sum of X = 18 the sum of X squared = 18 the sum of X Y = 51.5
y 15.0 x 18 x 2 18 xy 51.5
x
x 18
3 y
y 15
2.5
6 6 6 6
b
xy nxy 51.5 6 3 2.5 .25 a y bx 2.5 .25 3 1.75
x nx 80 6 3
2 2 2
Associative Forecasting Example
y 1.75 .25 x
Sales 1.75 .25 payroll
Associative Forecasting Example
If payroll next year is estimated to be $6 billion, then:
Sales in $ millions 1.75 .25 6
1.75 1.5 3.25
Sales $3,250,000
Associative Forecasting Example
Monitoring and Controlling Forecasts
Tracking Signal
• Measures how well the forecast is predicting actual values
• Ratio of cumulative forecast errors to mean absolute
deviation (MAD)
– Good tracking signal has low values
– Positive tracking signal indicate demand is greater
than forecast.
– Negative tracking signal indicate demand is less than
forecast.
– If forecasts are continually high or low, the forecast
has a bias error
Monitoring and Controlling Forecasts
Cumulative error
Tracking signal
MAD
(Actual demand in period i Forecast demand in period i )
Actual Forecast
n
Tracking Signal
A Plot of Tracking Signals
Tracking Signal Example
Cum Absolute CUM ABS
Actual Forecast Erro Forecast Forecast Tracking Signal (C
QTR Demand Demand Error r Error Error MAD UM Error/MAD)
1 90 100 –10 –10 10 10 10.0 10 10 1
negative 10 divided by 10 = negative 1
2 95 100 –5 –15 5 15 7.5 15 7.5 2
negative 15 divided by 7.5 = negative 2
3 115 100 +15 0 15 30 10.0
0 divided by 10 = 0
0 10 0
10 divided by 10 = negative 1
4 100 110 –10 –10 10 40 10.0 10 10 1
5 125 110 +15 +5 15 55 11.0 5 11 0.5
5 divided by 11 = 0.5
35 divided by 14.2 = 2.5
6 140 110 +30 +35 30 85 14.2 35 14.2 2.5
Forecast errors 85
At the end of quarter 6, MAD 14.2
n 6
