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Chapter 3

Forecasting

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Forecast
Forecast a statement about the future

value of a variable of interest


We make forecasts about such things as

weather, demand, and resource availability


Forecasts are an important element in making
informed decisions

Instructor Slides

3-2

Two Important Aspects of Forecasts


Expected level of demand
The level of demand may be a function of some

structural variation such as trend or seasonal


variation
Accuracy
Related to the potential size of forecast error

Instructor Slides

3-3

Elements of a Good Forecast


The forecast
should be timely
should be accurate
should be reliable
should be expressed in meaningful units
should be in writing
technique should be simple to understand
and use
should be cost effective

Steps in the Forecasting Process


1. Determine the purpose of the forecast
2. Establish a time horizon
3. Select a forecasting technique
4. Obtain, clean, and analyze appropriate

data
5. Make the forecast
6. Monitor the forecast

Features Common to All Forecasts


Techniques assume some underlying causal
system that existed in the past will persist into
the future
2. Forecasts are not perfect
3. Forecasts for groups of items are more accurate
than those for individual items
4. Forecast accuracy decreases as the forecasting
horizon increases
1.

Instructor Slides

3-6

Forecast Accuracy and Control


Forecast errors should be

monitored
Error = Actual Forecast
If errors fall beyond acceptable bounds,

corrective action may be necessary

Forecast Accuracy Metrics


Actual

MAD

MSE

Forecast t

MAD weights all errors


evenly

Actual

Forecast

t
t

n 1

Actual

MAPE

Forecast t

n Actual t

100

MSE weights errors according


to their squared values

MAPE weights errors


according to relative error

Forecast Error Calculation


Period

Actual
(A)

Forecast
(F)

(A-F)
Error

|Error|

Error2

107

110

-3

125

121

16

115

112

118

120

-2

108

109

-1

Sum

13

39

n=5

n-1 = 4

MAD

MSE

AVG(A)

114.6

= 2.6

MAPE=MAD / AVG(A)

= 9.75 =2.6/114.6= 2.27%

Forecasting Approaches
Qualitative Forecasting
Qualitative techniques permit the inclusion of soft information

such as:
Human factors
Personal opinions
Hunches
These factors are difficult, or impossible, to quantify
Quantitative Forecasting
Quantitative techniques involve either the projection of

historical data or the development of associative methods that


attempt to use causal variables to make a forecast
These techniques rely on hard data

Judgmental Forecasts
Forecasts that use subjective inputs such

as opinions from consumer surveys,


sales staff, managers, executives, and
experts
Executive opinions
Sales force opinions
Consumer surveys
Delphi method

Time-Series Forecasts
Forecasts that project patterns identified

in recent time-series observations


Time-series - a time-ordered sequence of

observations taken at regular time intervals


Assume that future values of the time-

series can be estimated from past values


of the time-series

Time-Series Behaviors
Trend
Seasonality
Cycles
Irregular variations
Random variation

Historical Monthly Product Demand Consisting of a


Growth Trend, Cyclical Factor, and Seasonal
Demand

Exhibit 9.4

Common Types of Trends

Exhibit 9.5a

Common Types of Trends (contd)

Exhibit 9.5b

Trends and Seasonality


Trend
A long-term upward or downward movement in data
Population shifts
Changing income

Seasonality
Short-term, fairly regular variations related to the

calendar or time of day


Restaurants, service call centers, and theaters all
experience seasonal demand

Trend, Cyclical, with Variations

Cycles and Variations


Cycle
Wavelike variations lasting more than one year
These are often related to a variety of economic, political, or

even agricultural conditions

Random Variation
Residual variation that remains after all other behaviors
have been accounted for
Irregular variation
Due to unusual circumstances that do not reflect typical

behavior
Labor strike
Weather event

Time-Series Forecasting - Nave Forecast


Nave Forecast
Uses a single previous value of a time series as

the basis for a forecast


The forecast for a time period is equal to the
previous time periods value
Can be used when
The time series is stable
There is a trend
There is seasonality

Time-Series Forecasting - Averaging


These Techniques work best when a

series tends to vary about an average


Averaging techniques smooth variations in the

data
They can handle step changes or gradual
changes in the level of a series
Techniques
Moving average
Weighted moving average
Exponential smoothing

Moving Average
Technique that averages a number of the

most recent actual values in generating


a forecast
n
At i

Ft MA t i 1
n
where
Ft Forecast for time period t
MA t n period moving average
At 1 Actual value in period t 1
n Number of periods in the moving average

Forecast Demand Based on a Three- and


Five-Week Simple Moving Average
Week

Demand

Forecast

Forecast

(3-week)

(5-week)

800

1400

1000

1500

(1000+1400+800)/3 =1067

1500

(1500+1000+1400)/3 = 1300

1300

(1500+1500+1000)/3 = 1333

(1500+1500+1000+1400+ 800)/5 =1240

1800

(1300+1500+1500)/3 = 1433

(1300+1500+1500+1000+1400)/5 =1340

1700

(1800+1300+1500)/3 = 1533

(1800+1300+1500+1500+1000)/5 =1420

1300

1600

(1700+1800+1300+1500+1500)/5 =1560

10

1700

1600

(1300+1700+1800+1300+1500)/5 =1520

11

1700

1567

(1700+1300+1700+1800+1300)/5 =1560

Moving Average
As new data become available, the

forecast is updated by adding the


newest value and dropping the oldest
and then recomputing the the average
The number of data points included in
the average determines the models
sensitivity
Fewer data points used-- more responsive
More data points used-- less responsive

Forecast Demand Based on a Three- and


Nine-Week Simple Moving Average

Exhibit 9.6

Moving Average Forecast of Three- and


Nine-Week Periods versus Actual Demand

Exhibit 9.7

Weighted Moving Average


The most recent values in a time series

are given more weight in computing a


forecast
The choice of weights, w, is somewhat arbitrary

and involves some trial and error

Ft w n Atn w n1 At(n1) ... w1 At1


where

w t weightforperiod t,w t1 weightforperiod t 1,etc.


At theactualvalueforperiod t,At1 theactualvalueforperiod t 1,etc.

Exponential Smoothing
A weighted averaging method that is

based on the previous forecast plus a


percentage of the forecast error
Ft Ft 1 ( At 1 Ft 1 )
where
Ft Forecast for period t
Ft 1 Forecast for the previous period

=Smoothing constant
At 1 Actual demand or sales from the previous period

Exponential Smoothing
Saturday Hotel Occupancy ( =0.5)
Period
t
1
2
3
4
5
6

Occupancy
Forecast
At
Ft
79
--84
79.00
83
79+.5(84-79)=81.50 or 82
81
81.5+.5(83-81.5)=82.25 or 82
98
82.25+.5(81-82.25)=81.63 or 82
100
81.63+.5(98-81.63)= 89.81 or 90

Forecast
Error
|At - Ft|
5
1
1
16
10
MAD =33/5= 6.6

Forecast Error (Mean Absolute Deviation) = lAt Ftl / n

The first actual value as the forecast for period 2


17-29

Linear Trend
A simple data plot can reveal the

existence and nature of a trend


Linear trend equation
Ft a bt
where
Ft Forecastforperiod t
a ValueofFt att 0
b Slopeoftheline
t Specifiednumberoftimeperiodsfrom t 0

Estimating slope and intercept


Slope and intercept can be estimated

from historical data


b

n ty t y
n t t
2

y b t

a
n

or y bt

where
n Number of periods
y Value of the time series

Figure 3-9

3-32

Linear Trend Example


Week (t)

Sales (y)

t2

ty

150

150

157

314

162

486

166

16

664

177

25

885

t= 15

y= 812

t2=55

(ty)=2499

Linear Trend Example

n ty t y
n t t
2

5(2499) 15(812)

5(55) 225

12495 12180

6.3
275 225
y b t 812-6.3(15)

a
=
143.5
n
5
y 143.5 6.3t

Linear Trend Example


Substituting values of t into this
equation, the forecast for next 2
periods are:
F6= 143.5+6.3 (6) = 181.3
F7= 143.5+6.3 (7) = 187.6

Techniques for Seasonality


Seasonality regularly repeating movements in

series values that can be tied to recurring events


Expressed in terms of the amount that actual

values deviate from the average value of a series


Models of seasonality
Additive

Seasonality is expressed as a quantity that gets added to

or subtracted from the time-series average in order to


incorporate seasonality

Multiplicative

Seasonality is expressed as a percentage of the average

(or trend) amount which is then used to multiply the


value of a series in order to incorporate seasonality

Instructor Slides

3-36

Models of Seasonality

Instructor Slides

3-37

Computing Seasonal Relatives Using Simple Average (SA) Method


Example 8A, page 150
Manager of a Call center recorded the volume of calls received

between 9 and 10 a.m. for 21 days and wants to obtain a seasonal


index for each day for that hour.
Volume

Season

Overall

Day

Week 1

Week 2

Week 3

Average

Average

SA Index

Tues

67

60

64

63.667

71.571

0.8896

Wed

75

73

76

74.667

71.571

1.0432

Thurs

82

85

87

84.667

71.571

1.1830

Fri

98

99

96

97.667

71.571

1.3646

Sat

90

86

88

88.000

71.571

1.2295

Sun

36

40

44

40.000

71.571

0.5589

Mon

55

52

50
Overall
Avg

52.333

71.571

0.7312

71.571

7.0000

Seasonal Relatives
Seasonal relatives
The seasonal percentage used in the multiplicative
seasonally adjusted forecasting model
Using seasonal relatives
To deseasonalize data
Done in order to get a clearer picture of the
nonseasonal components of the data series
Divide each data point by its seasonal relative
To incorporate seasonality in a forecast
Obtain trend estimates for desired periods using a
trend equation
Add seasonality by multiplying these trend
estimates by the corresponding seasonal
relative

Seasonal Relatives Example


Example 7, page 149
A coffee shop owner wants to predict quarterly

demand for hot chocolate for periods 9 and 10, which


happen to be the 1st and 2nd quarters of a particular
year. The sales data consist of both trend and
seasonality. The trend portion of demand is projected
using the equation Ft = 124 + 7.5 t. Quarter relatives
are
Q1 = 1.20, Q2 = 1.10, Q3 = 0.75, Q4 = 0.95,

Seasonal Relatives Example (Cond)


Example 7, page 149
Use this information to deseasonalize sales for Q1 through

Q8.
Period

Quarter

Sales

158.4

153.0

110.0

146.3

192.0

187.0

132.0

173.8

Quarter
Relative

Deseasonalized
sales

1.20

132.0

1.10

139.1

0.75

146.7

0.95

154.0

1.20

160.0

1.10

170.0

0.75

176.0

0.95

182.9

Seasonal Relatives Example (Cond)


Example 7, page 149
Use this information to predict for periods 9 and 10.
F9 = 124 +7.5( 9) = 191.5

F10= 124 +7.5(10) = 199.0


Multiplying the trend value by the appropriate quarter
relative yields a forecast that includes both trend and
seasonality.
Given that t =9 is a 1st quarter and t = 10 is a 2nd quarter.
The forecast demand for period 9 = 191.5(1.20) = 229.8
The forecast demand for period 10 = 199.0(1.10) = 218.9

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