PRODUCTION AND

OPERATIONS
MANAGEMENT
Ch. 5: Forecasting

POM - J. Galvn

Learning Objectives

Understand techniques to foresee the

future

POM - J. Galvn

What is Forecasting?
Process of predicting
a future event
Underlying basis of
all business decisions

Sales will
be $200
Million!

Production
Inventory
Personnel
Facilities
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Types of Forecasts by Time

Horizon

Short-range forecast
Up

to 1 year; usually < 3 months

Job scheduling, worker assignments

Medium-range forecast
3

months to 3 years
Sales & production planning, budgeting

Long-range forecast
3+

years
New product planning, facility location
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Short-term vs. Longer-term

Forecasting

Medium/long range forecasts deal with

more comprehensive issues and support
management decisions regarding planning
and products, plants and processes.
Short-term forecasting usually employs
different methodologies than longer-term
forecasting
Short-term forecasts tend to be more
accurate than longer-term forecasts.
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Influence of Product Life

Cycle

Stages of introduction & growth

require longer forecasts than
maturity and decline
Forecasts useful in projecting
staffing levels,
inventory levels, and
factory capacity

as product passes through stages

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Types of Forecasts

Economic forecasts
Address

business cycle
e.g., inflation rate, money supply etc.

Technological forecasts
Predict

technological change
Predict new product sales

Demand forecasts
Predict

existing product sales

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Seven Steps in Forecasting

Determine the use of the forecast

Select the items to be forecast
Determine the time horizon of the
forecast
Select the forecasting model(s)
Gather the data
Make the forecast
Validate and implement results
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Realities of Forecasting

Forecasts are seldom perfect

Most forecasting methods assume
that there is some underlying
stability in the system
Both product family and aggregated
product forecasts are more accurate
than individual product forecasts
POM - J. Galvn

Forecasting Approaches
Qualitative Methods Quantitative Methods
Used when situation is Used when situation
vague & little data
is stable & historical
exist
data exist
New products
Existing products
New technology
Current technology
Involves intuition,
Involves mathematical
experience
techniques
e.g., forecasting sales e.g., forecasting sales
on Internet
of color televisions
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Overview of Qualitative Methods

Jury of executive opinion

Pool opinions of high-level executives, sometimes
augment by statistical models
Sales force composite
estimates from individual salespersons are
reviewed for reasonableness, then aggregated
Delphi method
Panel of experts, queried iteratively
Consumer Market Survey
Ask the customer

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Jury of Executive Opinion

Involves small group of high-level managers

Group estimates demand by working

together

Combines managerial experience with

statistical models
Relatively quick
Group-think
disadvantage
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1995 Corel Corp.

Sales Force Composite

Each salesperson
projects their sales
Combined at district &
national levels
Sales reps know
customers wants
Tends to be overly
optimistic

Sales

1995 Corel Corp.

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Delphi Method

Iterative group
process
3 types of people
Decision makers
Staff
Respondents

Reduces groupthink

Decision Makers
Staff
(What

(Sales?)
(Sales will be 50!)

will sales
be?
survey)

Respondents

(Sales will be 45, 50, 55)

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Consumer Market Survey

Ask customers
about purchasing
plans
What consumers
say, and what they
actually do are
often different
Sometimes difficult
to answer

How many hours will

you use the Internet
next week?

1995 Corel
Corp.
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Overview of Quantitative
Approaches

Nave approach
Moving averages
Exponential
smoothing
Trend projection

Time-series
Models

Linear regression

Causal
models

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16

Quantitative Forecasting Methods

(Non-Naive)
Quantitative
Forecasting
Causal
Models

Time Series
Models

Moving
Average

Exponential
Smoothing

Trend
Projection

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Linear
Regression
17

What is a Time Series?

Set of evenly spaced numerical data

Obtained by observing response variable at
regular time periods
Forecast based only on past values
Assumes that factors influencing past,
present, & future will continue
Example
Year: 1993 1994 1995 1996 1997
Sales: 78.7 63.5 89.7 93.2 92.1

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Time Series Components

Trend

Cyclical

Seasonal

Random
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Trend Component

Persistent, overall upward or

downward pattern
Due to population, technology etc.
Several years duration
Response

Mo., Qtr., Yr.

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1984-1994 T/Maker Co.

20

Cyclical Component

Repeating up & down movements

Due to interactions of factors
influencing economy
Usually 2-10 years duration
Cycle
Response

Mo., Qtr., Yr.

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Seasonal Component

Regular pattern of up & down

fluctuations
Due to weather, customs etc.
Occurs within 1 year
Summer
Response
1984-1994 T/Maker Co.

POM Qtr.
- J. Galvn
Mo.,

22

Random Component

Erratic, unsystematic, residual

fluctuations
Due to random variation or
unforeseen events
Union

strike
Tornado

Short duration &

nonrepeating
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General Time Series Models

Any observed value in a time series is the

product (or sum) of time series components
Multiplicative model
Yi = Ti Si Ci Ri (if quarterly or mo. data)
Additive model
Yi = Ti + Si + Ci + Ri (if quarterly or mo.
data)

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Naive Approach
Assumes demand in next
period is the same as
demand in most recent
period
e.g., If May sales were 48,
then June sales will be 48
Sometimes cost effective
& efficient
1995 Corel Corp.
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Moving Average Method

MA is a series of arithmetic means

Used if little or no trend

Used often for smoothing

Provides overall impression of data over time

Equation

Demand in Previous n Periods

MA
n

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Moving Average Graph

Sales
8
6
4
2
0
93

Actual

Forecast

94

95 96
Year
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97

98
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Disadvantages of
Moving Average Method

Increasing n makes forecast

less sensitive to changes
Do not forecast trend well
Require much historical
data
1984-1994 T/Maker Co.

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Linear Trend Projection

Used for forecasting linear trend line

Assumes relationship between
response variable, Y, and time, X, is
a linear function

Yi a bX i

Estimated by least squares method

Minimizes sum of squared errors

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Scatter Diagram
Sales
4
3
2
1
0
92

Sales vs. Time

93

94

95

96

Time
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Least Squares Equations

Equation:

i a bx i
Y
n

x i y i nx y

Slope:

b i n
x i n x
i

Y-Intercept:

a y bx
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Multiplicative Seasonal Model

Find average historical demand for each season by

summing the demand for that season in each year, and
dividing by the number of years for which you have data.
Compute the average demand over all seasons by
dividing the total average annual demand by the number
of seasons.
Compute a seasonal index by dividing that seasons
historical demand (from step 1) by the average demand
over all seasons.
Estimate next years total demand
Divide this estimate of total demand by the number of
seasons then multiply it by the seasonal index for that
season. This provides the seasonal forecast.
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Linear Regression Model

Shows linear relationship between

dependent & explanatory variables
Example:

Sales & advertising (not time)

Y-intercept

Slope

^
Yi = a + b X i
Dependent
(response) variable

Independent
(explanatory) variable
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Linear Regression Equations

Equation:

i a bx i
Y
n

x i y i nx y

Slope:

b i n
x i n x
i

Y-Intercept:

a y bx
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Interpretation of Coefficients

Slope (b)
Estimated

Y changes by b for each 1 unit

increase in X
If

b = 2, then sales (Y) is expected to increase

by 2 for each 1 unit increase in advertising ( X)

Y-intercept (a)
Average

value of Y when X = 0

If

a = 4, then average sales (Y) is expected to

be 4 when advertising (X) is 0

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Correlation

Answers: how strong is the linear

relationship between the variables?
Coefficient of correlation Sample
correlation coefficient denoted r
Values range from -1 to +1
Measures degree of association

Used mainly for understanding

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Coefficient of Correlation and

Regression Model
Y

r=1

^=a +b X
Y
i
i

r = -1

^=a +b X
Y
i
i

X
Y

r = .89

X
Y

^=a +b X
Y
i
i

r=0
^=a +b X
Y
i
i

X
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X
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Guidelines for Selecting

Forecasting Model

You want to achieve:

No

pattern or direction in forecast error

^

Error

= (Yi - Yi) = (Actual - Forecast)

Seen in plots of errors over time
Smallest

forecast error

Mean

square error (MSE)

Mean absolute deviation (MAD)

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Pattern of Forecast Error

Trend Not Fully
Accounted for

Desired Pattern

Error

Error

0
Time (Years)

Time (Years)

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Tracking Signal

Measures how well forecast is

predicting actual values
Ratio of running sum of forecast
errors (RSFE) to mean absolute
deviation (MAD)
Good

tracking signal has low values

Should be within upper and lower

control limits
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Tracking Signal Plot

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Forecasting in the Service

Sector

Presents unusual challenges

special

need for short term records

needs differ greatly as function of
industry and product
issues of holidays and calendar
unusual events

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Forecasting example
SALES DURING LAST YEAR
LAST YEAR

Real sales

Spring

200

Summer

350

Fall

300

Winter

150

TOTAL ANNUAL SALES

ESTIMATION:

1000
Annual increase of sales

10,00%

What are the estimated seasonal sales amount for next year?
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Forecasting example (II)

LAST YEAR

Past
sales

Average sales for

each season

Seasonal
factor

Total past annual

sales/
n of seasons

Past sales/
Avg. Sales

Spring

200

250

0,8

Summer

350

250

1,4

Fall

300

250

1,2

Winter

150

250

0,6

1000

1000

TOTAL ANNUAL
SALES

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Forecasting example (III)

NEXT YEAR

(10%
increase)

SALES 1100

NEXT YEAR

Average sales for

each season

Seasonal
factor

Next year's
seasonal
forecast

Total estimated
annual sales/n
of seasons

As
calculated

Avg.sales*
Factor

Spring

275

0,8

220

Summer

275

1,4

385

Fall

275

1,2

330

Winter

275

0,6

165

TOTAL
ANNUAL
SALES

1100

1100
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1100
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