Forecasting: Mcgraw-Hill/Irwin

FORECASTING
McGraw-Hill/Irwin Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
181
The Role of
Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights reserved.
Forecasting
Forecasting is a vital function and affects every
significant management decision.
Finance and accounting use forecasts as the basis for
budgeting and cost control.
Marketing relies on forecasts to make key decisions such as
new product planning and personnel compensation.
Production uses forecasts to select suppliers; determine
capacity requirements; and drive decisions about purchasing,
staffing, and inventory.
Different roles require different forecasting approaches.

Decisions about overall directions require strategic forecasts.
Tactical forecasts are used to guide day-to-day decisions.
182
Forecasting and
Decoupling Point
Decoupling point: Point at which inventory is stored,
which allows SC to operate independently.
The choice of the decoupling point in a SC is strategic.
Forecasting helps determine the level of inventory

needed at the decoupling points.
The decision will be affected by the error produced in

the forecast and the type of product (easily
inventoried or easily perishable).
183
Types of Forecasting
There are four basic types of forecasts.
Qualitative
Time series analysis (primary focus of this
chapter)
Causal relationships
Simulation
Time series analysis is based on the

idea that data relating to past demand
can be used to predict future demand.
184
Components of
Demand
Average
demand for a Trend
period of time
Seasonal Cyclical
element elements
Random Autocorrelatio
variation n
185
Trends
Identification of trend lines is a common
starting point when developing a forecast.
Common trend types include linear, S-
curve, asymptotic, and exponential.
186
Time Series Analysis
Using the past to predict the future
Short term forecasting less than 3 months
Used mainly for tactical decisions
Medium term forecasting 3 months to 2

years
Used to develop a strategy that will be implemented over
the next 6 to 18 months (e.g., meeting demand)
Long term forecasting greater than 2 years
Useful for detecting general trends and identifying major

turning points
187
Model Selection
Choosing an appropriate forecasting

model depends upon
Time horizon to be forecast
Data availability
Accuracy required
Size of forecasting budget
Availability of qualified personnel
188
Forecasting Method Selection
Guide
Forecas
Forecasting Amount of
Data Pattern t
Method Historical Data
Horizon
6 to 12 months; Stationary (i.e.,
Simple moving
weekly data are no trend or Short
average
often used seasonality)
Weighted moving
average and 5 to 10 observations
Stationary Short
simple exponential needed to start
smoothing
Exponential 5 to 10 observations
Stationary and
smoothing with needed to start Short
trend
trend
Stationary,
10 to 20 Short to
Linear regression trend, and
observations medium
seasonality
189
Simple Moving
Average
Forecast is the average of a fixed number of past
periods.
Useful when demand is not growing or declining

rapidly and no seasonality is present.
Removes some of the random fluctuation from the

data.
Selecting the period length is important.

Longer periods provide more smoothing.
Shorter periods react to trends more quickly.
1810

Simple Moving
Average Formula
1811
Simple Moving
Average Example
18-12
1812
Weighted Moving
Average
The simple moving average formula
implies equal weighting for all periods.
A weighted moving average allows
unequal weighting of prior time periods.
The sum of the weights must be equal to one.
Often, more recent periods are given higher
weights than periods farther in the past.
1813
Selecting Weights
Experience and/or trial-and-error are the
simplest approaches.
The recent past is often the best indicator

of the future, so weights are generally
higher for more recent data.
If the data are seasonal, weights should

reflect this appropriately.
1814
Exponential
Smoothing
A weighted average method that includes all
past data in the forecasting calculation
More recent results weighted more heavily
The most used of all forecasting techniques
An integral part of computerized forecasting
1815
Exponential
Smoothing
Well accepted for six reasons
Exponential models are surprisingly accurate
Formulating an exponential model is
relatively easy
The user can understand how the model
works
Little computation is required to use the
model
Computer storage requirements are small
Tests for accuracy are easy to compute
1816
Exponential
Smoothing Model
18-17
1817
Exponential
Smoothing Example
Forecas
Week Demand
t
1 820 820

2 775 820
3 680 811
4 655 785
5 750 759
6 802 757
7 798 766
8 689 772
9 775 756
10 760
18-18
1818
Exponential Smoothing Effect
of Trends
The presence of a trend in the data causes the
exponential smoothing forecast to always lag
behind the actual data
This can be corrected by adding a trend adjustment
The trend smoothing constant is delta ()

Ft = FITt-1 + (A t-1 - FITt-1 )
1819
Example Exponential Smoothing
with Trend Adjustment
Calculate the new forecast, assuming the
following:
The previous forecast including trend (FITt-1) is 110
and the previous estimate of the trend (Tt-1) is 10
= 0.2 and = 0.3
Actual demand for period t-1 is 115
Ft = FITt-1 + (At-1 FITt-1) = 110 + 0.2(115-110) = 111.0
Tt = Tt-1 + (Ft-1 FITt-1) = 10 + 0.3(111-110) = 10.3
FITt = Ft + Tt = 111.0 + 10.3 = 121.3
1820
Choosing Alpha and
Delta
Relatively small values for and are
common
Usually in the range 0.1 to 0.3
depends upon how much random
variation is present
depends upon how steady the trend is
Measurement of forecast error can be used
to select values of and to minimize
overall forecast error
1821
Linear Regression
Analysis
Regression is used to identify the functional
relationship between two or more correlated
variables, usually from observed data.
One variable (the dependent variable) is
predicted for given values of the other variable
(the independent variable).
Linear regression is a special case that assumes
the relationship between the variables can be
explained with a straight line.

Y = a + bt
1822
Example 18.2 Least Squares
Method
The least squares method Quarte Sale Quarte Sale
r s r s
determines the parameters
2,60
a and b such that the sum of 1 600 7
0
the squared errors is 1,55 2,90
minimized least squares 2 8
0 0
1,50 3,80
3 9
0 0
1,50 4,50
4 10
0 0
5 2,40 4,00
11
0 0
3,10 4,90
6 12
0 0
1823
Example 18.2
Calculations
1 600 600 1 360,000 801.3

2 1,550 3,100 4 2,402,500 1,160.9
3 1,500 4,500 9 2,250,000 1,520.5

4 1,500 6,000 16 2,250,000 1,880.1
5 2,400 12,000 25 5,760,000 2,239.7

6 3,100 18,600 36 9,610,000 2,599.4

7 2,600 18,200 49 6,760,000 2,959.0
8 2,900 23,200 64 8,410,000 3,318.6
The forecast is extended to periods 13-16
9 3,800 34,200 81 14,440,000 3,678.2
10 4,500 45,000 100 20,250,000 4,037.8
11 4,000 44,000 121 16,000,000 4,397.4

12 4,900 58,800 144 24,010,000 4,757.1

Sum 78 33,350 268,200 650 112,502,500

18-24
1824
Regression with Excel
Microsoft
Excel
includes data
analysis
tools, which
can perform
least squares
regression on
a data set.
1825
Time Series
Decomposition
Chronologically ordered data are referred
to as a time series.
A time series may contain one or many
elements.
Trend, seasonal, cyclical, autocorrelation, and
random
Identifying these elements and separating
the time series data into these
components is known as decomposition.
1826
Seasonal Variation
Seasonal variation may be either
additive or multiplicative (shown
here with a changing trend).
1827
Determining Seasonal Factors :
Simple Proportions Example 18.3
The seasonal factor (or index) is the ratio
of the amount sold during each season
divided by the average for all seasons.
Average Sales
Seasonal
Season Past Sales for Each
Factor
Season
Spring 200 = 250 = 0.8
Summer 350 = 250 = 1.4
Fall 300 = 250 = 1.2
Winter 150 = 250 = 0.6

Total 1000
1828
Example 18.3 (Continued)
Expecte Next
Average
d Years
Sales for Season
Demand Season
Each al
for al
Season Factor
Next Foreca
(1,100y4)
Year st
Spring 275 X 0.8 = 220
Summer 275 X 1.4 = 385
Fall 275 X 1.2 = 330
Winter 275 X 0.6 = 165
1100
1829
Decomposition Using Least
Squares Regression
Decompose the time series into its
components
Find seasonal component
Deseasonalize the demand
Find trend component
Forecast future values of each component

Project trend component into the future
Multiply trend component by seasonal
component
1830
Decomposition Steps
1 and 2
Using the data for periods 1-12, apply time series
analysis (decomposition, linear regression, trend
estimate & seasonal indices) to forecast for periods
13-16
1831
Decomposition Steps
3 and 4
Develop a least squares regression line for the
deseasonalized data.
Project the regression line through the period of
the forecast.
Regression Results:
Y = 555.0 + 342.2t
Forecast for
periods 13-
16
1832
Decompostion Step 5
Create the final forecast by adjusting
the regression line by the seasonal
factor.
Perio Quart Y from Seasonal Forecast (F x
d er Regression Factor Seasonal Factor
13 I 5,003.5 0.82 4,102.87
14 II 5,345.7 1.10 5,880.27
15 III 5,687.9 0.97 5,517.26
16 IV 6,030.1 1.12 6,753.71
1833
Forecast Errors
Forecast error is the difference between the
forecast value and what actually occurred.
All forecasts contain some level of error.
Sources of error
Bias when a consistent mistake is made
Random errors that are not explained by the model
being used
Measures of error
Mean absolute deviation (MAD)
Mean absolute percent error (MAPE)
Tracking signal
1834
Forecast Error
Measurements
Ideally, MAD will be zero MAPE scales the forecast error to
(no forecasting error). the magnitude of demand.
Larger values of MAD
indicate a less accurate
model.
Tracking signal indicates

whether forecast errors are
accumulating over time (either
positive or negative errors).
1835
Error
Computing Forecast
1836
Causal Relationship
Forecasting
Causal relationship forecasting uses
independent variables other than time to
predict future demand.
This independent variable must be a leading
indicator.
Many apparently causal relationships are

actually just correlated events care must
be taken when selecting causal variables.
1837
Multiple Regression
Techniques
Often, more than one independent
variable may be a valid predictor of
future demand.
In this case, the forecast analyst may

utilize multiple regression.
Analogous to linear regression analysis,
but with multiple independent variables.
Multiple regression supported by statistical
software packages.
1838
Qualitative
Forecasting
Techniques
Generally used to take advantage of expert
knowledge.
Useful when judgment is required, when products
are new, or if the firm has little experience in a
new market.
Examples
Market research
Panel consensus
Historical analogy
Delphi method
1839
Collaborative Planning, Forecasting,
and Replenishment (CPFR)
A web-based process used to coordinate the efforts
of a supply chain.
Demand forecasting
Production and purchasing
Inventory replenishment
Integrates all members of a supply chain
manufacturers, distributors, and retailers.
Depends upon the exchange of internal
information to provide a more reliable view of
demand.
1840
CPFR Steps
Creation of
Joint Developmen Inventory
a front-end Sharing
business t of demand replenishme
partnership forecasts
planning forecasts nt
agreement
1841
Principles
Forecasting is a fundamental step in any planning
process.
Forecast effort should be proportional to the

magnitude of decisions being made.
Web-based systems (CPFR) are growing in

importance and effectiveness.
All forecasts have errors understanding and

minimizing this error is the key to effective
forecasting processes.
1842

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FORECASTING

Different roles require different forecasting approaches.

The choice of the decoupling point in a SC is strategic.

Forecasting helps determine the level of inventory

The decision will be affected by the error produced in

Time series analysis is based on the

Used mainly for tactical decisions

Medium term forecasting 3 months to 2

Long term forecasting greater than 2 years

Useful for detecting general trends and identifying major

Choosing an appropriate forecasting

Useful when demand is not growing or declining

Removes some of the random fluctuation from the

Selecting the period length is important.

The recent past is often the best indicator

If the data are seasonal, weights should

More recent results weighted more heavily

The most used of all forecasting techniques

An integral part of computerized forecasting

Ft = FITt-1 + (At-1 FITt-1) = 110 + 0.2(115-110) = 111.0

Tt = Tt-1 + (Ft-1 FITt-1) = 10 + 0.3(111-110) = 10.3

FITt = Ft + Tt = 111.0 + 10.3 = 121.3

1 600 600 1 360,000 801.3

3 1,500 4,500 9 2,250,000 1,520.5

5 2,400 12,000 25 5,760,000 2,239.7

10 4,500 45,000 100 20,250,000 4,037.8

11 4,000 44,000 121 16,000,000 4,397.4

Spring 200 = 250 = 0.8

Summer 350 = 250 = 1.4

Fall 300 = 250 = 1.2

Winter 150 = 250 = 0.6

Forecast future values of each component

Tracking signal indicates

Many apparently causal relationships are

In this case, the forecast analyst may

Forecast effort should be proportional to the

Web-based systems (CPFR) are growing in

All forecasts have errors understanding and

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