Chapter 2:

Forecasting

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 Learning Objectives
 List the elements of a good forecast.
 Outline the steps in the forecasting process.
 Describe at least three qualitative
forecasting techniques and the advantages
and disadvantages of each.
 Compare and contrast qualitative and
quantitative approaches to forecasting.

3-2
 Learning Objectives
 Briefly describe averaging techniques, trend
and seasonal techniques, and regression
analysis, and solve typical problems.
 Describe two measures of forecast
accuracy.
 Describe two ways of evaluating and
controlling forecasts.
 Identify the major factors to consider when
choosing a forecasting technique.

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FORECAST:
 A statement about the future value of a
variable of interest such as demand.
 Forecasting is used to make informed
decisions.
 Long-range
 Short-range

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 Forecasts
 Forecasts affect decisions and activities
throughout an organization
 Accounting, finance
 Human resources
 Marketing
 MIS
 Operations
 Product / service design

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 Uses of Forecasts

Accounting Cost/profit estimates

Finance Cash flow and funding

Human Resources Hiring/recruiting/training

Marketing Pricing, promotion, strategy

MIS IT/IS systems, services

Operations Schedules, MRP, workloads

Product/service design New products and services

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 Features of Forecasts
 Assumes causal system
past ==> future
 Forecasts rarely perfect because of
randomness
 Forecasts more accurate for
groups vs. individuals I see that you will
get an A this semester.

 Forecast accuracy decreases

as time horizon increases

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Elements of a Good Forecast

Timely

Reliable Accurate

Written

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Steps in the Forecasting Process

“The forecast”

Step 6 Monitor the forecast

Step 5 Make the forecast
Step 4 Obtain, clean and analyze data
Step 3 Select a forecasting technique
Step 2 Establish a time horizon
Step 1 Determine purpose of forecast

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 Types of Forecasts

 Judgmental - uses subjective inputs

 Time series - uses historical data
assuming the future will be like the
past
 Associative models - uses
explanatory variables to predict the
future

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 Judgmental Forecasts
 Executive opinions
 Sales force opinions
 Consumer surveys
 Outside opinion
 Delphi method
 Opinions of managers and staff
 Achieves a consensus forecast

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 Time Series Forecasts
 Trend - long-term movement in data
 Seasonality - short-term regular
variations in data
 Cycle – wavelike variations of more than
one year’s duration
 Irregular variations - caused by unusual
circumstances
 Random variations - caused by chance

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 Forecast Variations
Figure 3.1

Irregular
variatio
n
Trend

Cycles

90
89
88
Seasonal variations

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Naive Forecasts
Uh, give me a minute....
We sold 250 wheels last
week.... Now, next week
we should sell....

The forecast for any period equals

the previous period’s actual value.

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 Naïve Forecasts
 Simple to use
 Virtually no cost
 Quick and easy to prepare
 Data analysis is nonexistent
 Easily understandable
 Cannot provide high accuracy
 Can be a standard for accuracy

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 Uses for Naïve Forecasts
 Stable time series data
 F(t) = A(t-1)
 Seasonal variations
 F(t) = A(t-n)
 Data with trends
 F(t) = A(t-1) + (A(t-1) – A(t-2))

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 Techniques for Averaging

 Moving average
 Weighted moving average
 Exponential smoothing

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 Moving Averages
 Moving average – A technique that averages a
number of recent actual values, updated as
new values become available.
At-n + … At-2 + At-1
Ft = MAn=
n
 Weighted moving average – More recent
values in a series are given more weight in
computing the forecast.
wnAt-n + … wn-1At-2 + w1At-1
Ft = WMAn=
n
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 Simple Moving Average
Actual
MA5
47
45
43
41
39
37 MA3
35
1 2 3 4 5 6 7 8 9 10 11 12

At-n + … At-2 + At-1

Ft = MAn=
n
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 Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

• Premise--The most recent observations

might have the highest predictive value.
 Therefore, we should give more weight to
the more recent time periods when
forecasting.

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 Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

 Weighted averaging method based on
previous forecast plus a percentage of the
forecast error
 A-F is the error term,  is the % feedback

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Example 3 - Exponential Smoothing

Period Actual Alpha = 0.1 Error Alpha = 0.4 Error

1 42
2 40 42 -2.00 42 -2
3 43 41.8 1.20 41.2 1.8
4 40 41.92 -1.92 41.92 -1.92
5 41 41.73 -0.73 41.15 -0.15
6 39 41.66 -2.66 41.09 -2.09
7 46 41.39 4.61 40.25 5.75
8 44 41.85 2.15 42.55 1.45
9 45 42.07 2.93 43.13 1.87
10 38 42.36 -4.36 43.88 -5.88
11 40 41.92 -1.92 41.53 -1.53
12 41.73 40.92

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Picking a Smoothing Constant

Actual
50
.4
 .1
Demand

45

40

35
1 2 3 4 5 6 7 8 9 10 11 12
Period

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 Common Nonlinear Trends
Figure 3.5

Parabolic

Exponential

Growth

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 Linear Trend Equation
Ft

Ft = a + bt

0 1 2 3 4 5 t
 Ft = Forecast for period t
 t = Specified number of time periods
 a = Value of Ft at t = 0
 b = Slope of the line

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Calculating a and b

n  (ty) -  t  y
b =
2
n t - (  t) 2

 y - b t
a =
n

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 Techniques for Seasonality
 Seasonal variations
 Regularly repeating movements in series values
that can be tied to recurring events.
 Seasonal relative
 Percentage of average or trend
 Centered moving average
 A moving average positioned at the center of the
data that were used to compute it.

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 Associative Forecasting

 Predictor variables - used to predict values

of variable interest
 Regression - technique for fitting a line to a
set of points
 Least squares line - minimizes sum of
squared deviations around the line

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Linear Model Seems Reasonable
X Y Computed
7 15
relationship
2 10
6 13 50

4 15 40

14 25 30

15 27 20

10
16 24
0
12 20 0 5 10 15 20 25

14 27
20 44
15 34
7 17
A straight line is fitted to a set of sample points.

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 Linear Regression Assumptions
 Variations around the line are random
 Deviations around the line normally
distributed
 Predictions are being made only within the
range of observed values
 For best results:
 Always plot the data to verify linearity
 Check for data being time-dependent
 Small correlation may imply that other variables
are important
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 Forecast Accuracy
 Error - difference between actual value and
predicted value
 Mean Absolute Deviation (MAD)
 Average absolute error
 Mean Squared Error (MSE)
 Average of squared error
 Mean Absolute Percent Error (MAPE)
 Average absolute percent error

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 MAD, MSE, and MAPE

 Actual  forecast
MAD =
n
2
 ( Actual  forecast)
MSE =
n -1

( Actual  forecas / Actual*100)

MAPE =
t
n

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 MAD, MSE and MAPE
 MAD
 Easy to compute
 Weights errors linearly
 MSE
 Squares error
 More weight to large errors
 MAPE
 Puts errors in perspective

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 Controlling the Forecast
 Control chart
 A visual tool for monitoring forecast errors
 Used to detect non-randomness in errors
 Forecasting errors are in control if
 All errors are within the control limits
 No patterns, such as trends or cycles, are
present

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 Sources of Forecast errors
 Model may be inadequate
 Irregular variations
 Incorrect use of forecasting technique

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 Tracking Signal
•Tracking signal
–Ratio of cumulative error to MAD

Tracking signal =
(Actual-forecast)
MAD
Bias – Persistent tendency for forecasts to be
Greater or less than actual values.

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 Choosing a Forecasting
Technique
 No single technique works in every
situation
 Two most important factors
 Cost
 Accuracy
 Other factors include the availability of:
 Historical data
 Computers
 Time needed to gather and analyze the data
 Forecast horizon
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 Operations Strategy
 Forecasts are the basis for many decisions
 Work to improve short-term forecasts
 Accurate short-term forecasts improve
 Profits
 Lower inventory levels
 Reduce inventory shortages
 Improve customer service levels
 Enhance forecasting credibility

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 Supply Chain Forecasts
 Sharing forecasts with supply can
 Improve forecast quality in the supply chain
 Lower costs
 Shorter lead times
 Gazing at the Crystal Ball (reading in text)

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