Operations Management

Chapter 4 Forecasting
PowerPoint presentation to accompany Heizer/Render Principles of Operations Management, 6e Operations Management, 8e

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Outline
What Is Forecasting?
Forecasting Time Horizons The Influence of Product Life Cycle

Types Of Forecasts

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Outline Continued
The Strategic Importance Of Forecasting
Human Resources Capacity SupplySupply-Chain Management

Seven Steps In The Forecasting System

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Outline Continued
Forecasting Approaches
Overview of Qualitative Methods Overview of Quantitative Methods

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Outline Continued
TimeTime-series Forecasting
Decomposition of a Time Series Nave Approach Moving Averages Exponential Smoothing Exponential Smoothing with Trend Adjustment Trend Projections Seasonal Variations in Data Cyclical Variations in Data
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Outline Continued
Associative Forecasting Methods: Regression And Correlation Analysis
Using Regression Analysis to Forecast Standard Error of the Estimate Correlation Coefficients for Regression Lines MultipleMultiple-Regression Analysis
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Outline Continued
Monitoring And Controlling Forecasts
Adaptive Smoothing Focus Forecasting

Forecasting In The Service Sector

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Learning Objectives
When you complete this chapter, you should be able to :
Identify or Define:
Forecasting Types of forecasts Time horizons Approaches to forecasts

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Learning Objectives
When you complete this chapter, you should be able to :
Describe or Explain:
Moving averages Exponential smoothing Trend projections Regression and correlation analysis Measures of forecast accuracy
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Forecasting at Tupperware
Each of 50 profit centers around the world is responsible for computerized monthly, quarterly, and 12-month sales projections 12These projections are aggregated by region, then globally, at Tupperwares World Headquarters Tupperware uses all techniques discussed in text
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Tupperwares Process

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Three Key Factors for Tupperware

The number of registered consultants or sales representatives The percentage of currently active dealers (this number changes each week and month) Sales per active dealer, on a weekly basis
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Forecast by Consensus
Although inputs come from sales, marketing, finance, and production, final forecasts are the consensus of all participating managers The final step is Tupperwares version of the jury of executive opinion

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What is Forecasting?
Process of predicting a future event Underlying basis of all business decisions
Production Inventory Personnel Facilities
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??

Forecasting Time Horizons

ShortShort-range forecast
Up to 1 year, generally less than 3 months Purchasing, job scheduling, workforce levels, job assignments, production levels

MediumMedium-range forecast
3 months to 3 years Sales and production planning, budgeting

LongLong-range forecast
3+ years New product planning, facility location, research and development
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Distinguishing Differences
Medium/long range forecasts deal with more comprehensive issues and support management decisions regarding planning and products, plants and processes ShortShort-term forecasting usually employs different methodologies than longer-term longerforecasting ShortShort-term forecasts tend to be more accurate than longer-term forecasts longer 2006 Prentice Hall, Inc. 4 16

Influence of Product Life Cycle

Introduction Growth Maturity Decline Introduction and growth require longer forecasts than maturity and decline As product passes through life cycle, forecasts are useful in projecting
Staffing levels Inventory levels Factory capacity
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Product Life Cycle

Introduction Company Strategy/Issues
Best period to increase market share R&D engineering is critical

Growth
Practical to change price or quality image Strengthen niche

Maturity
Poor time to change image, price, or quality Competitive costs become critical Defend market position

Decline
Cost control critical

CDCD-ROM Internet Sales Color printers DriveDrive-through restaurants

Fax machines

FlatFlat-screen monitors

DVD

3 1/2 Floppy disks

Figure 2.5
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Product Life Cycle

Introduction
Product design and development critical Frequent product and process design changes Short production runs High production costs Limited models Attention to quality

Growth
Forecasting critical Product and process reliability Competitive product improvements and options Increase capacity Shift toward product focus Enhance distribution

Maturity
Standardization Less rapid product changes more minor changes Optimum capacity Increasing stability of process Long production runs Product improvement and cost cutting

Decline
Little product differentiation Cost minimization Overcapacity in the industry Prune line to eliminate items not returning good margin Reduce capacity

OM Strategy/Issues

Figure 2.5
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Types of Forecasts
Economic forecasts
Address business cycle inflation rate, money supply, housing starts, etc.

Technological forecasts
Predict rate of technological progress Impacts development of new products

Demand forecasts
Predict sales of existing product

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Strategic Importance of Forecasting

Human Resources Hiring, training, laying off workers Capacity Capacity shortages can result in undependable delivery, loss of customers, loss of market share SupplySupply-Chain Management Good supplier relations and price advance

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Seven Steps in Forecasting

Determine the use of the forecast Select the items to be forecasted 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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The Realities!
Forecasts are seldom perfect Most techniques assume an underlying stability in the system Product family and aggregated forecasts are more accurate than individual product forecasts

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Forecasting Approaches
Qualitative Methods Used when situation is vague and little data exist
New products New technology

Involves intuition, experience

e.g., forecasting sales on Internet

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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
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Overview of Qualitative Methods

Jury of executive opinion
Pool opinions of high-level highexecutives, sometimes augment by statistical models

Delphi method
Panel of experts, queried iteratively

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Overview of Qualitative Methods

Sales force composite
Estimates from individual salespersons are reviewed for reasonableness, then aggregated

Consumer Market Survey

Ask the customer

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Jury of Executive Opinion

Involves small group of high-level highmanagers Group estimates demand by working together Combines managerial experience with statistical models Relatively quick GroupGroup-think disadvantage
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Sales Force Composite

Each salesperson projects his or her sales Combined at district and national levels Sales reps know customers wants Tends to be overly optimistic

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Delphi Method
Iterative group process, continues until consensus is reached Staff (Administering 3 types of survey) participants
Decision makers Staff Respondents
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Decision Makers (Evaluate responses and make decisions)

Respondents (People who can make valuable judgments)

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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

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Overview of Quantitative Approaches

1. Naive approach 2. Moving averages 3. Exponential smoothing 4. Trend projection 5. Linear regression
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TimeTime-Series Models

Associative Model

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Time Series Forecasting

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 and present will continue influence in future
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Time Series Components

Trend Cyclical

Seasonal

Random

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Components of Demand
Demand for product or service

Trend component Seasonal peaks

Actual demand Average demand over four years

| 3 Year | 4
Figure 4.1
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Random variation
| 1 | 2

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Trend Component
Persistent, overall upward or downward pattern Changes due to population, technology, age, culture, etc. Typically several years duration

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Seasonal Component
Regular pattern of up and down fluctuations Due to weather, customs, etc. Occurs within a single year
Period Week Month Month Year Year Year
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Length Day Week Day Quarter Month Week

Number of Seasons 7 4-4.5 28-31 4 12 52

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Cyclical Component
Repeating up and down movements Affected by business cycle, political, and economic factors Multiple years duration Often causal or associative relationships
0
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10

15

20
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Random Component
Erratic, unsystematic, residual fluctuations Due to random variation or unforeseen events Short duration and nonrepeating

M
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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 and efficient

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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
demand in previous n periods Moving average = n
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Moving Average Example

Month January February March April May June July Actual Shed Sales 10 12 13 16 19 23 26 3-Month Moving Average

(10 + 12 + 13)/3 = 11 2/3 13)/3 (12 + 13 + 16)/3 = 13 2/3 (13 + 16 + 19)/3 = 16 (16 + 19 + 23)/3 = 19 1/3

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Graph of Moving Average

30 28 26 24 22 20 18 16 14 12 10 | J
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Moving Average Forecast Actual Sales

Shed Sales

| F

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Weighted Moving Average

Used when trend is present
Older data usually less important

Weights based on experience and intuition

Weighted moving average = (weight for period n) n) x (demand in period n) n) weights

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Weighted Moving Last month Average 3

2 1 6 Actual Shed Sales
10 12 13 16 19 23 26

Weights Applied

Period

Two months ago Three months ago Sum of weights 3-Month Weighted Moving Average

Month
January February March April May June July

[(3 x 13) 13) [(3 x 16) [(3 x 19) [(3 x 23)

+ (2 x 12) + (10)]/6 = 121/6 12) (10)]/6 + (2 x 13) + (12)]/6 = 141/3 + (2 x 16) + (13)]/6 = 17 + (2 x 19) + (16)]/6 = 201/2
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Potential Problems With Moving Average

Increasing n smooths the forecast but makes it less sensitive to changes Do not forecast trends well Require extensive historical data

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Moving Average And Weighted Moving Average

30 Sales demand 25 20 15 10 5 |
Figure 4.2
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Weighted moving average

Actual sales Moving average

| F

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Exponential Smoothing
Form of weighted moving average
Weights decline exponentially Most recent data weighted most

Requires smoothing constant (E)

Ranges from 0 to 1 Subjectively chosen

Involves little record keeping of past data

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Exponential Smoothing
New forecast = last periods forecast + E (last periods actual demand last periods forecast) forecast) Ft = Ft 1 + E(At 1 - Ft 1)
where Ft = new forecast Ft 1 = previous forecast E = smoothing (or weighting) constant (0 e E u 1)
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Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs Actual demand = 153 Smoothing constant E = .20

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Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs Actual demand = 153 Smoothing constant E = .20 New forecast = 142 + .2(153 142)

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Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs Actual demand = 153 Smoothing constant E = .20 New forecast = 142 + .2(153 142) = 142 + 2.2 = 144.2 144 cars

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Effect of Smoothing Constants

Weight Assigned to
Smoothing Constant E = .1 E = .5 Most Recent Period (E) .1 .5 2nd Most 3rd Most 4th Most 5th Most Recent Recent Recent Recent Period Period Period Period E(1 - E) E(1 - E)2 E(1 - E)3 E(1 - E)4 .09 .25 .081 .125 .073 .063 .066 .031

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Impact of Different E
225

Demand

200

Actual demand

E = .5

175

E = .1
150 | 1 | 2 | 3 | 4 | 5 Quarter
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Choosing E
The objective is to obtain the most accurate forecast no matter the technique
We generally do this by selecting the model that gives us the lowest forecast error
Forecast error = Actual demand - Forecast value = At - Ft
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Common Measures of Error

Mean Absolute Deviation (MAD) MAD)
|actual - forecast| MAD = n

Mean Squared Error (MSE) MSE)

(forecast errors)2 errors) MSE = n
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Common Measures of Error

Mean Absolute Percent Error (MAPE) MAPE)
n

MAPE =

100 |actuali - forecasti|/actuali

i=1

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Comparison of Forecast Error

Quarter Actual Tonnage Unloaded Rounded Forecast with E = .10 Absolute Deviation for E = .10 Rounded Forecast with E = .50 Absolute Deviation for E = .50

1 2 3 4 5 6 7 8

180 168 159 175 190 205 180 182

175 176 175 173 173 175 178 178

5 8 16 2 17 30 2 4 84

175 178 173 166 170 180 193 186

5 10 14 9 20 25 13 4 100

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Comparison of Forecast Error

|deviations| Rounded Absolute MAD = Actual Forecast Deviation n Tonage with for
Quarter

For E180.10 175 = 1 2 168 = 84/8 = 10.50 176

3 4 For 5 6 7 8 159 175 E175.50 173 = 190 173 205 = 100/8 = 175 180 178 182 178

Unloaded

E = .10

E = .10

Rounded Forecast with E = .50

Absolute Deviation for E = .50

5 8 16 2 17 12.50 30 2 4 84

175 178 173 166 170 180 193 186

5 10 14 9 20 25 13 4 100

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 (forecast errors) Rounded Absolute MSE = Actual Forecast Deviation n Tonage with for
Quarter

Comparison of Forecast Error2

Unloaded E = .10 E = .10 Rounded Forecast with E = .50 Absolute Deviation for E = .50

For E180.10 175 = 1 5 2 168 1,558/8 = 194.75 176 8 =

3 4 For 5 6 7 8 159 175 E175.50 173 = 190 173 = 2051,612/8 = 175 180 178 182 178

16 2 17 201.50 30 2 4 84 MAD 10.50

175 178 173 166 170 180 193 186

5 10 14 9 20 25 13 4 100 12.50

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Comparison of Forecast n Error

MAPE = Actual
Quarter

1 2 3 4 5 6 7 8

For 180 .10 175 E= 5 168 176 8 = 45.62/8 = 5.70%

175 .50 173 173 = 54.8/8 175 178 178 MAD MSE 16 2 17 = 6.85% 30 2 4 84 10.50 194.75

i =Rounded 1 Forecast Tonage with Unloaded E = .10

100 |deviationi|/actuali n
Absolute Deviation for E = .10

Rounded Forecast with E = .50

Absolute Deviation for E = .50

159 For 175 E= 190 205 180 182

175 178 173 166 170 180 193 186

5 10 14 9 20 25 13 4 100 12.50 201.50

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Comparison of Forecast Error

Quarter Actual Tonnage Unloaded Rounded Forecast with E = .10 Absolute Deviation for E = .10 Rounded Forecast with E = .50 Absolute Deviation for E = .50

1 2 3 4 5 6 7 8

180 168 159 175 190 205 180 182

175 176 175 173 173 175 178 178 MAD MSE MAPE

5 8 16 2 17 30 2 4 84 10.50 194.75 5.70%

175 178 173 166 170 180 193 186

5 10 14 9 20 25 13 4 100 12.50 201.50 6.85%

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Exponential Smoothing with Trend Adjustment

When a trend is present, exponential smoothing must be modified
Forecast exponentially exponentially including (FITt) = smoothed (Ft) + (Tt) smoothed trend forecast trend

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Exponential Smoothing with Trend Adjustment

Ft = E(At - 1) + (1 - E)(Ft - 1 + Tt - 1) )(F Tt = F(Ft - Ft - 1) + (1 - F)Tt - 1
Step 1: Compute Ft Step 2: Compute Tt Step 3: Calculate the forecast FITt = Ft + Tt
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Exponential Smoothing with Trend Adjustment Example

Month( Month(t) 1 2 3 4 5 6 7 8 9 10
Table 4.1
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Actual Demand (At) 12 17 20 19 24 21 31 28 36

Smoothed Forecast, Ft 11

Smoothed Trend, Tt 2

Forecast Including Trend, FITt 13.00

Exponential Smoothing with Trend Adjustment Example

Month( Month(t) 1 2 3 4 5 6 7 8 9 10
Table 4.1
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Actual Smoothed Smoothed Demand (At) Forecast, Ft Trend, Tt 12 11 2 17 20 19 Step 1: Forecast for Month 2 24 21 F2 = EA1 + (1 - E)(F1 + T1) 31 28 F2 = (.2)(12) + (1 - .2)(11 + 2) 36

Forecast Including Trend, FITt 13.00

= 2.4 + 10.4 = 12.8 units

Exponential Smoothing with Trend Adjustment Example

Month( Month(t) 1 2 3 4 5 6 7 8 9 10
Table 4.1
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Actual Smoothed Smoothed Demand (At) Forecast, Ft Trend, Tt 12 11 2 17 12.80 20 19 Step 2: Trend for Month 2 24 21 T2 = F(F2 - F1) + (1 - F)T1 31 28 T2 = (.4)(12.8 - 11) + (1 - .4)(2) 36

Forecast Including Trend, FITt 13.00

= .72 + 1.2 = 1.92 units

Exponential Smoothing with Trend Adjustment Example

Month( Month(t) 1 2 3 4 5 6 7 8 9 10
Table 4.1
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Actual Smoothed Smoothed Demand (At) Forecast, Ft Trend, Tt 12 11 2 17 12.80 1.92 20 19 Step 3: Calculate FIT for Month 2 24 21 FIT2 = F2 + T1 31 28 FIT2 = 12.8 + 1.92 36

Forecast Including Trend, FITt 13.00

= 14.72 units

Exponential Smoothing with Trend Adjustment Example

Month( Month(t) 1 2 3 4 5 6 7 8 9 10
Table 4.1
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Actual Demand (At) 12 17 20 19 24 21 31 28 36

Smoothed Forecast, Ft 11 12.80 15.18 17.82 19.91 22.51 24.11 27.14 29.28 32.48

Smoothed Trend, Tt 2 1.92 2.10 2.32 2.23 2.38 2.07 2.45 2.32 2.68

Forecast Including Trend, FITt 13.00 14.72 17.28 20.14 22.14 24.89 26.18 29.59 31.60 35.16

Exponential Smoothing with Trend Adjustment Example

35 30 Product demand 25 20 15 10 5 0 | 1
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Actual demand (At)

Forecast including trend (FITt)

| 2

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| 5

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| 9

Time (month)

Figure 4.3
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Trend Projections
Fitting a trend line to historical data points to project into the medium-to-long-range medium-to-longLinear trends can be found using the least squares technique
^ y = a + bx
^ where y = computed value of the variable to be predicted (dependent variable) a = y-axis intercept yb = slope of the regression line x = the independent variable
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Least Squares Method

Values of Dependent Variable Actual observation (y value)
Deviation5 Deviation3 Deviation4 Deviation1 Deviation2 Deviation7

Deviation6

^ Trend line, y = a + bx

Time period
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Figure 4.4
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Least Squares Method

Values of Dependent Variable Actual observation (y value)
Deviation5 Deviation3 Deviation7

Deviation6

Least squares method minimizes the sum of the Deviation squared errors (deviations)
4

Deviation1 Deviation2

^ Trend line, y = a + bx

Time period
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Figure 4.4
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Least Squares Method

Equations to calculate the regression variables
^ y = a + bx

7xy - nxy b= 7x2 - nx2 a = y - bx

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Least Squares Example

Year 1999 2000 2001 2002 2003 2004 2005 Time Period (x) 1 2 3 4 5 6 7 x = 28 x=4 b= Electrical Power Demand 74 79 80 90 105 142 122 y = 692 y = 98.86 = x2 xy 74 158 240 360 525 852 854 xy = 3,063 1 4 9 16 25 36 49 x2 = 140

xy - nxy x2 - nx2

3,063 - (7)(4)(98.86) 140 - (7)(42)

= 10.54

a = y - bx = 98.86 - 10.54(4) = 56.70

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Least Squares Example

Year Time Period (x) Electrical Power Demand 74 79 is 80 90 105 + 10.54x 142 122 x2 1 4 9 16 25 36 49 7x2 = 140 xy 74 158 240 360 525 852 854 7xy = 3,063 1999 1 2000 2 The trend line 2001 3 2002 4 ^= 2003 y 5 56.70 2004 6 2005 7 7x = 28 x=4

7y = 692 y = 98.86

3,063 - (7)(4)(98.86) 7xy - nxy b= = = 10.54 140 - (7)(42) 7x2 - nx2 a = y - bx = 98.86 - 10.54(4) = 56.70
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Least Squares Example

160 150 140 130 120 110 100 90 80 70 60 50 | 1999
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Trend line, ^ y = 56.70 + 10.54x

Power demand

| 2000

| 2001

| 2002

| 2003 Year

| 2004

| 2005

| 2006

| 2007
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Least Squares Requirements

1. We always plot the data to insure a linear relationship 2. We do not predict time periods far beyond the database 3. Deviations around the least squares line are assumed to be random

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Seasonal Variations In Data

The multiplicative seasonal model can modify trend data to accommodate seasonal variations in demand
1. Find average historical demand for each season 2. Compute the average demand over all seasons 3. Compute a seasonal index for each season 4. Estimate next years total demand 5. Divide this estimate of total demand by the number of seasons, then multiply it by the seasonal index for that season
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Seasonal Index Example

Month Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec
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Demand 2003 2004 2005 80 70 80 90 113 110 100 88 85 77 75 82 85 85 93 95 125 115 102 102 90 78 72 78 105 85 82 115 131 120 113 110 95 85 83 80

Average 2003-2005 200390 80 85 100 123 115 105 100 90 80 80 80

Average Monthly 94 94 94 94 94 94 94 94 94 94 94 94

Seasonal Index

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Seasonal Index Example

Month Demand 2003 2004 2005 Average 2003-2005 2003Average Monthly Seasonal Index 0.957 Jan 80 85 105 90 94 Feb 70 85 85 80 94 Mar 80 93 average 2003-2005 monthly demand 82 85 94 Seasonal index = 115 Apr 90 95 100 94 average monthly demand May 113 125 131 123 94 = 90/94 = .957 Jun 110 115 120 115 94 Jul 100 102 113 105 94 Aug 88 102 110 100 94 Sept 85 90 95 90 94 Oct 77 78 85 80 94 Nov 75 72 83 80 94 Dec 82 78 80 80 94
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Seasonal Index Example

Month Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec
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Demand 2003 2004 2005 80 70 80 90 113 110 100 88 85 77 75 82 85 85 93 95 125 115 102 102 90 78 72 78 105 85 82 115 131 120 113 110 95 85 83 80

Average 2003-2005 200390 80 85 100 123 115 105 100 90 80 80 80

Average Monthly 94 94 94 94 94 94 94 94 94 94 94 94

Seasonal Index 0.957 0.851 0.904 1.064 1.309 1.223 1.117 1.064 0.957 0.851 0.851 0.851
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Seasonal Index Example

Month Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec
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Demand 2003 2004 2005

Average 2003-2005 2003-

Average Monthly

Seasonal Index 0.957 0.851 0.904 1.064 1.309 1.223 1.117 1.064 0.957 0.851 0.851 0.851
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80 85 105 90 94 70 85 Forecast for 2006 85 80 94 80 93 82 85 94 Expected annual demand = 1,200 90 95 115 100 94 113 125 131 123 94 110 115 120 1,200 115 94 Jan x .957 = 96 94 100 102 113 12 105 88 102 110 100 94 1,200 85 90 Feb 95 x90 .851 = 85 94 77 78 85 12 80 94 75 72 83 80 94 82 78 80 80 94

Seasonal Index Example

2006 Forecast
140 130 120 Demand 110 100 90 80 70 | J | F | M | A | M | J | J | A | S | O | N | D

2005 Demand 2004 Demand 2003 Demand

Time
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San Diego Hospital

Trend Data
10,200 10,000 Inpatient Days 9,800 9,600 9530 9,400 9,200 9,000 | | | | | | | | | | | | Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec 67 68 69 70 71 72 73 74 75 76 77 78 Month
Figure 4.6
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9573 9551 9594

9616 9637

9659 9680

9702 9723

9745 9766

San Diego Hospital

Seasonal Indices
1.06 Index for Inpatient Days 1.04 1.02 1.00 0.98 0.96 0.94 0.92 0.97 1.04 1.02 1.01 0.99 0.99 0.97 0.96 1.00 0.98 1.03 1.04

| | | | | | | | | | | | Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec 67 68 69 70 71 72 73 74 75 76 77 78 Month
Figure 4.7

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San Diego Hospital

Combined Trend and Seasonal Forecast
10,200 Inpatient Days 10,000 9911 9,800 9,600 9,400 9,200 9,000 9265 9520 9542 9411 9355 9764 9691 9949 9724 9572 10068

| | | | | | | | | | | | Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec 67 68 69 70 71 72 73 74 75 76 77 78 Month
Figure 4.8

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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

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Associative Forecasting
Forecasting an outcome based on predictor variables using the least squares technique
^ y = a + bx
^ where y = computed value of the variable to be predicted (dependent variable) a = y-axis intercept yb = slope of the regression line x = the independent variable though to predict the value of the dependent variable
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Associative Forecasting Example

Sales ($000,000), y 2.0 3.0 2.5 2.0 2.0 3.5 Local Payroll ($000,000,000), x 1 3 4 4.0 2 1 3.0 7
Sales 2.0 1.0 0 | 1 | 2 | | | | 3 4 5 6 Area payroll | 7

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Associative Forecasting Example

Sales, y 2.0 3.0 2.5 2.0 2.0 3.5 y = 15.0 Payroll, x 1 3 4 2 1 7 x = 18 x2 1 9 16 4 1 49 x2 = 80 xy - nxy x2 - nx2 xy 2.0 9.0 10.0 4.0 2.0 24.5 xy = 51.5 51.5 - (6)(3)(2.5) 80 - (6)(32)

x = x/6 = 18/6 = 3 y = y/6 = 15/6 = 2.5

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b=

= .25

a = y - bx = 2.5 - (.25)(3) = 1.75

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Associative Forecasting Example

^ y = 1.75 + .25x .25x If payroll next year is estimated to be $600 million, then: Sales = 1.75 + .25(6) Sales = $325,000

Sales = 1.75 + .25(payroll) .25(payroll)

4.0 Sales 3.25 3.0 2.0 1.0 0 | 1 | 2 | | | | 3 4 5 6 Area payroll | 7
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Standard Error of the Estimate

A forecast is just a point estimate of a future value This point is actually the mean of a probability distribution
4.0 Sales 3.25 3.0 2.0 1.0 0
Figure 4.9
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| 1

| 2

| | | | 3 4 5 6 Area payroll

| 7

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Standard Error of the Estimate

Sy,x = (y - yc)2 n-2

where y = y-value of each data point yc = computed value of the dependent variable, from the regression equation n = number of data points
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Standard Error of the Estimate

Computationally, this equation is considerably easier to use Sy,x = y2 - ay - bxy n-2

We use the standard error to set up prediction intervals around the point estimate
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Standard Error of the Estimate

Sy,x = y2 - ay - bxy = n-2
4.0 Sales 3.25 3.0 2.0 1.0 0
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39.5 - 1.75(15) - .25(51.5) 6-2

Sy,x = .306 The standard error of the estimate is $30,600 in sales

| 1

| 2

| | | | 3 4 5 6 Area payroll

| 7
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Correlation
How strong is the linear relationship between the variables? Correlation does not necessarily imply causality! Coefficient of correlation, r, measures degree of association
Values range from -1 to +1

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Correlation Coefficient
r= n7xy - 7x7y [n7x2 - (7x)2][n7y2 - (7y)2] ][n

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Correlation Coefficient
y

r=
correlation: r = +1

nxy - xy
x
correlation: 0<r<1

[nx2 - (x)2][ny2 Positive)2] ][n (b) - (y (a) Perfect positive x

y y

(c) No correlation: r=0

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(d) Perfect negative x correlation: r = -1

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Correlation
Coefficient of Determination, r2, measures the percent of change in y predicted by the change in x
Values range from 0 to 1 Easy to interpret

For the Nodel Construction example: r = .901 r2 = .81

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Multiple Regression Analysis

If more than one independent variable is to be used in the model, linear regression can be extended to multiple regression to accommodate several independent variables ^ y = a + b 1 x1 + b 2 x2 Computationally, this is quite complex and generally done on the computer
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Multiple Regression Analysis

In the Nodel example, including interest rates in the model gives the new equation: ^ y = 1.80 + .30x1 - 5.0x2 .30x 5.0x An improved correlation coefficient of r = .96 means this model does a better job of predicting the change in construction sales Sales = 1.80 + .30(6) - 5.0(.12) = 3.00 Sales = $300,000
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Monitoring and Controlling Forecasts

Tracking Signal
Measures how well the forecast is predicting actual values Ratio of running sum of forecast errors (RSFE) to mean absolute deviation (MAD)
Good tracking signal has low values If forecasts are continually high or low, the forecast has a bias error
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Monitoring and Controlling Forecasts

Tracking RSFE = signal MAD (actual demand in period i forecast demand in period i) Tracking signal = |actual - forecast|/n) forecast|/n)
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Tracking Signal
Signal exceeding limit Tracking signal + 0 MADs Lower control limit Time Upper control limit

Acceptable range

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Tracking Signal Example

Qtr Actual Demand Forecast Demand Error RSFE Absolute Forecast Error Cumulative Absolute Forecast Error MAD

1 2 3 4 5 6

90 95 115 100 125 140

100 100 100 110 110 110

-10 -5 +15 -10 +15 +30

-10 -15 0 -10 +5 +35

10 5 15 10 15 30

10 15 30 40 55 85

10.0 7.5 10.0 10.0 11.0 14.2

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Tracking Signal Example

Qtr

Tracking Actual Signal Forecast (RSFE/MAD) Demand Demand Error

RSFE

Absolute Forecast Error

Cumulative Absolute Forecast Error MAD

1 2 3 4 5 6

90 100 -1 -10 -10/10 = 95 100 -2 -5 -15/7.5 = 115 0/10 = 0 +15 100 100 110 -10/10 = -1 -10 125 110 +15 +5/11 = +0.5 140 110 +30 +35/14.2 = +2.5

-10 -15 0 -10 +5 +35

10 5 15 10 15 30

10 15 30 40 55 85

10.0 7.5 10.0 10.0 11.0 14.2

The variation of the tracking signal between -2.0 and +2.5 is within acceptable limits
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Adaptive Forecasting
Its possible to use the computer to continually monitor forecast error and adjust the values of the E and F coefficients used in exponential smoothing to continually minimize forecast error This technique is called adaptive smoothing
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Focus Forecasting
Developed at American Hardware Supply, focus forecasting is based on two principles:
1. Sophisticated forecasting models are not always better than simple models 2. There is no single techniques that should be used for all products or services This approach uses historical data to test multiple forecasting models for individual items The forecasting model with the lowest error is then used to forecast the next demand
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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 Holidays and other calendar events Unusual events

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Fast Food Restaurant Forecast

20%
Percentage of sales

15% 10% 5%

1111-12

1-2 2-3

3-4 4-5

5-6

7-8 8-9

9-10 10-11 10Figure 4.12

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1212-1 (Lunchtime)
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6-7 (Dinnertime) Hour of day