CHAPTER 18: FORECASTING

LO18–1: Understand how forecasting is essential to supply chain

planning.
LO18–2: Evaluate demand using quantitative forecasting models.
LO18–3: Apply qualitative techniques to forecast demand.
LO18–4: Apply collaborative techniques to forecast demand.

McGraw-Hill/Irwin Copyright ©2017 McGraw-Hill Education. All rights reserved.

Forecasting in Operations and Supply Chain
Management
• 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

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-2

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 supply chain 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)

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-3

Types of Forecasting
• There are four basic types of forecasts
1. Qualitative
2. Time series analysis
3. Causal relationships
4. Simulation
• Time series analysis is based on the idea that data
relating to past demand can be used to predict future
demand
• Chapter focuses on qualitative and time series techniques

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-4

Components of Demand
1. Average demand for a period of time
2. Trend
3. Seasonal element
4. Cyclical elements
5. Random variation
6. Autocorrelation

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-5

 Historical Product Demand Consisting of a Growth
Trend and Seasonal Demand

Exhibit 18.1 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-6
Remaining Components
• Cyclical factors are more difficult to determine because
the time span may be unknown or the cause of the cycle
may not be considered
• Political elections, war, economic conditions, or sociological
pressures
• Random variations are caused by chance events
• If we cannot identify the cause of variation, it is assumed to be
purely random chance
• Autocorrelation denotes that the value expected at any
point is highly correlated with its own past values

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-7

 Trend Lines
• Identification of trend lines is a common starting point
when developing a forecast
• Common trend types include linear, S-curve, asymptotic,
and exponential

Exhibit 18.2 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-8
Time Series Analysis
• Short term: forecast under three months
• Tactical decisions
• Medium term: three months to two years
• Capturing seasonal effects
• Long term: forecast longer than two years
• Detecting general trends
• Identifying major turning points

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-9

Factors Affecting Forecasting Model Selection
1. Time horizon to be forecast
2. Data availability
3. Accuracy required
4. Size of forecasting budget
5. Availability of qualified personnel

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-10

 A Guide to Selecting an Appropriate Forecasting
Method

Exhibit 18.3 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-11
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

• Ft = Forecast in the coming period (t)

• n = Number of periods to be averaged
• At-1 = Actual occurrence in the just pasted period (t-1)
• At-2, At-3, and At-n = Actual occurrences two periods ago, an so on

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-12

 Simple Moving Average – Example

Exhibit 18.4 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-13
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

w1 = Weight to be given to the actual occurrence for period t-1

w2 = Weight to be given to the actual occurrence for period t-2
wn = Weight to be given to the actual occurrence for period t-n
n = Total number of prior periods in the forecast

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-14

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
• That is, the sales from the same period last time should be
weighted the heaviest

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-15

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
• Well accepted for six reasons
1. Exponential models are surprisingly accurate
2. Formulating an exponential model is relatively easy
3. The user can understand how the model works
4. Little computation is required to use the model
5. Computer storage requirements are small
6. Tests for accuracy are easy to compute

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-16

Exponential Smoothing Model
• Only three pieces of data are required:
1. Most recent forecast
2. Actual demand for the forecast period
3. Smoothing constant alpha ()
• Determines the level of smoothing and speed of reaction

• Ft = The exponentially smoothed forecast for period t

• Ft-1 = The exponentially smoothed forecast made for the prior period
• At-1 = The actual demand in the prior period
•  = The desired response rate, or smoothing constant

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-17

 Exponential Smoothing Example (=0.20)
Week Demand Forecast
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  

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-18

First Forecast
• No way to find F1 since Ft is a function of Ft-1
• When exponential smoothing is first used for an item, an
initial forecast may be obtained by using a simple
estimate
• Like the first period’s demand
• Or by using an average of preceding periods, such as the average
of the first two or three periods
• For working homework, assume F1 = A1

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-19

 Exponential Forecasts vs. Actual Demand
for Product over Time Showing Forecast Lag

Exhibit 18.5 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-20
Exponential Smoothing with Trend
• An trend in data causes the exponential forecast to
always lag the actual data
• Can be corrected somewhat by adding in a trend
adjustment
• To correct the trend, we need two smoothing constants
• Smoothing constant alpha ()
• Trend smoothing constant delta (δ)

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-21

Trend Effects Equations

Ft = The exponentially smoothed forecast that does not

include trend for period t
Tt = The exponentially smoothed trend for period t
FITt = The forecast including trend for period t
FITt-1 = The forecast including trend made for the prior period
At-1 = The actual demand for the prior period
δ = Smoothing constant (delta)
 = Smoothing constant (alpha)
Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-22
Example 18.1: Forecast Including Trend
• Previous forecast including trend of 110 units
• Previous trend estimate of 10 units
• Alpha of 0.20
• Delta of 0.30
• Actual demand of 115

• If actual 120, instead of 121.3, forecast for next period is…

• .26

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-23

Choosing Alpha and Delta
• Exponential smoothing requires that the smoothing
constants be given a value between 0 and 1
• Typically fairly small values are used for alpha and delta in
the range of .1 to .3
• The values depend on how much random variation there
is in demand and how steady the trend factor is

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-24

Linear Regression Analysis
• Regression is used to identify the functional relationship between
two or more correlated variables, usually from observed data
• Dependent variable is predicted for given values of the
independent variable
• Linear regression is special case that assumes the relationship
between the variables can be explained with a straight line
• Useful for long-term forecasting
• Y = a + bt
• Y = Dependent variable computed by the equation
• y = The actual dependent variable data point
• a = Y intercept
• b = Slope of the line
• t = Time period

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-25

 Example 18.2: Least Squares Method
Quarter Sales Quarter Sales
1 600 7 2,600
2 1,550 8 2,900
3 1,500 9 3,800
4 1,500 10 4,500
5 2,400 11 4,000
6 3,100 12 4,900

Exhibit 18.6 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-26
 Example 18.1: Calculating Totals

Exhibit 18.7 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-27
Example 18.1: Other Calculations

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-28

 Regression with Excel

Exhibit 18.8 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-29
 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
• Seasonal variation may be either additive or multiplicative
• Additive: Forecast including trend and seasonal = Trend + Seasonal
• Multiplicative: Forecast including trend and seasonal = Trend × Seasonal
factor

Exhibit 18.9 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-30
Example 18.3: Simple Proportion
• In past years, firm sold an average of 1,000 units each
year
• 200 in spring
• 350 in summer
• 300 in fall
• 150 in winter
• Find the seasonal factors
• Using those factors, if we expected demand for next year
to be 1,100 units, compute demand per period

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-31

Example 18.3: Finding Seasonal Factors

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-32

Example 18.3: Forecast for Next Year

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-33

Decomposition Using Least Squares Regression
1. Decompose the time series into its components
a. Find seasonal component
b. Deseasonalize the demand
c. Find trend component
2. Forecast future values of each component
a. Project trend component into the future
b. Multiply trend component by seasonal component

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-34

 Example: Deseasonalized Demand

Exhibit 18.11 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-35
Example Continued
• Step 1: determine the seasonal factor
• Column 4 develops an average for the same quarters in the three-
year period
• Average of all 12 periods (column 3) is
• Average of the same quarters for each year

• Seasonal factor is value from column 4 divided by overall average

of 2,779.2

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-36

Example Continued
• Step 2: deseasonalize the original data
• Column 3 is divided by the appropriate seasonal factor

1.
2.
3.
• Step 3: develop a least squares regression line for the
deseasonalized data
• Y = a + bt
• Calculations shown in exhibit
• Values are a = 554.9 and b = 342.2

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-37

Example Continued

• Step 4: project the regression line through the period to be forecast

• Use slope and intercept given earlier
• Use period numbers (t) of 13-16
• Results shown in third column above
• Step 5: create the final forecast by adjusting the regression line by
the seasonal factor
• Third column times appropriate seasonal factor in column four
• Final forecast shown in fifth column above

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-38

Forecast Errors
• Forecast error is the difference between the forecast
value and what actually occurred
• Can come from a variety of sources
• 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

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-39

Measures of Error
• Mean absolute deviation (MAD)

• Ideally, MAD will be zero (no forecasting error)

• Larger values of MAD indicate a less accurate model
• Mean absolute percent error (MAPE)

• Scales the forecast error to the magnitude of demand

• Tracking signal

• Indicates whether forecast errors are accumulating over time

(either positive or negative errors)

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-40

 Computing Forecast Error

Exhibit 18.15 Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-41
Causal Relationship Forecasting
• Causal relationship forecasting uses independent
variables other than time to predict future demand
• This independent variable must be a leading indicator
• For example, using rain to forecast sales of umbrellas
• Many apparently causal relationships are actually just
correlated events
• Care must be taken when selecting causal variables

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-42

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
• Requires collecting additional data to perform the forecast
• Some of that data will likely come from outside the firm
• Microsoft Excel supports multiple regression

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-43

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

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-44

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

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-45

CPFR Steps

Creation of a
Joint Development Inventory
front-end Sharing
business of demand replenishme
partnership forecasts
planning forecasts nt
agreement

Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-46

Summary
• Strategic forecasts are longer term and usually involve forecasting
demand for a group of products
• Tactical forecasts would cover only a short period of time
• Demand can be broken down or “decomposed” into basic
elements, such as trend, seasonality, and random variation
• Four different time series models are evaluated
• (1) simple moving average, (2) weighted moving average, (3) exponential
smoothing, and (4) linear regression
• Causal relationship forecasting is different from time series
• The quality of a forecast is measured based on its error
• Qualitative techniques depend more on judgment or the opinions
of experts
• These techniques typically involve a structured process so that experience
can be acquired and accuracy assessed
Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-47
Practice Exam
1. This is a type of forecast used to make long-term
decisions, such as where to locate a warehouse or how
many employees to have in a plant next year
2. This is the type of demand that is most appropriate for
using forecasting models
3. This is a term used for actually influencing the sale of a
product or service
4. These are the six major components of demand
5. This type of analysis is most appropriate when the past
is a good predictor of the future
6. This is identifying and separating time series data into
components of demand
Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-48
Practice Exam Continued
7. Your forecast is, on average, incorrect by about 10 percent
• The average demand is 130 units
• What is the MAD

8. If the tracking signal for your forecast was consistently

positive, you could then say this about your forecasting
technique
9. What would you suggest to improve the forecast described
in question 8
10. You know that sales are greatly influenced by the amount
your firm advertises in the local paper
• What forecasting technique would you suggest trying

11. What forecasting tool is most appropriate when closely

working with customers dependent on your products
Copyright ©2017 McGraw-Hill Education. All rights reserved. 18-49