Forecasting

Chapter 3
Course
Structure Introduction

Operations Strategy & Competitiveness

Quality Management
Strategic Decisions (some)
Design of Products Process Selection Capacity and
and Services and Design Facility Decisions

Forecasting

Tactical & Operational Decisions

Forecasting

 Predict the next number in the pattern:

a) 3.7, 3.7, 3.7, 3.7, 3.7, ?

b) 2.5, 4.5, 6.5, 8.5, 10.5, ?

c) 5.0, 7.5, 6.0, 4.5, 7.0, 9.5, 8.0, 6.5, ?

Forecasting

 Predict the next number in the pattern:

a) 3.7, 3.7, 3.7, 3.7, 3.7, 3.7

b) 2.5, 4.5, 6.5, 8.5, 10.5, 12.5

c) 5.0, 7.5, 6.0, 4.5, 7.0, 9.5, 8.0, 6.5, 9.0

Outline

 What is forecasting?
 Types of forecasts
 Time-Series forecasting
 Naïve
 Moving Average
 Exponential Smoothing
 Regression
 Good forecasts
What is Forecasting?

 Process of predicting a
future event based on
historical data
 Educated Guessing
 Underlying basis of
all business decisions
 Production
 Inventory
 Personnel
 Facilities
 Why do we need to forecast?

In general, forecasts are almost always wrong.

So,
Throughout the day we forecast very different
things such as weather, traffic, stock market,
state of our company from different perspectives.

Virtually every business attempt is based on

forecasting. Not all of them are derived from
sophisticated methods. However, “Best"
educated guesses about future are more valuable
for purpose of Planning than no forecasts and
hence no planning.
 Importance of Forecasting in OM

Departments throughout the organization

depend on forecasts to formulate and execute
their plans.

Finance needs forecasts to project cash flows

and capital requirements.

Human resources need forecasts to anticipate

hiring needs.

Production needs forecasts to plan production

levels, workforce, material requirements,
inventories, etc.
Importance of Forecasting in OM

Demand is not the only variable of interest

to forecasters.

Manufacturers also forecast worker

absenteeism, machine availability, material
costs, transportation and production lead
times, etc.

Besides demand, service providers are also

interested in forecasts of population, of
other demographic variables, of weather,
etc.
Types of Forecasts by Time Horizon
Quantitative
 Short-range forecast methods

 Usually < 3 months

 Job scheduling, worker assignments Detailed
use of
 Medium-range forecast system

 3 months to 2 years
 Sales/production planning

 Long-range forecast
 > 2 years Design
of system
 New product planning
Qualitative
Methods
Forecasting During the Life Cycle

Introduction Growth Maturity Decline

Qualitative models Quantitative models

- Executive judgment
- Time series analysis
- Market research
- Regression analysis
-Survey of sales force
-Delphi method
Sales

Time
Qualitative Forecasting Methods

Qualitative
Forecasting

Models
Sales Delphi
Executive Market
Force Method
Judgement Research/
Composite
Survey

Smoothing
 Qualitative Methods
Briefly, the qualitative methods are:

Executive Judgment: Opinion of a group of high level experts or

managers is pooled

Sales Force Composite: Each regional salesperson provides

his/her sales estimates. Those forecasts are then reviewed to
make sure they are realistic. All regional forecasts are then
pooled at the district and national levels to obtain an overall
forecast.

Market Research/Survey: Solicits input from customers

pertaining to their future purchasing plans. It involves the use of
questionnaires, consumer panels and tests of new products and
services.
 Qualitative Methods

Delphi Method: As opposed to regular panels where the individuals

involved are in direct communication, this method eliminates the effects of
group potential dominance of the most vocal members. The group involves
individuals from inside as well as outside the organization.

Typically, the procedure consists of the following steps:

Each expert in the group makes his/her own forecasts in form of
statements
The coordinator collects all group statements and summarizes
them
The coordinator provides this summary and gives another set of
questions to each
group member including feedback as to the input of other experts.
The above steps are repeated until a consensus is reached.

.
Quantitative Forecasting Methods

Quantitative
Forecasting

Time Series Regression

Models Models

2. Moving 3. Exponential
1. Naive
Average Smoothing
a) simple a) level
b) weighted b) trend
c) seasonality
Time Series Models

 Try to predict the future based on past data

 Assume that factors influencing the past

will continue to influence the future
Time Series Models: Components

Random Trend

Seasonal Composite
Product Demand over Time
Demand for product or service

Year Year Year Year

1 2 3 4
 Product Demand over Time
Trend component
Seasonal peaks
Demand for product or service

Actual demand
Random line
variation
Year Year Year Year
1 2 3 4
Now let’s look at some time series approaches to forecasting…
Borrowed from Heizer/Render - Principles of Operations Management, 5e, and Operations Management, 7e
Quantitative Forecasting Methods

Quantitative
Time Series
Models

Models

2. Moving 3. Exponential
1. Naive
Average Smoothing
a) simple a) level
b) weighted b) trend
c) seasonality
1. Naive Approach

 Demand in next period is the same as

demand in most recent period
 May sales = 48 →June forecast = 48

 Usually not good

2a. Simple Moving Average

 Assumes an average is a good estimator of future

behavior
 Used if little or no trend
 Used for smoothing

AAt t ++AAt -t1-1++AAt -t 2-2 ++...

...++AAt -t n-n11
FFt t 11 ==
nn

Ft+1 = Forecast for the upcoming period, t+1

n = Number of periods to be averaged
At = Actual occurrence in period t
2a. Simple Moving Average

You’re manager in Amazon’s electronics

department. You want to forecast ipod sales
for months 4-6 using a 3-period moving
average. Sales
Month (000)
1 4
2 6
3 5
4 ?
5 ?
6 ?
2a. Simple Moving Average

You’re manager in Amazon’s electronics

department. You want to forecast ipod sales
for months 4-6 using a 3-period moving
average. Sales Moving Average
Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 ? (4+6+5)/3=5
5 ?
6 ?
2a. Simple Moving Average

What if ipod sales were actually 3 in month 4

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3? 5
5 ?
6 ?
2a. Simple Moving Average

Forecast for Month 5?

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3 5
5 ? (6+5+3)/3=4.667
6 ?
2a. Simple Moving Average

Actual Demand for Month 5 = 7

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3 5
5 ?7 4.667
6 ?
2a. Simple Moving Average

Forecast for Month 6?

Sales Moving Average

Month (000) (n=3)
1 4 NA
2 6 NA
3 5 NA
4 3 5
5 7 4.667
6 ? (5+3+7)/3=5
2b. Weighted Moving Average
 Gives more emphasis to recent data
FFtt11 == w
w11A
Att ++ w
w22A
Att-1-1 ++w
w33A
Att--22 ++...
...++w
wnnA
Att--nn11

 Weights
decrease for older data
sum to 1.0 Simple
Simple moving
moving
average
average models
models
weight
weight all
all previous
previous
periods
periods equally
equally
2b. Weighted Moving Average: 3/6, 2/6, 1/6

Month Sales Weighted

(000) Moving
Average
1 4 NA
2 6 NA
3 5 NA
4 ? 31/6 = 5.167
5 ?
6 ?
2b. Weighted Moving Average: 3/6, 2/6, 1/6

Month Sales Weighted

(000) Moving
Average
1 4 NA
2 6 NA
3 5 NA
4 3 31/6 = 5.167
5 7 25/6 = 4.167
6 32/6 = 5.333
3a. Exponential Smoothing

 Assumes the most recent observations have

the highest predictive value
 gives more weight to recent time periods

FFt+1
t+1
=
= F
F tt
+
+ (A
(A tt
-
- F
F t)
t)
et

Ft+1 = Forecast value for time t+1Need initial

Need initial
At = Actual value at time t forecast
forecastFFt t
to
tostart.
 = Smoothing constant start.
3a. Exponential Smoothing – Example 1
FFt+1
t+1
=
= F
F tt
+
+ (A
(A tt
-
- F
F t)
t)
i Ai
Week Demand
1 820 Given
Given the
the weekly
weekly demand
demand
2 775 data
data what
what are
are the
the exponential
exponential
3 680 smoothing
smoothing forecasts
forecasts for
for
4 655 periods
periods 2-10 using =0.10?
2-10 using =0.10?
5 750
6 802 Assume
Assume FF11=D
=D11
7 798
8 689
9 775
10
3a. Exponential Smoothing – Example 1
FFt+1
t+1
=
= F
F tt
+
+ (A
(A tt
-
- F
F t)
t)
i Ai Fi
Week Demand  = 0.1 0.6
1 820 820.00 820.00
2 775 820.00 820.00
3 = F1+ (A793.00
680 F2815.50 1–F1) =820+(820–820)
4 655 801.95 725.20=820
5 750 787.26 683.08
6 802 783.53 723.23
7 798 785.38 770.49
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28
3a. Exponential Smoothing – Example 1
FFt+1
t+1
=
= F
F tt
+
+ (A
(A tt
-
- F
F t)
t)
i Ai Fi
Week Demand  = 0.1 0.6
1 820 820.00 820.00
2 775 820.00 820.00
3 680 815.50 793.00
F3 = F2+ (A2–F2) =820+(775–820)
4 655 801.95 725.20
5 750 787.26 683.08=815.5
6 802 783.53 723.23
7 798 785.38 770.49
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28
3a. Exponential Smoothing – Example 1
FFt+1
t+1
=
= F
F tt
+
+ (A
(A tt
-
- F
F t)
t)
i Ai Fi
Week Demand  = 0.1 0.6
1 820 820.00 820.00
2 775 820.00 820.00
3 680 815.50 793.00
4 655 801.95 725.20
5 750 787.26 683.08
6 802 783.53 723.23 This process
7 798 785.38 770.49 continues
8 689 786.64 787.00
through week 10
9 775 776.88 728.20
10 776.69 756.28
3a. Exponential Smoothing – Example 1
FFt+1
t+1
=
= F
F tt
+
+ (A
(A tt
-
- F
F t)
t)
i Ai Fi
Week Demand  = 0.1  = 0.6
1 820 820.00 820.00
2 775 820.00 820.00
3 680 815.50 793.00
4 655 801.95 725.20
5 750 787.26 683.08 What if the
6 802 783.53 723.23  constant
7 798 785.38 770.49 equals 0.6
8 689 786.64 787.00
9 775 776.88 728.20
10 776.69 756.28
3a. Exponential Smoothing – Example 2
FFt+1
t+1
=
= F
F tt
+
+ (A
(A tt
-
- F
F t)
t)
i Ai Fi
Month Demand  = 0.3  = 0.6
January 120 100.00 100.00
February 90 106.00 112.00
March 101 101.20 98.80
April 91 101.14 100.12
May 115 98.10 94.65 What if the
June 83 103.17 106.86  constant
July 97.12 92.54 equals 0.6
August
September
 3a. Exponential Smoothing – Example 3

Company
Company A, A, aa personal
personal computer
computer producer
producer purchases
purchases
generic
generic parts
parts and
and assembles
assembles them
them to to final
final product.
product.
Even
Even though
though most
most ofof the
the orders
orders require
require customization,
customization,
they
they have
have many
many common
common components.
components. Thus, Thus,
managers
managers ofof Company
Company A A need
need aa good
good forecast
forecast ofof
demand
demand soso that
that they
they can
can purchase
purchase computer
computer parts parts
accordingly
accordingly toto minimize
minimize inventory
inventory cost
cost while
while meeting
meeting
acceptable
acceptable service
service level.
level. Demand
Demand data data forfor its
its
computers
computers for
for the
the past
past 55 months
months isis given
given in in the
the
following table..
following table
3a. Exponential Smoothing – Example 3
FFt+1
t+1
=
= F
F tt
+
+ (A
(A tt
-
- F
F t)
t)
i Ai Fi
Month Demand  = 0.3  = 0.5
January 80 84.00 84.00
February 84 82.80 82.00
March 82 83.16 83.00
April 85 82.81 82.50
May 89 83.47 83.75 What if the
June 85.13 86.38  constant
July ?? ?? equals 0.5
3a. Exponential Smoothing
How to choose α
depends on the emphasis you want to
place on the most recent data

Increasing α makes forecast more

sensitive to recent data
Forecast Effects of Smoothing Constant 

Ft+1 = Ft +  (At - Ft)

or Ft+1 =  At + (1- ) At - 1 + (1- )2At - 2 + ...
w1 w2 w3

Weights
= Prior Period 2 periods ago 3 periods ago
 (1 - ) (1 - )2

= 0.10
10% 9% 8.1%
= 0.90 90% 9% 0.9%
To Use a Forecasting Method

 Collect historical data

 Select a model
 Moving average methods
 Select n (number of periods)
 For weighted moving average: select weights
 Exponential smoothing
 Select 

 Selections should produce a good forecast

…but what is a good forecast?

A Good Forecast

 Has a small error

 Error = Demand - Forecast
Measures of Forecast Error
et
nn

a. MAD = Mean Absolute Deviation 

 AA --FF
t=1
tt tt
MAD
MAD== t=1
nn

nn

b. MSE = Mean Squared Error  A - F 

 At t - Ft t 
22

t=
t =11
MSE =
MSE =
nn

c. RMSE = Root Mean Squared Error RMSE

RMSE == MSE
MSE

 Ideal values =0 (i.e., no forecasting error)

 nn

MAD Example 
 AA --FF
t=1
tt tt = 40 =10
MAD
MAD== t=1 4
nn

What
What isis the
the MAD
MAD value
value given
given the
the forecast
forecast
values
values in
in the
the table
table below?
below?
At Ft
Month Sales Forecast |At – Ft|
1 220 n/a
2 250 255 5
3 210 205 5
4 300 320 20
5 325 315 10
= 40
 nn

 A - F 
 At t - Ft t 
22

= 550 =137.5
MSE/RMSE Example MSE =
MSE =
t =t =11
nn 4

What
What isis the
the MSE
MSE value?
value? RMSE = √137.5
=11.73
At Ft
Month Sales Forecast |At – Ft| (At – Ft)2
1 220 n/a
2 250 255 5 25
3 210 205 5 25
4 300 320 20 400
5 325 315 10 100
= 550
 Measures of Error

1. Mean Absolute Deviation

(MAD)
n
t At Ft et |et| e 2
e
t
MAD  1
t
84 = 14
Jan 120 100 20 20 400
n
6
-16 16
Feb 90 106 256 2a. Mean Squared Error
-1 1 1 (MSE)
Mar 101 102 n

-10 10 100 
 te  2

April 91 101 MSE  1 1,446

17 17 289 n = 241
May 115 98 6
-20 20 400
2b. Root Mean Squared Error
June 83 103 -10 (RMSE)
84 1,446
RMSE  MSE
An accurate forecasting system will have small MAD, MSE and RMSE;
ideally equal to zero. A large error may indicate that either the forecasting = SQRT(241)
method used or the parameters such as α used in the method are wrong.
Note: In the above, n is the number of periods, which is 6 in our example
=15.52
Forecast Bias

 How can we tell if a forecast has a positive

or negative bias?

 TS = Tracking Signal
Good tracking signal has low values

RSFE  (actual t  forecast t )

TS = = t
MAD Mean absolute
MAD deviation
30
Exponential Smoothing (continued)

 We looked at using exponential smoothing

to forecast demand with only random
variations
Ft+1 = Ft +  (At - Ft)
Ft+1 = Ft +  At –  Ft
Ft+1 =  At + (1-) Ft
Exponential Smoothing (continued)

 We looked at using exponential smoothing

to forecast demand with only random
variations
 What if demand varies due to randomness
and trend?

 What if we have trend and seasonality in

the data?
 Regression Analysis as a Method for Forecasting
Regression analysis takes
advantage of the relationship
between two variables. Demand
is then forecasted based on the
knowledge of this relationship
and for the given value of the
related variable.

Ex: Sale of Tires (Y), Sale of Autos

(X) are obviously related

If we analyze the past data of these

two variables and establish a
relationship between them, we
may use that relationship to
forecast the sales of tires given
the sales of automobiles.

The simplest form of the

relationship is, of course, linear, Sales of Autos (100,000)
hence it is referred to as a
regression line.
 Formulas

y=a+bx

where,


x

xy  n x y
y
b
 x  nx
2 2

x
y
a  y  bx
Regression – Example
yy == aa++ bb X
X b
 xy  n x y a  y  bx
 x  nx
2 2

MonthAdvertising Sales X 2 XY
January 3 1 9.00 3.00
February 4 2 16.00 8.00
March 2 1 4.00 2.00
April 5 3 25.00 15.00
May 4 2 16.00 8.00
June 2 1 4.00 2.00
July

TOTAL 20 10 74 38
 General Guiding Principles for Forecasting

1. Forecasts are more accurate for larger groups of items.

2. Forecasts are more accurate for shorter periods of
time.
3. Every forecast should include an estimate of error.
4. Before applying any forecasting method, the total
system should be understood.
5. Before applying any forecasting method, the method
should be tested and evaluated.
6. Be aware of people; they can prove you wrong very
easily in forecasting