Chapter One

Forecasting

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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
1. Short-range forecast
► Up to 1 year, generally less than 3 months
► Purchasing, job scheduling, job assignments,
production levels
2. Medium-range forecast
► 3 months to 3 years
► Sales and production planning, budgeting
3. Long-range forecast
► 3+ years
► New product planning, facility location,
research and development
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 Types of Forecasts
1. Economic forecasts
► It is making prediction about the economy. For
instance, GDP, inflation, unemployment or the
fiscal deficit, etc.
2. Technological forecasts
► Predict rate of technological progress
► Impacts development of new products
3. Demand forecasts
► Predict sales of existing products and services

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 Strategic Importance of
Forecasting
► Supply-Chain Management–good
supplier relations, advantages in product
innovation, cost and speed to market
► Human Resources – hiring, training,
laying off workers
► Capacity – capacity shortages can result
in undependable delivery, loss of
customers, loss of market share

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 Seven Steps in Forecasting
1. Determine the use of the forecast
2. Select the items to be forecasted
3. Determine the time horizon of the
forecast
4. Select the forecasting model(s)
5. Gather the data needed to make the
forecast
6. Make the forecast
7. Validate and implement results
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 The Realities!
► Forecasts are seldom perfect,
unpredictable outside factors may
impact the forecast
► 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

1. Jury of executive opinion

► Pool opinions of high-level experts,
sometimes augment by statistical
models
2. Delphi method
► Panel of experts, queried iteratively

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 Overview of Qualitative Methods

3. Sales force composite

► Estimates from individual salespersons
are reviewed for reasonableness, then
aggregated
4. Market Survey
► Ask the customer

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 Jury of Executive Opinion
► Involves small group of high-level experts
and managers
► Group estimates demand by working
together
► Combines managerial experience with
statistical models
► Relatively quick
► ‘Group-think’
disadvantage

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 Delphi Method
► Iterative group
process, continues Decision Makers
(Evaluate responses
until consensus is and make decisions)
reached
► 3 types of Staff
(Administering
participants survey)
► Decision makers
► Staff
► Respondents Respondents
(People who can make
valuable judgments)
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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
► May be overly optimistic

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 Market Survey
► Ask customers about purchasing
plans
► Useful for demand and product
design and planning
► What consumers say, and what they
actually do may be different
► May be overly optimistic

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 Overview of Quantitative
Approaches
1. Naive approach
2. Moving averages
3. Exponential Time-series
smoothing models
4. Trend projection
5. Linear regression Associative
model

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 Time-Series Forecasting

► Forecast based only on past values, no

other variables important
► Assumes that factors influencing past
and present will continue influence in
future

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 Time Series Components
Time Series Data
• A time series variable (Y) consists of data
observed over n periods of time.
• Businesses use time series data
- to monitor a process to determine if it is
stable
- to predict the future (forecasting)
• Time series data can also be used to
understand economic, population, health,
crime, sports, and social problems.
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 Time Series Components
Time Series Data
• Time series data are
usually plotted as a line
or bar graph.
• Time is on the
horizontal (X) axis.
• This reveals how a
variable changes over
time.
• Fluctuations are easier
to see on a line graph.
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 Time Series Components
Time Series Data
• The following notation is used:
yt is the value of the time series in period t
t is an index denoting the time period
(t = 1, 2, …, n)
n is the number of time periods
y1, y2, …, yn is the data set for analysis
• To distinguish time series data from cross-
sectional data, use yt instead of xi for an
individual observation.
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 Time Series Components
Measuring Time Series
• Time series data may be measured at a point in
time.
• For example, prime rate of interest is measured at
a particular point in time.
• Time series data may also be measured over an
interval of time.
• For example, Gross Domestic Product (GDP) is a
flow of goods and services measured over an
interval of time.

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 Time Series Components
Periodicity
• The Periodicity is the time interval over which data
are collected.
• Data can be collected once every
- decade
- year (e.g., 1 observation per year)
- quarter (e.g., 4 observations per year)
- month (e.g., 12 observations per year)
- week
- day
- hour

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 Time Series Components
• Time series decomposition seeks to separate a
time series Y into four components:
- Trend (T)
- Cycle (C)
- Seasonal (S)
- Irregular (I)

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 Time Series Components
Trend • Trend (T) is the general
movement over all years
(t = 1, 2, ..., n).
• Trends may be steady
and predictable,
increasing, decreasing, or
staying the same.
• A mathematical trend can
be fitted to any data but
may or may not be useful
for predictions.

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 Time Series Components
Trend

Steady Trend Erratic Pattern

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 Time Series Components

Cycle • Cycle (C) is a repetitive

up-and-down
movement about a
trend that covers
several years.
• Over a small number of
time periods, cycles are
undetectable or may
resemble a trend.

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 Time Series Components
Seasonal • Seasonal (S) is a
repetitive cyclical pattern
within a year (or within a
week, day, or other time
period).
• Over a small number of
time periods, cycles are
undetectable or may
resemble a trend.

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 Time Series Components
Irregular • Irregular (I) is a random
disturbance that follows
no pattern.
• It is also called the error
component or random
noise reflecting all
factors other than trend,
cycle and seasonality.
• Short run forecasts are
best if data are irregular.

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 Naive Approach
► Assumes demand in next
period is the same as
demand in most recent period
► e.g., If January sales were 68, then
February sales will be 68
► Sometimes cost effective and
efficient
► Can be good starting point

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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

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 Moving Average Example
MONTH ACTUAL SHED SALES 3-MONTH MOVING AVERAGE
January 10
February 12
March 13
April 16 (10 + 12 + 13)/3 = 11 2/3
May 19 (12 + 13 + 16)/3 = 13 2/3
June 23 (13 + 16 + 19)/3 = 16
July 26 (16 + 19 + 23)/3 = 19 1/3
August 30 (19 + 23 + 26)/3 = 22 2/3
September 28 (23 + 26 + 30)/3 = 26 1/3
October 18 (29 + 30 + 28)/3 = 28
November 16 (30 + 28 + 18)/3 = 25 1/3
December 14
(28 + 18 + 16)/3 = 20 2/3

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 Weighted Moving Average
► Used when some trend might be
present
► Older data usually less important
► Weights based on experience and
intuition

Weighted
moving
average

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 Weighted Moving Average
MONTH ACTUAL SHED SALES 3-MONTH WEIGHTED MOVING AVERAGE
January 10
February 12
March 13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 = 12 1/6
May 19
WEIGHTS APPLIED PERIOD
June 23
3 Last month
July 26
2 Two months ago
August 30
1 Three months ago
September 28
6 Sum of the weights
October 18
Forecast for this month =
November 16
3 x Sales last mo. + 2 x Sales 2 mos. ago + 1 x Sales 3 mos. ago
December 14
Sum of the weights

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 Weighted Moving Average
MONTH ACTUAL SHED SALES 3-MONTH WEIGHTED MOVING AVERAGE
January 10
February 12
March 13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 = 12 1/6
May 19 [(3 x 16) + (2 x 13) + (12)]/6 = 14 1/3
June 23 [(3 x 19) + (2 x 16) + (13)]/6 = 17
July 26 [(3 x 23) + (2 x 19) + (16)]/6 = 20 1/2
August 30 [(3 x 26) + (2 x 23) + (19)]/6 = 23 5/6
September 28 [(3 x 30) + (2 x 26) + (23)]/6 = 27 1/2
October 18
[(3 x 28) + (2 x 30) + (26)]/6 = 28 1/3
November 16
[(3 x 18) + (2 x 28) + (30)]/6 = 23 1/3
December 14
[(3 x 16) + (2 x 18) + (28)]/6 = 18 2/3

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 Exponential Smoothing
► Form of weighted moving average
► Requires smoothing constant ()
► Ranges from 0 to 1
► Subjectively chosen
► Involves little record keeping of past
data

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 Exponential Smoothing
New forecast = Last period’s forecast
+  (Last period’s actual demand
– Last
period’s forecast)
Ft = Ft – 1 + (At – 1 - Ft – 1)

where Ft = new forecast

Ft – 1 = previous period’s forecast
 = smoothing (or weighting) constant (0 ≤  ≤ 1)
At – 1 = previous period’s actual demand

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 Exponential Smoothing
Example
Predicted demand = 142 Ford Mustangs
Actual demand = 153
Smoothing constant  = .20

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 Exponential Smoothing
Example
Predicted demand = 142 Ford Mustangs
Actual demand = 153
Smoothing constant  = .20

New forecast = 142 + .2(153 – 142)

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 Exponential Smoothing
Example
Predicted demand = 142 Ford Mustangs
Actual demand = 153
Smoothing constant  = .20

New forecast = 142 + .2(153 – 142)

= 142 + 2.2
= 144.2 ≈ 144 cars

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 Choosing 
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)

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 Determining the MAD
ACTUAL
TONNAGE FORECAST WITH
QUARTER UNLOADED FORECAST WITH  = .10  = .50
1 180 175 175

2 168 175.50 = 175.00 + .10(180 – 175) 177.50

3 159 174.75 = 175.50 + .10(168 – 175.50) 172.75

4 175 173.18 = 174.75 + .10(159 – 174.75) 165.88

5 190 173.36 = 173.18 + .10(175 – 173.18) 170.44

6 205 175.02 = 173.36 + .10(190 – 173.36) 180.22

7 180 178.02 = 175.02 + .10(205 – 175.02) 192.61

8 182 178.22 = 178.02 + .10(180 – 178.02) 186.30

9 ? 178.59 = 178.22 + .10(182 – 178.22) 184.15

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 Determining the MAD
ACTUAL FORECAST ABSOLUTE FORECAST ABSOLUTE
TONNAGE WITH DEVIATION WITH DEVIATION
QUARTER UNLOADED  = .10 FOR a = .10  = .50 FOR a = .50
1 180 175 5.00 175 5.00

2 168 175.50 7.50 177.50 9.50

3 159 174.75 15.75 172.75 13.75

4 175 173.18 1.82 165.88 9.12

5 190 173.36 16.64 170.44 19.56

6 205 175.02 29.98 180.22 24.78

7 180 178.02 1.98 192.61 12.61

8 182 178.22 3.78 186.30 4.30

Sum of absolute deviations: 82.45 98.62

Σ|Deviations|
MAD = 10.31 12.33
n

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 Mean Squared Error (MSE)

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 Determining the MSE
ACTUAL
TONNAGE FORECAST FOR
QUARTER UNLOADED  = .10 (ERROR)2
1 180 175 52 = 25
2 168 175.50 (–7.5)2 = 56.25
3 159 174.75 (–15.75)2 = 248.06
4 175 173.18 (1.82)2 = 3.31
5 190 173.36 (16.64)2 = 276.89
6 205 175.02 (29.98)2 = 898.80
7 180 178.02 (1.98)2 = 3.92
8 182 178.22 (3.78)2 = 14.29
Sum of errors squared = 1,526.52

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 Trend Projections
Fitting a trend line to historical data points to
project into the medium to long-range
Linear 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
b= slope of the regression line
x= the independent variable

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 Values of Dependent Variable (y-values) Least Squares Method
Actual observation Deviation7
(y-value)

Deviation5 Deviation6

Deviation3
Least squares method minimizes the
sum of Deviation
the squared
4
errors (deviations)

Deviation1
(error) Deviation2
Trend line, ^y = a + bx

| | | | | | |
1 2 3 4 5 6 7
Figure 4.4
Time period
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 Least Squares Method
Equations to calculate the regression variables

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 Least Squares Example

ELECTRICAL ELECTRICAL
YEAR POWER DEMAND YEAR POWER DEMAND
1 74 5 105
2 79 6 142
3 80 7 122
4 90

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 Least Squares Example
ELECTRICAL POWER
YEAR (x) DEMAND (y) x2 xy
74 1 74
1
79 4 158
2
80 9 240
3
90 16 360
4
105 25 525
5
142 36 852
6
122 49 854
7
Σx = 28 Σy = 692 Σx2 = 140 Σxy = 3,063

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 Least Squares Example
ELECTRICAL POWER
YEAR (x) DEMAND (y) x2 xy
74 1 74
1
79 4 158
2
80 9 240
3
90 16 360
4
105 25 525
5
142 36 852
6 Demand in year 8 = 56.70 + 10.54(8)
122 = 141.02, or 141
49 megawatts 854
7
Σx = 28 Σy = 692 Σx2 = 140 Σxy = 3,063

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 Least Squares Example
Trend line,
160 – ^y = 56.70 + 10.54x

150 –
Power demand (megawatts)

140 –
130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
50 –
| | | | | | | | |
1 2 3 4 5 6 7 8 9
Year Figure 4.5
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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 = value of the dependent variable (in
our example, sales)
a = y-axis intercept
b = slope of the regression line
x = the independent variable

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 Associative Forecasting
Example
NODEL’S SALES AREA PAYROLL NODEL’S SALES AREA PAYROLL
(IN $ MILLIONS), y (IN $ BILLIONS), x (IN $ MILLIONS), y (IN $ BILLIONS), x
2.0 1 2.0 2
3.0 3 2.0 1
2.5 4 3.5 7

4.0 –
Nodel’s sales
(in$ millions)

3.0 –

2.0 –

1.0 –

| | | | | | |

0 1 2 3 4 5 6 7
Area payroll (in $ billions)
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 Associative Forecasting
Example
SALES, y PAYROLL, x x2 xy
2.0 1 1 2.0
3.0 3 9 9.0
2.5 4 16 10.0
2.0 2 4 4.0
2.0 1 1 2.0
3.5 7 49 24.5
Σy = 15.0 Σx = 18 Σx2 = 80 Σxy = 51.5

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 Associative Forecasting
Example
SALES, y PAYROLL, x x2 xy
2.0 1 1 2.0
3.0 3 9 9.0
2.5 4 16 10.0
2.0 2 4 4.0
2.0 1 1 2.0
3.5 7 49 24.5
Σy = 15.0 Σx = 18 Σx2 = 80 Σxy = 51.5

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 Associative Forecasting
Example
SALES, y PAYROLL, x x2 xy
2.0 1 1 2.0
3.0 4.0 – 3 9 9.0
Nodel’s sales
(in$ millions)

2.5 4 16 10.0
3.0 –
2.0 2 4 4.0
2.0 2.0 – 1 1 2.0
3.5 7 49 24.5
1.0 –
Σy = 15.0 Σx = 18 Σx2 = 80 Σxy = 51.5
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll (in $ billions)

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 Associative Forecasting
Example

If payroll next year is estimated to be $6 billion,

then:

Sales (in $ millions) = 1.75 + .25(6)

= 1.75 + 1.5 = 3.25

Sales = $3,250,000

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 Associative Forecasting
Example

If payroll4.0
next
–
year is estimated to be $6 billion,
then: 3.25
Nodel’s sales
(in$ millions)

3.0 –

2.0 –
Sales (in$ millions) = 1.75 + .25(6)
1.0 –
= 1.75 + 1.5 = 3.25
| | | | | | |
0 1 2 3 4 5 6 7
Sales = $3,250,000
Area payroll (in $ billions)

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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

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 Correlation Coefficient
Figure 4.10
y y

x x
(a) Perfect negative (e) Perfect positive
correlation y correlation
y

y
x x
(b) Negative correlation (d) Positive correlation

x
(c) No correlation

High Moderate Low Low Moderate High

| | | | | | | | |

–1.0 –0.8 –0.6 –0.4 –0.2 0 0.2 0.4 0.6 0.8 1.0
Correlation coefficient values

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 Correlation Coefficient
y x x2 xy y2
2.0 1 1 2.0 4.0
3.0 3 9 9.0 9.0
2.5 4 16 10.0 6.25
2.0 2 4 4.0 4.0
2.0 1 1 2.0 4.0
3.5 7 49 24.5 12.25
Σy = 15.0 Σx = 18 Σx2 = 80 Σxy = 51.5 Σy2 = 39.5

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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

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:

An improved correlation coefficient of r = .96 suggests

this model does a better job of predicting the change
in construction sales

Sales = 1.80 + .30(6) - 5.0(.12) = 3.00

Sales = $3,000,000

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 Monitoring and Controlling
Forecasts
Tracking Signal
► Measures how well the forecast is predicting
actual values
► Ratio of cumulative forecast errors 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 Cumulative error
signal =
MAD

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 Tracking Signal Example
ABSOLUTE CUM ABS TRACKING
ACTUAL FORECAST CUM FORECAST FORECAST SIGNAL (CUM
QTR DEMAND DEMAND ERROR ERROR ERROR ERROR MAD ERROR/MAD)
1 90 100 –10 –10 10 10 10.0 –10/10 = –1

2 95 100 –5 –15 5 15 7.5 –15/7.5 = –2

3 115 100 +15 0 15 30 10. 0/10 = 0

4 100 110 –10 –10 10 40 10. 10/10 = –1

5 125 110 +15 +5 15 55 11.0 +5/11 = +0.5

6 140 110 +30 +35 30 85 14.2 +35/14.2 = +2.5

At the end of quarter 6,

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