Chapter 4 – Forecasting

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5.1 Introduction to Forecasting

Forecasts are a basic input in the decision processes of operations

management because they provide information on future demand.

The importance of forecasting to operations management cannot be

overstated. The primary goal of operations management is to match supply
to demand.

Having a forecast of demand is essential for determining how much capacity

or supply will be needed to meet demand.

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5.1 Introduction to Forecasting

For instance, operations needs to know what capacity will be needed to

make staffing and equipment decisions, budgets must be prepared,
purchasing needs information for ordering from suppliers, and supply chain
partners need to make their plans.

Businesses make plans for future operations based on anticipated future

demand. Anticipated demand is derived from two possible sources, actual
customer orders and forecasts.

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5.1 Introduction to Forecasting

Two aspects of forecasts are important. One is the expected level of

demand; the other is the degree of accuracy that can be assigned to a
forecast (i.e., the potential size of forecast error).

The expected level of demand can be a function of some structural

variation, such as a trend or seasonal variation.

Forecast accuracy is a function of the ability of forecasters to correctly

model demand, random variation, and sometimes unforeseen events.

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5.2 Explain why forecasts are generally wrong

1. Forecasting techniques generally assume that the same underlying causal system that
existed in the past will continue to exist in the future.

2. Forecasts are not perfect; actual results usually differ from predicted values; the ­
presence of randomness precludes a perfect forecast. Allowances should be made for
forecast errors.

3. Forecasts for groups of items tend to be more accurate than forecasts for individual
items because forecasting errors among items in a group usually have a canceling
effect.

4. Forecast accuracy decreases as the time period covered by the forecast—the time ­
horizon—increases.
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5.3 Elements of Good Forecast

1. The forecast should be timely referred. Usually, a certain amount of time

is needed to respond to the information contained in a forecast.

• For example, capacity cannot be expanded overnight, nor can inventory levels be
changed immediately. Hence, the forecasting horizon must cover the time
necessary to implement possible changes.

2. The forecast should be accurate, and the degree of accuracy should be

stated. This will enable users to plan for possible errors and will provide a
basis for comparing alternative forecasts.

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5.3 Elements of Good Forecast

3. The forecast should be reliable; it should work consistently. A technique

that sometimes provides a good forecast and sometimes a poor one will
leave users with the uneasy feeling that they may get burned every time
a new forecast is issued.

4. The forecast should be expressed in meaningful units. Financial planners

need to know how many dollars will be needed, production planners
need to know how many units will be needed, and schedulers need to
know what machines and skills will be required. The choice of units
depends on user needs.

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5.3 Elements of Good Forecast

5. The forecast should be in writing. Although this will not guarantee that
all concerned are using the same information, it will at least increase the
likelihood of it.
6. The forecasting technique should be simple to understand and use.

7. The forecast should be cost-effective: The benefits should outweigh the

costs.

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5.4 Outline the steps in the forecasting process.

There are six basic steps in the forecasting process:

1. Determine the purpose of the forecast. How will it be used and when
will it be needed? This step will provide an indication of the level of
detail required in the forecast, the amount of resources (personnel,
computer time, dollars) that can be justified, and the level of accuracy
necessary.

2. Establish a time horizon. The forecast must indicate a time interval,

keeping in mind that accuracy decreases as the time horizon increases.

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5.4 Outline the steps in the forecasting process.

3. Obtain, clean, and analyze appropriate data. Obtaining the data can
involve significant effort. Once obtained, the data may need to be
“cleaned” to get rid of outliers and obviously incorrect data before
analysis.

4. Select a forecasting technique.

5. Make the forecast.

6. Monitor the forecast errors. The forecast errors should be monitored to

determine if the forecast is performing in a satisfactory manner

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Forecasting Error

Forecast error is the difference between the value that occurs and the value
that was predicted for a given time period.

Hence, Error = Actual − Forecast: et = At - Ft

Where t = Any given time period

Positive errors result when the forecast is too low, negative errors when
the forecast is too high. For example, if actual demand for a week is 100
units and forecast demand was 90 units, the forecast was too low; the error
is 100 − 90 = +10.
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5.5 Approaches to Forecasting

There are two general approaches to forecasting: qualitative and

quantitative.

Qualitative methods consist mainly of subjective inputs, which often defy

precise numerical description.

Quantitative methods involve either the projection of historical data or the

development of associative models that attempt to utilize causal
(explanatory) variables to make a forecast.

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5.5 Approaches to Forecasting (Qualitative Forecasts)

In some situations, forecasters rely solely on judgment and opinion to make

forecasts. In such instances, forecasts are based on executive opinions,
consumer surveys, opinions of the sales staff, and opinions of experts.

1. Executive Opinions
A small group of upper-level managers may meet and collectively develop a
forecast.

2. Salesforce Opinions
Members of the customer service staff are good sources of information
because of their direct contact with consumers.

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5.5 Approaches to Forecasting (Qualitative Forecasts)

3. Consumer Surveys
it is the consumers who ultimately determine demand,

4. Delphi Method (Opinions of Experts)

involves circulating a series of questionnaires among individuals who
possess the knowledge and ability to contribute meaningfully.

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5.5 Approaches to Forecasting (Quantitative Forecasts)

FORECASTS BASED ON TIME-SERIES DATA

A time series is a time-ordered sequence of observations taken at regular

intervals (e.g., hourly, daily, weekly, monthly, quarterly, annually).

Forecasting techniques based on time-series data are made on the

assumption that future values of the series can be estimated from past
values.

Although no attempt is made to identify variables that influence the series,

these methods are widely used, often with quite satisfactory results

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5.5 Approaches to Forecasting (Quantitative Forecasts)

Analysis of time-series data requires the analyst to identify the underlying

behavior of the series. These behaviors can be classified as follows:

1. Trend
2. Seasonality
3. Cycles

4. Irregular Variations - are due to unusual circumstances such as severe

weather conditions, strikes, or a major change in a product or service.

5. Random Variations - are residual variations that remain after all other
behaviors have been accounted for.
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Trends

A long-term upward or downward movement in data. Population shifts,

changing incomes, and cultural changes often account for such movements.

Trend with
random and
irregular
variations

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Seasonality

Seasonality refers to short-term, fairly regular variations generally related to

factors such as the calendar or time of day. Restaurants, supermarkets, and
theaters experience weekly and even daily “seasonal” variations.

Seasonal with
random and
irregular
variations

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Cycles

Cycles are wavelike variations of more than one year’s duration. These are
often related to a variety of economic, political.

Cycles with
random and
irregular
variations

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NAÏVE METHOD (Quantitative)

A naive forecast uses a single previous value of a time series as the basis of a
forecast. The naive approach can be used with a stable series (variations
around an average), with seasonal variations, or with trend.

1. Stable series - the last data point becomes the forecast for the next
period.
2. Seasonal variations - the forecast for this “season” is equal to the value
of the series last “season.”

3. Trend - the forecast is equal to the last value of the series plus or minus
the difference between the last two values of the series

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NAÏVE METHOD (Trend Example)

Period Actual Changes from Forecast

previous value
1 50
2 53 +3
3 53+3 = 56

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Techniques for Averaging (Quantitative)

Averaging techniques generate forecasts that reflect recent values of a time

series (e.g., the average value over the last several periods).

These techniques work best when a series tends to vary around an average,
although they also can handle step changes or gradual changes in the level
of the series.

Two techniques for averaging:

1. Moving average
2. Weighted moving average

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Moving Average (Quantitative)

A moving average forecast uses a number of the most recent actual data
values in generating a forecast. The moving average forecast can be
computed using the following equation:
where

Ft = Forecast for time period t

MAn = n period moving average

At−i = Actual value in period t − i

n = Number of periods (data points) in the

moving average

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Moving Average (Quantitative) - Example

Compute a three-period moving average forecast given demand for

shopping carts for the last five periods.

Period Actual
1 42  
2 40
3 43
The 3 most
4 40 recent
demand
5 41

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Weighted Moving Average (Quantitative)

A weighted average is similar to a moving average, except that it typically

assigns more weight to the most recent values in a time series.

where

wt−1 = Weight for period t − 1, etc.

At−1 = Actual value for period t − 1, etc.

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Weighted Moving Average (Quantitative) - Example

Given the following demand data, Compute a weighted average forecast

using a weight of .40 for the most recent period, .30 for the next most
recent, .20 for the next, and .10 for the next.

Period Actual
1 42 SOLUTION
2 40
F6 = .10(40) + .20(43) + .30(40) + .40(41) = 41.0
3 43
The 4 most
4 40 recent
demand
5 41

Note that if four weights are used, only the four most recent demands are used to prepare the forecast.

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