Forecasting

McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Forecast
Forecast – a statement about the future value of a
variable of interest
 We make forecasts about such things as weather,
demand, and resource availability
 Forecasts are an important element in making informed
decisions

Instructor Slides 3-2

Forecasts affect decisions and activities throughout an
organization

Accounting Cost/profit estimates

Finance Cash flow and funding

Human Resources Hiring/recruiting/training

Marketing Pricing, promotion, strategy

MIS IT/IS systems, services

Operations Schedules, MRP, workloads

Product/service design New products and services

 Elements of a Good Forecast
The forecast
 should be timely
 should be accurate
 should be reliable
 should be expressed in meaningful units
 should be in writing
 technique should be simple to understand and use
 should be cost effective

Instructor Slides 3-4

Forecasting Approaches
 Qualitative Forecasting
 Qualitative techniques permit the inclusion of soft information such as:
 Human factors
 Personal opinions
 Hunches
 These factors are difficult, or impossible, to quantify

 Quantitative Forecasting
 Quantitative techniques involve either the projection of historical data or
the development of associative methods that attempt to use causal
variables to make a forecast
 These techniques rely on hard data
Forecasting Techniques
 Judgmental Forecasts (Qualitative)
 Forecasts that use subjective inputs such as opinions from consumer
surveys, sales staff, managers, executives, and experts.

 Time-Series Forecasts (Quantitative)

 Forecasts that project patterns identified in recent time-series observations.

 Associative Model (Quantitative)

 Forecasting technique that uses explanatory variables to predict future
demand.
Judgmental Forecasts
Forecasts that use subjective inputs such as
opinions from consumer surveys, sales staff,
managers, executives, and experts

 Salesforce opinions
 Executive opinions
 Consumer surveys
 Delphi method
 Time-Series Forecasts
Forecasts that project patterns identified in recent
time-series observations
 Time-series - a time-ordered sequence of observations
taken at regular time intervals
Assume that future values of the time-series can be
estimated from past values of the time-series

Instructor Slides 3-8

 Time-Series Behaviors
Trend
Seasonality
Cycles
Irregular variations
Random variation

Instructor Slides 3-9

Trends and Seasonality
 Trend
 A long-term upward or downward movement in data
 Population shifts
 Changing income

 Seasonality
 Short-term, fairly regular variations related to the calendar or time
of day
 Restaurants, service call centers, and theaters all experience
seasonal demand
Cycles and Variations
 Cycle
 Wavelike variations lasting more than one year
 These are often related to a variety of economic, political, or even
agricultural conditions
 Random Variation
 Residual variation that remains after all other behaviors have been
accounted for
 Irregular variation
 Due to unusual circumstances that do not reflect typical behavior
 Labor strike
 Weather event
 Time-Series Behaviors

Instructor Slides 3-12

 Time-Series Forecasting - Naïve Forecast
Naïve Forecast
 Uses a single previous value of a time series as the basis
for a forecast
The forecast for a time period is equal to the
previous time period’s value
 Can be used with
a stable time series
seasonal variations
trend

Instructor Slides 3-13

Naïve Forecasts

Forecast for any period = previous period’s

actual value

Ft = At-1
F: forecast A: Actual t: time period
Naïve Forecast Example

Week Sales (actual) Sales (forecast) Error

t A F A-F
1 20 -
2 25 20 5
3 15 25 -10
4 30 15 15
5 27 30 -3
Naïve Forecasts
Simple to use
Virtually no cost
Quick and easy to prepare
Data analysis is nonexistent
Easily understandable
Cannot provide high accuracy
Can be a standard for accuracy
Uses for Naïve Forecasts
 Time-Series Forecasting - Averaging
These Techniques work best when a series tends to
vary about an average
 Averaging techniques smooth variations in the data
 They can handle step changes or gradual changes in the
level of a series
 Techniques
1. Moving average
2. Weighted moving average
3. Exponential smoothing

Instructor Slides 3-18

 Moving Average
Technique that averages a number of the most recent
actual values in generating a forecast
n

A t i
Ft  MA n  i 1
n
where
Ft  Forecast for time period t
MA n  n period moving average
At 1  Actual value in period t  1
n  Number of periods in the moving average
Instructor Slides 3-19
 Moving Average
As new data become available, the forecast is updated
by adding the newest value and dropping the oldest
and then re-computing the average
The number of data points included in the average
determines the model’s sensitivity
 Fewer data points used-- more responsive
 More data points used-- less responsive

Instructor Slides 3-20

Moving Average Example

Week Sales (actual) Sales (forecast) Error

t A F = MA3 A-F
20
1 -  

2 25 -  

3 15 -  

4 30 20 10

5 27 23.3333 3.66667

6   24  
Simple Moving Average
Responsiveness vs. Stability
• Smaller m, responsiveness , stability 
• Larger m, responsiveness , stability 
• Must maintain stability when fluctuations are high.
Figure 3-4 Revised Forecast Forecast
Actual (MA3) (MA5)
47
45
43
41
39
37
35
1 2 3 4 5 6 7 8 9 10 11 12
3-22
 Weighted Moving Average
The most recent values in a time series are given more
weight in computing a forecast
 The choice of weights, w, is somewhat arbitrary and
involves some trial and error
Ft  wt ( At )  wt 1 ( At 1 )  ...  wt  n ( At  n )
where
wt  weight for period t , wt 1  weight for period t  1, etc.
At  the actual value for period t , At 1  the actual value for period t  1, etc.

Instructor Slides 3-23

Weighted Moving Average Example

Week Sales (actual) Sales (forecast) Error

t A F = MA3 A-F
1 20 -
2 25 -
3 15 -
4 30 19 11
5 27 24.5 2.5
6 25.5
 Exponential Smoothing
A weighted averaging method that is based on the
previous forecast plus a percentage of the forecast
error
Ft  Ft 1   ( At 1  Ft 1 )
where
Ft  Forecast for period t
Ft 1  Forecast for the previous period
 = Smoothing constant
At 1  Actual demand or sales from the previous period

Instructor Slides 3-25

Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

Exponential Smoothing method based on previous
forecast plus a percentage of the previous forecast
error.
A-F is the error term,  is the % feedback
 Example 3 - Exponential Smoothing

Period Actual Alpha = 0.1 Error Alpha = 0.4 Error

1 42
2 40 42 -2.00 42 -2
3 43 41.8 1.20 41.2 1.8
4 40 41.92 -1.92 41.92 -1.92
5 41 41.73 -0.73 41.15 -0.15
6 39 41.66 -2.66 41.09 -2.09
7 46 41.39 4.61 40.25 5.75
8 44 41.85 2.15 42.55 1.45
9 45 42.07 2.93 43.13 1.87
10 38 42.36 -4.36 43.88 -5.88
11 40 41.92 -1.92 41.53 -1.53
12 41.73 40.92
Picking a Smoothing Constant

Actual
50
.4
45  .1
Demand

40

35
1 2 3 4 5 6 7 8 9 10 11 12
Period
 Associative Forecasting Techniques
Associative techniques are based on the
development of an equation that summarizes
the effects of predictor variables
Predictor variables - variables that can be used to
predict values of the variable of interest
Home values may be related to such factors as home and
property size, location, number of bedrooms, and number
of bathrooms

Instructor Slides 3-29

 Simple Linear Regression
Regression - a technique for fitting a line to a set of
data points
 Simple linear regression - the simplest form of
regression that involves a linear relationship between
two variables
The object of simple linear regression is to obtain an
equation of a straight line that minimizes the sum of
squared vertical deviations from the line (i.e., the least
squares criterion)

Instructor Slides 3-30

 Simple Linear Regression

Instructor Slides 3-31

 Backup

Instructor Slides 4-32

 Simple Linear Regression Assumptions
1. Variations around the line are random
2. Deviations around the average value (the line)
should be normally distributed
3. Predictions are made only within the range of
observed values

Instructor Slides 3-33

 Least Squares Line
yc  a  bx
where
yc  Predicted (dependent) variable
x  Predictor (independe nt) variable
b  Slope of the line
a  Value of yc when x  0 (i.e., the height of the line at the y intercept)
and
n xy   x  y 
b
n x 2   x 
2

a
 y  b x
or y  b x
n
where
n  Number of paired observatio ns
Instructor Slides 3-34
 Forecast Accuracy and Control
Forecasters want to minimize forecast errors
 It is nearly impossible to correctly forecast real-world
variable values on a regular basis
 So, it is important to provide an indication of the extent
to which the forecast might deviate from the value of the
variable that actually occurs
Forecast accuracy should be an important forecasting
technique selection criterion
 Error = Actual – Forecast
 If errors fall beyond acceptable bounds, corrective action
may be necessary

Instructor Slides 3-35

 Sources of forecast errors
The model may be inadequate.
Irregular variation may be occur.
The forecasting technique may be used incorrectly or
the results misinterpreted.
There are always random variation in the data.
 Monitoring the Forecast
 Tracking forecast errors and analyzing them can provide useful
insight into whether forecasts are performing satisfactorily
 Sources of forecast errors
 The model may be inadequate
 Irregular variations may have occurred
 The forecasting technique has been incorrectly applied
 Random variation
 Control charts are useful for identifying the presence of non-
random error in forecasts
 Tracking signals can be used to detect forecast bias

Instructor Slides 3-37

 Choosing a Forecasting Technique
Factors to consider
 Cost
 Accuracy
 Availability of historical data
 Availability of forecasting software
 Time needed to gather and analyze data and prepare a
forecast
 Forecast horizon

Instructor Slides 3-38

 Thank You

Instructor Slides 4-39