Chapter 3

Forecasting

(William J Stevenson)

1-1
 Learning Objectives

 List the elements of a good forecast.

 Outline the steps in the forecasting process.
 Describe at least three qualitative forecasting techniques and
the advantages and disadvantages of each.
 Compare and contrast qualitative and quantitative approaches
to forecasting.
 Briefly describe averaging techniques, trend and seasonal
techniques, and regression analysis, and solve typical
problems.
 Describe two measures of forecast accuracy.
 Describe two ways of evaluating and controlling forecasts.
 Identify the major factors to consider when choosing a
forecasting technique.

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 Forecasts

 A statement about the future value of a variable of interest

such as demand.

 Forecasting is used to make informed decisions.

 Long-range

 Short-range

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 Forecasts

 Forecasts affect decisions and activities throughout an

organization

 Accounting, finance
 Human resources
 Marketing
 MIS
 Operations
 Product/service design

3-4
Uses of Forecasts

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

3-5
 Features of Forecasts
 Assumes causal system past ==> future
 Forecasts rarely perfect because of randomness
 Forecasts more accurate for groups vs. individuals
 Forecast accuracy decreases as time horizon increases

I see that you will

get an A this semester.

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Elements of a Good Forecast

Timely

Reliable Accurate

e
f ul us
n g Written to
ni y
s
ea Ea
M

3-7
Steps in the Forecasting Process

“The forecast”

Step 6 Monitor the forecast

Step 5 Make the forecast
Step 4 Obtain, clean and analyze data
Step 3 Select a forecasting technique
Step 2 Establish a time horizon
Step 1 Determine purpose of forecast

3-8
 Approaches of Forecasting

 Judgmental - uses subjective inputs

 Time series - uses historical data assuming the future will be

like the past

 Associative models - uses explanatory variables to predict the

future

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 Judgmental Forecasts

 Executive opinions

 Sales force opinions

 Consumer surveys

 Outside opinion

 Delphi method
 Opinions of managers and staff
 Achieves a consensus forecast

3-10
 Time Series Forecasts

 Trend - long-term movement in data

 Seasonality - short-term regular variations in data

 Cycle – wavelike variations of more than one year’s duration

 Irregular variations - caused by unusual circumstances

 Random variations - caused by chance

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Forecast Variations
Figure 3.1

Irregular
variation

Trend

Cycles

90
89
88
Seasonal variations

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Naive Forecasts

Uh, give me a minute....

We sold 250 wheels last week....
Now, next week we should sell....

The forecast for any period

equals the previous period’s
actual value.

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 Naive 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

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 Uses for Naive Forecasts

 Stable time series data

 F(t) = A(t-1)

 Seasonal variations
 F(t) = A(t-1)

 Data with trends

 F(t) = A(t-1) + (A(t-1) – A(t-2))

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 Techniques for Averaging

 Moving average

 Weighted moving average

 Exponential smoothing

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 Moving Averages

 Moving average – A technique that averages a number of

recent actual values, updated as new values become available.

At-n + … At-2 + At-1

Ft = MAn=
n
 Weighted moving average – More recent values in a series are
given more weight in computing the forecast.

Ft = WMAn= wnAt-n + … wn-1At-2 + w1At-1

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Simple Moving Average

Actual
MA5
47
45
43
41
39
37 MA3
35
1 2 3 4 5 6 7 8 9 10 11 12

At-n + … At-2 + At-1

Ft = MAn=
n
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 Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

• Premise - The most recent observations might have the highest
predictive value.

 Therefore, we should give more weight to the more recent

time periods when forecasting.

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 Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

 Weighted averaging method based on previous forecast plus a

percentage of the forecast error

 A – F is the error term,  is a percentage

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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

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Picking a Smoothing Constant

Actual
50

.4  .1
Demand

45

40

35
1 2 3 4 5 6 7 8 9 10 11 12
Period

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Common Nonlinear Trends
Figure 3.5

Parabolic

Exponential

Growth

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 Linear Trend Equation

Ft

Ft = a + bt

0 1 2 3 4 5 t

 Ft = Forecast for period t

 t = Specified number of time periods
 a = Value of Ft at t = 0
 b = Slope of the line

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Calculating a and b

n  (ty) -  t y
b =
n t 2 - ( t) 2

 y - b t
a =
n

3-25
Linear Trend Equation Example

t y
2
W eek t S a le s ty
1 1 150 150
2 4 157 314
3 9 162 486
4 16 166 664
5 25 177 885

2
 t = 15  t = 55  y = 812  ty = 2 4 9 9
2
(  t) = 2 2 5

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Linear Trend Calculation

5 (2499) - 15(812) 12495 -12180

b = = = 6.3
5(55) - 225 275 -225

812 - 6.3(15)
a = = 143.5
5

y = 143.5 + 6.3t

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 Techniques for Seasonality

 Seasonal variations
 Regularly repeating movements in series values that can be
tied to recurring events.

 Seasonal relative
 Percentage of average or trend

 Centered moving average

 A moving average positioned at the center of the data that
were used to compute it.

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 Associative Forecasting

 Predictor variables - used to predict values of variable interest

 Regression - technique for fitting a line to a set of points

 Least squares line - minimizes sum of squared deviations

around the line

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Linear Model Seems Reasonable

X Y Computed
7 15 relationship
2 10
6 13 50

4 15 40

14 25 30

15 27 20

16 24 10

0
12 20 0 5 10 15 20 25

14 27
20 44
15 34
7 17
A straight line is fitted to a set of sample points.

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 Linear Regression Assumptions

 Variations around the line are random

 Deviations around the line normally distributed

 Predictions are being made only within the range of observed

values

 For best results:

 Always plot the data to verify linearity
 Check for data being time-dependent
 Small correlation may imply that other variables are
important

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 Forecast Accuracy

 Error - difference between actual value and predicted value

 Mean Absolute Deviation (MAD)

 Average absolute error

 Mean Squared Error (MSE)

 Average of squared error

 Mean Absolute Percent Error (MAPE)

 Average absolute percent error

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MAD, MSE, and MAPE

 Actual forecast
MAD =
n
2
 ( Actual  forecast)
MSE =
n -1

( Actual forecast / Actual) *100)

MAPE =
n

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 MAD, MSE and MAPE

 MAD
 Easy to compute
 Weights errors linearly

 MSE
 Squares error
 More weight to large errors

 MAPE
 Puts errors in perspective

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Example 10

Period Actual Forecast (A-F) |A-F| (A-F)^2 (|A-F|/Actual)*100

1 217 215 2 2 4 0.92
2 213 216 -3 3 9 1.41
3 216 215 1 1 1 0.46
4 210 214 -4 4 16 1.90
5 213 211 2 2 4 0.94
6 219 214 5 5 25 2.28
7 216 217 -1 1 1 0.46
8 212 216 -4 4 16 1.89
-2 22 76 10.26

MAD= 2.75
MSE= 10.86
MAPE= 1.28

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 Controlling the Forecast

 Control chart
 A visual tool for monitoring forecast errors
 Used to detect non-randomness in errors

 Forecasting errors are in control if

 All errors are within the control limits
 No patterns, such as trends or cycles, are present

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 Sources of Forecast Errors

 Model may be inadequate

 Irregular variations

 Incorrect use of forecasting technique

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 Tracking Signal

•Tracking signal
Ratio of cumulative error to MAD

 (Actual - forecast)
Tracking signal =
MAD

Bias – Persistent tendency for forecasts to be greater or

less than actual values.

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 Choosing a Forecasting Technique

 No single technique works in every situation

 Two most important factors

 Cost
 Accuracy

 Other factors include the availability of:

 Historical data
 Computers
 Time needed to gather and analyze the data
 Forecast horizon

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 Operations Strategy

 Forecasts are the basis for many decisions

 Work to improve short-term forecasts

 Accurate short-term forecasts improve

 Profits
 Lower inventory levels
 Reduce inventory shortages
 Improve customer service levels
 Enhance forecasting credibility

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 Supply Chain Forecasts

 Sharing forecasts with supply can

 Improve forecast quality in the supply chain
 Lower costs
 Shorter lead times

 Gazing at the Crystal Ball (reading in text)

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Exponential Smoothing

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Linear Trend Equation

3-43
Simple Linear Regression

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