Operations

Management
Chapter 4 –
Forecasting
 Learning Objectives
When you complete this chapter you should
be able to :
1. Understand the three time horizons and
which models apply for each use
2. Explain when to use each of the four
qualitative models
3. Apply the naive, moving average, exponential
smoothing, and trend methods
 Learning Objectives
When you complete this chapter you should
be able to :
4. Compute three measures of forecast accuracy
5. Develop seasonal indices
6. Conduct a regression
 What is Forecasting?
► Process of predicting a
future event
► Underlying basis
of all business decisions
??
► Weather
► Inventory
► Personnel
 Forecasting Time Horizons
1. Short-range forecast
► Up to 1 year, generally less than 3 months
► Purchasing, job scheduling, workforce levels,
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
 Distinguishing Differences
1. Medium/long range forecasts deal with more
comprehensive issues and support
management decisions regarding planning
and products, plants and processes
2. Short-term forecasting usually employs
different methodologies than longer-term
forecasting
3. Short-term forecasts tend to be more
accurate than longer-term forecasts
 Types of Forecasts
1. Economic forecasts
► Address business cycle – inflation rate, money
supply, housing starts, etc.
2. Technological forecasts
► Predict rate of technological progress
► Impacts development of new products
3. Demand forecasts
► Predict sales of existing products and services
 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
 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
 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
 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
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
Overview of Qualitative Methods

3. Sales force composite

► Estimates from individual salespersons
are reviewed for reasonableness, then
aggregated
4. Market Survey
► Ask the customer
 Overview of Quantitative
Approaches
1. Naive approach
2. Moving averages
3. Exponential Time-series
smoothing models
4. Trend projection
Associative
5. Linear regression
model
 Time-Series Forecasting

► Set of evenly spaced numerical data

► Obtained by observing response
variable at regular time periods
► Forecast based only on past values, no
other variables important
► Assumes that factors influencing past
and present will continue influence in
future
Time-Series Components

Trend Cyclical

Seasonal Random
 Trend Component

► Persistent, overall upward or

downward pattern
► Changes due to population,
technology, age, culture, etc.
► Typically several years duration
 Seasonal Component
► Regular pattern of up and down
fluctuations
► Due to weather, customs, etc.
► Occurs within a single year
 Cyclical Component
► Repeating up and down movements
► Affected by business cycle, political,
and economic factors
► Multiple years duration
► Often causal or
associative
relationships

0 5 10 15 20
 Random Component
► Erratic, unsystematic, ‘residual’
fluctuations
► Due to random variation or unforeseen
events
► Short duration
and nonrepeating

M T W T
F
 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
 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

Moving average =
å demand in previous n periods
n
 3 Month Moving Average
Example
MONTH ACTUAL SHED SALES 3-MONTH MOVING AVERAGE
January 10
February 12
March 13
April 16 (10 + 12 + 13)/3 = 11,66
May 19 (12 + 13 + 16)/3 = 13,67
June 23 (13 + 16 + 19)/3 = 16
July 26 (16 + 19 + 23)/3 = 19,33
August 30 (19 + 23 + 26)/3 = 22,67
September 28 (23 + 26 + 30)/3 = 26,33
October 18 (26 + 30 + 28)/3 = 28
November 16 (30 + 28 + 18)/3 = 25,33
December 14 (28 + 18 + 16)/3 = 20,67
 Weighted Moving Average
► Used when some trend might be
present
► Older data usually less important
► Weights based on experience and
intuition

(( )(
Weighted å Weight for period n Demand in period n
moving =
))
average å Weights
 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
June WEIGHTS
23 APPLIED PERIOD

July 26 3 Last month

August 30 2 Two months ago

September 28 1 Three months ago

October 18 6 Sum of the weights

November Forecast for

16this month =
December 3 x14
Sales last mo. + 2 x Sales 2 mos. ago + 1 x Sales 3 mos. ago
Sum of the weights
 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 = 12,17
May 19 [(3 x 16) + (2 x 13) + (12)]/6 = 14,33
June 23 [(3 x 19) + (2 x 16) + (13)]/6 = 17
July 26 [(3 x 23) + (2 x 19) + (16)]/6 = 20,5
August 30 [(3 x 26) + (2 x 23) + (19)]/6 = 23,83
September 28 [(3 x 30) + (2 x 26) + (23)]/6 = 27,5
October 18 [(3 x 28) + (2 x 30) + (26)]/6 = 28,33
November 16 [(3 x 18) + (2 x 28) + (30)]/6 = 23,33
December 14 [(3 x 16) + (2 x 18) + (28)]/6 = 18,67
 Potential Problems With
Moving Average
► Increasing n smooths the forecast but
makes it less sensitive to changes
► Does not forecast trends well
► Requires extensive historical data
 Graph of Moving Averages
Weighted moving average
30 –

25 –

20 –
Sales demand

15 – Actual sales

10 – Moving average

5–
| | | | | | | | | | | |

J F M A M J J A S O N D
Figure 4.2
Month

© 2014 Pearson Education, Inc. 4 - 28

 Exponential Smoothing
► Form of weighted moving average
► Weights decline exponentially
► Most recent data weighted most
► Requires smoothing constant ()
► Ranges from 0 to 1
► Subjectively chosen
► Involves little record keeping of past
data
 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
 Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs

Actual demand = 153
Smoothing constant  = .20

© 2014 Pearson Education, Inc. 4 - 31

 Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs

Actual demand = 153
Smoothing constant  = .20

New forecast = 142 + .2(153 – 142)

© 2014 Pearson Education, Inc. 4 - 32

 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

© 2014 Pearson Education, Inc. 4 - 33

 Forecast Error
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
Common Measures of Error

Mean Absolute Deviation (MAD)

MAD =
å Actual - Forecast
n
 Determining the MAD

During the past 8 quarters, the Port of Baltimore has unloaded

large quantities of grain from ships. The port’s operations manager
wants to test the use of exponential smoothing to see how well
the technique works in predicting tonnage unloaded. He guesses
that the forecast of grain unloaded in the first quarter was 175
tons. Two values of α are to be examined : α=.10 or α=.50
 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

 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
Common Measures of Error

Mean Squared Error (MSE)

å (Forecast errors)
2

MSE =
n
 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

å (Forecast errors)
2

MSE = = 1,526.52 / 8 = 190.8

n
Common Measures of Error

Mean Absolute Percent Error (MAPE)

n

å100 Actual -Forecast

i i
/ Actuali
MAPE = i=1
n
 Determining the MAPE
ACTUAL
TONNAGE FORECAST FOR ABSOLUTE PERCENT ERROR
QUARTER UNLOADED  = .10 100(ERROR/ACTUAL)
1 180 175.00 100(5/180) = 2.78%
2 168 175.50 100(7.5/168) = 4.46%
3 159 174.75 100(15.75/159) = 9.90%
4 175 173.18 100(1.82/175) = 1.05%
5 190 173.36 100(16.64/190) = 8.76%
6 205 175.02 100(29.98/205) = 14.62%
7 180 178.02 100(1.98/180) = 1.10%
8 182 178.22 100(3.78/182) = 2.08%
Sum of % errors = 44.75%

MAPE =
å absolute percent error 44.75%
= = 5.59%
n 8
 Comparison of Forecast Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded  = .10  = .10  = .50  = .50
1 180 175 5.00 175 5.00
2 168 175.5 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
82.45 98.62
 Comparison of Forecast Error
∑ |deviations|
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
MADTonnage
= with for with for
Quarter Unloaded
n
a = .10 a = .10  = .50  = .50
1 For  =180
.10 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 = 82.45/8
174.75 = 10.31
15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 For  =190
.50 173.36 16.64 170.44 19.56
6 205 = 175.02
98.62/8 = 29.98
12.33 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
 Comparison of Forecast Error
∑ (forecast errors)
Rounded 2
Absolute Rounded Absolute
MSE = Actual Forecast Deviation Forecast Deviation

Quarter
Tonnage
Unloaded
n
with
a = .10
for
a = .10
with
 = .50
for
 = .50
1 For  =180
.10 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 = 1,526.54/8
159 174.75 = 190.82
15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 For  =190
.50 173.36 16.64 170.44 19.56
6 205 175.02
= 1,561.91/8 = 29.98
195.24 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
 Comparison
n
of Forecast Error
∑100|deviation
Rounded i|/actuali Rounded
Absolute Absolute
Actual
MAPE =Tonnage
i=1 Forecast Deviation Forecast Deviation
with for with for
Quarter Unloaded a = .10 n a = .10 a = .50  = .50
1 For 180
= .10 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 = 44.75/8
174.75 = 5.59%
15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 For 190
= .50 173.36 16.64 170.44 19.56
6 205 = 175.02
54.05/8 29.98
= 6.76% 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 190.82 195.24
 Comparison of Forecast Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded  = .10  = .10  = .50  = .50
1 180 175 5.00 175 5.00
2 168 175.5 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
82.45 98.62
MAD 10.31 12.33
MSE 190.82 195.24
MAPE 5.59% 6.76%
 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
 Least Squares Method
Equations to calculate the regression variables

ŷ = a + bx

b=
å xy - nxy
å x - nx
2 2

a = y - bx
© 2014 Pearson Education, Inc. 4 - 49
 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
 Least Squares Example
ELECTRICAL POWER
YEAR (x) DEMAND (y) x2 xy
1 74 1 74
2 79 4 158
3 80 9 240
4 90 16 360
5 105 25 525
6 142 36 852
7 122 49 854
Σx = 28 Σy = 692 Σx2 = 140 Σxy = 3,063

x=
å x 28
= =4 y=
å y 692
= = 98.86
n 7 n 7
 Least Squares Example
å xy - nxy 3,063 - ( 7) ( 4) (98.86) 295
b= = POWER = = 10.54
å x - nxDEMAND (y)140 - (7) ( 4 ) x 28
ELECTRICAL
2 2 2 2
YEAR (x) xy
1 74 1 74

()
2 79 4 158
3
a = y - bx = 98.8680
-10.54 4 = 56.70 9 240
4 90 16 360
5 105 ŷ = 56.70 +10.54x25
Thus, 525
6 142 36 852
7 122 49 854
Σx = 28 Σy = 692 Σx2 = 140 Σxy = 3,063

x=
å
Demandx in28
=
å
year 8 = 56.70 +y 10.54(8)
= 4 = y141.02,
= =
692
= 98.86
n 7 n or 141
7 megawatts
 Least Squares Example
Trend line,
160 – y^ = 56.70 + 10.54x
150 –
140 –
Power demand (megawatts)

130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
50 –
| | | | | | | | |
1 2 3 4 5 6 7 8 9
Year Figure 4.5
Least Squares Requirements

1. We always plot the data to insure a

linear relationship
2. We do not predict time periods far
beyond the database
3. Deviations around the least squares
line are assumed to be random
 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
 Correlation Coefficient
Figure 4.10
y y

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

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
 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
 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

ŷ = a + b1x1 + b2 x2

Computationally, this is quite complex and

generally done on the computer