FORECASTING

Topic 4

© Pearson Education
 Outline
What is Forecasting?
Forecasting Approaches
ü Qualitative Methods
ü Quantitative Methods
Naive Approach
Moving Averages
Exponential Smoothing
Exponential Smoothing with Trend
Adjustment
Trend Projections
Seasonal Variations in Data
Linear Regression
 What is Forecasting?
▶ Process of predicting a
future event
▶ Underlying basis
of all business
??
decisions
▶ Production
▶ Inventory
▶ Personnel
▶ Facilities
 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
▶ Tend to be more accurate than longer-term forecasts
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
 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 Forecasting
▶ Used when situation is vague and little data
such as new products, new technology
▶ Involves intuition, experience
Quantitative Forecasting
▶ 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 Quantitative
Approaches
1. Naive approach
2. Moving averages
3. Exponential Time-series
smoothing models
4. Trend projection
5. Linear regression Associative
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
 Components of Demand
Trend
component

Demand for product or service

Seasonal peaks

Actual demand
line

Average demand
over 4 years

Random variation
| | | |
1 2 3 4
Time (years)
Figure 4.1
 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
PERIOD LENGTH “SEASON” LENGTH NUMBER OF “SEASONS” IN PATTERN
Week Day 7
Month Week 4 – 4.5
Month Day 28 – 31
Year Quarter 4
Year Month 12
Year Week 52
 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

∑ demand in previous n periods

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

((
Weighted ∑ Weight for period n Demand in period n
moving =
)( ))
average ∑ 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 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
 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 –

Sales demand 25 –

20 –

15 – Actual sales

10 – Moving average

5–
| | | | | | | | | | | |
J F M A M J J A S O N D
Figure 4.2 Month
 Exponential Smoothing
▶ Form of weighted moving average
▶ Weights decline exponentially
▶ Most recent data weighted most
▶ Requires smoothing constant (a)
▶ Ranges from 0 to 1
▶ Subjectively chosen
▶ Involves little record keeping of past
data
 Exponential Smoothing
New forecast = Last period’s forecast
+ a (Last period’s actual demand
– Last period’s forecast)

Ft = Ft – 1 + a(At – 1 - Ft – 1)
OR
Ft = a(At - 1) + (1 - a)(Ft – 1)

where Ft = new forecast

Ft – 1 = previous period’s forecast
a = smoothing (or weighting) constant (0 ≤ a ≤ 1)
At – 1 = previous period’s actual demand
 Exponential Smoothing
Example
Predicted demand = 142 Ford Mustangs
Actual demand = 153
Smoothing constant a = .20
 Exponential Smoothing
Example
Predicted demand = 142 Ford Mustangs
Actual demand = 153
Smoothing constant a = .20

New forecast = 142 + .2(153 – 142)

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

New forecast = 142 + .2(153 – 142)

= 142 + 2.2
= 144.2 ≈ 144 cars
 Impact of Different a
225 –

Actual a = .5
demand
200 –
Demand

175 –

a = .1
150 – | | | | | | | | |
1 2 3 4 5 6 7 8 9
Quarter
 Impact of Different a
225 –

Actual a = .5
▶ Chose
200 – high of a
values
demand
when underlying average
Demand

is likely to change
▶ Choose low values of a
175 –

when underlying average a = .1

is stable|
150 – | | | | | | | |
1 2 3 4 5 6 7 8 9
Quarter
 Choosing a
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)

∑ Actual - Forecast
MAD =
n
 Determining the MAD
ACTUAL
TONNAGE FORECAST WITH
QUARTER UNLOADED FORECAST WITH a = .10 a = .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 a = .10 FOR a = .10 a = .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)

2

MSE =
∑ (Forecast errors)
n
 Determining the MSE
ACTUAL
TONNAGE FORECAST FOR
QUARTER UNLOADED a = .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

MSE =
∑ (Forecast errors)
= 1,526.52 / 8 = 190.8
n
 Comparison of Forecast Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .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
MAD =
Tonnage with for with for
Quarter Unloaded
n
a = .10 a = .10 a = .50 a = .50
1 For a 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 a 190
= .50 173.36 16.64 170.44 19.56
6 205 = 98.62/8
175.02 = 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
Rounded errors) 2
Absolute Rounded Absolute
MSE =Tonnage
Actual Forecast Deviation Forecast Deviation

Quarter Unloaded
n
with
a = .10
for
a = .10
with
a = .50
for
a = .50
1 For a 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 a 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 of Forecast Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .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
 Comparison of Forecast Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .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
 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

Values of Dependent Variable (y-values)

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
 Least Squares Method
Equations to calculate the regression variables

ŷ = a + bx

∑ xy − nxy
b= 2 2
∑ x − nx
a = y − bx
 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 28 ∑ y 692
x= = =4 y= = = 98.86
n 7 n 7
 Least Squares Example
∑ xy − nxy 3,063 − (7) ( 4) (98.86) 295
b= = POWER
ELECTRICAL
2 2
= = 10.54
YEAR (x) ∑ x − nxDEMAND (y)140 − (7) ( 4 ) x 28
2 2 xy
1 74 1 74
2 79 4 158
3 80 ()
a = y − bx = 98.86 −10.54 4 = 56.70 9 240
4 90 16 360
5 Thus,
105 ŷ = 56.70 +10.54x25 525
6 142 36 852
7 122 49 854
Σx = 28 Σy = 692 Σx2 = 140 Σxy = 3,063

∑
Demandx in ∑
28year 8 = 56.70 y+ 10.54(8)
692
x= = =4 y= = = 98.86
n 7 = 141.02,
n or 141
7 megawatts
 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
Seasonal Variations In Data

The multiplicative
seasonal model can
adjust trend data for
seasonal variations
in demand
 Seasonal Variations In Data
Steps in the process for monthly seasons:

1. Find average historical demand for each month

2. Compute the average demand over all months
3. Compute a seasonal index for each month
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the
number of months, then multiply it by the
seasonal index for that month
 Seasonal Index Example
DEMAND
AVERAGE AVERAGE
YEARLY MONTHLY SEASONAL
MONTH YEAR 1 YEAR 2 YEAR 3 DEMAND DEMAND INDEX
Jan 80 85 105 90
Feb 70 85 85 80
Mar 80 93 82 85
Apr 90 95 115 100
May 113 125 131 123
June 110 115 120 115
July 100 102 113 105
Aug 88 102 110 100
Sept 85 90 95 90
Oct 77 78 85 80
Nov 75 82 83 80
Dec 82 78 80 80
Total average annual demand = 1,128
 Seasonal Index Example
DEMAND
AVERAGE AVERAGE
YEARLY MONTHLY SEASONAL
MONTH YEAR 1 YEAR 2 YEAR 3 DEMAND DEMAND INDEX
Jan 80 85 105 90 94
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Average
Apr 90 95 1,128
115 100 94
monthly = = 94
May 113 125 131
12 months 123 94
demand
June 110 115 120 115 94
July 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 82 83 80 94
Dec 82 78 80 80 94
Total average annual demand = 1,128
 Seasonal Index Example
DEMAND
AVERAGE AVERAGE
YEARLY MONTHLY SEASONAL
MONTH YEAR 1 YEAR 2 YEAR 3 DEMAND DEMAND INDEX
Jan 80 85 105 90 94 .957( = 90/94)
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Apr 90 95 115 100 94
May 113 125 131 123 94
Seasonal110
June Average
115 monthly
120 demand
115 for past 394
years
=
July index 100 102 Average
113 monthly
105demand 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 82 83 80 94
Dec 82 78 80 80 94
Total average annual demand = 1,128
 Seasonal Index Example
DEMAND
AVERAGE AVERAGE
YEARLY MONTHLY SEASONAL
MONTH YEAR 1 YEAR 2 YEAR 3 DEMAND DEMAND INDEX
Jan 80 85 105 90 94 .957( = 90/94)
Feb 70 85 85 80 94 .851( = 80/94)
Mar 80 93 82 85 94 .904( = 85/94)
Apr 90 95 115 100 94 1.064( = 100/94)
May 113 125 131 123 94 1.309( = 123/94)
June 110 115 120 115 94 1.223( = 115/94)
July 100 102 113 105 94 1.117( = 105/94)
Aug 88 102 110 100 94 1.064( = 100/94)
Sept 85 90 95 90 94 .957( = 90/94)
Oct 77 78 85 80 94 .851( = 80/94)
Nov 75 82 83 80 94 .851( = 80/94)
Dec 82 78 80 80 94 .851( = 80/94)
Total average annual demand = 1,128
 Seasonal Index Example
Seasonal forecast for Year 4
MONTH DEMAND MONTH DEMAND

Jan 1,200 July 1,200

x .957 = 96 x 1.117 = 112
12 12
Feb 1,200 Aug 1,200
x .851 = 85 x 1.064 = 106
12 12
Mar 1,200 Sept 1,200
x .904 = 90 x .957 = 96
12 12
Apr 1,200 Oct 1,200
x 1.064 = 106 x .851 = 85
12 12
May 1,200 Nov 1,200
x 1.309 = 131 x .851 = 85
12 12
June 1,200 Dec 1,200
x 1.223 = 122 x .851 = 85
12 12
 Seasonal Index Example
Year 4 Forecast
140 – Year 3 Demand
130 – Year 2 Demand
Year 1 Demand
120 –
Demand

110 –
100 –
90 –
80 –
70 –
| | | | | | | | | | | |
J F M A M J J A S O N D
Time
 San Diego Hospital
Trend Data Figure 4.6

10,200 –

10,000 –
Inpatient Days

9,800 – 9745
9659 9702
9573 9616 9766
9,600 – 9530 9680 9724
9594 9637
9,400 – 9551

9,200 –

9,000 – | | | | | | | | | | | |
Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec
67 68 69 70 71 72 73 74 75 76 77 78
Month
 San Diego Hospital

Seasonality Indices for Adult Inpatient Days at San Diego Hospital

MONTH SEASONALITY INDEX MONTH SEASONALITY INDEX

January 1.04 July 1.03

February 0.97 August 1.04

March 1.02 September 0.97

April 1.01 October 1.00

May 0.99 November 0.96

June 0.99 December 0.98

 San Diego Hospital
Seasonal Indices Figure 4.7

1.06 –
1.04 1.04
Index for Inpatient Days

1.04 – 1.03
1.02
1.02 – 1.01
1.00
1.00 – 0.99
0.98
0.98 – 0.99
0.96 – 0.97 0.97
0.96
0.94 –
0.92 – | | | | | | | | | | | |
Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec
67 68 69 70 71 72 73 74 75 76 77 78
Month
 San Diego Hospital

Period 67 68 69 70 71 72

Month Jan Feb Mar Apr May June

Forecast with 9,911 9,265 9,164 9,691 9,520 9,542

Trend &
Seasonality
Period 73 74 75 76 77 78

Month July Aug Sept Oct Nov Dec

Forecast with 9,949 10,068 9,411 9,724 9,355 9,572

Trend &
Seasonality
 San Diego Hospital
Combined Trend and Seasonal Forecast Figure 4.8

10,200 –
10068
10,000 – 9911 9949
Inpatient Days

9,800 – 9764 9724

9691
9,600 – 9572

9,400 – 9520 9542

9411
9265 9355
9,200 –

9,000 – | | | | | | | | | | | |
Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec
67 68 69 70 71 72 73 74 75 76 77 78
Month
 Adjusting Trend Data

ŷseasonal = Index × ŷtrend forecast

Quarter I: ŷI = (1.30)($100,000) = $130,000

Quarter II: ŷII = (.90)($120,000) = $108,000
Quarter III: ŷIII = (.70)($140,000) = $98,000
Quarter IV: ŷIV = (1.10)($160,000) = $176,000
 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
 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
 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)
 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

∑ x 18 ∑ y 15
x= = =3 y= = = 2.5
6 6 6 6
∑ xy − nxy 51.5 − (6)(3)(2.5)
b= 2
=
2 2
= .25 a = y − bx = 2.5 − (.25)(3) = 1.75
∑ x − nx 80 − (6)(3 )
 Associative Forecasting
Example
SALES, y PAYROLL, x x2 xy
2.0 1 1 2.0
3.0 3 9 9.0
ŷ = 1.75 + .25x
2.5 4 16 10.0
2.0 2 Sales = 1.75
4 + .25(payroll)
4.0
2.0 1 1 2.0
3.5 7 49 24.5
Σy = 15.0 Σx = 18 Σx2 = 80 Σxy = 51.5

∑ x 18 ∑ y 15
x= = =3 y= = = 2.5
6 6 6 6
∑ xy − nxy 51.5 − (6)(3)(2.5)
b= 2
=
2 2
= .25 a = y − bx = 2.5 − (.25)(3) = 1.75
∑ x − nx 80 − (6)(3 )
 Associative Forecasting
Example
SALES, y PAYROLL, x x2 xy
2.0 1 1 2.0
4.0 –
3.0 3 9 9.0
ŷ = 1.75 + .25x

Nodel’s sales
2.5 3.0 – 4 16 10.0

(in$ millions)
2.0 2 Sales = 1.75
4 + .25(payroll)
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∑ x 1 18 2 3 4 y 5 15 6
∑ 7
x= = =3 y= = = 2.5
6 6 Area payroll (in6$ billions)
6
∑ xy − nxy 51.5 − (6)(3)(2.5)
b= 2
= 2
= .25 2
a = y − bx = 2.5 − (.25)(3) = 1.75
∑ x − nx 80 − (6)(3 )
 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
 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)
Standard Error of the Estimate
▶ A forecast is just a point estimate of a
future value
▶ This point is
actually the
4.0 –
mean of a 3.25
probability

Nodel’s sales
3.0 –

(in$ millions)
Regression line,
distribution 2.0 – ŷ = 1.75 + .25x

1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Figure 4.9 Area payroll (in $ billions)
Standard Error of the Estimate

n = number of data points

We use the standard error to set up prediction
intervals around the point
estimate
 Standard Error of the Estimate
2

S y,x =
∑ − a∑ y − b∑ xy
y
=
39.5 −1.75(15.0) − .25(51.5)
n−2 6−2
= .09375
= .306 (in $ millions)
4.0 –
3.25

Nodel’s sales
3.0 –

(in$ millions)
The standard error 2.0 –
of the estimate is
1.0 –
$306,000 in sales
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll (in $ billions)
 Prediction Intervals
Upper limit = Y + t*Sy,x α=0.05 n= 6 data
Lower limit = Y - t*Sy,x
tα/2, n-2 =2.78 (see Student’s t Distribution Table)
Upper limit = $3,250,000 + 2.78 * $306,000
=$4,100,680
Lower limit = $3,250,000 - 2.78 * $306,000
= $2,399,320
We are 95% confident the actual sales for next year will be between
$2,399,320 and $4,100,680.
© 2011 Pearson Education, Inc. publishing as Prentice Hall
 Correlation
▶ How strong is the linear relationship
between the variables?
▶ 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 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
 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

(6)(51.5) – (18)(15.0)
r=
!(6)(80) – (18)2 #!(16)(39.5) – (15.0)2 #
" $" $

309 − 270 39 39
= = = = .901
(156)(12) 1,872 43.3
 Coefficient of Determination
▶ 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
 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