IPE 493:

Industrial Management

By
Dr. Prianka Binte Zaman
Associate Professor
Department of IPE, BUET
Forecasting
FORECASTING
 A statement about the future value of a variable of interest.
Example: demand forecast.
 Forecasts are made with reference to a specific time horizon.
 Underlying basis of all business decisions
➢ Production
➢ Inventory
➢ Personnel
➢ Facilities
Types of Forecasts by Time
Horizon
 Short-range forecast
◼ Up to 1 year; usually less than 3 months
◼ Job scheduling, worker assignments
 Medium-range forecast
◼ 3 months to 3 years
◼ Sales & production planning, budgeting
 Long-range forecast
◼ 3+ years
◼ New product planning, facility location

4-4
Uses of Forecasts

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
A properly prepared forecast should fulfill certain requirements:
1. The forecast should be timely. 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.
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.
Elements of a 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. In addition, a written forecast will
permit an objective basis for evaluating the forecast once actual results
are in.
6. The forecasting technique should be simple to understand and
use. Users often lack confidence in forecasts based on sophisticated
techniques; they do not understand either the circumstances in which
the techniques are appropriate or the limitations of the techniques.
Misuse of techniques is an obvious consequence. Not surprisingly, fairly
simple forecasting techniques enjoy widespread popularity because
users are more comfortable working with them.
7. The forecast should be cost-effective: The benefits should
outweigh the costs. that they may get burned every time a new
forecast is issued.
 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.
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. A forecast has to be monitored to determine
whether it is performing in a satisfactory manner. If it is not, re
examine the method, assumptions, validity of data, and so on;
modify as needed; and prepare a revised forecast.
Types of Forecasts
 Qualitative/Judgmental forecasts rely on analysis of subjective
inputs obtained from various sources, such as consumer surveys,
the sales staff, managers and executives, and panels of experts. Quite
frequently, these sources provide insights that are not otherwise
available.
 Quantitative/Time-series forecasts simply attempt to project
past experience into the future. These techniques use historical data
with the assumption that the future will be like the past. Some models
merely attempt to smooth out random variations in historical data;
others attempt to identify specific patterns in the data and project or
extrapolate those patterns into the future, without trying to identify
causes of the patterns.
 Associative models use equations that consist of one or more
explanatory variables that can be used to predict demand. For
example, demand for paint might be related to variables such as the
price per gallon and the amount spent on advertising, as well as to
specific characteristics of the paint (e.g., drying time, ease of cleanup).
Judgmental Forecasts
Executive opinions: A small group of upper-level managers
(e.g., in marketing, operations, and finance) may meet and
collectively develop a forecast. This approach is often used as
a part of long-range planning and new product development.
It has the advantage of bringing together the considerable
knowledge and talents of various managers. However, there is
the risk that the view of one person will prevail, and the
possibility that diffusing responsibility for the forecast over the
entire group may result in less pressure to produce a good
forecast.
Judgmental Forecasts
Sales force opinions: Members of the sales staff or the customer
service staff are often good sources of information because of their
direct contact with consumers. They are often aware of any
plans the customers may be considering for the future. There are,
however, several drawbacks to using sales force opinions. One is
that staff members may be unable to distinguish between what
customers would like to do and what they actually will do.
Another is that these people are sometimes overly influenced by
recent experiences. Thus, after several periods of low sales,
their estimates may tend to become pessimistic. After several
periods of good sales, they may tend to be too optimistic.
In addition, if forecasts are used to establish sales quotas, there
will be a conflict of interest because it is to the salesperson’s
advantage to provide low sales estimates.
 Judgmental Forecasts
Consumer surveys: Because it is the consumers who ultimately determine
demand, it seems natural to solicit input from them. In some instances, every
customer or potential customer can be contacted. However, usually there are
too many customers or there is no way to identify all potential customers.
Therefore, organizations seeking consumer input usually resort to consumer
surveys, which enable them to sample consumer opinions. The obvious
advantage of consumer surveys is that they can tap information that might
not be available elsewhere. On the other hand, a considerable amount of
knowledge and skill is required to construct a survey, administer it, and
correctly interpret the results for valid information. Surveys can be expensive
and time-consuming. In addition, even under the best conditions, surveys of
the general public must contend with the possibility of irrational behavior
patterns. For example, much of the consumer’s thoughtful information
gathering before purchasing a new car is often undermined by the glitter of a
new car showroom or a high-pressure sales pitch. Along the same lines, low
response rates to a mail survey should—but often don’t—make the results
suspect. If these and similar pitfalls can be avoided, surveys can produce
useful information.
Judgmental Forecasts
❖ Another approach is the Delphi method,
an iterative process intended to
achieve a consensus forecast.
❖ This method involves circulating a series
of questionnaires among individuals who Decision Makers
possess the knowledge and ability to
(Sales?)
contribute meaningfully.
❖ Responses are kept anonymous, which (Sales will be 50!)
Staff
tends to encourage honest responses
(What will
and reduces the risk that one person’s sales be?
opinion will prevail. survey)
❖ Each new questionnaire is developed using
the information extracted from the
previous one, thus enlarging the scope of
information on which participants can base
their judgments. Respondents
❖ The Delphi method has been applied to a
(Sales will be 45, 50, 55)
variety of situations, not all of which
involve forecasting. The discussion here is
limited to its use as a forecasting tool.
Judgmental Forecasts
❖ As a forecasting tool, the Delphi method is useful for technological
forecasting, that is, for assessing changes in technology and their
impact on an organization.
❖ Often the goal is to predict when a certain event will occur.
❖ For instance, the goal of a Delphi forecast might be to predict when
video telephones might be installed in at least 50 percent of residential
homes or when a vaccine for a disease might be developed and ready
for mass distribution.
❖ For the most part, these are long-term, single-time forecasts, which
usually have very little hard information to go by or data that are costly
to obtain, so the problem does not lend itself to analytical techniques.
Rather, judgments of experts or others who possess sufficient
knowledge to make predictions are used.
Time series Forecasts
Time series: A time-ordered sequence of observations
taken at regular intervals. The behaviours of the time
series data can be described as follows:
➢ Trend - A long-term upward or downward movement in
data.
➢ Seasonality -Short-term regular variations in data related
to the calendar or time of day.
➢ Cycle – Wavelike variations lasting more than one year.
➢ Irregular variations – Caused by unusual circumstances,
not reflective of typical behavior.
➢ Random variations - caused by chance, Residual
variations after all other behaviors are accounted for.
Product Demand Charted over 4
Years with Trend and Seasonality
Seasonal peaks Trend component
Demand for product or service

Actual
demand line

Average demand
over four years
Random
variation

Year Year Year Year

1 2 3 4
Naive Forecasts

The forecast for any period equals the previous period’s actual
value.
Characteristics of naive forecast:

➢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
Techniques for Averaging
 Moving average
 Weighted moving average
 Exponential smoothing
Moving Averages

 Moving average – A technique that averages

a number of recent actual values, updated as
new values become available. n

 For n period moving average

 Ai
Ft = i =1
n= 2,3,4,5,….. n

 Weighted moving average – More recent

values in a series are given more weight n
in computing the forecast.  Ai wi
 w is the respective weight Ft = i =1
n

 wi
i =1
Moving Average Example
You’re manager of a museum store that sells
historical replicas. You want to forecast sales
(000) for 2003 using a 3-period moving average.

1998 4
1999 6
2000 5
2001 3
2002 7
Moving Average Solution
Time Response Moving Moving
Yi Total Average
(n=3) (n=3)
1998 4 NA NA
1999 6 NA NA
2000 5 NA NA
2001 3 4+6+5=15 15/3 = 5
2002 7
2003 NA
Moving Average Solution
Time Response Moving Total Moving Average
Yi (n=3) (n=3)
1998 4 NA NA
1999 6 NA NA
2000 5 NA NA
2001 3 4+6+5=15 15/3 = 5
2002 7 6+5+3=14 14/3=4 2/3
2003 NA
Moving Average Solution
Time Response Moving Total Moving Average
Yi (n=3) (n=3)
1998 4 NA NA
1999 6 NA NA
2000 5 NA NA
2001 3 4+6+5=15 15/3=5.0
2002 7 6+5+3=14 14/3=4.7
2003 NA 5+3+7=15 15/3=5.0
Example of moving average and
weighted moving average
Example:
Period Demand Forecast
1 42
2 40 42
3 43
4 40
5 42
Simple moving average (4 months)
F6 = (40 + 43 + 40 + 42) / 4 = 41.25
 Compute a weighted average forecast using a weight of 0.40 for the
most recent period, 0.30 for the next most recent, 0.20 for the next,
and 0.10 for the next.
 Weighted moving average (4 months)
F6 = (42 * 0.4 + 40 * 0.3 + 43 * 0.2 + 40 * 0.1) = 41.4
(0.4 + 0.3 + 0.2 + 0.1)
Simple Moving Average

Actual
5-period
47
45
43
41
39
37 3-period

35
1 2 3 4 5 6 7 8 9 10 11 12
Actual Demand, Moving Average,
Weighted Moving Average
Weighted moving average
35
Actual sales
30
25
Sales Demand

20
15
10 Moving average
5
0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Month
 Exponential Smoothing
Ft = Ft-1 + (At-1 - Ft-1)

Next forecast = Previous forecast +  (Actual demand – Previous forecast)

Forecasting error

 Percentage of error / smoothing constant

A-F is the error term,  is the % feedback

3-27
Exponential Smoothing
Exponential smoothing ( = 0.1)

Ft = Ft-1 +  (At-1 – Ft-1)

F3 = F2 +  (A2 – F2)
= 42 + 0.1 (40 – 42) = 41.8

F4 = F3 +  (A3 – F3)
= 41.8 + 0.1 (43 – 41.8) = 41.92

F5 = F4 +  (A4 – F4)
= 41.92 + 0.1 (40 – 41.92)= 41.728
Example 3 - Exponential Smoothing
Actual Alpha = 0.1 Error Abs Alpha = 0.4 Error Abs
42
40 42 -2.00 2.00 42 -2 2
43 41.8 1.20 1.20 41.2 1.8 1.8
40 41.92 -1.92 1.92 41.92 -1.92 1.92
41 41.73 -0.73 0.73 41.15 -0.15 0.15
39 41.66 -2.66 2.66 41.09 -2.09 2.09
46 41.39 4.61 4.61 40.25 5.75 5.75
44 41.85 2.15 2.15 42.55 1.45 1.45
45 42.07 2.93 2.93 43.13 1.87 1.87
38 42.36 -4.36 4.36 43.88 -5.88 5.88
40 41.92 -1.92 1.92 41.53 -1.53 1.53
41.73 4.45 40.92 2.44
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
Example:
Example:
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 - The least squares regression method is a
mathematical technique that finds the best-fitting line or
curve for a set of data points, providing a visual demonstration
of the relationship between the data points. Each point of data
represents the relationship between a known independent variable
and an unknown dependent variable. This method is commonly
used by statisticians and traders who want to identify trading
opportunities and trends. Least squares regression is used to
predict the behavior of dependent variables.

The method works by minimizing the sum of the offsets or

residuals of points from the plotted curve.
Linear Regression
Least Squares Method
Actual
observation Deviation
Values of Dependent Variable

Deviation Deviation

Deviation
Deviation Point on
regression
Deviation
line
Deviation

Yˆ = a + bx
Time
Linear Regression
No. of obs Unit Sales, x (in $ Profits, y (in $
millions) millions)
1 $7 $0.15
2 2 0.10
3 6 0.13
4 4 0.15
5 14 0.25
6 15 0.27
7 16 0.24
8 12 0.20 Computed
9
10
14
20
0.27
0.44
relationship
11 15 0.34
12 7 0.17
50

40

A straight line is fitted to a set of

30

sample points.
20

10

0
0 5 10 15 20 25
Linear Regression
y = a + bx
n xy −  x  y
b=
n x − ( x )
2 2

a = y − bx
n= number of observations
Linear Regression
No. of obs Unit Sales, x (in Profits, y (in $ xy x2
$ millions) millions)
1 $7 $0.15 1.05 49
2 2 0.10 0.2 4
3 6 0.13 0.78 36
4 4 0.15 0.6 16
5 14 0.25 3.5 196
6 15 0.27 4.05 225
7 16 0.24 3.84 256
8 12 0.20 2.4 144
9 14 0.27 3.78 196
10 20 0.44 8.8 400
11 15 0.34 5.1 225
12 7 0.17 1.19 49
- ∑x= 132 ∑y= 2.71 ∑xy= 35.29 ∑x2= 1796
Linear Regression
12 * 35 .29 − 132 * 2.71
b=
12 *1796 − (132 )
2

 b = 0.0159
Linear Regression
12 * 35 .29 − 132 * 2.71
b=
12 *1796 − (132 )
2

 b = 0.0159

a = y − bx
2.71 132
a= − 0.0159
12 12
 a = 0.0506
Linear Regression
12 * 35 .29 − 132 * 2.71
b=
12 *1796 − (132 )
2

 b = 0.0159

a = y − bx
2.71 132
a= − 0.0159
12 12
 a = 0.0506

y = 0.0506 + 0.0159 x
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
Forecast Accuracy
 Error - difference between actual value and predicted value
 Mean Absolute Deviation (MAD)
➢ Average absolute error
➢ Easy to compute
➢ Weights errors linearly
 Mean Squared Error (MSE)
➢ Average of squared error
➢ Squares error
➢ More weight to large errors
 Mean Absolute Percent Error (MAPE)
➢ Average absolute percent error
MAD, MSE and MAPE
 Actual − forecast
MAD =
n
2
 ( Actual − forecast)
MSE =
n- 1

( Actual − forecast / Actual)*100

MAPE =
n
Example
Period Actual Forecast (A-F) |A-F| (A-F)^2 (|A-F|/Actual)*100
1 217 215
2 213 216
3 216 215
4 210 214
5 213 211
6 219 214
7 216 217
8 212 216
Example
Period Actual Forecast (A-F) |A-F| (A-F)^2 (|A-F|/Actual)*100
1 217 215 2
2 213 216 -3
3 216 215 1
4 210 214 -4
5 213 211 2
6 219 214 5
7 216 217 -1
8 212 216 -4
Example
Period Actual Forecast (A-F) |A-F| (A-F)^2 (|A-F|/Actual)*100
1 217 215 2 2
2 213 216 -3 3
3 216 215 1 1
4 210 214 -4 4
5 213 211 2 2
6 219 214 5 5
7 216 217 -1 1
8 212 216 -4 4
Example
Period Actual Forecast (A-F) |A-F| (A-F)^2 (|A-F|/Actual)*100
1 217 215 2 2 4
2 213 216 -3 3 9
3 216 215 1 1 1
4 210 214 -4 4 16
5 213 211 2 2 4
6 219 214 5 5 25
7 216 217 -1 1 1
8 212 216 -4 4 16
Example
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
Example
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 %