Chapter 3

Forecasting

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or

3-1
distribution without the prior written consent of McGraw-Hill Education
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 important to making
informed decisions

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the prior 3-3
written consent of McGraw-Hill Education
Two Important Aspects of Forecasts
Expected level of demand
The level of demand may be a function of
some structural variation such as trend or
seasonal variation
Accuracy
Related to the potential size of forecast
error

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the prior 3-4
written consent of McGraw-Hill Education
Forecast Uses
Plan the system
 Generally involves long-range plans related to:
Types of products and services to offer
Facility and equipment levels
Facility location
Plan the use of the system
 Generally involves short- and medium-range plans
related to:
Inventory management
Workforce levels
Purchasing
Production
Budgeting
Scheduling
Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the prior written 3-5
consent of McGraw-Hill Education
Features Common to All Forecasts
1. Techniques assume some underlying
causal system that existed in the past
will persist into the future
2. Forecasts are not perfect
3. Forecasts for groups of items are more
accurate than those for individual
items
4. Forecast accuracy decreases as the
forecasting horizon increases
Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the 3-6
LO 3.1 prior written consent of McGraw-Hill Education
 Forecasts are not perfect:
Because random variation is
always present, there will
always be some residual error,
even if all other factors have
been accounted for.

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-7
LO 3.2 the prior written consent of McGraw-Hill Education
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

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-8
LO 3.3 the prior written consent of McGraw-Hill Education
 Steps in the Forecasting Process
1. Determine the purpose of the forecast
2. Establish a time horizon
3. Obtain, clean, and analyze appropriate data
4. Select a forecasting technique
5. Make the forecast
6. Monitor the forecast errors

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-9
LO 3.4 the prior written consent of McGraw-Hill Education
 Forecast Accuracy and Control
Allowances should be made for
forecast errors
 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 errors should be monitored
 Error = Actual – Forecast
 If errors fall beyond acceptable bounds,
corrective action may be necessary
Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-10
LO 3.5 the prior written consent of McGraw-Hill Education
 Forecast Error Calculation
Actual Forecast (A-F)
Period
(A) (F) Error |Error| Error2 [|Error|/Actual]x100
1 107 110 -3 3 9 2.80%

2 125 121 4 4 16 3.20%

3 115 112 3 3 9 2.61%

4 118 120 -2 2 4 1.69%

5 108 109 1 1 1 0.93%

Sum 13 39 11.23%

n=5 n-1 = 4 n=5

MAD MSE MAPE

= 2.6 = 9.75 = 2.25%

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the 3-12
LO 3.5 prior written consent of McGraw-Hill Education
 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
 These techniques rely on hard data
 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
Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-13
LO 3.6 the prior written consent of McGraw-Hill Education
Qualitative Forecasts
Forecasts that use subjective inputs such as opinions from
consumer surveys, sales staff, managers, executives, and
experts
Executive opinions
A small group of upper-level managers may meet
and collectively develop a forecast
Sales force opinions
Members of the sales or customer service staff can
be good sources of information due to their direct
contact with customers and may be aware of plans
customers may be considering for the future

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-14
LO 3.6 the prior written consent of McGraw-Hill Education
Qualitative Forecasts
Forecasts that use subjective inputs such as opinions
from consumer surveys, sales staff, managers,
executives, and experts
Consumer surveys
 Since consumers ultimately determine demand, it makes
sense to solicit input from them
 Consumer surveys typically represent a sample of consumer
opinions
Other approaches
 Managers may solicit 0pinions from other managers or staff
people or outside experts to help with developing a forecast.
 The Delphi method is an iterative process intended to achieve
a consensus

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-15
LO 3.6 the prior written consent of McGraw-Hill Education
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

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the prior 3-16
written consent of McGraw-Hill Education
 Time-Series Behaviors
Trend
Seasonality
Cycles
Irregular variations
Random variation

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the prior written 3-17
consent of McGraw-Hill Education
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
Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the prior written 3-18
consent of McGraw-Hill Education
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
Irregular variation
 Due to unusual circumstances that do not reflect
typical behavior
 Labor strike
 Weather event
Random Variation
 Residual variation that remains after all other
behaviors have been accounted for
Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the prior written 3-19
consent of McGraw-Hill Education
 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
Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-20
LO 3.7 the prior written consent of McGraw-Hill Education
Quantitative Forecast

3-21
 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

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-22
LO 3.8 the prior written consent of McGraw-Hill Education
 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

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-23
LO 3.16 the prior written consent of McGraw-Hill Education
Operations Strategy
The better forecasts are, the more able
organizations will be to take advantage of future
opportunities and reduce potential risks
 A worthwhile strategy is to work to improve short-term
forecasts
 Accurate up-to-date information can have a
significant effect on forecast accuracy:
 Prices
 Demand
 Other important variables
 Reduce the time horizon forecasts have to cover
 Sharing forecasts or demand data through the supply
chain can improve forecast quality
Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the 3-24
prior written consent of McGraw-Hill Education
Moving Average
Technique that averages a number of the most recent
actual values in generating a forecast
n

A t i
At  n  ...  At  2  At 1
Ft  MA n  i 1

n n
where
Ft  Forecast for time period t
MA n  n period moving average
At i  Actual value in period t  i
n  Number of periods in the moving average
3-25
LO 3.8 Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without
the prior written consent of McGraw-Hill Education
 Moving Average (cont.)
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

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-26
LO 3.8 the prior written consent of McGraw-Hill Education
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.

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-27
LO 3.9 the prior written consent of McGraw-Hill Education
 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

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-28
LO 3.10 the prior written consent of McGraw-Hill Education
 Linear Trend
A simple data plot can reveal the existence and
nature of a trend
Linear trend equation
Ft  a  bt
where
Ft  Forecast for period t
a  Value of Ft at t  0
b  Slope of the line
t  Specified number of time periods from t  0

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the 3-29
LO 3.11 prior written consent of McGraw-Hill Education
 Estimating Slope and Intercept
Slope and intercept can be estimated from historical
data
n ty   t  y
b
n t   t 
2
2

a
 y  b t
or y  bt
n
where
n  Number of periods
y  Value of the time series

3-30
LO 
3.11 Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the
prior written consent of McGraw-Hill Education
 Trend-Adjusted Exponential Smoothing
The trend adjusted forecast consists of two
components
 Smoothed error
 Trend factor

TAFt +1  St  Tt
where
St  Previous forecast plus smoothed error
Tt  Current trend estimate

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution 3-31
LO 3.12
 without the prior written consent of McGraw-Hill Education
 Trend-Adjusted Exponential Smoothing (cont.)
Alpha and beta are smoothing constants
Trend-adjusted exponential smoothing has the ability
to respond to changes in trend

TAFt +1  St  Tt
St  TAFt +  At  TAFt 
Tt  Tt1   TAFt  TAFt1  Tt1 

 3-32
Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without
LO 3.12 the prior written consent of McGraw-Hill Education
 Techniques for Seasonality
Seasonality – regularly repeating movements in
series values that can be tied to recurring events
Expressed in terms of the amount that actual
values deviate from the average value of a series
Models of seasonality
 Additive
Seasonality is expressed as a quantity that gets added
to or subtracted from the time-series average in order
to incorporate seasonality
 Multiplicative
Seasonality is expressed as a percentage of the average
(or trend) amount which is then used to multiply the
value of a series in order to incorporate seasonality
Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-33
LO 3.13 the prior written consent of McGraw-Hill Education
 Seasonal Relatives
Seasonal relatives
 The seasonal percentage used in the multiplicative
seasonally adjusted forecasting model
Using seasonal relatives
 To deseasonalize data
Done in order to get a clearer picture of the nonseasonal
(e.g., trend) components of the data series
Divide each data point by its seasonal relative
 To incorporate seasonality in a forecast
1. Obtain trend estimates for desired periods using a
trend equation
2. Add seasonality by multiplying these trend estimates
by the corresponding seasonal relative

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the 3-34
LO 3.13 prior written consent of McGraw-Hill Education
 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

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the 3-35
LO 3.14 prior written consent of McGraw-Hill Education
 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)

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the 3-36
LO 3.14 prior written consent of McGraw-Hill Education
 Least Squares Line
yc  a  bx
where
yc  Predicted (dependent) variable
x  Predictor (independent) 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   x 
2
 2

a
 y  b x
or y  b x
n
where
n  Number of paired observations
3-37
LO 3.14 Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the
prior written consent of McGraw-Hill Education
 Correlation Coefficient
 Correlation, r
 A measure of the strength and direction of relationship between
two variables
 Ranges between -1.00 and +1.00

n xy   x  y 
r
 
n  x 2   x 
2
 
n  y 2   y 
2

 r2, square of the correlation coefficient

 A measure of the percentage of variability in the values of y that is
“explained” by the independent variable
 Ranges between 0 and 1.00

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without the 3-38
LO 3.14 prior written consent of McGraw-Hill Education
 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

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-39
LO 3.14 the prior written consent of McGraw-Hill Education
 Issues to Consider:
Always plot the line to verify that a linear
relationship is appropriate
The data may be time-dependent
 If they are
use analysis of time series
use time as an independent variable in a
multiple regression analysis
A small correlation may indicate that other
variables are important

Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution without 3-40
LO 3.14 the prior written consent of McGraw-Hill Education
 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 due to
a. omission of an important variable
b. a change or shift in the variable the model cannot handle
c. the appearance of a new variable
 Irregular variations may have occurred
 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

LO 3.15 Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or distribution 3-41
without the prior written consent of McGraw-Hill Education
 Control Chart Construction

1. Compute the MSE.

2. Estimate of standard deviation of the distributi on of errors
s  MSE
3. UCL : 0  z MSE
4. LCL : 0  z MSE
where z  Number of standard deviations from the mean
3-42
LO 3.15 Copyright ©2018 McGraw-Hill Higher Education. All rights reserved. No reproduction or
distribution without the prior written consent of McGraw-Hill Education