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FORECASTING
1. Forecasting vs. Prediction:
Forecasting: Estimating Future by Casting Forward Past Data.
Prediction: Estimating Future based on Subjective
Considerations other than just Past Data.
3. Forecasting Objectives:
Forecasting in POM: Item Demand (Workload for Capacity
Planning)
Forecasting in Finance: Dollars Revenue (Cash Flow
Requirement)
Forecasting in Marketing: Unit of Sales (Selling Capability)
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Forecasting in Operations
Forecast for
operations
Time horizon
MGT level
Long range
Top
Capacity Requirement
Planning
Long/
Intermediate
Top / middle
Middle
Low
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Forecasting Systems
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Forecasting Techniques
Qualitative Approach:
1. Delphi Methods: (Expert's Subjective Ratings)
2. Marketing Research and Analysis: (Customer Survey)
3. Historical Analogy: (Knowledge of Similar Products)
4. ...................
Quantitative Approach: (Two General Techniques)
A: Time Series Analysis:
1. Simple Moving Average
2. Weighted Moving Average
3. Exponential Smoothing
4. .................
B: Causal Relationship Models:
1. Regression Analysis
2. Econometric Models
3. ................
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Exercise #1
Assume that your stock of merchandise is maintained based on the
forecast demand. If the distributors sales personnel call on the first
day of each month, compute your forecast sales by each of the three
methods requested here.
June
Actual demand 140
July
180
August
170
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4. Track Signal:
TS = Bias/MAD ( -1 TS +1)
(TS is a Measure of Forecasting Error in terms of both the
"Direction" and the "Size".)
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Exercise #2
Month
Actual
1
26
2
32
3
39
4
40
5
38
6
47
7
50
8
59
9
56
Demand
a) What is the forecast for period 10 using the following models?
i) Four period moving average
ii) Four period weighted moving average with weights of 0.1,
0.15, 0.25 and 0.5 for month 6, 7, 8 and 9 respectively
iii) Simple exponential smoothing with alpha =0.2, assuming
that the forecast for month 9 is 60.
b) If the forecasts for period 1 to period 9 were 30, 35, 42, 42, 40, 50,
53, 61, 59, respectively, determine the bias, MAD and tracking
signal. How would you improve the forecasting accuracy in this
situation?
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Base Level:
Trend (Linear):
Seasonal Effects:
Cyclical Effects:
Random Errors:
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Exercises
Demand Forecasting- Simple Regression
1. Finley Heaters Inc. is a mid sized manufacturer of residential water heaters. Sales have grown
during the last several years, and the companys production capacity needs to be increased. The
companys management wonders if national housing starts might be a good indicator of the
companys sales.
Year
1
2
3
4
5
6
7
a. Develop a simple linear regression analysis between Finley Heaters sales and national
housing starts. Forecast Finley Heaters sales for the next two years. The National Home
Builders Association estimates that national housing starts will be 7.1 million and 8.0
million for the next two years.
b. What percentage of variation in Finley Heaters sales is explained by national housing
starts?
c. Would you recommend that Finley Heaters management use forecast from Part a to plan
facility expansion? Why or why not? What could be done to improve the forecast?
2. Chasewood Apartments is a 300/unit complex near Fairway University that attracts mostly
university students. Manager Joan Newman suspects that the number of units leased during each
semester is impacted by the number of students enrolled at the university. The university
enrollment and number of apartment units leased during the past eight semesters is:
Semester
1
2
3
4
5
6
7
University Enrollment
(thousands)
7.2
6.3
6.7
7.0
6.9
6.4
7.1
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6.7
246
a. Use a simple regression analysis to develop a model to forecast the number of apartment
units leased, based on university enrollment. If the enrollment for next semester is
expected to be 6,600 students, forecast the number of apartment units that will be leased.
b. What percent of variation in apartment units leased is explained by university
enrollment?
c. How useful do you think university enrollment is for forecasting the number of apartment
units leased?
Demand
(units)
169
227
176
Week
4
5
6
Demand
(units)
171
163
157
Week
7
8
9
Demand
(units)
213
175
178
Week
10
11
12
Demand
(units)
158
188
169
a. Use the moving average method of short-range forecasting with an averaging period of
three weeks to develop a forecast of the demand for the CRT 5922 component in week
13.
b. If a smoothing constant of 0.25 is used and the exponential smoothing forecast for week
11 was 170.76 units, what is the exponential smoothing forecast for week 13?
c. Which forecasting method is preferred- the AP=3 moving average method or the =0.25
exponential smoothing method? The criterion for choosing between the methods is mean
absolute deviation (MAD) over the most recent nine weeks. Assume that the exponential
smoothing forecast for week 3 is the same as the actual demand.
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4. The number of Texas tax auditors needed by the Internal Revenue Service varies from quarter
to quarter. The past 12 quarters of data are shown below:
Year
1
Quarter
1
2
3
4
1
2
3
4
1
2
3
4
Auditors
132
139
136
140
134
142
140
139
135
137
139
141
a. Use moving averages to forecast the number of auditors needed next quarter if AP=2,
AP=4, and AP=6.
b. Which of these forecasts exhibit the best forecast accuracy over the past six quarters of
historical data based on mean absolute deviation?
Plastic Pellets
Price/ Pound
$ 0.39
0.41
0.45
0.44
0.40
0.41
0.38
0.36
Month
9
10
11
12
13
14
15
16
Plastic Pellets
Price/ Pound
0.35
0.38
0.39
0.43
0.37
0.38
0.36
0.39
a. Use exponential smoothing to forecast monthly plastic pellet prices. Compute what the
forecasts would have been for all the months of historical data for =0.1, =0.3, and
=0.5 if assumed forecast for all s in the first month is $0.39.
b. Which alpha value results in the last mean absolute deviation for Months 7-16?
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c. Use the best alpha value from part b to compute the forecasted plastic pellets price for
month 17.
Quarter
1
1
1
1
1
2
3
4
Sales
(millions of
dollars)
9.2
5.4
4.3
14.1
Year
Quarter
2
2
2
2
1
2
3
4
Sales
(millions of
dollars)
10.3
6.4
5.4
16.0
Use seasonalized time series regression analysis to develop a forecast of next years quarterly
sales revenue for the line of personal computers.
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to change their responsibilities according to current requirements. The benefits of instituting flexibility
almost always outweigh the costs.
Standardize products. Standardization is not the antonym of flexibility. It essentially means that
the changes to a base product must be incremental. Customers expect multiple, unique products, and a
company must be able to change the volume of these products as necessary.
Segment products. Not all products change regularly. Unless a firm is in a very dynamic market,
there always will be products that are more stable than others. Putting these items aside and setting a
standard schedule for them reduces complexity. For example, if 70 percent of output can be
predicted with 95 percent accuracy, that means 25 percent of the errors in the remaining 30 percent
of the output would have a less significant impact.
Postpone. This is more important-and more possible than ever before. Technology enables us to do
final assembly much closer to the customer and without any major increase in cost. Forecasting should
be moved upstream, as well. If company leaders at the fuel pump manufacturer from the beginning of
this article had kept basic product design constant and limited variation to modules, then the firm could
have absorbed market fluctuations much more easily.
Make "small" work. The shorter the term, the better the forecast. As such, every aspect of business
must be rewired to enable small batch sizes. Smaller vehicles can be used to transport material more
frequently. Delivering or picking up goods from multiple sites and then returning to the original
location with them should be considered. Rather than waiting for a batch of goods, work must be able
to proceed on individual pieces; and, wherever small batch sizes are not economical, the processes
should be changed to make them work. Keep in mind: Making small work means that goods will reach
the market much faster. So, if the cumulative lead time is 30 days, the market has to be approximated
by at least 30 days. If small batches can reduce this time to 10 days, the market has to be pre-empted by
only 10 days.
Increase the speed of information transfer. Accurate and fast information is the lifeline of a
strong business. Data on actual customer usage should be tracked whenever possible, and technology
tools should be used to enable information entry once, at the point of occurrence. Operating with high
speed and accuracy ensures the forecasting model will work on current information. Plus, it becomes
much more likely that employees can react accurately.
Rework business rules. Given that the stakes of the game have changed, the rules need to be
altered, as well. For example, an after-sales service firm stored fast-moving components at all its
regional depots. Company leaders decided to shift all the slow-moving spare parts to a central
warehouse. Then, they would be flown to the different regions on an as-needed basis. Instead of
forecasting all the components at each location, a few components now are stored and forecast
only at the central location, significantly increasing accuracy.
Monitor international politics. Buying and selling internationally involves a lot of risk.
Politics, social issues, and economics have to be monitored to create scenarios of possible impact.
Forecasting never can predict such events, and operations management professionals must
recognize this and buffer the forecasts when necessary.
Elevate forecasting. Forecasting cannot be merely an operational tool. Senior managers must
recognize the limitations of the process and lead the necessary changes in design, manufacturing,
and distribution. Results of forecasting processes must be monitored at the highest level in order to
develop other processes and reduce dependence on forecasts.
Recognize the goal. Firms are not in business to make accurate forecasts; they're in business to
make more money. Forecasting is merely a tool that helps along the way.
Forecasting is bound to be inaccurate, but it is nonetheless necessary for a firm's survival-especially
when an organization has multiplying product variants in a dynamic global marketplace. Software
solutions offer some assistance, but the current tools never will be 100 percent effective. Thus,
operations management professionals must refocus their efforts to create processes that can deliver
standard output with forecasts of limited accuracy.
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Question: Summarize what you have learned from reading this article.
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Judgmental forecasts also have the advantage of being able to incorporate "soft" or
"inside" information that can be helpful predictor is in changing environments. These types
of information might include a rumor about a competitor launching a new product or an
impending labor strike.
Judgmental forecasts, however, often are inaccurate due to limitations in human
cognitive ability. People naturally have a limited attention span and can process only a
restricted amount of information at a time. Similarly, research has documented that
judgmental forecasts are influenced by short-term memory and the inability of forecasters
to understand causal relationships. In addition, judgmental forecasts can be biased because
they are subjective. Biases include optimism, wishful thinking, lack of consistency, and
political manipulation. For example, consider the manager who is optimistic one day after a
large sale or highly pessimistic another day following a sales slump. Such events often lead
people to inadvertently bias their forecasts, which can result in degradation of accuracy.
Unlike judgmental-also called managerial-forecasts, statistical forecasts are based on ,
mathematical principles and are typically generated by any one of the many software
packages available. Statistical forecasts are consistent, objective, and unbiased, always
producing the same forecast for the same data set. Also, statistical forecasts can process large
amounts of data at one time. This is particularly effective for generating forecasts for a large
number of stock keeping units (SKUs), when managerial involvement would be timeconsuming and costly.
However, statistical models are only as good as the data upon which they are based.
When changes occur in the data that are not incorporated in the model, the generated
forecasts can't be accurate. Statistical forecasts also are based on historical data and are
ineffective when market conditions change, such as a new competitor entering the
marketplace or a snow storm delaying a shipment.
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A winning combination
More and more, successful forecasting uses composite methodologies. Judgmental
and statistical forecasts can '
be combined in different ways in order to take advantage of their individual strengths. One way is to take a mathematical average of both
methods to generate a final forecast.
By far the most popular method in practice, however, is managerial adjustment of
statistical forecasts. This method requires managers to adjust the statistical fore cast up or
down based on their opinions, often called a "managerial override."
Managerially adjusting statistical forecasts often can improve forecast accuracy by
including information not available to the statistical model. However, if performed
incorrectly, adjustments can cause inaccuracy due to inherent human biases. Managers
should follow established rules for effectively adjusting statistical forecasts.
Rule following
In order to gain the best from both forecasting methods, it is critical to understand
rules on how and when statistical forecasts should be adjusted.
Only practitioners with domain knowledge should adjust statistical forecasts.
Domain knowledge is information managers gain through on-the-job expe rience.
Becoming familiar with their environment, managers learn many cause-and-effect
relationships and environmental cues. Research studies repeatedly have found that
judgmental adjustment is more likely to improve accuracy when the adjustment is based on
domain knowledge.
Managers with domain knowledge understand which cues in the environ ment are
significant and which are unimportant. Specific information available in the forecast
environment is called contextual information. Examples of contextual information include
a price increase, an impending strike, or new policies that may affect the forecast. Domain
knowledge enables managers to evaluate the importance of specific contextual informa tion.
If this information is not contained in the statistical forecasting model, the manager can
incorporate the information by adjusting the statistical forecasts.
Adjust statistical forecasts when there are known changes in the environment .
To be useful, judgment should incorporate information that is not captured by the
statistical forecast. For example, statistical forecasts should account for discon tinuities or
pattern changes in the data. Judgmental adjustment of the statistical forecast can improve
accuracy if the forecaster can identify these patterns in the data and incorporate this
information in the adjustment.
The adjustment should compensate for specific events not captured by the statistical
model or not yet observed in the time series. These events can include machines down due
to repair, advertising campaigns, and labor strikes.
Structure the judgmental adjustment process.
One of the disadvantages of human judgment is the limited ability to consider and process
large amounts of information. Structuring available data through a procedure or decision-
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support system is helpful in forecasting and decision making. Judgmental adjustment has
been shown to lead to greater improvements in accuracy if the process is structured, as
opposed to an ad hoc adjustment. Structuring can be complex, such as that generated by a
computer-aided decision support system, or as simple as using a paper and pencil. The
important thing is that it is used.
Document all judgmental adjustments made and measure forecast accuracy
Like all forecasts, judgmentally adjusted forecasts need to be measured using forecast
accuracy measures. In addition, records should be kept of all adjustments made and the
reasons for the adjustment. Over time, managers can evaluate what types of adjustments led
to the greatest improvement and which adjustments were ineffective - enabling future
improvement. This process can have a powerful effect on improving forecast accuracy.
However, to succeed, accurate records must be kept over time. Also, an important aspect of
accuracy is ensuring that the numbers and the arithmetic are correct.
Current conditions
The rules provided raise a number of implications for managers. First, managers
must decide what type of forecasting procedure to use and whether to adjust a statistical
forecast. This depends on the amount and type of available information. A sufficient
amount of quantifiable data need to exist in order to apply a statis tical forecast. Without
such data, forecasts may need to be based solely on judgment. This may be the case for
forecasting demand for a brand-new product or for long range strategic forecasting
decisions where information is hard to quantify.
When good, quantifiable, historical data are available, reliance should be placed on
statistical forecasts. Only when forecasters know of events and information that influence
the forecast should judgment be used to adjust it.
Judgmental
adjustments
only
should be made when there is contextual information in the presence of domain knowledge,
forecasting process structure, and adequate feedback. For example, in studies where
managers judgmental forecasts significantly outperformed statistical forecasts, the
managers in question had been responsible for generating forecasts over a period of years.
They kept records of their forecasts and received regular feedback. Repetition and good
feedback over a long period of time enabled these managers to develop expertise; thereby,
giving them the tools to create more effective forecasts.
Many forecasting situations do not provide this advantage. For example, in
inventory management, managers may be responsible for hundreds of different SKUs.
There often are changes in product mix, customer mix, and markets. In such environments,
achieving high levels of knowledge and familiarity may be impossible.
Another issue to consider is the cost of managerial involvement. Though there are
benefits with judgmental adjustment, are these benefits significant in terms of cost? The
cost of managerial involvement can be high when making forecast adjustments and
developing domain knowledge. The benefits of a more refined forecast need to make financial
sense. Managers should be selective as to which forecasts they adjust. In addition, focusing on
a smaller number of forecasts will enable a manager to achieve greater accuracy.
Questions: Based on this article, why the combining forecasting approach may give
you the best results?
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