Forecasting for Operations Decisions

W S William

Forecasting is the art and science of predicting future events.

Institute of Business Forecasting

Elements of a Good Forecast

Timely

Reliable

Accurate

Written

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Key Issues in Forecasting

Choice of forecasting horizon (a week, a month etc.)

A forecasting method with desired accuracy. The unit of forecasting ( gross sales, individual product demand etc.)

Forecast Horizon
Forecast horizon is the period for which forecast is prepared Long-Range (years) ( e.g. Process selection, Capacity addition) Medium-Range (months) (e.g. Manpower planning, procurement of long lead time items) Short-Range (weeks) (e.g. Production schedules, overtimes etc.)

Examples of Production Resource Forecasts

Forecast Horizon
Long-Range

Time Span

Item Being Forecast

Product lines Factory capacities Planning for new products Capital expenditures Facility location or expansion R&D Product groups Department capacities Sales planning Production planning and budgeting

Units of Measure
Dollars, tons, etc.

Years

MediumRange

Months

Dollars, tons, etc.

Short-Range

Weeks

Specific product quantities Machine capacities Planning Purchasing Scheduling Workforce levels Production levels Job assignments

Physical units of products

Principles of Forecasting

Forecasting is almost always wrong

Every forecast should include an estimate of the forecast error The greater the degree of aggregation, the more accurate the forecast Long-term forecasts are usually less accurate than shortterm forecasts

Forecasting Methods
Broadly, forecasting methods fall under two categories: Qualitative Methods : These are subjective in nature (Executive Opinion, Market Research , Delphi Method) Quantitative Methods: They use mathematical or simulation methods base d on historical demand or relationships between variables. Extrapolated or Time Series (Use past data to forecast future)

Explanatory or Causal Method (Establishes a relationship between dependent and independent variables); y= f(x)

Components of Demand

Horizontal Component
Trend Component Seasonal Component

Simple Moving Average

An averaging period (AP) is given or selected The forecast for the next period is the arithmetic average of the AP most recent actual demands It is called a simple average because each period used to compute the average is equally weighted . . . more

Simple Moving Average

It is called moving because as new demand data becomes available, the oldest data is not used By increasing the AP, the forecast is less responsive to fluctuations in demand (low impulse response) By decreasing the AP, the forecast is more responsive to fluctuations in demand (high impulse response)

Simple Moving Average

Week 1 2 3 4 5 6 7 8 9 10 11 12

Demand 650 678 720 785 859 920 850 758 892 920 789 844

A t-1 + A t-2 + A t-3 +...+A t- n Ft = n

Lets develop 3-week and 6-week moving average forecasts for demand. Assume you only have 3 weeks and 6 weeks of actual demand data for the respective forecasts

Simple Moving Average

Week 1 2 3 4 5 6 7 8 9 10 11 12 Demand 3-Week 6-Week 650 678 720 785 682.67 859 727.67 920 788.00 850 854.67 768.67 758 876.33 802.00 892 842.67 815.33 920 833.33 844.00 789 856.67 866.50 844 867.00 854.83
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Simple Moving Average

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Weighted Moving Average

This is a variation on the simple moving average where instead of the weights used to compute the average being equal, they are not equal This allows more recent demand data to have a greater effect on the moving average, therefore the forecast . . . more

Weighted Moving Average

The weights must add to 1.0 and generally decrease in value with the age of the data The distribution of the weights determine impulse response of the forecast

Weighted Moving Average

Ft = w 1 A t-1 + w 2 A t- 2 + w 3 A t-3 + ...+ w n A t- n
Week 1 2 3 4 Demand 650 678 720

Determine the 3-period n weighted moving w i = 1 average forecast i=1 for period 4 Weights (adding up to 1.0): t-1: .5 t-2: .3 t-3: .2

Moving Average Method

Step1: Select the number of periods for which moving average will be computed, thus number N is called an order of moving average
Step 2: Take the average demand for the most recent N periods. This average demand then becomes the forecast for the next period.

Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

Premise--The most recent observations might have the highest predictive value.

Therefore, we should give more weight to the more recent time periods when forecasting.

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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 - minimizes sum of squared deviations around the line

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Simple Linear Regression

Relationship between one independent variable, X, and a dependent variable, Y. Assumed to be linear (a straight line) Form: Y = a + bX

Y = dependent variable X = independent variable a = y-axis intercept b = slope of regression line

Simple Linear Regression Model

Yt = a + bx

0 1 2 3 4 5

x (weeks)

b is similar to the slope. However, since it is calculated with the variability of the data in mind, its formulation is not as straightforward as our usual notion of slope

Calculating a and b
a = y - bx
xy - n(y)(x) x - n(x )
2 2

b=

Regression Equation Example

Week 1 2 3 4 5

Sales 150 157 162 166 177

Develop a regression equation to predict sales based on these five points.

Regression Equation Example

Week Week*Week Sales Week*Sales 1 1 150 150 2 4 157 314 3 9 162 486 4 16 166 664 5 25 177 885 3 55 162.4 2499 Average Sum Average Sum
xy - n( y)(x) 2499 - 5(162.4)(3) 63 b= = = 6.3 55 5(9 ) 10 x - n(x )
2 2

a = y - bx = 162.4 - (6.3)(3) = 143.5

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Regression Equation Example

y = 143.5 + 6.3t
180 175 170 165 160 155 150 145 140 135
1 2 3 4 5

Sales

Sales Forecast

Period
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Forecast Accuracy
Accuracy is the typical criterion for judging the performance of a forecasting approach Accuracy is how well the forecasted values match the actual values

Monitoring Accuracy Accuracy of a forecasting approach needs to be monitored to assess the confidence you can have in its forecasts and changes in the market may require reevaluation of the approach Accuracy can be measured in several ways Mean absolute deviation (MAD) Mean squared error (MSE)

Mean Squared Error (MSE)

MSE = (Syx)2 Small value for Syx means data points tightly grouped around the line and error range is small. The smaller the standard error the more accurate the forecast. MSE = 1.25(MAD) When the forecast errors are normally distributed

Example--MAD
Month 1 2 3 4 5 Sales 220 250 210 300 325 Forecast n/a 255 205 320 315

Determine the MAD for the four forecast periods

Solution
Month 1 2 3 4 5 Sales 220 250 210 300 325 Forecast Abs Error n/a 255 5 205 5 320 20 315 10 40

A
MAD =
t=1

- Ft

40 = = 10 4

Tracking Signal
Tracking signal
Ratio of cumulative error to MAD

Tracking signal

(Actual -forecast) = MAD

Bias Persistent tendency for forecasts to be Greater or less than actual values.

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Criteria for Selecting a Forecasting Method

Cost Accuracy Data available Time span

Nature of products and services

Impulse response and noise dampening

Reasons for Ineffective Forecasting

Not involving a broad cross section of people Not recognizing that forecasting is integral to business planning Not recognizing that forecasts will always be wrong (think in terms of interval rather than point forecasts) Not forecasting the right things (forecast independent demand only) Not selecting an appropriate forecasting method (use MAD to evaluate goodness of fit) Not tracking the accuracy of the forecasting models

Thank you