LESSON 4: FORECASTING

Outline

Forecasting Success Stories

Decisions Based on Forecasts
Characteristics of Forecasts
Components of demand
Evaluation of forecasts

Forecasting Success Stories

Sharing forecasting information
along the supply chain is not very
common. The result is forecast error
as much as 60 percent of actual
demand. US economy alone can
save $179 billion in inventory
investment with a coordinated
forecasting. Wal-Mart has initiated
such a process with WarnerLambert, a manufacturer of
Listerine.
Hewlett-Packard uses forecasting
method for new product
development.

Forecasting Success Stories

Taco Bell developed a forecasting
method that gives customer demand
for every 15-minute interval. The
forecast is used to determine the
number of employees required. Taco
Bell achieved labor savings of more
than $40 million from 1993 to 1996.
Compaq delayed the announcement
of several new Pentium-based
models in 1994. The decision was
based on a forecasting method and
contrary to the company belief.

Forecasting Success Stories

Forecasting is necessary to determine the number of
reservations an airline should accept for a particular
flight - overbooking, traffic management, discount
allocation, etc.

Decisions Based on Forecasts

Production
Aggregate planning,
inventory control,
scheduling
Marketing
New product
introduction, salesforce allocation,
promotions
Finance
Plant/equipment
investment, budgetary
planning

Personnel
Workforce planning,
hiring, layoff

Decisions Based on Forecasts

The decisions should not be
segregated by functional area,
as they influence each other
and are best best made jointly.
For example, Coca-cola
considers the demand forecast
over the coming quarter and
decides on the timing of various
promotions. The promotion
information is then used to
update the demand forecast.
Based on this forecast, CocaCola will decide on a
production plan for the quarter.

This plan may require

additional investment, hiring,
or perhaps subcontracting of
production. Coke will make
these decisions based on the
production plan and existing
capacity, and it must make
them all in advance of actual
production.

Characteristics of Forecasts
Forecasts are always
wrong; so consider both
expected value and a
measure of forecast error.
Long-term forecasts are
less accurate than shortterm forecasts. For
example, 7-Eleven Japan

has a replenishment process

that enables it to respond to
an order within hours. If a
store manager places an
order by 10 am, the order is
delivered by 7 pm the same
day. The store manager thus
has to forecast what will sell
that night less than 12 hours
before the actual sale.

Characteristics of Forecasts
Some time series (called aggregate series) are obtained
by summing up more than one time series (called
disaggregate series) . For example, annual sales are
obtained by adding 12 monthly sales. The annual sales
is an aggregate series and monthly sales is a
disaggregate series. Aggregate forecasts are more
accurate than disaggregate forecasts. Variation in GDP
of a country is much less than the annual earnings of a
company. Consequently, it is easy to forecast the GDP
of a country with less than 2% error. However, it is much
more difficult to forecast annual earning of a company
with less than a 2% error.

Components of Demand
Average demand
Trend
Gradual shift in average demand
Seasonal pattern
Periodic oscillation in demand which repeats
Cycle
Similar to seasonal patterns, length and magnitude
of the cycle may vary
Random movements
Auto-correlation

Qantity

Components of Demand

Time
(a) Average: Data cluster about a horizontal line.

Quantity

Components of Demand

Time
(b) Linear trend: Data consistently increase or decrease.

Components of Demand

Quantity

Year 1

Months
(c) Seasonal influence: Data consistently show
peaks and valleys.

Components of Demand

Quantity

Year 1

Year 2
|

Months
(c) Seasonal influence: Data consistently show
peaks and valleys.

Components of Demand

Quantity

Components of Demand

Years
(c) Cyclical movements: Gradual changes over
extended periods of time.

Components of Demand
Suppose that a company
has institute a sales
incentive system that
provides a bonus for the
employee with the best
improvement in bookings
from one month to the next.
With such an incentive in
place, a month of poor sales
is often followed by a month
of good sales. Similarly, a
month of good sales would
usually be followed by a lull.

Components of Demand
This means that sales in
consecutive months tend to
be negatively correlated.
This information can be
used to improve sales
forecasts. Autocorrelation is
the correlation among
values of observed data
separated by a fixed number
of periods. In the example
above, we would say that
the series has a negative
autocorrelation of order one.

Trend
Random
movement
Time

Demand

Demand

Components of Demand

Trend with
seasonal pattern
Time

Snow Skiing
Seasonal
Long term growth trend

Demand for skiing products increased

sharply after the Nagano Olympics

Evaluation of Forecast
There are many forecasting techniques and software. The
performance of a forecasting technique can be measured by
the error produced over time.
We shall now discuss various measures used to evaluate
forecasting techniques. Let,
Dt Actual data in period t
F t Forecast in period t
Et Forecast error in period t Ft Dt
Standard deviation of forecast errors
MSE Mean Squared Error
MAD Mean Absolute Deviation
MAPE Mean Absolute Percentage Error

Evaluation of Forecast

Measures of Forecast Error

Et = Ft - Dt

MSE =
=

2
t

n
MSE

MAD =
MAPE =

|Et |
n

[ |Et | (100) ] / Dt
n

Evaluation of Forecast

Month,
t

Demand,
Dt

Forecast,
Ft

1
2
3
4
5
6
7
8

200
240
300
270
230
260
210
275

225
220
285
290
250
240
250
240

Total

Error,
Et

Absolute
Error
Absolute
Percent
Squared, Error,
Error,
2
Et
|Et|
(|Et|/Dt)(100)

Evaluation of Forecast

Measures of Error

MSE =
MAD =

MAPE =

=
=

READING AND EXERCISES

Lesson 4
Reading:
Section 2.1-2.6, pp. 55-66 (4th Ed.), pp. 51-63 (5th
Ed.)
Exercises:
12, 13, 15, pp. 65-66 (4th Ed.), pp. 62-63 (5th Ed.)