Lecture Two

Forecasting
 Introduction
a statement about the future value of a
Forecast variablesuch as demand.predictions about
the future

The better those predictionsthe better anticipation of the

futurethus the better planningconsequentlymore
informed decisions can be taken.

Some forecasts are long range (plan the system)covering several

years or moreimportant for decisions that will have long-term
consequencesdeciding the right capacity for the next 20 years

Other forecasts are short term (plan the use of the system)covering
a day or weekimportant for planning and scheduling day to day
operations
 Introduction
Why forecasting is important for operations
managers

The primary goal of operations management is to match supply to

demandso, having a forecast of demand is essential for determining
how much capacity or supply will be needed to meet demand.

Two aspects of forecasts are importantthe expected level of demand

and the degree of accuracy that can be assigned to a forecast (forecast
error).
Features common to all forecasts
Forecast
Forecast techniques
techniques generally
generally assume
assume
that
that the
the same
same underlying
underlying causal
causal system
system
that
that existed
existed inin the
the past
past will
will continue
continue to
to
exist
exist in
in the
the future.
future.
Forecast
Forecast are
are not
not perfectactual
perfectactual results
results
usually
usually differs
differs from
from predicted
predicted values
values
allowances
allowances should
should bebe made
made for
for forecast
forecast
errors.
errors.
Forecasts
Forecasts for
for aa group
group ofof items
items tend
tend to
to be
be
more
more accurate
accurate thanthan forecasts
forecasts for for individual
individual
itemsgrouping
itemsgrouping may may arise
arise ifif parts
parts oror raw
raw
materials
materials are
are used
used for
for multiple
multiple products
products
Forecasts
Forecasts accuracy
accuracy decreases
decreases as
as the
the time
time
period
period covered
covered by
by the
the forecast
forecast increases
increases
 Forecasting accuracy
Forecast accuracy is vitalforecasters want to minimize forecast errors.

Forecast
Forecast error
error isis the
the difference
difference between
between the
the
value
value that
that occurs
occurs and
and thethe value
value that
that was
was
predicted
predicted for
for a
a given
given time
time periodhence,
periodhence,
Error
Error == Actual
Actual Forecast
Forecast
e
ett =
=A Att -- F
Ftt
 Forecasting accuracy
There are three commonly used measures for summarizing errors:

The mean absolute

deviation (MAD)
The mean squared error
(MSE)

The mean absolute percent

error (MAPE)
Note:
MAD is the easiest to computebut weights errors linearly.
MSE squares errors, thereby giving more weight to larger errorswhich
cause more problems.
MAPE should be used when there is a need to put errors in perspective
for example, an error of 10 in a forecast of 15 is hugebut insignificant
in a forecast of 10000.
 Forecasting accuracy
Example Compute MAD, MSE, and MAPE for the following data,
showing actual and forecasted numbers of accounts serviced
 Forecasting accuracy
Example:
 Approaches to forecasting
There are two general approaches to forecasting; qualitative and
quantitative.
Qualitative methodsconsists of Quantitative methodsinvolve either the
subjective inputwith no numerical projection of historical data or the
descriptions development of models with explanatory
It permits inclusion of soft information (ex. variables
Personal opinions) It only analyze objective dataavoiding
personal bias

In practice, either or both approaches are used to develop a forecast

There are variety of forecasting techniques that are classified as:

Judgmental forecastrely on analysis of subjective inputs
Time series forecastsattempt to project past experience into the future
Associative modelsuse equations that consists of explanatory variables
that can be used to predict demand(e.g. demand for paint might be related
to the variables price per gallon, amount spent on advertizing, drying time,
etc)
 Qualitative forecasts
In some situations, forecasters rely solely on judgment and opinion to
make forecasts

When
If managers must have a forecast quicklythey may have no
enough time to collect and analyze quantitative data.
When a new products will be introduced.
When no historical data are available or when it is obsolete
especially when political and economic conditions are
changing).
There are several techniques associated with judgment and
opinion; executive opinions, sales force opinions and
consumer surveys
 Forecasts based on time series
A time-ordered sequence of observations taken at regular intervals
(hourly, daily, weekly, monthly, quarterly, annually)

The data may be measurements of demand, earnings, shipments,

output, etc.

Forecasting techniquesbased on time series dataare made

on the assumption that future values of the series can be
estimated from past valueswith no attempt to identify variables
that influence the series.
 Forecasts based on time series
Analysis of time-series data requires the analyst to identify the
underlying behavior of the series. This can be done by plotting the
data and visually examining the plot. One or more pattern may
appear:
Trendlong-term upward or downward movement in the data.
Seasonalityshort-term, fairly regular variationsgenerally related
to factors such as the calendar or time of day.
Cycleswavelike variations.
Irregular variationsdue to unusual circumstancessevere
weather conditions, etc. They do not reflect typical behavior
whenever possible, these should be identified and removed from
the data.
Random variationsresidual variations that remain after all other
behaviors have been accounted for.
Forecasts based on time series
 Forecasts based on time series
Nave method:
Uses a single previous value of a time series as the basis of a forecast.
It can be used with a stable series (variations around an average), with
seasonal variations or with trends.

A demand forecast should be based on a time series of

past demand i.e. actual demandrather than unit sales.
Sales would not truly reflect demand if one or more stock
outs occurred.
 Forecasts based on time series
Nave method:
Stable series:..If demand for a product last week was 20 casesthenthe
forecast for the next week is 20 cases.

Seasonal variations:..The forecast for this season is equal to the value of the
series last season. For example: the forecast for demand for product X this
summer is equal to the demand for product X last summer.

Trend variationsThe forecast is equal to the last value of the series plus or
minus the difference between the last two values of the series.

Period Actual Change from previous value Forecast

t-2 50
t-1 53 +3
t 53 + 3 = 56
 Forecasts based on time series
Techniques for averaging:
Historical data typically contains a certain amount of random
variations arising from relatively unimportant factors.

Averaging techniques smooth variations in the datato remove

randomness and leave only real variations such as changes in demand.

It smoothes fluctuations in a time seriesbecause the individual highs

and lows in the data offset each other when they are combined into an
average
A forecast based on an average thus tends to exhibit less variability
than the original data.
 Forecasts based on time series
Techniques for averaging:

Many of these movements merely reflect random variability rather

than a true change in the series
Minor variations are treated as random variationswhereas larger
variations are more likely to reflect real changes.
 Forecasts based on time series
Averaging techniques generate forecasts that reflects recent values of
a time series (the average value over the last several periods). Three
techniques for averaging:

Moving
Moving average
average
Weighted
Weighted moving
moving
average
average
Exponential
Exponential smoothing
smoothing
 Forecasts based on time series
Techniques for averaging: Moving average
It uses a number of the most recent actual data values in generating a
forecastit can be computed using the following equation:
 Forecasts based on time series
Techniques for averaging: Moving average
Example Compute a three-period moving average forecast given
demand for shopping carts for the last five periods.

Period Demand
1 42
2 40
3 43
4 40
5 41

If actual demand in period 6 turns out to be 38.

 Forecasts based on time series
Techniques for averaging: Moving average
The moving average can incorporate as many data points as desired.

moving
moving average
average with
with relatively
relatively few
few data
data moving
moving average
average based
based on
on more
more data
data
points
points points
points
Better responsiveness permit quick Smooth more but be less responsive to
adjustment to a step change in the real changesavoiding responding to
databut it will also cause the forecast random variations.
to be somewhat responsive even to
random variations.

The decision maker must weight the cost of responding more slowly to
changes in the data against the cost of responding to what might
simply be random variations.
 Forecasts based on time series
Techniques for averaging: Moving average
The fewer the data point in an average, the more sensitive
(responsive) the average tends to be.
 Forecasts based on time series
Techniques for averaging: weighted moving average
It assigns more weight to the most recent values in a time seriesfor
example, the most recent value might be assigned a weight of 0.4, the
next most recent value a weight of 0.3, the next after that a weight of
0.2 and the next of 0.1.

The heaviest weights are assigned to the most recent values.

 Forecasts based on time series
Techniques for averaging: weighted moving average
Example Given the following demand
data, Period Demand
1 42
a. Compute a weighted average forecast 2 40
using a weight of 0.40 for the most recent 3 43
period, 0.30 for the next most recent,
0.20 for the next, and 0.10 for the next. 4 40
5 41

b. If the actual demand for period 6 is 39,

forecast demand for period 7 using the
same weights as in part a.
 Forecasts based on time series
Techniques for averaging: Exponential smoothing
In exponential smoothing each new forecast is based on the previous
forecast plus a percentage of the difference between the forecast and
the actual value of the series at that point. That is

commonly used values for range from 0.05 to 0.5.

 Forecasts based on time series
Techniques for averaging: Exponential smoothing
For example Suppose the previous forecast was 42 units, actual
demand was 40 units and is 0.1.
The new forecast is Ft = 42 + 0.1(40-42) = 41.8

Note If is large
(near to 1), we quickly
picks up any changes in
demand however
this responds to noise
(unexplained sporadic
increase/decrease in
demand that might not
last very long).
 Forecasts based on time series
ExampleCompare the error performance of these three forecasting techniques
using MAD, MSE and MAPE: a two period moving average, exponential
smoothing with = 0.1 for periods 3 through 11 using the following data:
 Forecasts based on time series
Techniques for trend:
Analysis of trend involves developing an equation that will suitably
describe trend. Trend equation is an important technique that can be
used to develop forecasts when trend is present.
 Forecasts based on time series
Techniques for trendtrend equation
For example:
Consider the trend equation Ft = 45 + 5t. The value of Ft when t = 0 is
45 and the slope of the line is 5which means that on the average,
the value of Ft will increase by five units for each time period.
If t = 10, then the forecast Ft is 45 + 5 (10) = 95 units

The coefficient of the line a and b,

can be computed from historical
data using the following two
equations:
 Forecasts based on time series
Techniques for trendtrend equation
Example:
Cell phone sales for a California-based firm over the last 10 weeks are shown in
the table below.
Determine the equation of the trend line, and predict sales for weeks 11 and 12.
Week Unit sales
1 700
2 724
3 720
4 728
5 740
6 742
7 758
8 750
9 770
10 775
 Forecasts based on time series
Techniques for trendtrend equation
Week (t) Y ty
n = 10, t = 55 and t2 = 385
1 700 700
Then:
2 724 1448
10(41358) 55(7407)
3 720 2160 b = = 7.51
4 728 2912 10(385) 55(55)
5 740 3700 7407 7.51(55)
a = = 699.4
6 742 4452 10
7 758 5306
The trend line is:
8 750 6000
Ft = 699.4 + 7.51t
9 770 6930
10 775 7750
Sum 7407 41358

Substituting the values of t into this equation, the forecast for the next two
periods (at t = 11 and t = 12) are:
F11 = 699.4 + 7.51 (11) = 782.01
F12 = 699.4 + 7.51 (12) = 789.52
 Associative forecasting techniques
It relies on identification of related variables that can be used to
predict values of the variables of interest.

For example: real state prices are usually related to property location
and square footage.; crop yield are related to soil conditions and the
amounts and timing of water and fertilizers applications.

The essence of associative techniques is the development of an

equation that summarizes the effect of predictor variablesthe primary
method of analysis is known as regression.
 Associative forecasting techniques
Simple linear regression
This involves a linear relationship between two variables
As shown in the following
equation:
Yc = a + bx
Where
Yc = dependent variable
X = independent variable
b = slope of the line
a = value of Yc when X =
0
 Associative forecasting techniques
Three conditions are required for an indicator (the
uncontrollable variables that tend to lead or precede changes in
the variable of interest; demand) to be valid:

The relationship between movements of an indicator and movements

of the dependent variable should have a logical explanation.

Movements of the indicator must precede movements of the

dependent variable by enough time so that the forecast isn't outdated
before it can be acted upon.

A fairly high correlation should exist between the two variables.

 Associative forecasting techniques
Correlation measures the strength and direction of relationship
between two variablesit ranges from -1.00 to +1.00

A correlation of +1.00 indicates that changes in one variable

is always matched by changes in the other

A correlation of -1.00 indicates that increases in one variable

are matched by decreases in the other

A correlation close to zero indicates little linear relationship

between two variables.
 Associative forecasting techniques
The correlation between two variables can be calculated using
the following formula:

The square of the correlation coefficient provides a measure of

the percentage of variability in the values of Y that is explained
by the independent variable. It ranges form 0 to -1.

A high value of r2 indicate that the independent variable is a

good predictor of values of the dependent variable.
 Associative forecasting techniques
Example:
Sales of new houses and three-months lagged unemployment
are shown in the following table:
Determine if unemployment levels can be used to predict
demand for new houses and if so derive predictive equation.

Period 1 2 3 4 5 6 7 8 9 10 11
Units sold 20 41 17 35 25 31 38 50 15 19 14
unemployment 7.2 4.0 7.3 5.5 6.8 6.0 5.4 3.6 8.4 7.0 9.0
 Associative forecasting techniques
1- plot the data to see if linear model seems reasonable
 Associative forecasting techniques
2- check the correlation coefficient to confirm that it is not close
to zero:
r = -o.966
This is a fairly high negative correlation. Then the regression
equation is:
y = 71.85 6.91 X

Note that the equation pertains only to unemployment levels in

the range 3.6 to 9.0, because sampled observations covered
only that range.
 Associative forecasting techniques
Multiple regression analysis
Is an extension to the simple regressionhowever, it allows to build a
model with several independent variables

As shown in the following equation:

Y = a + b1x1 + b2x2

Where
Y = dependent variable
X1 and X2= independent variables
b1 and b2= Coefficient for the two independent variables
a = Constant, the value of Y when X = 0