OTM 841

OPERATIONS MANAGEMENT

Lecture 3 & 4:
Forecasting
16th February 2024
Dr. Muhammad Moazzam
Assistant Professor Operations and Supply Chain
NUST BUSINESS SCHOOL (NBS)
National University of Sciences & Technology, Islamabad, Pakistan
 Dr. Muhammad Moazzam

Outline

● What Is Forecasting?
● Seven Steps in the Forecasting System
● Forecasting Approaches
● Time-Series Forecasting
● Associative Forecasting Methods: Regression
and Correlation Analysis
● Monitoring and Controlling Forecasts
● Forecasting in the Service Sector

Dr. Muhammad Moazzam 2

 Dr. Muhammad Moazzam

Learning Objectives

When you complete this chapter, you

should be able to:
1. Apply forecasting tools and techniques
on business scenarios
2. Compute three measures of forecast
accuracy
3. Develop seasonal indices
4. Conduct regression and correlation
analysis

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 Dr. Muhammad Moazzam

What is Forecasting?

► Process of predicting a
future event
► Underlying basis
of all business decisions
► Production
??
► Inventory

► Personnel

► Facilities

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 Dr. Muhammad Moazzam

Forecasting Time Horizons

1. Short-range forecast
► Up to 1 year, generally less than 3 months
► Purchasing, job scheduling, workforce levels, job
assignments, production levels
2. Medium-range forecast
► 3 months to 3 years
► Sales and production planning, budgeting
3. Long-range forecast
► 3+ years
► New product planning, facility location, research
and development
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 Dr. Muhammad Moazzam

Types of Forecasts

1. Economic forecasts
► Address business cycle – inflation rate, money
supply, housing starts, etc.
2. Technological forecasts
► Predict rate of technological progress
► Impacts development of new products
3. Demand forecasts
► Predict sales of existing products and services
based on POS data

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 Dr. Muhammad Moazzam

Strategic Importance of Forecasting

● Supply-Chain Management
⌂ Good supplier relations, advantages in product
innovation, cost and speed to market
● Human Resources
⌂ Hiring, training, laying off workers
● Capacity Planning
⌂ Capacity shortages can result in undependable
delivery, loss of customers, loss of market share

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 Dr. Muhammad Moazzam

Seven Steps in Forecasting

Determine the Determine the
Select the items
use of the time horizon of
to be forecasted
forecast the forecast

Gather the data Select the

Make the
needed to make forecasting
forecast
the forecast model(s)

Validate and
implement
results

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 Dr. Muhammad Moazzam

The Realities!

● Forecasts are seldom perfect, unpredictable

outside factors may impact the forecast
● Most techniques assume an underlying stability
in the system
● Product family and aggregated forecasts are
more accurate than individual product forecasts

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 Dr. Muhammad Moazzam

Forecasting Approaches
Qualitative Methods
● Used when situation is vague and little data
exist
⌂ New products
⌂ New technology
● Involves intuition, experience
⌂ e.g., forecasting sales on Internet

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 Dr. Muhammad Moazzam

Forecasting Approaches

Quantitative Methods

● Used when situation is ‘stable’ and historical data

exist
⌂ Existing products
⌂ Current technology
● Involves mathematical techniques
⌂ e.g., forecasting sales of color televisions

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 Dr. Muhammad Moazzam

Qualitative Methods

● Jury of executive opinion

⌂ Involves high-level experts and managers
● Delphi method
⌂ Iterative group process, continues until consensus is
reached
⌂ Decision makers, staff, and respondents
● Sales force composite
● Market Survey

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 Dr. Muhammad Moazzam

Quantitative Approaches

1. Naive approach
2. Moving averages
Time-series
3. Exponential smoothing models
4. Trend projection
Associative
5. Linear regression model

Dr. Muhammad Moazzam 13

 Time Series Analysis
Trend
component
Demand for product or service

Seasonal peaks

Actual demand
line

Average demand
over 4 years

Random variation
| | | |
1 2 3 4
Time (years)
Figure 4.1

14
 Trend Component
► Persistent, overall upward or
downward pattern
► Changes due to population,

technology, age, culture, etc.

► Typically, several year duration

15
 Seasonal Component
► Regular pattern of up and down
fluctuations
► Due to weather, customs, etc.
► Occurs within a single year
PERIOD LENGTH “SEASON” LENGTH NUMBER OF “SEASONS” IN PATTERN
Week Day 7
Month Week 4 – 4.5
Month Day 28 – 31
Year Quarter 4
Year Month 12
Year Week 52

16
 Cyclical Component
► Repeating up and down movements
► Affected by business cycle, political,
and economic factors
► Multiple years duration
► Often causal or
associative
relationships

0 5 10 15 20
17
 Random Component
► No discernible patterns
► Hard to predict
► Due to random variation or unforeseen
events
► Short duration
and nonrepeating

M T
W T 18
F
 1. Naive Approach
► Assumes demand in next
period is the same as
demand in most recent period
► e.g., If January sales were 68, then
February sales will be 68
► Sometimes cost effective and
efficient
► Can be good starting point

19
2. Moving Average Method
► MA is a series of arithmetic means
► Used if little or no trend
► Used often for smoothing
► Provides overall impression of data
over time

20
 Moving Average Example
Donna’s Garden Supply wants a 3-month moving-average forecast, including a
forecast for next January, for shed sales.
MONTH ACTUAL SHED SALES 3-MONTH MOVING AVERAGE
January 10
February 12
12
March 13
13
April 16 (10 + 12 + 13)/3 = 11 2/3
May 19 (12 + 13 + 16)/3 = 13 2/3
June 23 (13 + 16 + 19)/3 = 16
July 26 (16 + 19 + 23)/3 = 19 1/3
August 30
(19 + 23 + 26)/3 = 22 2/3
September 28
(23 + 26 + 30)/3 = 26 1/3
October 18
November 16 (29 + 30 + 28)/3 = 28

December 14 (30 + 28 + 18)/3 = 25 1/3

(28 + 18 + 16)/3 = 20 2/3
The forecast for December is 20 2/3. To project the demand for sheds in the coming
January, we sum the October, November, and December sales and divide by 3:
21
January forecast = (18 + 16 + 14)/3 = 16.
 Activity-IMonth Call Volume
1 6,809
2 6,465
► A call Centre 3 6,569
data 4 8,266
5 7,257
► On Excel, 6 7,064
7 7,784
compute 3- 8 8,724
months moving 9 6,992
average 10 6,822
11 7,949
► Develop a 12 9,650
13
graph

22
 Weighted Moving Average
► Used when some trend might be
present
► Older data usually less important
► Weights based on experience and
intuition

Weighted
moving
average

23
 Weighted Moving Average
Donna’s Garden Supply wants to forecast storage shed sales by weighting the past
3 months, with more weight given to recent data to make them more significant.
MONTH ACTUAL SHED SALES 3-MONTH WEIGHTED MOVING AVERAGE
January 10
February 12
12
March 13
13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 = 12 1/6
May 19
June WEIGHTS
23 APPLIED PERIOD
July 26 3 Last month
August 30 2 Two months ago
September 28 1 Three months ago
October 18 6 Sum of the weights
November Forecast for
16this month =
December 3 x 14
Sales last mo. + 2 x Sales 2 mos. ago + 1 x Sales 3 mos. ago
Sum of the weights

24
 Weighted Moving Average
MONTH ACTUAL SHED SALES 3-MONTH WEIGHTED MOVING AVERAGE
January 10
February 12
12
March 13
13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 = 12 1/6
May 19 [(3 x 16) + (2 x 13) + (12)]/6 = 14 1/3
June 23
[(3 x 19) + (2 x 16) + (13)]/6 = 17
July 26
[(3 x 23) + (2 x 19) + (16)]/6 = 20 1/2
August 30
[(3 x 26) + (2 x 23) + (19)]/6 = 23 5/6
September 28
[(3 x 30) + (2 x 26) + (23)]/6 = 27 1/2
October 18
November 16 [(3 x 28) + (2 x 30) + (26)]/6 = 28 1/3
December 14 [(3 x 18) + (2 x 28) + (30)]/6 = 23 1/3
[(3 x 16) + (2 x 18) + (28)]/6 = 18 2/3
The forecast for January is 15 1/3. Do you see how this number is computed?

25
 Potential Problems With
Moving Average
► Increasing n smooths the forecast but
makes it less sensitive to changes
► Does not forecast trends well

► Requires extensive historical data

26
 Graph of Moving Averages
Weighted moving average

30 –

25 –
Sales demand

20 –
Actual sales
15 –

Moving average
10 –

5–
| | | | | | | | | |

F M A M J J A S O N
Figure 4.2 Month

27
 Exponential Smoothing
 Form of weighted moving average
 Weights decline exponentially
 Most recent data weighted most
 Requires smoothing constant ()
 Ranges from 0 to 1
 Subjectively chosen
 Involves little record keeping of past data

28
 Exponential Smoothing
New forecast = Last period’s forecast +  (Last
period’s actual demand – Last
period’s forecast)

Ft = Ft – 1 +  (At – 1 - Ft – 1)

where Ft = new forecast

Ft – 1 = previous period’s forecast
 = smoothing (or weighting) constant (0 ≤  ≤ 1)
At – 1 = previous period’s actual demand

29
Exponential Smoothing Example

In January, a car dealer predicted February demand

for 142 Ford Mustangs. Actual February demand
was 153 autos. Using a smoothing constant chosen
by management at  = .20, the dealer wants to
forecast March demand using the exponential
smoothing model.

Predicted demand = 142 Ford Mustangs

Actual demand = 153
Smoothing constant a = .20

4 - 30
 Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs

Actual demand = 153
Smoothing constant  = .20

New forecast = 142 + .2(153 – 142)

= 142 + 2.2
= 144.2 ≈ 144 cars

4 - 31
 Effect of Smoothing
Constants
o Smoothing constant generally .05 ≤ a ≤ .50
o As a increases, older values become less significant
WEIGHT ASSIGNED TO
SMOOTHI MOST 2ND MOST 3RD MOST 4th MOST 5th MOST
NG RECENT RECENT RECENT RECENT RECENT
CONSTAN PERIOD PERIOD PERIOD PERIOD PERIOD
T (a ) a(1 – a) a(1 – a)2 a(1 – a)3 a(1 – a)4
a = .1 .1 .09 .081 .073 .066
a = .5 .5 .25 .125 .063 .031

When is high the

When is low the
forecast places less
forecast places less
weight in the old
weight in the
demand
recent demand
32
 Impact of Different 
225 –

Actual demand a = .5
200 –
Demand

175 –

150 –
a = .1

| | | | | | | | |
1 2 3 4 5 6 7 8 9

Quarter

33
 Impact of Different 
225 –
o Chose high values of  when
200 –
underlyingActual
average
demand is more a = .5

likely to change
Demand

o
175 – Choose low values of  when
underlying average is stable
150 –
a = .1

| | | | | | | | |
1 2 3 4 5 6 7 8 9

Quarter

34
 Activity-II
Emergency calls to Rescue 1122 Islamabad for the past 4
weeks are shown in the following table:

Week Calls Week Calls

1 50 5 45
2 35 6 35
3 25 7 20
4 40 8 30

Assume an initial forecast for 50 calls for week1.

a) Forecast number of calls for weeks 2-9 using
exponential smoothing method at α = .5
b) Draw a graph of actual demand and the forecasted
demand for 9 weeks 35
 Choosing 
The objective is to obtain the most accurate
forecast no matter the technique

We generally do this by selecting the model that gives

us the lowest forecast error

Forecast error = Actual demand – Forecast value

= At – Ft

36
Common Measures of Error

1. Mean Absolute Deviation (MAD)

37
 Determining the MAD:
Example
During the past 8 quarters, the Port of Baltimore
has unloaded large quantities of grain from
ships. The port’s operations manager wants to
test the use of exponential smoothing to see
how well the technique works in predicting
tonnage unloaded. He guesses that the forecast
of grain unloaded in the first quarter
was 175 tons. Two values of are to be
examined: = .10 and = .50.

38
 Determining the MAD
ACTUAL
TONNAGE FORECAST WITH
QUARTER UNLOADED FORECAST WITH a = .10 a = .50
1 180 175 175

2 168 175.50 = 175.00 + .10(180 – 175) 177.50

3 159 174.75 = 175.50 + .10(168 – 175.50) 172.75

4 175 173.18 = 174.75 + .10(159 – 174.75) 165.88

5 190 173.36 = 173.18 + .10(175 – 173.18) 170.44

6 205 175.02 = 173.36 + .10(190 – 173.36) 180.22

7 180 178.02 = 175.02 + .10(205 – 175.02) 192.61

8 182 178.22 = 178.02 + .10(180 – 178.02) 186.30

9 ? 178.59 = 178.22 + .10(182 – 178.22) 184.15

39
 Determining the MAD
ACTUAL FORECAST ABSOLUTE FORECAST ABSOLUTE
TONNAGE WITH DEVIATION WITH DEVIATION
QUARTER UNLOADED a = .10 FOR a = .10 a = .50 FOR a = .50
1 180 175 5.00 175 5.00

2 168 175.50 7.50 177.50 9.50

3 159 174.75 15.75 172.75 13.75

4 175 173.18 1.82 165.88 9.12

5 190 173.36 16.64 170.44 19.56

6 205 175.02 29.98 180.22 24.78

7 180 178.02 1.98 192.61 12.61

8 182 178.22 3.78 186.30 4.30

Sum of absolute deviations: 82.45 98.62

Σ|Deviations|
MAD = 10.31 12.33
n

40
Common Measures of Error

2. Mean Squared Error (MSE)

41
 Determining the MSE
ACTUAL
TONNAGE FORECAST FOR
QUARTER UNLOADED a = .10 (ERROR)2
1 180 175 52 = 25
2 168 175.50 (–7.5)2 = 56.25
3 159 174.75 (–15.75)2 = 248.06
4 175 173.18 (1.82)2 = 3.31
5 190 173.36 (16.64)2 = 276.89
6 205 175.02 (29.98)2 = 898.80
7 180 178.02 (1.98)2 = 3.92
8 182 178.22 (3.78)2 = 14.29
Sum of errors squared = 1,526.52

Compare with value of

42
Common Measures of Error

3. Mean Absolute Percent Error (MAPE)

43
 Common Measures of Error
The Port of Baltimore wants to now calculate the
MAPE when = .10.
FORECAST ABSOLUTE PERCENT ERROR =
QUARTER ACTUAL = .10 100(|ERROR|/ACTUAL)
1 180 175.00 100(5/180) = 2.78%
2 168 175.50 100(7.5/168) = 4.46%
3 159 174.75 100(15.75/159) = 9.90%
4 175 173.18 100(1.82/175) = 1.05%
5 190 173.36 100(16.64/190) = 8.76%
6 205 175.02 100(29.98/205) = 14.62%
7 180 178.02 100(1.98/180) = 1.10%
8 182 178.22 100(3.78/182) = 2.08%
SUM OF % ERROR= 44.75%

Compare with value of

44
Comparison of Forecast Error

Rounded Absolute Rounded Absolute

Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 190.82 195.24
MAPE 5.59% 6.76%

45
 Activity-III
▶ Apply MAD, MSE, and MAPE on the data
provided in Activity-II

46
Exponential Smoothing with Trend Dr. Muhammad Moazzam

Adjustment

When a trend is present, exponential smoothing

must be modified to respond to trend

Forecast Exponentially Exponentially

including (FITsmoothed
t) = (Ft) + smoothed (Tt)
trend forecast trend

Dr. Muhammad Moazzam 47

Exponential Smoothing with Trend
Adjustment
Assume that demand for our product or service has
been increasing by 100 units per month and that we
have been forecasting with = 0.4 in our exponential
smoothing model. The following table shows a severe
lag in the second, third, fourth, and fifth months, even
when our initial estimate for month 1 is perfect:
Exponential Smoothing with Trend Adjustment

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

Tt = (Ft - Ft - 1) + (1 - )Tt - 1

= exponentially smoothed forecast average of the data series in

period t
= exponentially smoothed trend in period t
= actual demand in period t
= smoothing constant for the average (1)
= smoothing constant for the trend (1)
Exponential Smoothing with Trend Adjustment:
Procedure
Step 1: Compute Ft
Step 2: Compute Tt
Step 3: Calculate the forecast FITt = Ft + Tt
Example for Exponential Smoothing with Trend
Adjustment

A Portland manufacturer wants to forecast the demand for a pollution-

control equipment. Past data shows that there is an increasing trend.
The company assumes the initial forecast for month 1 was 11 units and
the trend over that period was 2 units. α = 0.2 β =0.4
 Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17
3 20
Step 1: Forecast for Month 2
4 19
5 24 F2 =α A1 + (1 - α)(F1 + T1)
6 21
7 31 F2 = (.2)(12) + (1 - .2)(11 + 2)
8 28 = 2.4 + 10.4 = 12.8 units
9 36
10
 Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80
3 20
Step 2: Trend for Month 2
4 19
5 24 T2 = β(F2 - F1) + (1 - β)T1
6 21
7 31 T2 = (.4)(12.8 - 11) + (1 - .4)(2)
8 28 = .72 + 1.2 = 1.92 units
9 36
10
 Exponential Smoothing with
Trend Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80 1.92
3 20
Step 3: Calculate FIT for Month 2
4 19
5 24 FIT2 = F2 + T2
6 21
7 31 FIT2 = 12.8 + 1.92
8 28 = 14.72 units
9 36
10
Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80 1.92 14.72
3 20 15.18 2.10 17.28
4 19 17.82 2.32 20.14
5 24 19.91 2.23 22.14
6 21 22.51 2.38 24.89
7 31 24.11 2.07 26.18
8 28 27.14 2.45 29.59
9 36 29.28 2.32 31.60
10 32.48 2.68 35.16
Exponential Smoothing with
Trend Adjustment Example
35 –
Actual demand (At)
30 –
Product demand

25 –

20 –

15 –

10 –
Forecast including trend (FITt)
with  = .2 and  = .4
5 –

0 – | | | | | | | | |
1 2 3 4 5 6 7 8 9
Time (month)
 Trend Projections
Fitting a trend line to historical data points to project into the medium
to long-range
Linear trends can be found using the least squares technique

y^ = a + bx
^ where y = computed value of the
variable to be predicted (dependent
variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable
 Least Squares Method
Values of Dependent Variable

Actual observation Deviation7

(y-value)

Deviation5 Deviation6

Deviation3

Deviation4

Deviation1
(error) Deviation2
Trend line, y ^= a + bx

Time period
 Least Squares Method
Values of Dependent Variable

Actual observation Deviation7

(y-value)

Deviation5 Deviation6

Deviation3 Least squares method

minimizes the sum of the
squared errors (deviations)
Deviation4

Deviation1
(error) Deviation2
Trend line, y ^= a + bx

Time period
 Least Squares Method

Equations to calculate the regression variables

^ = a + bx
y

Sxy - nxy
b=
Sx2 - nx2

a = y - bx
 Least Squares Example
The demand for electric power at N.Y. Edison over 7 years is shown in
the table, in megawatts. The firm wants to forecast demand for years
2013 by fitting a straight-line trend to these data.
Time Electrical Power
Year Period (x) Demand (megawatt) x2 xy
2006 1 74 1 74
2007 2 79 4 158
2008 3 80 9 240
2009 4 90 16 360
2010 5 105 25 525
2011 6 142 36 852
2012 7 122 49 854
∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063
x=4 y = 98.86

∑xy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
∑x2 - nx2 140 - (7)(42)

a = y - bx = 98.86 - 10.54(4) = 56.70

 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
2003 1 74 1 74
2004 2 79 4 158
2005The trend
3 line is 80 9 240
2006 4 90 16 360
2007 ^
y =5 56.70 + 10.54x
105 25 525
2008 6 142 36 852
2009 7 122 49 854
∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063
x=4 y = 98.86

∑xy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
∑x2 - nx2 140 - (7)(42)

a = y - bx = 98.86 - 10.54(4) = 56.70

 Least Squares Example
Trend line,
160 –
150 –
y^ = 56.70 + 10.54x
140 –
Power demand

130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
50 –
| | | | | | | | |
2006 2007 2008 2009 2010 2011 2012 2013 2014
Year
 Least Squares Requirements

1. We always plot the data to ensure a linear relationship

2. We do not predict time periods far beyond the database

3. Deviations around the least squares line are assumed to

be random and normally distributed.
 Seasonal Variations In Data

The multiplicative seasonal model

can adjust trend data for seasonal
variations in demand (jet skis, snow
mobiles)
 Seasonal Variations In Data
Steps in the process:

1. Find average historical demand for each season (or month)

2. Compute the average demand over all seasons
3. Compute a seasonal index for each season
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the number of seasons,
then multiply it by the seasonal index for that season
 Seasonal Index Example
A Des Moines distributor of Sony laptop computers wants to develop
monthly indices for sales. Data from the past 3 years, by month, are
available.
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012 Monthly Index
Jan 80 85 105 90 94
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Apr 90 95 115 100 94
May 113 125 131 123 94
Jun 110 115 120 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94
Mar 80 93 Average
82 85 monthly demand
2010-2012 94
Seasonal 90
Apr index =95 115 Average monthly
100 94
demand
May 113 125 131 123 94
Jun 110 = 90/94
115 120 = .957 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90 95 115 100 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 115 94 1.223
Jul 100 102 113 105 94 1.117
Aug 88 102 110 100 94 1.064
Sept 85 90 95 90 94 0.957
Oct 77 78 85 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012
Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 Forecast
85 for 2013
80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90Expected
95 annual demand
115 100 = 1,200 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 1,200 115 94 1.223
Jul 100 102Jan 113 x105
.957 = 96 94 1.117
12
Aug 88 102 110 100 94 1.064
Sept 85 90 1,200 90
Feb 95 x .851 = 85 94 0.957
Oct 77 78 85 12 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
 Seasonal Index Example
2013 Forecast
140 – 2012 Demand
130 – 2011 Demand
2010 Demand
120 –
Demand

110 –
100 –
90 –
80 –
70 –
| | | | | | | | | | | |
J F M A M J J A S O N D
Time
 Associative Forecasting Methods

Used when changes in one or more independent variables can be

used to predict the changes in the dependent variable

Most common technique is linear regression analysis

We apply this technique just as we did in the time series example

 Associative Forecasting
Forecasting an outcome based on predictor variables using the least
squares technique

y^ = a + bx
^ where y = computed value of the
variable to be predicted (dependent
variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable
though to predict the value of the
dependent variable
 Associative Forecasting Example
Nodel Construction Company renovates old homes in West Bloomfield,
Michigan. Over time, the company has found that its dollar volume of
renovation work is dependent on the West Bloomfield area payroll. Management
wants to establish a mathematical relationship to help predict sales.

Sales Area Payroll

($ millions), y ($ billions), x
2.0 1
3.0 3
2.5 4
2.0 2 4.0 –
2.0 1
3.0 –

Sales
3.5 7
2.0 –

1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
 Associative Forecasting Example

Sales, y Payroll, x x2 xy
2.0 1 1 2.0
3.0 3 9 9.0
2.5 4 16 10.0
2.0 2 4 4.0
2.0 1 1 2.0
3.5 7 49 24.5
∑y = 15.0 ∑x = 18 ∑x2 = 80 ∑xy = 51.5

∑xy - nxy 51.5 - (6)(3)(2.5)

x = ∑x/6 = 18/6 = 3 b= = = .25
∑x2 - nx2 80 - (6)(32)

y = ∑y/6 = 15/6 = 2.5 a = y - bx = 2.5 - (.25)(3) = 1.75

 Associative Forecasting Example

y^ = 1.75 + .25x Sales = 1.75 + .25(payroll)

If payroll next year

is estimated to be $6 4.0 –
billion, then: 3.25
3.0 –

Sales = 1.75 + .25(6) Nodel’s sales 2.0 –

Sales = $3,250,000
1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
 Correlation
• How strong is the linear relationship between the variables?
• Correlation does not necessarily imply causality!
• Coefficient of correlation, r, measures degree of association
• Values range from -1 to +1

nSxy - SxSy
r=
[nSx2 - (Sx)2][nSy2 - (Sy)2]
 y
y Correlation Coefficient
nSxy - SxSy
r=
[nSx2 - (Sx)2][nSy2 - (Sy)2] (b) Positive x
(a) Perfect positive x correlation:
correlation: 0<r<1
r = +1

y y

(c) No correlation: x (d) Perfect negative x

r=0 correlation:
r = -1
 Correlation Analysis: Example
In previous example , we looked at the relationship between Nodel
Construction Company’s renovation sales and payroll in its hometown of West
Bloomfield. The VP now wants to know the strength of the association between
area payroll and sales.
 Correlation
Coefficient of Determination, r2, measures the percent of change in y
predicted by the change in x
1. Values range from 0 to 1
2. Easy to interpret

For the Nodel Construction example:

r = .901
r2 = .81
 Activity
Dave Fletcher, the general manager of North Carolina Engineering Corporation
(NCEC), thinks that his firm’s engineering services contracted to highway
construction firms are directly related to the volume of highway construction
business contracted with companies in his geographic area. He wonders if this
is really so, and if it is, can this information help him plan his operations better
by forecasting the quantity of his engineering services required by construction
firms in each quarter of the year? The following table presents the sales of his
services and total amounts of contracts for highway construction over the past
eight quarters:

a) Using this data, develop a regression equation for predicting the level of
demand of NCEC’s services.
b) Determine the coefficient of correlation and the standard error of the
estimate.
 Multiple Regression Analysis

If more than one independent variables are to be used in the model,

linear regression can be extended to multiple regression to
accommodate several independent variables

^y = a + b x + b x …
1 1 2 2

Computationally, this is quite complex and generally done on the

computer
 Multiple Regression Analysis

In the Nodel example, including interest rates in the model gives

the new equation:
^
y = 1.80 + .30x1 - 5.0x2

An improved correlation coefficient of r = .96 means this model

does a better job of predicting the change in construction sales

Sales = 1.80 + .30(6) - 5.0(.12) = 3.00

Sales = $3,000,000
 Focus Forecasting
► Developed at American Hardware Supply,
based on two principles:
1. Sophisticated forecasting models are not
always better than simple ones
2. There is no single technique that should be
used for all products or services

► Uses historical data to test multiple

forecasting models for individual items
► Forecasting model with the lowest error used
to forecast the next demand

84
 Forecasting in the Service
Sector
► Presents unusual challenges
► Special need for short term records i.e.
Barber shops, Banks
► Needs differ greatly as function of
industry and product i.e. flower shop
► Holidays and other calendar events
► Unusual events

85
 Fast Food Restaurant Forecast
Percentage of sales by hour of day

20% – Figure 4.12

15% –

10% –

5% –

11-12 1-2 3-4 5-6

7-8 9-10
12-1
(Lunchtime) 2-3 4-5
(Dinnertime) 6-7
8-9 Hour of day10-11
86
 FedEx Call Center Forecast
Figure 4.12
12% –

10% –

8% –

6% –

4% –

2% –

0% – 2 4 6 8 10 12 2 4 6 8 10 12
A.M. P.M.
Hour of day

87