Chapter 3
Forecasting
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Forecast
Forecast – a statement about the future
value of a variable of interest
We make forecasts about such things as
weather, demand, and resource availability
Forecasts are important to making informed
decisions
3-2
Two Important Aspects of Forecasts
Expected level of demand
The level of demand may be a function of some
structural variation such as trend or seasonal
variation
Accuracy
Related to the potential size of forecast error
3-3
Forecast Uses
Plan the system
Generally involves long-range plans related to:
Types of products and services to offer
Facility and equipment levels
Facility location
Plan the use of the system
Generally involves short- and medium-range
plans related to:
Inventory management
Workforce levels
Purchasing
Production
Budgeting
Scheduling
3-4
Forecasts are not Perfect
Forecasts are not perfect:
Because random variation is always
present, there will always be some
residual error, even if all other factors
have been accounted for.
3-5
Elements of a Good Forecast
The forecast
should be timely
should be accurate
should be reliable
should be expressed in meaningful units
should be in writing
technique should be simple to understand and
use
should be cost-effective
3-6
Steps in the Forecasting Process
1. Determine the purpose of the forecast
2. Establish a time horizon
3. Obtain, clean, and analyze appropriate data
4. Select a forecasting technique
5. Make the forecast
6. Monitor the forecast errors
3-7
Forecast Accuracy and Control
Allowances should be made for forecast
errors
It is important to provide an indication of the
extent to which the forecast might deviate from
the value of the variable that actually occurs
Forecast errors should be monitored
Error = Actual – Forecast
If errors fall beyond acceptable bounds,
corrective action may be necessary
3-8
Forecast Accuracy Metrics
MAD
Actual t Forecast t MAD weights all errors
n evenly
Actual t Forecast t
2
MSE weights errors according
MSE to their squared values
n 1
Actual t Forecast t
Actual t
100
MAPE weights errors
MAPE
n according to relative error
3-9
Forecast Error Calculation
Actual Forecast (A-F)
Period
(A) (F) Error |Error| Error2 [|Error|/Actual]x100
1 107 110 -3 3 9 2.80%
2 125 121 4 4 16 3.20%
3 115 112 3 3 9 2.61%
4 118 120 -2 2 4 1.69%
5 108 109 1 1 1 0.93%
Sum 13 39 11.23%
n=5 n-1 = 4 n=5
MAD MSE MAPE
= 2.6 = 9.75 = 2.25%
3-10
Forecasting Approaches
Qualitative Forecasting
Qualitative techniques permit the inclusion of soft
information such as:
Human factors
Personal opinions
These factors are difficult, or impossible, to
quantify
Quantitative Forecasting
These techniques rely on hard data
Quantitative techniques involve either the
projection of historical data or the development of
associative methods that attempt to use causal
variables to make a forecast 3-11
Qualitative Forecasts
Forecasts that use subjective inputs such as opinions from
consumer surveys, sales staff, managers, executives, and experts
Executive opinions
a small group of upper-level managers may meet and collectively
develop a forecast
Sales force opinions
members of the sales or customer service staff can be good
sources of information due to their direct contact with customers
and may be aware of plans customers may be considering for the
future
Consumer surveys
since consumers ultimately determine demand, it makes sense to
solicit input from them
consumer surveys typically represent a sample of consumer
opinions
Other approaches
managers may solicit opinions from other managers or staff
people or outside experts to help with developing a forecast. 3-12
the Delphi method is an iterative process intended to achieve a
Time-Series Forecasts
Forecasts that project patterns identified in
recent time-series observations
Time-series - a time-ordered sequence of
observations taken at regular time intervals
Assume that future values of the time-series
can be estimated from past values of the
time-series
3-13
Time-Series Forecasting - Naïve Forecast
Naïve Forecast
Uses a single previous value of a time series as
the basis for a forecast
The forecast for a time period is equal to the
previous time period’s value
Can be used with
a stable time series
seasonal variations
3-14
Time-Series Forecasting - Averaging
These techniques work best when a series
tends to vary about an average
Averaging techniques smooth variations in the
data
They can handle step changes or gradual
changes in the level of a series
Techniques
1. Moving average
2. Weighted moving average
3. Exponential smoothing
3-15
Moving Average
Technique that averages a number of the
most recent actual values in generating a
forecast n
At i
At n ... At 2 At 1
Ft MA n i 1
n n
where
Ft Forecast for time period t
MA n n period moving average
At i Actual value in period t i
n Number of periods in the moving average
3-16
Moving Average
As new data become available, the forecast is
updated by adding the newest value and
dropping the oldest and then re-computing
the average
The number of data points included in the
average determines the model’s sensitivity
Fewer data points used-- more responsive
More data points used-- less responsive
3-17
Moving Average Example
MONTH ACTUAL SHED SALES 3-MONTH MOVING AVERAGE
January 10
February 12
March 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 (29 + 30 + 28)/3 = 28
November 16 (30 + 28 + 18)/3 = 25 1/3
December 14
(28 + 18 + 16)/3 = 20 2/3
3-18
Weighted Moving Average
The most recent values in a time series are
given more weight in computing a forecast
The choice of weights, w, is somewhat
arbitrary and involves some trial and error
Ft wt ( At ) wt 1 ( At 1 ) ... wt n ( At n )
where
wt weight for period t , wt 1 weight for period t 1, etc.
At the actual value for period t , At 1 the actual value for period t 1, etc.
3-19
Weighted Moving Average
MONTH ACTUAL SHED SALES 3-MONTH WEIGHTED MOVING AVERAGE
January 10
February 12
March 13
April 16 [(0.5 x 13) + (0.3 x 12) + (0.2 x10)] =12.1
May 19
June WEIGHTS
23 APPLIED PERIOD
July 26 0.5 Last month
August 30 0.3 Two months ago
September 28 0.2 Three months ago
October Forecast for
18this month =
November 0.5 x Sales
16 last mo. +0. 3 x Sales 2 mos. ago + 0.2 x Sales 3 mos. ago
December 14
3-20
Weighted Moving Average
MONTH ACTUAL SHED SALES 3-MONTH WEIGHTED MOVING AVERAGE
January 10
February 12
March 13
April 16 [(0.5 x 13) + (0.3 x 12) + (0.2 x10)] = 12.1
May 19 [(0.5 x 16) + (0.3 x 13) + (0.2 x12)] = 14.3
3-21
Exponential Smoothing
A weighted averaging method that is based
on the previous forecast plus a percentage of
the forecast error
Ft Ft 1 ( At 1 Ft 1 )
where
Ft Forecast for period t
Ft 1 Forecast for the previous period
= Smoothing constant
At 1 Actual demand or sales from the previous period
3-22
Exponential Smoothing Example
Predicted demand = 142 cars
Actual demand = 153
Smoothing constant a = .20
© 2014 Pearson Education 4 - 23
Exponential Smoothing Example
Predicted demand = 142 cars
Actual demand = 153
Smoothing constant a = .20
New forecast = 142 + .2(153 – 142)
© 2014 Pearson Education 4 - 24
Exponential Smoothing Example
Predicted demand = 142 cars
Actual demand = 153
Smoothing constant a = .20
New forecast = 142 + .2(153 – 142)
= 142 + 2.2
= 144.2 ≈ 144 cars
© 2014 Pearson Education 4 - 25
Linear Trend
A simple data plot can reveal the existence
and nature of a trend
Linear trend equation
3-26
Estimating slope and intercept
Slope and intercept can be estimated from
historical data
3-27
Linear Trend Example
ELECTRICAL ELECTRICAL
YEAR POWER DEMAND YEAR POWER DEMAND
1 74 5 105
2 79 6 142
3 80 7 122
4 90
3-28
Linear Trend Example
ELECTRICAL POWER
YEAR (x) DEMAND (y) x2 xy
1 74 1 74
2 79 4 158
3 80 9 240
4 90 16 360
5 105 25 525
6 142 36 852
7 122 49 854
Σx Σy = 692 Σx2 = Σxy =
= 28 140 3,063
3-29
Linear Trend Example
ELECTRICAL POWER
YEAR (x) DEMAND (y) x2 xy
1 74 1 74
2 79 4 158
3 80 9 240
4 90 16 360
5 105 25 525
6 142 36 852
Demand in year 8 = 56.70 + 10.54(8)
7 122 = 141.02, or
49 141 megawatts
854
Σx Σy = 692 Σx2 = Σxy =
= 28 140 3,063
3-30
Linear Trend Example
Trend line,
^y = 56.70 + 10.54x
160 –
Power demand (megawatts)
150 –
140 –
130 –
120 –
110 –
100 –
90 –
80 –
70 – | | | | | | | | |
60 – 1 2 3 4 5
Year
6 7 8 9 4.5
Figure
3-31
50 –
Techniques for Seasonality
Seasonality – regularly repeating movements in
series values that can be tied to recurring
events
Expressed in terms of the amount that actual values
deviate from the average value of a series
Models of seasonality
Additive
Seasonality is expressed as a quantity that gets
added to or subtracted from the time-series
average in order to incorporate seasonality
Multiplicative
Seasonality is expressed as a percentage of the
average (or trend) amount which is then used to
multiply the value of a series in order to
incorporate seasonality 3-32
Seasonal Index Example
DEMAND
AVERAGE AVERAGE
YEARLY MONTHLY SEASONAL
MONTH YEAR 1 YEAR 2 YEAR 3 DEMAND DEMAND INDEX
Jan 80 85 105 90
Feb 70 85 85 80
Mar 80 93 82 85
Apr 90 95 115 100
May 113 125 131 123
June 110 115 120 115
July 100 102 113 105
Aug 88 102 110 100
Sept 85 90 95 90
Oct 77 78 85 80
Nov 75 82 83 80
Dec 82 78 80 80
Total average annual demand = 1,128
3-33
Seasonal Index Example
DEMAND
AVERAGE AVERAGE
YEARLY MONTHLY SEASONAL
MONTH YEAR 1 YEAR 2 YEAR 3 DEMAND DEMAND INDEX
Jan 80 85 105 90 94
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Apr
Average
90 95 115 100 94
May
monthly
113 125 131 123 94
June
demand
110 115 120 115 94
July 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 82 83 80 94
Dec 82 78 80 80 94
Total average annual demand = 1,128
3-34
Seasonal Index Example
DEMAND
AVERAGE AVERAGE
YEARLY MONTHLY SEASONAL
MONTH YEAR 1 YEAR 2 YEAR 3 DEMAND DEMAND INDEX
Jan 80 85 105 90 94 .957( = 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
Seasonal110
June 115 120 115 94
July index 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 82 83 80 94
Dec 82 78 80 80 94
Total average annual demand = 1,128
3-35
Seasonal Index Example
DEMAND
AVERAGE AVERAGE
YEARLY MONTHLY SEASONAL
MONTH YEAR 1 YEAR 2 YEAR 3 DEMAND DEMAND INDEX
Jan 80 85 105 90 94 .957( = 90/94)
Feb 70 85 85 80 94 .851( = 80/94)
Mar 80 93 82 85 94 .904( = 85/94)
Apr 90 95 115 100 94 1.064( = 100/94)
May 113 125 131 123 94 1.309( = 123/94)
June 110 115 120 115 94 1.223( = 115/94)
July 100 102 113 105 94 1.117( = 105/94)
Aug 88 102 110 100 94 1.064( = 100/94)
Sept 85 90 95 90 94 .957( = 90/94)
Oct 77 78 85 80 94 .851( = 80/94)
Nov 75 82 83 80 94 .851( = 80/94)
Dec 82 78 80 80 94 .851( = 80/94)
Total average annual demand = 1,128
3-36
Seasonal Index Example
A coffee shop owner wants to Period Sales
estimate demand for the next two (gal.)
quarters for hot chocolate. Sales data 1 158.4
consist of trend and seasonality. 2 153.0
a. Quarter relatives are 1.2o for the
3 110.0
first quarter, 1.10 for the second
quarter, 0.75 for the third quarter, and 4 146.3
0.95 for the fourth quarter. Use this
5 192.0
information to deseasonalize sales for
quarters 1 through 8. 6 187.0
b. Using the appropriate values of 7 132.0
quarter relatives and the equation F1 =
8 173.8
124 + 7.5 t for the trend component,
estimate the demand for periods 9 and
10. 3-37
Seasonal Index Example
Period Quarter Sales Quarter Deseasonalized
(Gal.) Relative Sales
1 1 158.4 1.20 132
2 2 153.0 1.10 139.1
3 3 110.0 0.75 146.7
4 4 146.3 0.95 154
5 1 192.0 1.20 160
6 2 187.0 1.10 170
7 3 132.0 0.75 176
8 4 173.8 0.95 182.9
The trend values:
Period 9 : F 9 = 124 + 7.5 (9) = 191.5 X (1.2) =
229.8
Period 10: F 10 = 124 + 7.5 (10) = 199 X ( 1.1) = 3-38
218.9
Monitoring the Forecast
Tracking forecast errors and analyzing them can
provide useful insight into whether forecasts are
performing satisfactorily
Sources of forecast errors:
The model may be inadequate due to
a. omission of an important variable
b. a change or shift in the variable the model cannot
handle
c. the appearance of a new variable
Irregular variations may have occurred
Random variation
Control charts are useful for identifying the presence
of non-random error in forecasts
3-39
Choosing a Forecasting Technique
Factors to consider
Cost
Accuracy
Availability of historical data
Availability of forecasting software
Time needed to gather and analyze data and
prepare a forecast
Forecast horizon
3-40
Thank You
3-41