Chapter 8 - Forecasting

Operations Management
by
R. Dan Reid & Nada R. Sanders
4th Edition © Wiley 2010

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Principles of Forecasting
Many types of forecasting models that
differ in complexity and amount of
data & way they generate forecasts:
1. Forecasts are rarely perfect
2. Forecasts are more accurate for
grouped data than for individual
items
3. Forecast are more accurate for
shorter than longer time periods
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Types of Forecasting
Methods
 Decide what needs to be forecast
 Level of detail, units of analysis & time
horizon required
 Evaluate and analyze appropriate data
 Identify needed data & whether it’s
available
 Select and test the forecasting model
 Cost, ease of use & accuracy
 Generate the forecast
 Monitor forecast accuracy over time
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Types of Forecasting
Methods
 Forecasting methods are classified
into two groups:

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 Types of Forecasting
Models
 Qualitative methods – judgmental
methods
 Forecasts generated subjectively by

the forecaster
 Educated guesses

 Quantitative methods – based on

mathematical modeling:
 Forecasts generated through

mathematical modeling
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 Qualitative Methods
Type Characteristics Strengths Weaknesses
Executive A group of managers Good for strategic or One person's opinion
opinion meet & come up with new-product can dominate the
a forecast forecasting forecast

Market Uses surveys & Good determinant of It can be difficult to

research interviews to identify customer preferences develop a good
customer preferences questionnaire

Delphi Seeks to develop a Excellent for Time consuming to

method consensus among a forecasting long-term develop
group of experts product demand,
technological
changes, and
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Quantitative Methods
 Time Series Models:
 Assumes information needed to generate a
forecast is contained in a time series of data
 Assumes the future will follow same patterns
as the past
 Causal Models or Associative Models
 Explores cause-and-effect relationships
 Uses leading indicators to predict the future
 Housing starts and appliance sales

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 Time Series Models
 Forecaster looks for data patterns as
 Data = historic pattern + random variation
 Historic pattern to be forecasted:
 Level (long-term average) – data fluctuates around a
constant mean
 Trend – data exhibits an increasing or decreasing pattern
 Seasonality – any pattern that regularly repeats itself
and is of a constant length
 Cycle – patterns created by economic fluctuations
 Random Variation cannot be predicted
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Time Series Patterns

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Time Series Models
 Naive: Ft 1  At

The forecast is equal to the actual value observed
during the last period – good for level patterns
 Simple Mean: Ft 1  A t / n

The average of all available data - good for level
patterns
 A t / n
 Moving Average:F t 1


The average value over a set time period
(e.g.: the last four weeks)

Each new forecast drops the oldest data point &
adds a new observation

More responsive to a trend but still lags behind
actual data

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Time Series Models con’t
 Weighted Moving Average: Ft 1  C t A t

 All weights must add to 100% or 1.00

e.g. Ct .5, Ct-1 .3, Ct-2 .2 (weights add to 1.0)

 Allows emphasizing one period over others; above

indicates more weight on recent data (Ct=.5)

 Differs from the simple moving average that

weighs all periods equally - more responsive to
trends
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Time Series Models con’t
 Exponential Smoothing: F αA  1  α F
t 1 t t  
Most frequently used time series method because
of ease of use and minimal amount of data
needed 

 Need just three pieces of data to start:

 Last period’s forecast (Ft)

 Last periods actual value (At) 
 Select value of smoothing coefficient, ,between 0 and
1.0
 If no last period forecast is available, average

the last few periods or use naive method
 Higher values (e.g. .7 or .8) may place too
much weight on last©period’s
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random variation 12
Time Series Problem
 Determine forecast for Period Actual
periods 7 & 8 1 300
 2-period moving average 2 315
 4-period moving average
3 290
 2-period weighted moving
4 345
average with t-1 weighted
0.6 and t-2 weighted 0.4 5 320
 Exponential smoothing 6 360
with alpha=0.2 and the 7 375
period 6 forecast being 375 8
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Time Series Problem
Solution
Period Actual 2-Period 4-Period [Link]. Expon. Smooth.

1 300

2 315

3 290

4 345

5 320

6 360

7 375 340.0 328.8 344.0 372.0

8 367.5 350.0 369.0 372.6

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Causal Models
 Often, leading indicators can help to predict
changes in future demand e.g. housing starts
 Causal models establish a cause-and-effect
relationship between independent and
dependent variables
 A common tool of causal modeling is linear
regression: Y a  bx
 Additional related variables may require
multiple regression modeling

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Linear Regression

Identify dependent (y)
and independent (x)
b
 XY  X  Y  variables
 X 2  X  X   Solve for the slope of the

lineb  XY  n X Y
2
X 2
 nX

 Solve for the y intercept

a Y  b X
 Develop your equation for
the trend line
Y=a + bX
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 Linear Regression Problem: A maker of golf shirts has
been tracking the relationship between sales and
advertising dollars. Use linear regression to find out what
sales might be if the company invested $53,000 in
advertising next year.

Sales $ Adv.$ b
 XY  n XY
XY X^ Y^2 2
(Y) (X) 2  X  nX 2

1 130 32 4160 230 16,90 28202  447.25147.25

4 0 b 1.15
9253  447.25
2

2 151 52 7852 270 22,80 a Y  b X 147.25  1.1547.25

4 1
a 92.9
3 150 50 7500 250 22,50 Y a  bX 92.9  1.15X
0 0 Y 92.9  1.1553 153.85
4 158 55 8690 302 24964
5
5 153.8 53
5
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Tot 589 189 2820 925 87165
 Correlation Coefficient
How Good is the Fit?
 Correlation coefficient (r) measures the direction and strength of
the linear relationship between two variables. The closer the r value
is to 1.0 the better the regression line fits the data points.
n XY   X  Y 
r
 X   X * n Y  Y 
2 2
2 2
n
428,202  189589
r 2
.982
4(9253) - (189) * 487,165  589
2

r 2 .982 .964
2

2
 Coefficient of determination r ( ) measures the amount of variation
in the dependent
2
variable about its mean that is explained by the
regressionr line. Values of ( ) close to 1.0 are desirable.

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Multiple Regression
 An extension of linear regression
but:
 Multiple regression develops a
relationship between a dependent
variable and multiple independent
variables. The general formula is:

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Measuring Forecast Error
 Forecasts are never perfect
 Need to know how much we should
rely on our chosen forecasting
method
 Measuring forecast error:
E t  A t  Ft

 Note that over-forecasts = negative

errors and under-forecasts =
positive errors
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 Measuring Forecasting Accuracy
 Mean Absolute Deviation MAD 
 actual  forecast
(MAD) n

measures the total error in a
forecast without regard to sign
 Cumulative Forecast Error CFE  actual  forecast 
(CFE)

Measures any bias in the forecast
 actual - forecast 2

MSE 
n
 Mean Square Error (MSE)

Penalizes larger errors CFE
TS 
MAD
 Tracking Signal

Measures if your model is working

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 Accuracy & Tracking Signal Problem: A company is
comparing the accuracy of two forecasting methods. Forecasts
using both methods are shown below along with the actual values
for January through May. The company also uses a tracking signal
with ±4 limits to decide when a forecast should be reviewed.
Which forecasting method is best?

Method A Method B
Month Actu F’cas Error Cum. Trackin F’cas Error Cum. Tracking
al t Error g t Error Signal
sales Signal

Jan. 30 28 2 2 2 27 2 2 1

Feb. 26 25 1 3 3 25 1 3 1.5
Marc 32 32 0 3 3 29 3 6 3
h
April 29 30 -1 2 2 27 2 8 4
May 31 30 1 3 3 29 2 10 5

MAD 1 2
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MSE 1.4 4.4
Forecasting Software
 Spreadsheets
 Microsoft Excel, Quattro Pro, Lotus 1-2-3
 Limited statistical analysis of forecast data
 Statistical packages
 SPSS, SAS, NCSS, Minitab
 Forecasting plus statistical and graphics
 Specialty forecasting packages
 Forecast Master, Forecast Pro, Autobox, SCA

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 Forecasting Across the
Organization
 Forecasting is critical to management of
all organizational functional areas
 Marketing relies on forecasting to predict
demand and future sales
 Finance forecasts stock prices, financial
performance, capital investment needs..
 Information systems provides ability to share
databases and information
 Human resources forecasts future hiring
requirements

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