Operations Management

Forecasting

What is Forecasting?
Basic input in decision process Two major aspect of forecasting

Expected demand
Degree of accuracy

Forecasting Time Horizon

Short-range forecast

Up to 1 year, generally less than 3 months Purchasing, job scheduling, workforce levels, job assignments, production levels 3 months to 3 years Sales and production planning, budgeting 3+ years New product planning, facility location, research and development

Medium-range forecast

Long-range forecast

Common features

Assumes same underlying causal system that existed in the past will continue in future Not perfect Group forecast will be more accurate compared to individual items. Accuracy decreases as time horizon increases

Types of Forecast

Economic forecasts

Address business cycle inflation rate, money supply, housing starts, etc. Predict rate of technological progress Impacts development of new products Predict sales of existing products and services

Technological forecasts

Demand forecasts

Seven Steps in Forecasting

Determine the use of the forecast Select the items to be forecasted Establish time horizon of the forecast Select the forecasting model(s) Gather the data Make the forecast Monitor forecast

Forecasting Accuracy

Impossible to predict future values on regular basis Forecasting error is bound to happen Need to measure and control the forecasting errors.

Common Measures of Errors

Mean Absolute Deviation (MAD)
|Actual - Forecast| MAD = n

Mean Squared Error (MSE)

(Forecast Errors)2 MSE = n-1

Common Measures of Errors

Mean Absolute Percent Error (MAPE)

MAPE =

i=1

100|Actuali - Forecasti|/Actuali
n

Forecasting Approaches
Qualitative Methods

Used when situation is vague and little data exist

New products

New technology

Involves intuition, experience

Qualitative Methods

Jury of executive opinion Sales force opinion Consumer Surveys Other Approaches

Quantitative Methods

1.

2.
3. 4. 5.

Naive approach Moving averages Exponential smoothing Trend projection Linear regression

Time-Series Models Associative Model

Time Series Forecasting

Set of evenly spaced numerical data

Obtained by observing response variable at regular time periods

Forecast based only on past values, no other variables important

Assumes that factors influencing past and present will continue influence in future

Time Series Forecasting

Trend

Cyclical

Seasonal

Random

Nave 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

Moving Average Approach

MA is a series of arithmetic means Used if little or no trend Used often for smoothing

Provides overall impression of data over time

demand in previous n periods

Moving average =
n

Moving Average Example

Month January February March April May June July

Actual Shed Sales

10 12 13 16 19 23 26

3-Month Moving Average

(10 + 12 + 13)/3 = 11 2/3 (12 + 13 + 16)/3 = 13 2/3 (13 + 16 + 19)/3 = 16 (16 + 19 + 23)/3 = 19 1/3

Weighted Moving Average

Used when trend is present

Older data usually less important

Weights based on experience and intuition

(weight for period n) x (demand in period n)
weights

Weighted moving average

Exponential Smoothing

Form of weighted moving average

Weights decline exponentially Most recent data weighted most Ranges from 0 to 1 Subjectively chosen

Requires smoothing constant ()

Involves little record keeping of past data

Exponential Smoothing
New forecast = Last periods forecast + (Last periods actual demand Last periods forecast) Ft = Ft 1 + (At 1 - Ft 1)
where Ft = Ft 1 = = new forecast previous forecast smoothing (or weighting) constant (0 1)

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

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

Equations to calculate the regression variables y = a + bx Sxy - nxy b= Sx2 - nx2 a = y - bx
^

Seasonal Variations In Data

The multiplicative seasonal model can adjust trend data for seasonal variations in demand

Seasonal Variations In Data

Steps in the process:
1. 2. Find average historical demand for each season Compute the average demand over all seasons

3.
4. 5.

Compute a seasonal index for each season

Estimate next years total demand Divide this estimate of total demand by the number of seasons, then multiply it by the seasonal index for that season

Associative Forecasting
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 ^

Standard Error of the Estimate

Sy,x =
where

(y - yc)2 n-2

y = y-value of each data point yc = computed value of the dependent variable, from the regression equation n = number of data points

Standard Error of the Estimate

Computationally, this equation is considerably easier to use y2 - ay - bxy n-2

Sy,x =

We use the standard error to set up prediction intervals around the point estimate

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

Correlation Coefficient
r= nSxy - SxSy [nSx2 - (Sx)2][nSy2 - (Sy)2]

Correlation

Coefficient of Determination, r2, measures the percent of change in y predicted by the change in x

Values range from 0 to 1 Easy to interpret

For the Nodel Construction example:

r = .901
r2 = .81

Multiple Regression Analysis

If more than one independent variable is to be used in the model, linear regression can be extended to multiple regression to accommodate several independent variables ^=a+b x +b x y 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

Monitoring Forecast
Control Chart

0 Z MSE
Tracking signal

Tracking Signal
(Actualt Forecastt) Tracking Signal = MADt
Note: MADt = MAD t-1+(|Actual-Forecast|t-MADt-1)