Causal models and the statistical tools of regression and correlation analysis can be used to augment the managerial

insight and judgment needed for making these forecasts. Such models relate the firms business to indicators that are more easily forecast or are available as general information. LINEAR REGRESSION OR LEAST SQUARES METHOD: Linear regression refers to the special class of regression where the relationship between variables forms a straight line. The linear regression line is of the form Y _ a _ bX, where Y is the value of the dependent variable that we are solving for, a is the Y-intercept, b is the slope, and X is the independent variable. (In time series analysis, X is units of time.) Linear regression is useful for long-term forecasting of major occurrences and aggregate planning. For example, linear regression would be very useful to forecast demands for product families. Even though demand for individual products within a family may vary widely during a time period, demand for the total product family is surprisingly smooth. The major restriction in using linear regression forecasting is, as the name implies, that past data and future projections are assumed to fall about a straight line. Although this does limit its application, sometimes, if we use a shorter period of time, linear regression analysis can still be used. For example, there may be short segments of the longer period that are approximately linear. DECOMPOSITION OF TIME SERIES: In practice, it is relatively easy to identify the trend (even without mathematical analysis, it is usually easy to plot and see the direction of movement) and the seasonal component (by comparing the same period year to year). It is considerably more difficult to identify the cycles (these may be many months or years long), autocorrelation, and random components. (The forecaster usually calls random anything left over that cannot be identified as another component.) When demand contains both seasonal and trend effects at the same time, the question is how they relate to each other. In this description, we examine two types of seasonal variation: additive and multiplicative.

Additive Seasonal Variation

Additive seasonal variation simply assumes that the seasonal amount is a constant no matter what the trend or average amount is. Forecast including trend and seasonal _Trend _ Seasonal Figure 3.5A shows an example of increasing trend with constant seasonal amounts.

Multiplicative Seasonal Variation

In multiplicative seasonal variation, the trend is multiplied by the seasonal factors. Forecast including trend and seasonal _Trend _ Seasonal factor Figure 3.5B shows the seasonal variation increasing as the trend increases because its size depends on the trend. The multiplicative seasonal variation is the usual experience. Essentially, this says that the larger the basic amount projected, the larger the variation around this that we can expect.

Seasonal Factor (or Index)

A seasonal factor is the amount of correction needed in a time series to adjust for the season of the year. We usually associate seasonal with a period of the year characterized by some particular activity. We use the word cyclical to indicate other than annual recurrent periods of repetitive activity. The following examples show how seasonal indexes are determined and used to forecast (1) a simple calculation based on past seasonal data and (2) the trend and seasonal index
January Amount A. Additive seasonal July January July January July January July January January Amount B. Multiplicative seasonal July January July January July January July January

FIGURE 3.5 Additive and Multiplicative Seasonal Variation Superimposed on Changing

Trend
62 Chapter 3 Forecasting

from a hand-fit regression line. We follow this with a more formal procedure for the decomposition of data and forecasting using least squares regression.

Short-Term Forecasting Techniques

In this section,well introduce two very common short-termforecasting techniques: moving averages and exponential smoothing. We choose these procedures since they are commonly available in commercial software and meet the criteria of low cost and little management involvement. The techniques are simple mathematical means for converting past information into forecasts.

Moving-Average Forecasting
Moving-average and exponential smoothing forecasting are both concerned with averaging past demand to project a forecast for future demand. This implies that the underlying demand pattern, at least for the next few days or weeks, is constant with random fluctuations about the average. Since were interested in averaged past data to project into the future, we could even use an average of all past demand data available for forecasting purposes. There are several reasons, however, why this may not be a desirable way of smoothing. In the first place, there may be so many periods of past data that

storing them all is an issue. Second, often the most recent history is most relevant in forecasting short-term demand in the near future. Recent data may reveal current conditions better than data several months or years old. For these reasons, the moving average procedure uses only a few of the most recent demand observations. Whenever a forecast is needed, the most recent past history of demand is used to do the averaging. Youll note the moving-average model does smooth the historical data, but it does so with an equal weight on each piece of historical information

Exponential Smoothing Forecasting

The exponential smoothing model for forecasting doesnt eliminate any past information, but so adjusts the weights given to past data that older data get increasingly less weight (hence the name exponential smoothing). The proportion of the error that will be incorporated into the forecast is called theexponential smoothing constant and is identified as _. result shows larger values of _ give more weight to recent demands and utilize older demand data less than is the case for smaller values of _; that is, larger values of _ provide more responsive forecasts, and smaller values produce more stable forecasts. The same argument can be made for the number of periods in an MAF model. This is the basic trade-off in determining what smoothing constant (or length of moving average) to use in a forecasting procedure. The higher the smoothing constant or the shorter the moving average, the more responsive forecasts are to changes in underlying demand, but the more nervous they are in the presence of randomness. Similarly, smaller smoothing constants or longer moving averages provide stability in the face of randomness but slower reactions to changes in the underlying demand. Ultimately, however, the trade-off between stability and responsiveness is reflected in the quality of the forecasts, a subject to which we now turn.