FORECASTING

FORECASTING „ The art and science of predicting future events

„ Forecast
The Role of the Manager
¾ is a statement about the future
„ Planning Future ?
¾ takes into account 2 kinds of information
„ Organizing ™ Current factors or conditions
Data
„ Staffing Information
Forecast ™ Past experience in similar situations
„ Leading
Forecasting Time Uses of Forecasts
„ Controlling Horizons ™ Plan the System
- long-range plans re new products and services
• Short-range
• Medium-range
™ Plan the Use of the System
- short-term and intermediate planning
Marvin I. Norona • Long-range Marvin I. Norona

Features Common to All Forecasts Elements of a Good Forecast

Î Forecasting techniques generally assume that . It should be timely.
same underlying causal system that existed in
the past will continue to exist in the future.
. It should be accurate and the degree of
accuracy should be stated.
Î Forecasts are rarely perfect.
Î Forecasts for groups of items tend to be more . It should be reliable; it should work
accurate than forecasts for individual items. consistently.
Î Forecast accuracy decreases as the time . It should be in writing.
period covered by the forecast – the time . The forecasting technique should be
horizon- increases simple to understand and use.

Marvin I. Norona Marvin I. Norona

7 Steps in the Forecasting System Forecasting Approaches

1) Determine the use of the forecast. „ Qualitative Methods
2) Select the items to be forecasted. - consist mainly of subjective inputs
3) Determine the time horizon of the forecast. „ Quantitative Techniques
4) Select the forecasting model(s). - involve either the extension of historical
5) Gather the data needed to make the forecast. data or the development of associative
6) Make the forecast. models
7) Validate and implement the results (Monitor the - avoid personal biases
forecast and check if the forecast is performing in
a satisfactory manner).
Marvin I. Norona Marvin I. Norona

1
 Overview of Qualitative Methods Overview of Quantitative Methods
¾ Useful when management needs a forecast quickly when
historical data is not available especially during 1. Naïve Approach
introduction of new products
¾ Forecasts are made on the following basis:
2. Moving Average Time-Series
1) Jury of Executive Opinion – has the advantage of 3. Exponential Smoothing Models
bringing together the knowledge and talents of a group of high
level experts or managers 4. Trend projection
2) Sales Force Composite – is a good source of information
because of direct customer contact 5. Linear regression 〈 Associative Model
3) Delphi method – uses group process that allows experts to Time-Series Models predict on the assumption that
make forecasts from anonymous responses from staff & the future is a function of the past.
respondents
4) Consumer Market Survey – solicits consumer opinions; is Associative (or causal) Models incorporate the variables or
expensive and time-consuming factors that might influence the quantity being forecast.
Marvin I. Norona Marvin I. Norona

Forecasting Based on
Time Series Data Decomposition of a Time Series
„ Time Series is a time-ordered sequence of 1. Trend is the gradual upward or downward
observations taken at regular intervals over a movement of the data over time.
period of time. 2. Seasonality is a data pattern that repeats
„ Time Series Forecasting itself after a period of days, weeks, months,
¾ uses a series of past data points to make a
or quarter.
forecast; assumes that future values of the 3. Cycles are patterns in the data that occur
series can be estimated from past values every several years.
¾ requires identifying the underlying behavior of 4. Random Variations are “blips” in the data
the series (pattern) after plotting the data. caused by chance and unusual situations.
Marvin I. Norona Marvin I. Norona

Product Demand Charted over 4 years with a

Growth Trend and Seasonality Indicated NAÏVE METHODS
Trend component
Seasonal peaks „ Naïve Forecast – the forecast for any period
D equals the previous period’s actual value
E
Actual demand line „ Naïve Approach can be used with:
„ a stable series (variations around an average) : The
M last data point becomes the forecast for the next
A period.
Average demand
over four years „ seasonal variations : the forecast for this “season” is
N
Random variation equal to the value of the series last “season”.
D „ trend : the forecast is equal to the last value of the
Year 1 Year 2 Year 3 Year 4 series plus or minus the difference between the last
T I M E two values of the series.
Marvin I. Norona Marvin I. Norona

2
 EXAMPLE: Using an appropriate naïve method, predict orders for
the following day for each of the 3 products of a commercial
bakery that has recorded sales (in dozens) as shown below:
Day Blueberry Cinnamon Cupcakes
TECHNIQUES FOR AVERAGING
Muffins Buns
1 30 18 45
„ Historical data typically contain a certain amount of
2 34 17 26 random variation, or “noise”.
3 32 19 27 „ Averaging techniques smooth variations in the time-
4 34 19 23
5 35 22 22
series because the individual highs and lows in the data
6 30 23 48 offset each other when they are combined into an
7 34 23 29 average.
8 36 25 20
„ Forecasts based on an average tend to exhibit less
9 29 24 14
10 31 26 18
variability than the original data.
11 35 27 47 „ Averaging techniques include:
12 31 28 26
1. Moving average
↓
13 37 29 27
14 34 31 24 2. Weighted moving average
15 33 33 22
16
3. Exponential smoothing
33 35 47
Marvin I. Norona Marvin I. Norona

For example, MA3 would refer to a three-period moving

Moving Average average forecast, and MA5 would refer to a five-period

moving average forecast.
Technique that averages a number of recent actual values,
updated as new values become available Compute a three-period moving average forecast given the above
demand for shopping carts for the last five periods.
n
Period Age Demand
Σ Ai
1 5 42
i=1
2 4 40
Ft = MAn = ----------- , where
3 3 43
n The 3 most
4 2 40 recent
i = an index that corresponds to periods 5 1 41 demands
n = number of periods (data points) in the moving average Solution:
Ai = actual value in period i 41 + 40 + 43
MA = moving average
What is F6 = MA4 ?
Ft = forecast for time period t F6 = MA3 = ------------------ = 41.33
If Actual = 39 for Period 6,
3
Marvin I. Norona Marvin I. Norona what is F7 = MA3?

Weighted Average Exponential Smoothing

More recent values in a series are given more weight in computing a
forecast. [Note: The sum of the weights must be 1.00 and the Weighted averaging method based on previous forecast plus a
heaviest weights are assigned to the most recent values] percentage of the forecast error:
Next Forecast = Previous Forecast + α(Actual – Previous Forecast)
Example: Compute a weighted average forecast using a weight of where (Actual – Previous Forecast) = Forecast Error
0.40 for the most recent period, 0.30 for the next most recent, 0.20 α = percentage of the error
for the next, and 0.10 for the next.
Period Demand F t = F t-1 + α(A t-1 - F t-1) , where
Solution:
1 42 F6 = .40(41) + .30(40) + .20(43) + .10(40) Ft = Forecast for period t
2 40
= 41.0 ans. F t-1 = Forecast for the previous period
3 43 α = Smoothing constant
If actual demand is 39 for Period 6, F7 = ?
4 40 A t-1 = Actual demand or sales for the previous period
5 41 F7 = .40(39) + .30(41) + .20(40) + .10(43)
= 40.2 ans.
or F t = (1- α)F t-1 + α A t-1
NOTE: If four weights are given, only the four most recent data points are used.
Marvin I. Norona Marvin I. Norona

3
 Exponential Smoothing TECHNIQUES FOR TREND
Smoothing Constant determines the quickness of forecast adjustment
¾
to error.
1. Trend Projection
¾ Low values of α are used when the underlying average tends to be 2. Trend-Adjusted Exponential Smoothing
stable; higher values when average is susceptible to change.
¾ Example: Prepare a forecast using exponential smoothing with a TRENDS:
smoothing constant of α = 0.40 given the following data: a) Linear A Linear Trend Equation has the form:
Period No. of Complaints Forecast Calculations
- Ft = F t-1 + α(A t-1 - F t-1)
b) Parabolic yt = a + bt , where
1 60
60
(The previous value of the series is c) Exponential t = specified no. of time periods from t = 0
2 65 used as the starting forecast.)
3 55 62 60 + .40(65 – 60) = 62 yt = Forecast for period t
4 58 59.2 62 + .40(55 – 62) = 59.2 a = value of yt at t = 0
5 64 58.72 59.2 + .40(58 – 59.2) = 58.72
b = slope of the line
6 ? 60.83 58.72 + .40(64 – 58.72) = 60.83
Marvin I. Norona Marvin I. Norona

Example: Develop a line trend equation for the

following data. Then use the equation to predict the
Linear Trend Equation next two values of the series.
n Σty - Σ t Σy
The coefficients of the line, a and b, can be computed from historical Period (t) t2 Demand (y) ty b = n Σt2 – ( Σt)2
data using these two equations: 1 1 44 44
n Σty - Σ t Σy 2 4 52 104 9(2,545) – 45(488)
y = 1.75
= 9(285) – (45)2
b = --------------------- 3 9 50 150
n Σt – ( Σt)
2 2 bt Σy - b Σ t
a+ 4 16 54 216
yt = a = n
Σy - b Σ t 5 25 55 275
Δy Δy = 488 – 1.75(45) = 45.47
a = ------------------- 6 36 55 330
Δt 9
n Δt b=
7 49 60 420
y = 45.47 + 1.75 t
where: a 8 64 56 448
y10 = 45.47 + 1.75 (10) = 62.97
n = number of periods
9
_______ 81
_________ 62
_________ 558
____________
y = value of the series 0 t Σ t = 45 Σ t2 =285 Σ y = 488 Σ ty = 2,545 y11 = 45.47 + 1.75 (11) = 64.72

Marvin I. Norona Marvin I. Norona

Solution con’t
SOLVED PROBLEM 3. Weighted Moving Average
Following are historical unit sales for a seven-month period:
FNov = 0.60(20) + 0.30(22) + 0.10(18)
Apr ………. 19 Aug ………. 18 = 20.4 units
May ………. 18 Sep ……….. 22
Jun ………. .15 Oct ……….. 20
4. Exponential Smoothing
Month Actual Forecast Ft = F t-1 + α (A t-1 –F t-1)
Jul .……….. 20
Apr 19 -
Forecast November sales volume using each of the following: May 18 19 (given)
FNov = 20 units (last data point)
1) The naïve approach. Jun 15 18.80 = 19 + 0.20(18 – 19)
FNov = MA5 = 20 + 22 + 18 + 20 + 15
Jul 20 18.04 = 18.80 + 0.20(15 - 18.80)
5
2) A five-month moving average. = 19.0 units Aug 18 18.43 = 18.04 + 0.20(20 - 18.04)

3) A weighted average using 0.60 for Oct, 0.30 for Sept, & 0.10 for Aug. Sep 22 18.34 = 18.43 + 0.20(18 – 18.43)
Oct 20 19.07 = 18.34 + 0.20(22 – 18.34)
4) Exponential smoothing with α = 0.20, assuming a May forecast of 19.
Nov 19.26 = 19.07 + 0.20(20 – 19.07)

5) A linear trend equation. Marvin I. Norona Marvin I. Norona

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 Solution con’t Trend-Adjusted Exponential Smoothing
n Σty - Σ t Σy
Variation of exponential smoothing used when a time series
5. Linear Trend Equation b = n Σt2 – ( Σt)2
„

exhibits trend.
Month Period (t) t2 Sales (y) ty 7(542) – 28(132)
= 0.50 „ Simple exponential smoothing fails to respond to trends as
Apr 1 1 19 19 = 7(140) – (28)2
it will exhibit a severe lag from the actual data points as the
May 2 4 18 36 Σy - b Σ t period t increases (as shown in the table below).
Jun 3 9 15 45 a = n
Month Actual Demand Forecast for Month t (Ft) w/ α =0.40
Jul 4 16 20 80 = 132 – 0.50(28) = 16.86 1 100 F1 = 100 (given)
7
Aug 5 25 18 90 2 200 F2 = 100 + 0.40(100 – 100) = 100
y = 16.86 + 0.50 t
Sep 6 36 22 132 3 300 F3 = 100 + 0.40(200 – 100) = 140
Oct 7 49 20 140 yNov = 16.86 + 0.50 (8) = 20.86 4 400 F4 = 140 + 0.40(300 – 140) = 204
_______ _________ ________ _________
Σ t=28 Σ t2 =140 Σ y=132 Σ ty=542 5 500 F5 = 204 + 0.40(400 – 204) = 282
Marvin I. Norona Marvin I. Norona

Trend-Adjusted Exponential Smoothing Trend-Adjusted Exponential Smoothing

The idea is to compute an exponentially smoothed average of the data and
„
then adjust for positive or negative lag in trend. Thus, the new formula is 3 Steps in Computing a Trend-Adjusted Forecast:
Forecast including trend (FITt)= exponentially smoothed forecast (Ft)
+ exponentially smoothed trend (Tt)
„ With this model, estimates for both the average and the trend are smoothed. 1) Compute Ft , the exponentially smoothed forecast for
This procedure requires two smoothing constants, α for the average and β for
the trend. Then, the average and trend are computed for each period:
period t, using the equation
Ft = α (A t-1) + (1 - α ) (F t-1 + T t-1)
Ft = α (Actual demand last period) + (1 - α ) (Forecast last period +
Trend estimate last period)
or Ft = α (A t-1) + (1 - α ) (F t-1 + T t-1) 2) Compute the smoothed trend Tt using the equation,
Tt = β (Ft - F t-1) + (1 - β) T t-1
Tt = β (Forecast this period – Forecast last period)
+ (1 - β) (Trend estimate last period)
or Tt = β (Ft - F t-1) + (1 - β) T t-1 3) Calculate the forecast including trend, FITt = Ft + Tt
Marvin I. Norona Marvin I. Norona

Example: A large Portland manufacturer uses exponential

smoothing to forecast demand for a piece of pollution control Trend-Adjusted Exponential Smoothing
equipment. It appears that an increasing trend is present. Solution to Sample Problem

Month (t) Actual Month (t) Actual „ Do the 3-step calculations for Month 2
Demand (At) Demand (At)
Step 1 : Forecast for month 2
1 12 6 21 F2 = α (A 1) + (1 - α ) (F 1 + T 1)
F2 = 0.2(12) + (1 – 0.2)(11 + 2)
2 17 7 31
= 2.4 + 0.8(13) = 2.4 + 10.4 = 12.8
3 20 8 28 Step 2 : Compute the trend in period 2
4 19 9 36 T2 = β (F2 - F1) + (1 - β) T1
T2 = 0.4(12.8 – 11) + (1 – 0.4)2
5 24 10 ?
= 0.4(1.8) + 0.6(2) = 0.72 + 1.2 = 1.92
Step 3 : Compute the forecast including trend (FIT2)
Smoothing constants are assigned the values of α = 0.2 and β = 0.4.
FIT2 = F2 + T2
Assume the initial forecast for month 1 (F1) was 11 units and the trend
= 12.8 + 1.92 = 14.72
over that period (T1) was 2 units.
Marvin I. Norona Marvin I. Norona

5
 Trend-Adjusted Exponential Smoothing
Trend-Adjusted Exponential Smoothing Solution to Sample Problem (con’t)
Solution to Sample Problem (con’t) The following table completes the forecast for the 10-month period:
Actual Smoothed Smoothed Forecast
„ Do the same calculations for the third month Month Demand Forecast, Ft Trend, Tt including Trend, FITt
1 12 11 2 -
Step 1 : Forecast for month 3
2 17 12.80 1.92 14.72
F3 = α (A 2) + (1 - α ) (F 2 + T 2)
F3 = 0.2(17) + (1 – 0.2)(12.8 + 1.92) 3 20 15.18 2.10 17.28
= 3.4 + 0.8(14.72) = 3.4 + 11.78 = 15.18 4 19 17.82 2.32 20.14
Step 2 : Compute the trend in period 3 5 24 19.91 2.23 22.14
T3 = β (F3 – F2) + (1 - β) T2
6 21 22.51 2.38 24.89
T3 = 0.4(15.18 – 12.8) + (1 – 0.4)1.92
= 0.4(2.38) + 0.6(1.92) = 0.952 + 1.152 = 2.10 7 31 24.11 2.07 26.18
Step 3 : Compute the forecast including trend (FIT3) 8 28 27.14 2.45 29.59
FIT3 = F3 + T3 9 36 29.28 2.32 31.60
= 15.18 + 2.10 = 17.28
10 - 32.48 2.68 35.16
Marvin I. Norona Marvin I. Norona

TECHNIQUES FOR SEASONALITY TECHNIQUES FOR SEASONALITY

„ Seasonal Variations are regularly repeating upward or „ Seasonality in a time series is expressed in terms of
downward movements in series values that can be tied up a) Moving Average, if the series tends to vary around
to recurring events. an average value
„ Six common seasonality patterns b) Trend Value, if the series exhibits a trend
Period of “Season” Number of
Pattern Length “ Seasons ” in Pattern ƒ 2 Models of Seasonality
Week Day 7
Month Week 4–4½
1) Additive Model – seasonality is expressed as a
Month Day 28 – 31
quantity, w/c is added or subtracted from the series
average in order to incorporate seasonality.
Year Quarter 4
Year Month 12 2) Multiplicative Model – seasonality is expressed as a
Year Week 52 percentage of the average (or trend), w/c is used to
multiply the value of a series to incorporate
Marvin I. Norona seasonality. Marvin I. Norona

Steps in Making a Forecast Using a

Multiplicative Seasonal Model
¾ is more widely used in business than the
additive model
¾ entails computation of
™ a seasonal index (when time series has
seasonality and trend is not present), or
™ a seasonal relative (when data has both
trend/average and seasonal components)
Seasonal Index (Data w/o Trend)
1) Find the average historical demand each season.
2) Compute the average demand over all seasons.
3) Compute a seasonal index for each season.
4) Estimate next period’s total volume.
5) Do the seasonal forecast by dividing the volume
by the number of seasons and then multiplying it
by the seasonal index for that season.

Marvin I. Norona Marvin I. Norona

6
 Use of Seasonal Index
Example: Monthly sales of Compaq laptop computers at Des
Moines distributor for 2001 – 2003 are shown below. Develop a
monthly forecast for 2004 if total demand for said
No. of Seasons mu
year is estimated Using Seasonal Relatives
to be 1,200 units. Average
ltip
ly b
Monthly
Average y
Sales Demand 2001-2003 Monthly Seasonal Demand „ Incorporating seasonality is useful when data has both trend and seasonality,
Month 2001 2002 2003 Demand
÷ Demand = Index Forecast and can be accomplished by the following steps:
1) Obtain trend estimates for desired periods using a trend equation.
Jan 80 85 105 90 94 .957 96
2) Add seasonality to the trend estimates by multiplying these trend estimates by
Feb 70 85 85 80 94 .851 85 the corresponding seasonal relative.
Mar 80 93 82 85 94 .904 90 ƒ Example : A furniture maker wants to predict quarterly demand for a certain
Apr 90 95 115 100 94 1.064 106 loveseat for periods 15 and 16, w/c happens to be the 2nd and 3rd quarters of
a particular year. The trend portion of demand is projected using the
May 113 125 131 123 94 1.309 131 equation yt = 124 + 7.5 t. Quarter relatives are Q1 = 1.20, Q2 = 1.10,
Jun 110 115 120 115 1,128 = 94 1.223 122 Q3 = 0.75, and Q4 = 0.95.
Jul 100 102 113 105 12 months 94 1.117 112 Solution : At t = 15, y15 = 124 + 7.5(15) = 236.5
Aug 88 102 110 100 94 1.064 106 At t = 16, y16 = 124 + 7.5(16) = 244.0
Sep 85 90 95 90 94 .957 96
Multiplying the trend values above by the appropriate quarter relative
yields the 2nd and 3rd quarter forecasts,
Oct 77 78 85 80 94 .851 85
Period 15 : 236.5(1.10) = 260.15
Nov 75 82 83 80 94 .851 85 Period 16 : 244.0(0.75) = 183.00
Dec 82 78 80 80 Marvin I. Norona 94 .851 85 Marvin I. Norona

Computing Seasonal Relatives

Example : A parking lot manager has the following record of the

Computing Seasonal Relatives number of cars per day in the lot for the past three weeks.
Estimate a Friday relative as well as a Tuesday relative.
Get the Centered Moving Average
„
Week 1 Week 2 Week3
9 same computations as those for a moving average forecast but
positioned in the middle of the periods used to compute the moving Day Volume Day Volume Day Volume
average Three-Period Seasonal Tues 67 Tues 60 Tues 64
Period Demand Centered Average Relative _____
1 40 Wed 75 Wed 73 Wed 76
2 46 42.67 1.08 Thurs 82 Thurs 85 Thurs 87
3 42
MA3= 42 + 46 + 40 Ratio = 46 / 42.67 Fri 98 Fri 99 Fri 96
3
ƒ Compute the Seasonal Relative
Sat 90 Sat 86 Sat 88
9 the ratio of the demand at period 2 to the CMA at that point
ƒ Achieve a reasonable estimate of seasonality for any season Sun 36 Sun 40 Sun 44
9 compute seasonal ratios for a number of seasons
9 average these ratios Mon 55 Mon 52 Mon 50
Marvin I. Norona Marvin I. Norona

Computing Seasonal Relatives Computing Seasonal Relatives

Solution : Since there are seven days (seasons) per Solution : Add the Friday seasonal ratios and average
week, a seven-period centered moving average is used. them to estimate the Friday relative. Do the same for
Centered Daily Ratios = the Tuesday ratios to obtain the relative for Tuesday.
Day Volume Moving Total MA7 Volume /MA
Sat 86 494 71.29 86 ÷ 71.29 = 1.21
Tue 67
Sun 40 498 71.71 40 ÷ 71.71 = 0.56
Wed 75
Mon 52 495 72.00 52 ÷ 72.00 = 0.72
Thurs 82
Tue 64 499 71.57 64 ÷ 71.57 = 0.89 (Tuesday)
Fri 98 71.86 98 ÷ 71.86 = 1.36 (Friday)
Wed 76 502 71.86 76 ÷ 71.86 = 1.06
Sat 90 70.86 90 ÷ 70.86 = 1.27
Thurs 87 504 72.43 87 ÷ 72.43 = 1.20
Sun 36 70.57 36 ÷ 70.57 = 0.51
Fri 96 501 72.14 96 ÷ 72.14 = 1.33 (Friday)
Mon 55 503 ÷ 7 = 71.00 55 ÷ 71.00 = 0.77
(Tuesday) Sat 88 503
Tue 60 496 ÷ 7 = 71.14 60 ÷ 71.14 = 0.84
Sun 44 507
Wed 73 494 ÷ 7 = 70.57 73 ÷ 70.57 = 1.03
Mon 50 505
Thurs 85 497 ÷ 7 = 71.14 85 ÷ 71.14 = 1.19
Friday Relative = (1.36 + 1.40 + 1.33)/3 = 1.36
Fri 99 498 etc. 70.71 99 ÷ 70.71 = 1.40 (Friday)
Marvin I. Norona Tuesday Relative = (0.84 + 0.89)
Marvin /2
I. Norona = 0.87

7
 TECHNIQUES FOR CYCLES Associative Forecasting Techniques
„ CYCLES are patterns in the data that occur every several years. „ The essence is to develop the best statistical relationship between the
[Forecasting them is difficult because it is very hard to predict the variable of interest or being forecast (w/c is the Dependent Variable)
turning points that indicate a new cycle is beginning.] and the related variables that can be used to predict values of the
„ The best way to predict business cycles is finding a leading variable variable of interest (called Predictor Variables).
with which the data series seems to correlate. Examples are „ For example, the sales of IBM PCs might be related to IBM’s
¾ Birthrates “lead” college enrollments by about 18 years, so changes in advertising budget, the company’s prices, competitors’ prices and
birthrates is a good predictor of swings in enrollment. promotional strategies, and even the nation’s economy and
¾ Housing construction permits are excellent leading variable for household unemployment rates. In this case PC sales would be the dependent
appliances and services. variable and the others would be called the independent variables.
„ ASSOCIATIVE FORECASTING METHODS consider variables that
„ The primary method of analysis is known as regression. It is a
are related to the quantity being predicted. This approach is more
powerful than the time-series methods that use only the historic technique for fitting a line to a set of points.
values for the forecasted variable. a) Simple Linear Regression – linear relationship between 2 variables
1. Regression Analysis b) Curvilinear Regression – non linear relationships are present
2. Correlation Analysis c) Multiple Regression – involves more than one predictor variable
Marvin I. Norona Marvin I. Norona

Linear Regression Analysis

Example : Nodel Construction Company renovates old homes in Orono,
Maine. Over time, the company has found that its dollar volume of
Linear Regression Analysis renovation work is dependent on the Orono area payroll.

„ A straight-line mathematical model to describe the functional relationships between The following table lists Nodel’s revenues (in hundred thousand dollars) and the
independent and dependent variables. amount of money earned by wage earners (in $ hundreds of millions) in Orono
„ Simple Linear Regression : to obtain an equation of a straight line that minimizes during the past six years. A linear relationship was found after plotting the data,
the sum of squared vertical deviations of data points from the line. so management wants to establish a mathematical model to help predict sales.
This least squares line has the equation: Computed Sales, y Payroll, x x2 xy n Σxy - Σ x Σy
y Relationship
yc = a + bx 2.0 1 1 2.0 b = n Σx2 – ( Σx)2 =
where,
Predicted variable

yc = predicted (dependent) variable 3.0 3 9 9.0

x = predictor (independent) variable 2.5 4 16 10.0 6(51.5) – (18)(15.0) = 0.25
b = slope of the line 2.0 2 4 4.0 6(80) – (18)2
a = y-intercept n Σxy - Σ x Σy 2.0 1 1 2.0
x Σy - b Σ x
0 Predictor variable 3.5
________ 7
________ 49
________ 24.5
_________
b = n Σx2 – ( Σx)2 a = n or
y Σ y = 15.0 Σ x = 18 Σ x2 = 80 Σ xy = 51.5
_ _
Σy - b Σ x y – b x
a +
bx The least squares line, therefore, is yc = 1.75 + 0.25x
a = n yc = Δy or Sales = 1.75 + 0.25 (payroll). So, if the local
_ _ Δt = 15 - .25(18)
b= chamber of commerce predicts Orono area payroll will be
or y - bx 6 6
$600 million next year, Nodel can estimate its sales to be
n = no. of paired observations x = 1.75
Marvin 0I.The
Norona
line intersects the y-axis where y =a. the slope of the line = b. = 1.75 + .25(6) = 3.25 or Marvin
Sales = $325,000.
I. Norona

Linear Regression Analysis Correlation Analysis

„ COEFFICIENT of CORRELATION (r) measures the strength and direction of
„ Three (3) conditions for an indicator to be valid: relationship between two variables. Correlation can range from –1.00 to +1.00
1) The relationship between the movement s of an indicator and the „ r = +1.00 indicates that changes in one variable are always matched by changes in
movements of the variable should have a logical explanation. the other
2) Movements of the indicator must precede movements of the dependent „ r = -1.00 indicates that increases in one variable are matched by decreases in the
variable by enough time so that the forecast isn’t outdated before it can other
be acted upon. „ r→ 0 indicates little linear relationship between two variables
3) A fairly high correlation should exist between the two variables
„ Correlation Formula is r =__ n (Σxy) – ( Σ x)( Σ y)
ƒ Basic assumptions in the use of linear regression: √ n (Σ x2 ) – ( Σ x)2 • √ n (Σ y2 ) – ( Σ y)2
1) Variations around the line are random (no patterns such as cycles or „ COEFFICIENT of DETERMINATION (r2) provides a measure of the amount
trends exist when the line and data are plotted). of variation in the dependent variable about the mean that is explained by the
independent variable in the regression equation.
2) Deviations around the line should be normally distributed. (A
The possible values of r2 range from 0 to 1.00. The closer r2 is to 1.00, the greater the
concentration of values close to the line with a small proportion of larger
„
percentage of explained variation. A high value of r2, say 0.80 or more would indicate
deviation supports the assumption of normality.) that the independent variable is a good predictor of values of the dependent variable.
3) Predictions are being made only within the range of observed values. „ A low value, say 0.25 or less, would indicate a poor predictor,and a value between
0.25 and 0.80 would indicate a moderate predictor.
Marvin I. Norona Marvin I. Norona

8
 Correlation Analysis
Example : Using the earlier data for Nodel Construction
Company, assess the relationship between the firm’s renovation
sales and payroll in its hometown of Orono, Maine. ACCURACY of FORECASTS
Sales,y Payroll, x x2 xy y2 „ Accuracy is based on historical error performance of a
2.0 1 1 2.0 4.0 forecast.
3.0 3 9 9.0 9.0
2.5 4 16 10.0 6.25 „ Forecast error is the difference between the actual value
2.0 2 4 4.0 4.0 and the value predicted for a given period. Hence, Error =
2.0 1 1 2.0 4.0
3.5 7 49 24.5 12.25 Actual – Forecast or (et = At – Ft)
________ ________ ________ _________ _________ „ Two commonly used measures for summarizing historical
Σ y = 15.0 Σ x = 18 Σ x2 = 80 Σ xy = 51.5 Σ y2 = 39.5
errors are:
r= n (Σxy) – ( Σ x)( Σ y) Mean Absolute Deviation (MAD) = ∑ |Actual - Forecast |
√ n (Σ x2 ) – ( Σ x)2 • √ n (Σ y2 ) – ( Σ y)2 n
Mean Squared Error (MSE) = ∑ (Actual - Forecast )2
r= 6 (51.5) – ( 18 )( 15.0 ) = 0.901
√ 6 ( 80 ) – ( 18 )2 • √ 6 (39.5 ) – ( 15.0 )2 n-1
„ Forecast Accuracy is a significant factor in choosing
This r of .901 appears to be a significant correlation and helps to confirm the
closeness of the relationship between the two variables. With r 2 = .81,
forecasting alternatives (by determining which yields the
payroll is a good predictor of NodelMarvin I. Norona Company’s renovation sales.
Construction lowest MAD or MSE for a Marvin
given set of data).
I. Norona

Example: The manager of a large manufacturer of industrial

Mean Absolute Percent Error
pumps must choose between two alternative forecasting „ The average of the absolute differences between the forecast
techniques to prepare forecasts for a six month period. Using MAD and actual values, expressed as a percent of actual value.
n

and MSE as criteria, which technique is better? 100 Σ | Actual i – Forecast i | / Actual i
i=1
MAPE = ------------------------------------------------
Forecast Forecast
Month Demand Technique 1 e |e| e2 Technique 2 e |e| e2
n
Example:
1 492 488 4 4 16 495 -3 3 9 Absolute Percent Error
2 470 484 -14 14 156 482 -12 12 144 Quarter Actual Forecast 100 | Error | / Actual
3 485 480 5 5 25 478 7 7 49 1 180 175 100 (5 / 180) = 2.77 %
4 493 490 3 3 9 488 5 5 25 2 168 176 100 (8 / 168) = 4.76 %
5 498 497 1 1 1 492 6 6 36 3 159 175 100 (16 / 159) = 10.06 %
6 492 493 -1 1 1 493 -1 1 1 4 175 173 100 (2 / 175) = 1.14 %
___ ____ ____ ___ ____ ____
-2 28 208 34 264 5 190 173 100 (17 / 190) = 8.95 %
2
6 205 175 100 (30 / 205) = 14.63 %
Check that each forecast has an average error of approximately zero.
7 180 178 100 (2 / 178) = 1.11 %
MAD1 = Σ | e | = 28 MSE1 = Σ (e )2 = 208 8 182 178 100 (4 / 182) = 2.20 %
= 4.67 = 41.6
n 6 n-1 6-1 sum of % errors = 45.62 %
MAD2 = Σ | e | = 34 MSE2 = Σ (e )2 = 264 = 52.8 Σ absolute percent errors 45.62%
= 5.67
n 6 n-1 6-1 MAPE = -------------------------- = -------- = 5.70%
Technique 1 is superior in this comparison because its MAD and MSE are smaller. n 8
Marvin I. Norona Marvin I. Norona

Tracking Signal
Example: Rick Carlson Bakery’s quarterly sales of croissants (in
thousands), as well as forecast demand error computations, are shown
below. Compute the tracking signal and determine whether forecasts are
MONITORING and CONTROLLING FORECASTS performing adequately.
Cumulative
↵

Absolute Absolute ÷n = Tracking

„ It is necessary to monitor forecast errors to ensure that the forecast is
Forecast Actual A – F = Forecast Forecast Cumulative Signal
performing adequately. MAD
Quarter Demand Demand Error RSFE | Error | | Error | (RSFE/MAD)
„ A forecast is generally deemed to perform adequately when the errors 1 100 90 -10 -10 10 10 10.0 -10/10 = -1
exhibit only random variations. 2 100 95 -5 -15 5 15 7.5 -15/7.5 = -2
„ Forecasts can be monitored using either of the following: 3 100 115 +15 0 15 30 10.0 0/10 = 0
4 110 100 -10 -10 10 40 10.0 -10/10 = -1
Tracking Signal – measurement of how well the forecast is predicting 5 110 125 +15 +5 15 55 11.0 +5/11 = +0.5
actual values. It is computed as the running sum of forecast errors (RSFE) 6 110 140 +30 +35 30 85 14.2 +35/14.2 = +2.5
divided by the corresponding value of mean absolute deviation (MAD), or
Tracking = RSFE = ∑ (Actual - Forecast ) , where MAD = ∑ |Actual - Forecast | At the end of quarter 6, MAD = ∑ |Actual – Forecast = 85 = 14.2
Signal MAD MAD n n 6
Control Chart – monitoring approach that sets limits for individual And Tracking signal = RSFE = 35 = 2.5 MADs
forecast errors (instead of cumulative errors). The limits are multiples of MAD 14.2
the square root of MSE, that is, s = √ MSE , where MSE = ∑ (Actual – Forecast)2 This tracking signal is within acceptable limits. We see that it drifted
Marvin I. Norona n-1 from –2.0 MADs to +2.5 MADs Marvin I. Norona

9
 Tracking Signal & Control Chart
Example : Monthly sales of sweaters at the Gold Shoppe for the past 24

Tracking Signal & Control Chart months, and forecasts for those months are shown below. Determine if the
forecast is working using these approaches:
1. A tracking signal, beginning with month 10, updating MAD with exponential
„ Bias in forecasts is reflected by the cumulative forecast error and is smoothing. Use action limits of ±4 and α=0.20.
defined as the persistent tendency for forecasts to be greater or 2. A control chart with 2s limits. Use data from the first eight months to
less than the actual value of a time series. develop the control chart, then evaluate the remaining data with the control
chart.
„ Tracking Signal values are compared to predetermined limits (or Month (Sales) Forecast Month (Sales) Forecast
called “action limits” based on judgment and experience. They often 1 54 50 13 51 41
range from ±3 to ±8; for the most part, limits of ±4 shall be used 2 58 51 14 64 57
which are roughly comparable to three (3) standard deviation limits. 3 61 57 15 67 58
Values within the limits suggest – but do not guarantee – that the 4 62 58 16 62 61
forecast is performing adequately. 5 56 61 17 58 62
6 53 55 18 55 58
„ MAD can be updated using exponential smoothing after an initial 7 45 53 19 49 57
value of MAD has been computed: 8 39 51 20 37 50
MADnew = MADold + α (⏐Actual - Forecast ⏐ - MADold ) 9 32 42 21 35 45
„ Control Chart method assumes the following: 10 31 33 22 32 34
1.Forecast errors are randomly distributed around a mean of zero. 11 37 32 23 42 34
2.The distribution of errorsMarvin
is normal. 12 42 39 24 45 39
I. Norona Marvin I. Norona

Tracking Signal & Control Chart Tracking Signal & Control Chart
Solution to Example Solution to Example (con’t)
Cumu- Cumulative
A F A–F Cumulative | A - F | = Cumulative MADt = MADt-1 Errort ÷ MADt =
lative
Month (Sales) Forecast (Error) Error |e| |e| t A F e |e| + .2(⏐ e ⏐ - MADt-1) __ Error Tracking Signal
1 54 50 4 4 4 4 10 5.8 (initial) -20 -20/5.800 = -3.45
2 58 51 7 11 7 11 11 30 25 5 5 5.640 = 5.8 + .2 ( 5 – 5.8 ) -15 -15/5.640 = -2.66
3 61 57 4 15 4 15 12 35 32 3 3 5.112 = 5.640 + .2 ( 3 – 5.64 ) -12 -12/5.112 = -2.35
4 62 58 4 19 4 19 13 51 41 10 10 6.090 = 5.112 + .2(10 – 5.112) -2 -2/6.090 = -0.33
5 56 61 -5 14 5 24 14 64 57 7 7 6.272 = 6.090 + .2 ( 7 – 6.090) 5 5/6.272 = 0.80
6 53 55 -2 12 2 36 15 67 58 9 9 6.818 = 6.272 + .2 ( 9 – 6.272) 14 14/6.818 = 2.05
7 45 53 -8 4 8 34 16 62 61 1 1 5.654 = 6.818 + .2 ( 1 – 6.818) 15 15/5.654 = 2.65
8 39 51 -12 -8 12 46 17 58 62 - 4 4 5.323 = 5.654 + .2 ( 4 – 5.654) 11 11/5.323 = 2.07
9 32 42 -10 -18 10 56 18 55 58 - 3 3 4.858 = 5.323 + .2 ( 3 – 5.323) 8 8/4.858 = 1.65
10 31 33 -2 -20 2 58 19 49 57 - 8 8 5.486 = 4.858 + .2 ( 8 - 4.858) 0 0/5.486 = 0.00
a) The sum of absolute errors through the 10th month is 58. Hence, the initial 20 37 50 -13 13 6.989 = 5.486 + .2(13 – 5.486) -13 -13/6.989 = -1.86
MAD is 58/10 = 5.8. The subsequent MADs are updated using the formula 21 35 45 -10 10 7.591 = 6.989 + .2(10 – 6.989) -23 -23/7.591 = -3.03
MADnew = MADold + α (⏐ e ⏐ - MADold ) and the results are in the following table. 22 32 34 - 2 2 6.473 = 7.591 + .2 ( 2 – 7.591) -25 -25/6.473 = -3.86
The tracking signal for any month is Cumulative error at that month 23 42 34 8 8 6.778 = 6.473 + .2 ( 8 – 6.473) -17 -17/6.778 = -2.51
Update MAD at that month 24 45 39 6 6 6.622 = 6.778 + .2 ( 6 – 6.778) -11 -11/6.622 = -1.66
Marvin I. Norona Because the tracking signal is within ±4Marvin
everyI. month,
Norona there is no evidence of a problem.

Tracking Signal & Control Chart

Solution to Example (con’t) CHOOSING A FORECASTING TECHNIQUE
b) 1. Make sure that the average error is approximately zero, because a large Factors to consider in choosing a forecasting technique:
average would suggest a biased forecast.
1. Cost – how much money is budgeted for generating the forecast?
Average error = ∑ errors
= -11 = -0.46 [OK] 2. Accuracy – generally speaking, the higher the accuracy, the higher
n 24 the cost, so it’s important to weigh the cost-accuracy trade-offs
2. Compute the standard deviation:
_____ carefully. The best forecast is not necessarily the most accurate or
____
s = √ MSE =
√ ∑ e2
n-1
[ using data from the first eight months ]
_____________________________________________
the least costly; rather, it is some combination of accuracy and cost
deemed by management.

= √ 42 + 72 + 42 + 42 + (-5)2 + (-2)2 + (-8)2 + (-12)2 = 6.91

8 - 1
3.
4.
Availability of historical data
Availability of computers
3. Determine 2s control limits: 5. Ability of decision makers to utilize certain techniques
0 ± 2(6.91) = -13.82 to +13.82
6. Time needed to gather and analyze data and prepare the forecast
4. Check if the rest of the data (errors for the rest of the months) are within 7. Any prior experience with a technique
the range, i.e., -13.82 ≤ error ≤ +13.82 [ YES ].
Marvin I. Norona Marvin I. Norona

10