CP2 Forecasting

ISM 3530 – Spring 2005
Forecasting: Page 1 of 24
TYPES OF FORECASTING METHODS
Qualitative methods: These types of forecasting methods are based on judgments or opinions,
and are subjective in nature. They do not rely on any mathematical computations.
Quantitative methods: These types of forecasting methods are based on quantitative models,
and are objective in nature. They rely heavily on mathematical computations.
QUALITATIVE FORECASTING METHODS
Qualitative Methods
Executive Opinion Market Research Delphi Method

Approach in which a Approach that uses Approach in which a
group of managers meet surveys and interviews to forecast is the product of a
and collectively develop a determine customer consensus among a group
forecast. preferences and assess of experts.
demand.
QUANTITATIVE FORECASTING METHODS
Quantitative forecasting methods can be divided into two categories: time series models and
causal models.
Quantitative Methods
Time Series Models Causal Models

Time series models look at past Causal models assume that the
patterns of data and attempt to variable being forecasted is
predict the future based upon the related to other variables in the
underlying patterns contained environment. They try to project
within those data. based upon those associations.
TIME SERIES MODELS
Model Description
Naïve Uses last period’s actual value as a forecast
Simple Mean (Average) Uses an average of all past data as a forecast
Uses an average of a specified number of the most recent

Simple Moving Average observations, with each observation receiving the same
emphasis (weight)
Uses an average of a specified number of the most recent
Weighted Moving Average observations, with each observation receiving a different
emphasis (weight)
A weighted average procedure with weights declining

Exponential Smoothing
exponentially as data become older
An exponential smoothing model with a mechanism for

Trend Adjusted Exponential
making adjustments when strong trend patterns are
Smoothing
inherent in the data
A mechanism for adjusting the forecast to accommodate

Seasonal Indexes
any seasonal patterns inherent in the data
Technique that uses the least squares method to fit a

Linear Trend Line
straight line to the data
PATTERNS THAT MAY BE PRESENT IN A TIME SERIES
Level or horizontal: Data are relatively constant over time, with no growth or decline.
Trend: Data exhibit a steady growth or decline over time.
Seasonality: Data exhibit upward and downward swings in a short to intermediate time frame
(most notably during a year).
Cycles: Data exhibit upward and downward swings in over a very long time frame.
Random: Erratic and unpredictable variation in the data over time.

DATA SET TO DEMONSTRATE FORECASTING METHODS
The following data set represents a set of hypothetical demands that have occurred over several
consecutive years. The data have been collected on a quarterly basis, and these quarterly values
have been amalgamated into yearly totals.
For various illustrations that follow, we may make slightly different assumptions about starting
points to get the process started for different models. In most cases we will assume that each year
a forecast has been made for the subsequent year. Then, after a year has transpired we will have
observed what the actual demand turned out to be (and we will surely see differences between
what we had forecasted and what actually occurred, for, after all, the forecasts are merely
educated guesses).
Finally, to keep the numbers at a manageable size, several zeros have been dropped off the
numbers (i.e., these numbers represent demands in thousands of units).
Year Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total Annual Demand

1 20 28 34 18 100
2 58 86 104 52 300
3 40 54 72 34 200
4 104 140 174 82 500
5 116 170 210 104 600
6 136 198 246 120 700
ILLUSTRATION OF THE NAÏVE METHOD
Naïve method: The forecast for next period (period t+1) will be equal to this period's actual
demand (At).
In this illustration we assume that each year (beginning with year 2) we made a forecast, then
waited to see what demand unfolded during the year. We then made a forecast for the subsequent
year, and so on right through to the forecast for year 7.
Actual
Demand Forecast
Year (At) (Ft) Notes
There was no prior demand data on
1 100 --
which to base a forecast for period 1
From this point forward, these forecasts
2 300 100
were made on a year-by-year basis.
3 200 300
4 500 200
5 600 500
6 700 600
7 700
MEAN (SIMPLE AVERAGE) METHOD
Mean (simple average) method: The forecast for next period (period t+1) will be equal to the
average of all past historical demands.
In this illustration we assume that each year (beginning with year 2) we made a forecast, then
waited to see what demand unfolded during the year. We then made a forecast for the subsequent
year, and so on right through to the forecast for year 7.
Actual
Demand Forecast
There was no prior demand data on
1 100 --
which to base a forecast for period 1
2 300 100
3 200 200
4 500 200
5 600 275
6 700 340
7 400
SIMPLE MOVING AVERAGE METHOD
Simple moving average method: The forecast for next period (period t+1) will be equal to the
average of a specified number of the most recent observations, with each observation receiving
the same emphasis (weight).
In this illustration we assume that a 2-year simple moving average is being used. We will also
assume that, in the absence of data at startup, we made a guess for the year 1 forecast (200).
Then, after year 1 elapsed, we made a forecast for year 2 using a naïve method (100). Beyond
that point we had sufficient data to let our 2-year simple moving average forecasts unfold
throughout the years.
Actual
Demand Forecast
This forecast was a guess at the
1 100 200
beginning.
This forecast was made using a naïve
2 300 100
approach.
3 200 200
4 500 250
5 600 350
6 700 550
7 650
ANOTHER SIMPLE MOVING AVERAGE ILLUSTRATION
In this illustration we assume that a 3-year simple moving average is being used. We will also
Then, after year 1 elapsed, we used a naïve method to make a forecast for year 2 (100) and year 3
(300). Beyond that point we had sufficient data to let our 3-year simple moving average forecasts
unfold throughout the years.
Actual
Demand Forecast
1 100 200
beginning.
2 300 100
approach.
3 200 300
approach.
4 500 200
5 600 333.333
6 700 433.333
7 600
WEIGHTED MOVING AVERAGE METHOD
Weighted moving average method: The forecast for next period (period t+1) will be equal to a
weighted average of a specified number of the most recent observations.
In this illustration we assume that a 3-year weighted moving average is being used. We will also
Then, after year 1 elapsed, we used a naïve method to make a forecast for year 2 (100) and year 3
(300). Beyond that point we had sufficient data to let our 3-year weighted moving average
forecasts unfold throughout the years. The weights that were to be used are as follows: Most
recent year, .5; year prior to that, .3; year prior to that, .2
Actual
Demand Forecast
1 100 200
beginning.
2 300 100
approach.
3 200 300
approach.
4 500 210
5 600 370
6 700 490
7 630
EXPONENTIAL SMOOTHING METHOD
Exponential smoothing method: The forecast for next period (period t+1) will be calculated as
follows:
Ft+1 = ∀ At + (1-∀ )Ft (equation 1)
Where ∀ is a smoothing coefficient whose value is between 0 and 1.
Although the exponential smoothing method only requires that you dig up two pieces of data to
apply it (the most recent actual demand and the most recent forecast), forecasts made with this
model will include a portion of every piece of historical demand. Furthermore, there will be
different weights placed on these historical demand values, with older data receiving lower
weights. This can be observed by expanding the above formula, as follows:
When we made the forecast for last period (Ft), it was made in the following fashion:
Ft = ∀ At-1 + (1-∀ )Ft-1 (equation 2)
If we substitute equation 2 into equation 1 we get the following:
Ft+1 = ∀ At + (1-∀ )[∀ At-1 + (1-∀ )Ft-1]
Which can be cleaned up to the following:
Ft+1 = ∀ At + ∀ (1-∀ )At-1 + (1-∀ )2Ft-1 (equation 3)
We could continue to play that game by recognizing that Ft-1 = ∀ At-2 + (1-∀ )Ft-2 (equation 4)
If we substitute equation 4 into equation 3 we get the following:
Ft+1 = ∀ At + ∀ (1-∀ )At-1 + (1-∀ )2[∀ At-2 + (1-∀ )Ft-2]
Which can be cleaned up to the following:
Ft+1 = ∀ At + ∀ (1-∀ )At-1 + ∀ (1-∀ )2At-2 + (1-∀ )3Ft-2
If you keep playing that game, you should recognize that
Ft+1 = ∀ At + ∀ (1-∀ )At-1 + ∀ (1-∀ )2At-2 + ∀ (1-∀ )3At-3 + ∀ (1-∀ )4At-4 + ∀ (1-∀ )5At-5
……….
As you raise those decimal weights to higher and higher powers, the values get smaller and
smaller.
EXPONENTIAL SMOOTHING ILLUSTRATION
In this illustration we assume that, in the absence of data at startup, we made a guess for the year
1 forecast (200). Then, for each subsequent year (beginning with year 2) we made a forecast
using the exponential smoothing model. After the forecast was made, we waited to see what
demand unfolded during the year. We then made a forecast for the subsequent year, and so on
right through to the forecast for year 7.
This set of forecasts was made using an ∀ value of .1

Actual
Demand Forecast
This was a guess, since there was no
1 100 200
prior demand data.
2 300 190
3 200 201
4 500 200.9
5 600 230.81
6 700 267.729
7 310.9561
A SECOND EXPONENTIAL SMOOTHING ILLUSTRATION

Actual
Demand Forecast
1 100 200
prior demand data.
2 300 180
3 200 204
4 500 203.2
5 600 262.56
6 700 330.048
7 404.0384
A THIRD EXPONENTIAL SMOOTHING ILLUSTRATION

Actual
Demand Forecast
1 100 200
prior demand data.
2 300 160
3 200 216
4 500 209.6
5 600 325.76
6 700 435.456
7 541.2736
LINEAR TREND LINE
Linear trend line method: This method is a version of the linear regression technique. It
attempts to draw a straight line through the historical data points in a fashion that comes as close
to the points as possible. (Technically, the approach attempts to reduce the vertical deviations of
the points from the trend line, and does this by minimizing the squared values of the deviations
of the points from the line). Ultimately, the statistical formulas compute a slope for the trend line
(b) and the point where the line crosses the y-axis (a). This results in the straight line equation
Y = a + bX
Where X represents the values on the horizontal axis (time), and Y represents the values on the
vertical axis (demand).
For the demonstration data, computations for b and a reveal the following
b = 120
a = -20
Y = -20 + 120X
This equation can be used to forecast for any year into the future. For example:
Year 7: Forecast = -20 + 120(7) = 820
Year 8: Forecast = -20 + 120(8) = 940
Year 10: Forecast = -20 + 120(10) = 1180

CALCULATING SEASONAL INDEX VALUES
Begin by dividing the total annual demand by 4 (which is the number of periods in the year) to
see what the quarterly demand would have been if the annual demand had been distributed
evenly throughout the year (this is column 7 below).
Col. 1 Col. 2 Col. 3 Col. 4 Col. 5 Col. 6 Col. 7

Annual
Year Q1 Q2 Q3 Q4 Annual/4
Demand
1 20 28 34 18 100 25
2 58 86 104 52 300 75
3 40 54 72 34 200 50
4 104 140 174 82 500 125
5 116 170 210 104 600 150
6 136 198 246 120 700 175
For each quarter in each year, divide the actual quarterly demand by the column 7 average. This
gives a measure of how each quarter's demand compared to a uniform split (each computation is
a seasonal index for the quarter and year in question). Then compute an average value for the
seasonal indexes for each quarter (average for the numbers in columns 2, 3, 4, and 5)
Col. 1 Col. 2 Col. 3 Col. 4 Col. 5 Col. 6 Col. 7

Annual
Demand
1 .800 1.120 1.360 .720 100 25
2 .773 1.147 1.387 .693 300 75
3 .800 1.080 1.440 .680 200 50
4 .832 1.120 1.392 .656 500 125
5 .773 1.133 1.400 .693 600 150
6 .777 1.131 1.406 .686 700 175
Q1 Q2 Q3 Q4
Avg. .793 1.122 1.397 .688
Any subsequent yearly forecast can be broken down into quarterly forecasts using these seasonal
index values. This is demonstrated on the next page.
USING SEASONAL INDEX VALUES
The following forecasts were made for the next 4 years using the linear trend line approach (the
trend line formula developed was Y = -20 + 120X, where Y is the forecast and X is the year
number).
Year Forecast
7 820
8 940
9 1060
10 1180
If these annual forecasts were evenly distributed over each year, the quarterly forecasts would
look like the following:
Annual
Forecast
7 205 205 205 205 820 205
8 235 235 235 235 940 235
9 265 265 265 265 1060 265
10 295 295 295 295 1180 295
S.I. .793 1.122 1.397 .688
However, seasonality in the past demand suggests that these forecasts should not be evenly
distributed over each quarter. We must take these even splits and multiply them by the seasonal
index (S.I.) values to get a more reasonable set of quarterly forecasts. The results of these
calculations are shown below.
Annual
Year Q1 Q2 Q3 Q4
Forecast
7 162.490 229.991 286.466 141.053 820
8 186.269 263.648 328.388 161.695 940
9 210.048 297.305 370.310 182.337 1060
10 233.827 330.962 412.232 202.979 1180
If you check these final splits, you will see that the sum of the quarterly forecasts for a particular
year will equal the total annual forecast for that year (sometimes there might be a slight rounding
discrepancy).
OTHER METHODS FOR MAKING SEASONAL FORECASTS
Let's go back and reexamine the historical data we have for this problem. I have put a little
separation between the columns of each quarter to let you better visualize the fact that we could
look at any one of those vertical strips of data and treat it as a time series. For example, the Q1
column displays the progression of quarter 1 demands over the past six years. One could simply
peel off that strip of data and use it along with any of the forecasting methods we have examined
to forecast the Q1 demand in year 7. We could do the same thing for each of the other three
quarterly data strips.
Year Q1 Q2 Q3 Q4
1 20 28 34 18
2 58 86 104 52
3 40 54 72 34
4 104 140 174 82
5 116 170 210 104
6 136 198 246 120
To illustrate, I have used the linear trend line method on the quarter 1 strip of data, which would
result in the following trend line:
Y = -2.8 + 23.3714X
For year 7, X = 7, so the resulting Q1 forecast for year 7 would be 160.800

CAUSAL MODELS METHOD
Causal models assume that the variable being forecasted (the dependent variable) is related to other
variables (independent variables) in the environment. This approach tries to project demand based upon
those associations. In its simplest form, linear regression is used to fit a line to the data. That line is then
used to forecast the dependent variable for some selected value of the independent variable.
The textbook illustrates an example in which the sales for a product seem to be related to the amount of
money spent on advertising. The following table shows varying amounts that have been spent on
advertising on past occasions, and the sales that corresponded to these expenditures.
Advertising Expenditure Sales Dollars

(thousands of $) (thousands of $)
32 130
52 151
50 150
55 158
The independent variable (X) is the advertising expenditure. The dependent variable (Y) is the
sales dollars.
Application of regression formulas yields the following forecasting model:
Y = 92.83 + 1.15X
If the company plans to spend $53,000 on advertising in a particular year (i.e., X = 53), the
forecast for sales will be:
Y = 92.83 + 1.15(53) = 153.87 (which means sales projections are $153,870)

MEASURING FORECAST ACCURACY
Forecast error: Forecast error is a measure of how accurate our forecast was in a given time
period. It is calculated as the actual demand minus the forecast, or
E t = At - Ft
Forecast error in one time period does not convey much information, so we need to look at the
accumulation of errors over time. Unfortunately, the accumulation of the Et values is not very
revealing, for some of them will be positive errors and some will be negative. These positive and
negative errors cancel one another, and looking at them alone might give a false sense of
security. To illustrate, consider our original data, and the accompanying pair of hypothetical
forecasts made with two different forecasting methods.
Hypothetical Hypothetical
Forecasts Forecast Forecasts Forecast
Actual Made With Error With Made With Error With
Demand Method 1 Method 1 Method 2 Method 2
Year At Ft At - Ft Ft At - Ft
1 100 105 -5 160 -60
2 300 310 -10 390 -90
3 200 195 5 110 90
4 500 490 10 620 -120
5 600 585 15 540 60
6 700 715 -15 580 120
Accumulated Forecast Errors 0 0
Based on the accumulated forecast errors over time, the two methods look equally good. But,
clearly Method 1 is generating better forecasts than Method 2.
MEASURING FORECAST ACCURACY
Mean Absolute Deviation (MAD): To eliminate the problem of positive errors canceling
negative errors, a simple measure is one that looks at the absolute value of the error (size of the
deviation, regardless of sign). When we disregard the sign and only consider the size of the error,
we refer to this deviation as the absolute deviation. If we accumulate these absolute deviations
over time and find the average value of these absolute deviations, we refer to this measure as the
mean absolute deviation (MAD). For our hypothetical two forecasting methods, the absolute
deviations can be calculated for each year and an average can be obtained for these yearly
absolute deviations, as follows:
Hypothetical Forecasting Method 1 Hypothetical Forecasting Method 2

Actual Forecast Absolute Forecast Absolute
Demand Forecast Error Deviation Forecast Error Deviation
Year At Ft At - Ft |At - Ft| Ft At - Ft |At - Ft|
1 100 105 -5 5 160 -60 60
2 300 310 -10 10 390 -90 90
3 200 195 5 5 110 90 90
4 500 490 10 10 620 -120 120
5 600 585 15 15 540 60 60
6 700 715 -15 15 580 120 120
Total Absolute Deviation 60 540
Mean Absolute Deviation 60/6=10 540/6=90
Clearly Method 1 has provided more accurate forecasts over this six year horizon, as evidenced
by its considerably smaller MAD.
MONITORING FORECAST ACCURACY OVER TIME
Tracking Signal: A tracking signal (T.S.) is a tool used to continually monitor the quality of our
forecasting method as we progress through time. Each period a tracking signal value is
calculated, and a determination is made as to whether it falls into an acceptable range (much like
we saw with control charts). If it drifts outside of the acceptable range, that is an indication that
the forecasting method being used is no longer providing accurate forecasts. Tracking signals
help to indicate whether there is bias creeping into the forecasting process. Bias is a tendency for
the forecast to be persistently under or persistently over the actual value of the data.
Tracking signal is calculated as follows:
algebraic sum of forecast errors (ASFE)

Tracking signal =
MAD
Illustration of the computation of tracking signals to accompany the progression of forecasts

made over time with hypothetical forecasting Method 1.
Total
Year At Ft At - Ft ASFE |At - Ft| |At - Ft| MAD T.S.
1 100 105 -5 -5 5 5 5 -1.00
2 300 310 -10 -15 10 15 7.5 -2.00
3 200 195 5 -10 5 20 6.67 -1.50
4 500 490 10 0 10 30 7.5 0
5 600 585 15 15 15 45 9 +1.67
6 700 715 15 0 15 60 10 0

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ISM 3530 – Spring 2005

TYPES OF FORECASTING METHODS

QUALITATIVE FORECASTING METHODS

Executive Opinion Market Research Delphi Method

QUANTITATIVE FORECASTING METHODS

Time Series Models Causal Models

TIME SERIES MODELS

Naïve Uses last period’s actual value as a forecast

Simple Mean (Average) Uses an average of all past data as a forecast

Uses an average of a specified number of the most recent

A weighted average procedure with weights declining

An exponential smoothing model with a mechanism for

A mechanism for adjusting the forecast to accommodate

Technique that uses the least squares method to fit a

PATTERNS THAT MAY BE PRESENT IN A TIME SERIES

Trend: Data exhibit a steady growth or decline over time.

Random: Erratic and unpredictable variation in the data over time.

DATA SET TO DEMONSTRATE FORECASTING METHODS

Year Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total Annual Demand

ILLUSTRATION OF THE NAÏVE METHOD

MEAN (SIMPLE AVERAGE) METHOD

SIMPLE MOVING AVERAGE METHOD

ANOTHER SIMPLE MOVING AVERAGE ILLUSTRATION

WEIGHTED MOVING AVERAGE METHOD

EXPONENTIAL SMOOTHING METHOD

Ft+1 = ∀ At + (1-∀ )Ft (equation 1)

Where ∀ is a smoothing coefficient whose value is between 0 and 1.

Ft = ∀ At-1 + (1-∀ )Ft-1 (equation 2)

If we substitute equation 2 into equation 1 we get the following:

Ft+1 = ∀ At + (1-∀ )[∀ At-1 + (1-∀ )Ft-1]

Which can be cleaned up to the following:

Ft+1 = ∀ At + ∀ (1-∀ )At-1 + (1-∀ )2Ft-1 (equation 3)

If we substitute equation 4 into equation 3 we get the following:

Ft+1 = ∀ At + ∀ (1-∀ )At-1 + (1-∀ )2[∀ At-2 + (1-∀ )Ft-2]

Which can be cleaned up to the following:

Ft+1 = ∀ At + ∀ (1-∀ )At-1 + ∀ (1-∀ )2At-2 + (1-∀ )3Ft-2

If you keep playing that game, you should recognize that

EXPONENTIAL SMOOTHING ILLUSTRATION

This set of forecasts was made using an ∀ value of .1

A SECOND EXPONENTIAL SMOOTHING ILLUSTRATION

This set of forecasts was made using an ∀ value of .2

A THIRD EXPONENTIAL SMOOTHING ILLUSTRATION

This set of forecasts was made using an ∀ value of .4

LINEAR TREND LINE

Year 7: Forecast = -20 + 120(7) = 820

Year 8: Forecast = -20 + 120(8) = 940

Year 10: Forecast = -20 + 120(10) = 1180

CALCULATING SEASONAL INDEX VALUES

Col. 1 Col. 2 Col. 3 Col. 4 Col. 5 Col. 6 Col. 7

Col. 1 Col. 2 Col. 3 Col. 4 Col. 5 Col. 6 Col. 7

USING SEASONAL INDEX VALUES

S.I. .793 1.122 1.397 .688

OTHER METHODS FOR MAKING SEASONAL FORECASTS

For year 7, X = 7, so the resulting Q1 forecast for year 7 would be 160.800

CAUSAL MODELS METHOD

Advertising Expenditure Sales Dollars

Application of regression formulas yields the following forecasting model:

Y = 92.83 + 1.15(53) = 153.87 (which means sales projections are $153,870)

MEASURING FORECAST ACCURACY

MEASURING FORECAST ACCURACY

Hypothetical Forecasting Method 1 Hypothetical Forecasting Method 2

MONITORING FORECAST ACCURACY OVER TIME