College of Business Administration

Cal State San Marcos

Production & Operations Management
HTM 305

Dr. M. Oskoorouchi

Summer 2006
CHAPTER
3
Forecasting
FORECAST:
- A statement about the future value of a variable of
interest such as demand.
- Forecasts affect decisions and activities throughout
an organization
- Accounting, finance
- Human resources
- Marketing
- MIS
- Operations
- Product / service design
What is Forecasting?
Accounting Cost/profit estimates
Finance Cash flow and funding
Human Resources Hiring/recruiting/training
Marketing Pricing, promotion, strategy
MIS IT/IS systems, services
Operations Schedules, MRP, workloads
Product/service design New products and services
Uses of Forecasts
- Assumes causal system
past ==> future
- Forecasts rarely perfect because of
randomness
- Forecasts more accurate for
groups vs. individuals
- Forecast accuracy decreases
as time horizon increases
I see that you will
get an A this semester.
Common in all forecasts
Elements of a Good Forecast
Timely
Accurate
Reliable
Written
Steps in the Forecasting Process
Step 1 Determine purpose of forecast
Step 2 Establish a time horizon
Step 3 Select a forecasting technique
Step 4 Gather and analyze data
Step 5 Prepare the forecast
Step 6 Monitor the forecast
The forecast
Types of Forecasts
- Judgmental - uses subjective inputs
- Time series - uses historical data
assuming the future will be like the past
- Associative models - uses explanatory
variables to predict the future
Judgmental Forecasts
- Executive opinions

- Sales force opinions

- Consumer surveys

- Outside opinion


Time Series Forecasts
- Trend - long-term movement in data
- Seasonality - short-term regular variations in
data
- Cycle wavelike variations of more than one
years duration
- Irregular variations - caused by unusual
circumstances
- Random variations - caused by chance
Forecast Variations
Trend
Irregular
variatio
n
Seasonal variations
90
89
88
Cycles
Naive Forecasts
Uh, give me a minute....
We sold 250 wheels last
week.... Now, next week
we should sell....
The forecast for any period equals
the previous periods actual value.
- Stable time series data
- F(t) = A(t-1)
- Seasonal variations
- F(t) = A(t-n)
- Data with trends
- F(t) = A(t-1) + (A(t-1) A(t-2))
Uses for Naive Forecasts
- Simple to use
- Virtually no cost
- Quick and easy to prepare
- Easily understandable
- Can be a standard for accuracy
- Cannot provide high accuracy

Naive Forecasts
Techniques for Averaging
- Moving average
- Weighted moving average
- Exponential smoothing
Moving Averages
- Moving average A technique that averages a
number of recent actual values, updated as new
values become available.



- The demand for tires in a tire store in the past 5
weeks were as follows. Compute a three-period
moving average forecast for demand in week 6.
83 80 85 90 94



MA
n
=
n
A
i
i = 1

n
Moving average & Actual demand
Moving Averages
- Weighted moving average More recent values in a
series are given more weight in computing the
forecast.

Example:
- For the previous demand data, compute a weighted
average forecast using a weight of .40 for the most
recent period, .30 for the next most recent, .20 for the
next and .10 for the next.
- If the actual demand for week 6 is 91, forecast demand
for week 7 using the same weights.
Exponential Smoothing
The most recent observations might have the
highest predictive value.
- Therefore, we should give more weight to the
more recent time periods when forecasting.
F
t
= F
t-1
+ o(A
t-1
- F
t-1
)
Exponential Smoothing
- Weighted averaging method based on previous
forecast plus a percentage of the forecast error
- A-F is the error term, o is the % feedback
F
t
= F
t-1
+ o(A
t-1
- F
t-1
)
Example - Exponential Smoothing
Period Actual 0.1 Error 0.4 Error
1 83
2 80 83 -3.00 83 -3
3 85 82.70 2.30 81.80 3.20
4 89 82.93 6.07 83.08 5.92
5 92 83.54 8.46 85.45 6.55
6 95 84.38 10.62 88.07 6.93
7 91 85.44 5.56 90.84 0.16
8 90 86.00 4.00 90.90 -0.90
9 88 86.40 1.60 90.54 -2.54
10 93 86.56 6.44 89.53 3.47
11 92 87.20 4.80 90.92 1.08
12 87.68 91.35
Picking a Smoothing Constant
Exponential Smoothing
70
75
80
85
90
95
100
2 3 4 5 6 7 8 9 10 11
Period
D
e
m
a
n
d
Actual Alpha=0.10 Alpha=0.40
Problem 1
- National Mixer Inc. sells can openers.
Monthly sales for a seven-month period
were as follows:
- Forecast September sales volume using
each of the following:
- A five-month moving average
- Exponential smoothing with a smoothing
constant equal to .20, assuming a March
forecast of 19.
- The naive approach
- A weighted average using .60 for August,
.30 for July, and .10 for June.

Month Sales
(1000)
Feb 19
Mar 18
Apr 15
May 20
Jun 18
Jul 22
Aug 20
Problem 2
- A dry cleaner uses exponential smoothing to
forecast equipment usage at its main plant. August
usage was forecast to be 88% of capacity. Actual
usage was 89.6%. A smoothing constant of 0.1 is
used.
- Prepare a forecast for September
- Assuming actual September usage of 92%, prepare
a forecast of October usage
Problem 3
- An electrical contractors records during the last five
weeks indicate the number of job requests:
Week: 1 2 3 4 5
Requests: 20 22 18 21 22

Predict the number of requests for week 6 using each of
these methods:
- Nave
- A four-period moving average
- Exponential smoothing with a smoothing constant of .30.
Use 20 for week 2 forecast.
- Assumes causal system
past ==> future
- Forecasts rarely perfect because of
randomness
- Forecasts more accurate for
groups vs. individuals
- Forecast accuracy decreases
as time horizon increases
Review: forecast
Review: forecast
- Nave technique
- Stable time series data
- Seasonal variations
- Data with trends

- Averaging
- Moving average
- Weighted moving average
- Exponential smoothing
Techniques for Trend

Develop an equation that will suitably describe
trend, when trend is present.

The trend component may be linear or nonlinear

We focus on linear trends
Common Nonlinear Trends
Parabolic
Exponential
Growth
Linear Trend Equation
- F
t
= Forecast for period t
- t = Specified number of time periods
- a = Value of F
t
at t = 0
- b = Slope of the line

- Example: F
t
=10+2t. Interpret 10 and 2. Plot F
F
t
= a + bt
0 1 2 3 4 5 t
F
t
Example
- Sales for over the last 5 weeks are shown below:

Week: 1 2 3 4 5
Sales: 150 157 162 166 177

- Plot the data and visually check to see if a linear
trend line is appropriate.
- Determine the equation of the trend line
- Predict sales for weeks 6 and 7.
Line chart
Sales
135
140
145
150
155
160
165
170
175
180
1 2 3 4 5
Week
S
a
l
e
s
Sales
Calculating a and b
b =
n (ty) - t y
n t
2
- ( t)
2
a =
y - b t
n



Linear Trend Equation Example
t y
Week t
2
Sales ty
1 1 150 150
2 4 157 314
3 9 162 486
4 16 166 664
5 25 177 885
E t = 15 E t
2
= 55 E y = 812 E ty = 2499
(E t)
2
= 225
Linear Trend Calculation
y = 143.5 + 6.3t
a =
812 - 6.3(15)
5
=
b =
5 (2499) - 15(812)
5(55) - 225
=
12495 - 12180
275 - 225
= 6.3
143.5
Linear Trend plot
135
140
145
150
155
160
165
170
175
180
1 2 3 4 5
Actual data Linear equation
Recall: Problem 1
- National Mixer Inc. sells can openers.
Monthly sales for a seven-month period
were as follows:

- Plot the monthly data
- Forecast September sales volume using
a line trend equation
- Which method of forecast seems least
appropriate?
- What does use of the term sales rather
than demand presume?
Month Sales
(1000)
Feb 19
Mar 18
Apr 15
May 20
Jun 18
Jul 22
Aug 20
Line chart
Month
Sales
F M A M J
J A S
20
0
Problem 4
- A cosmetics manufacturers marketing department has
developed a linear trend equation that can be used to predict
annual sales of its popular Hand & Foot Cream:






- Are annual sales increasing or decreasing? By how much?
- Predict annual sales for the year 2006 using the equation.

80 15
Annual sales (1000 bottles)
0 corresponds to 1990
t
t
F t
where
F
t
= +
=
=
Techniques for Seasonality
- Seasonality may refer to regular annual variation. There
are two models:

- Additive: expressed as a quantity (e.g., 20 units), which is
added or subtracted from the series average

- Multiplicative: a percentage of the average or seasonal
relative (e.g., 1.10), which is used to multiply the value of a
series to incorporate seasonality.
Additive vs. multiplicative
Example
- A furniture manufacturer wants to predict quarterly demand for a
certain loveseat for periods 15 and 16, which happen to be the
second and third quarters of a particular year. The series consists
of both trend and seasonality. The trend portion of demand is
projected using the equation



- Quarter relatives are


- Use this information to predict demand for periods 15 and 16.

124 7.5
t
F t = +
1 2 3 4
1.20, 1.10, 0.75, 0.95 Q Q Q Q = = = =
Problem
- A manager is using the equation below to forecast quarterly
demand for a product:

Y(t) = 6,000 + 80t

where t = 0 at Q2 of last year

- Quarter relatives are Q1 = .6, Q2 = .9, Q3 = 1.3, and Q4 = 1.2.

- What forecasts are appropriate for the last quarter of this year and the
first quarter of next year?
Problem
- A manager of store that sells and installs hot tubs
wants to prepare a forecast for January, February
and March of 2007. Her forecasts are a
combination of trend and seasonality. She uses the
following equation to estimate the trend component
of monthly demand:


Where t=0 is June of 2005. Seasonal relatives are
1.10 for Jan, 1.02 for Feb, and .95 for March. What
demands should she predict?
70 5
t
F t = +
Computing seasonal relatives
0
20
40
60
80
100
120
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
If your data appears to have seasonality, how do you compute the
seasonal relatives?
Computing seasonal relatives
- Calculate centered moving average for each
period.
- Obtain the ratio of the actual value of the period
over the centered moving average.
- Number of periods needed in a centered moving
average = Number of seasons involved:
- Monthly data: a 12-period moving average
- Quarterly data: a 4-period moving average

Example
- The manager of a parking lot has computed the
number of cars per day in the lot for three weeks.
Using a seven-period centered moving average,
calculate the seasonal relatives.

- Note that a seven period centered moving average
is used because there are seven days (seasons) per
week. See seasonal relatives1.xls
Problem 5
- Obtain estimates of quarter relatives for these data:

Year: 1 2 3 4
Quarter:
Demand:
1 2 3 4
14 18 35 46
1 2 3 4
28 36 60 71
1 2 3 4
45 54 84 88
1
58
Problem
- The manager of a restaurant believes that her
restaurant does about 10% of its business on Sunday
through Wednesday, 15% on Thursday night, 25%
on Friday night, and 20% on Saturday night.

- What seasonal relatives would describe this
situation?
Note:
- An alternative to deal with seasonality is to
deseasonalize data.
- Deseasonalize = Remove seasonal component
from data
- Gives clearer picture of the trend (nonseasonal
component)
- Deseasonalize can be done by dividing each data
point by its seasonal relative.
Forecasts: review
- Judgmental - uses subjective inputs
- Time series - uses historical data assuming the
future will be like the past
- Nave approach
- Averaging
- Techniques for trend
- Trend and seasonality
- Associative models - uses explanatory variables to
predict the future
Associative Forecasting
- Predictor variables - used to predict values of
variable interest
- Regression - technique for fitting a line to a set
of points
- Least squares line - minimizes sum of squared
deviations around the line
AppleGlo
First-Year
Advertising
Expenditures
($ millions)
First-Year
Sales
($ millions)
Region x y
Maine 1.8 104
New Hampshire 1.2 68
Vermont 0.4 39
Massachusetts 0.5 43
Connecticut 2.5 127
Rhode Island 2.5 134
New York 1.5 87
New Jersey 1.2 77
Pennsylvania 1.6 102
Delaware 1.0 65
Maryland 1.5 101
West Virginia 0.7 46
Virginia 1.0 52
Ohio 0.8 33
Suppose that J&T has a new product called
AppleGlo, which is a household cleaner. This
new product has been introduced into 14 sales
regions over the last two years. The
Advertising expenditure vs. the first year sales
are shown in the table for each region.
The company is considering introducing
AppleGlo into two new regions, with the
advertising campaign of $2.0 and $1.5
million.
The company would like to predict what the
expected first year sales of AppleGlo would
be in each region.

LINEAR REGRESSION
Questions: How to relate advertising to sales?
What is expected first-year sales if advertising expenditure is $1M?
How confident are you in the estimate? How good is the fit?
LINEAR REGRESSION
0
20
40
60
80
100
120
140
160
0 0.5 1 1.5 2 2.5
Advertising Expenditures ($Millions)




S
a
l
e
s

(
$
M
i
l
l
i
o
n
s
)

Correlation
The correlation coefficient is a quantitative
measure of the strength of the linear relationship
between two variables. The correlation ranges
from + 1.0 to - 1.0. A correlation of 1.0
indicates a perfect linear relationship, whereas a
correlation of 0 indicates no linear relationship.
An algebraic formula for correlation
coefficient

=
] ) ( ) ( ][ ) ( ) ( [
2 2 2 2
y y n x x n
y x xy n
r
Simple Linear Regression
Simple linear regression analysis
analyzes the linear relationship that exists
between two variables.
bx a y + =
where:
y = Value of the dependent variable
x = Value of the independent variable
a = Populations y-intercept
b = Slope of the population regression line
Simple Linear Regression
The coefficients of the line are




or

=
2 2
) ( x x n
y x xy n
b
x b y a =
y b x
a
n

=

Problem 7
- The manager of a seafood restaurant was
asked to establish a pricing policy on
lobster dinners. Experimenting with
prices produced the following data:

- Create the scatter plot and determine if
a linear relationship is appropriate.

- Determine the correlation coefficient
and interpret it

- Obtain the regression line and interpret
its coefficients.

Sold (y) Price (x)
200 6.00
190 6.50
188 6.75
180 7.00
170 7.25
162 7.50
160 8.00
155 8.25
156 8.50
148 8.75
140 9.00
133 9.25
Forecast Accuracy
- Source of forecast errors:
- Model may be inadequate
- Irregular variations
- Incorrect use of forecasting technique
- Random variation

- Key to validity is randomness
- Accurate models: random errors
- Invalid models: nonrandom errors

- Key question: How to determine if forecasting
errors are random?

Error measures
- Error - difference between actual value and predicted
value
- Mean Absolute Deviation (MAD)
- Average absolute error
- Mean Squared Error (MSE)
- Average of squared error
- Mean Absolute Percent Error (MAPE)
- Average absolute percent error
MAD, MSE, and MAPE
MAD =
Actual forecast
n
MSE =
Actual forecast)
- 1
2

n
(
Actual Forecast
100
Actual
MAPE
n

Example
Period Actual Forecast (A-F) |A-F| (A-F)^2 (|A-F|/Actual)*100
1 217 215 2 2 4 0.92
2 213 216 -3 3 9 1.41
3 216 215 1 1 1 0.46
4 210 214 -4 4 16 1.90
5 213 211 2 2 4 0.94
6 219 214 5 5 25 2.28
7 216 217 -1 1 1 0.46
8 212 216 -4 4 16 1.89
-2 22 76 10.26
MAD= 2.75
MSE= 10.86
MAPE= 1.28
Controlling the Forecast
- Control chart
- A visual tool for monitoring forecast errors
- Used to detect non-randomness in errors






- Forecasting errors are in control if
- All errors are within the control limits
- No patterns, such as trends or cycles, are present
Controlling the forecast
Control charts
- Control charts are based on the following
assumptions:
- when errors are random, they are Normally
distributed around a mean of zero.
- Standard deviation of error is
- 95.5% of data in a normal distribution is within 2
standard deviation of the mean
- 99.7% of data in a normal distribution is within 3
standard deviation of the mean
- Upper and lower control limits are often determine
via
MSE
0 2 0 3 MSE or MSE
Example
- Compute 2s control limits for
forecast errors of previous
example and determine if the
forecast is accurate.



- Errors are all between -6.59
and +6.59
- No pattern is observed
- Therefore, according to control
chart criterion, forecast is
reliable
-6.59
-4.59
-2.59
-0.59
1.41
3.41
5.41
0 10
3.295
2 6.59
s MSE
s
= =
=
Problem 8
- The manager of a travel agency has
been using a seasonally adjusted
forecast to predict demand for
packaged tours. The actual and
predicted values are

- Compute MAD, MSE, and MAPE.

- Determine if the forecast is working
using a control chart with 2s limits. Use
data from the first 8 periods to develop
the control chart, then evaluate the
remaining data with the control chart.
Period Demand Predicted
1 129 124
2 194 200
3 156 150
4 91 94
5 85 80
6 132 140
7 126 128
8 126 124
9 95 100
10 149 150
11 98 94
12 85 80
13 137 140
14 134 128
Problem
- Given the following demand data, prepare a nave
forecast for periods 2 through 10. Then determine each
forecast error, and use those values to obtain 2s control
limits. If demand in the next two periods turns out to be
125 and 130, can you conclude that the forecasts are in
control?

Period 1 2 3 4 5 6 7 8 9 10
Demand 118 117 120 119 126 122 117 123 121 124
Choosing a Forecasting Technique
- No single technique works in every situation
- Two most important factors
- Cost
- Accuracy
- Other factors include the availability of:
- Historical data
- Computers
- Time needed to gather and analyze the data
- Forecast horizon