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2002 South-Western/Thomson Learning TM

Forecasting

Overview
Introduction
Demand patterns & trends
Qualitative Forecasting Methods

Quantitative Forecasting Models

Linear Regression
Simple Moving Average
Weighted Moving Average

Introduction
Forecasting
The first step in planning
Estimating the future demand for products and services

and the necessary resources to produce these outputs

Forecasting is important for the demand management

Introduction
Demand estimates for products and services are the

starting point for all the other planning in operations

management.
Management teams develop sales forecasts based in part
on demand estimates.
The sales forecasts become inputs to both business
strategy and production resource forecasts.

Demand Management
Independent demand items are the only

items demand for which needs to be

forecast
These items include:
Finished goods and

Spare parts

Demand Management
Independent Demand
(finished goods and spare parts)

Dependent Demand

(components)

C(2)

B(4)

D(2)

E(1)

D(3)

F(2)
Exercise:
For your company, list
Independent demand
Dependant demand

Forecasting is an Integral Part

of Business Planning
Inputs:
Market,
Economic,
Other

Forecast
Method(s)

Sales
Forecast

Business
Strategy

Demand
Estimates

Management
Team

Production Resource
Forecasts

Some Reasons Why

Forecasting is Essential
New Facility Planning It can take 5 years to design and

build a new factory or design and implement a new

production process.
Production Planning Demand for products vary from
month to month and it can take several months to
change the capacities of production processes.
Workforce Scheduling Demand for services (and the
necessary staffing) can vary from hour to hour and
employees weekly work schedules must be developed in
advance.

Examples of Production Resource

Forecasts
Forecast
Horizon

Time Span

Item Being Forecast

Units of
Measure

Product lines
Factory capacities
Planning for new products
Capital expenditures
Facility location or expansion
R&D

Dollars, tons, etc.

Product groups
Department capacities
Sales planning
Production planning and budgeting

Dollars, tons, etc.

Specific product quantities

Machine capacities
Planning
Purchasing
Scheduling
Workforce levels
Production levels
Job assignments

Physical units of
products

Long-Range

Years

MediumRange

Months

Short-Range

Weeks

Comparing the Costs and Benefits

of Forecasting

Fundamentals of
Operations Management
4e

Exhibit 9.1

The McGraw-Hill Companies, Inc., 2003911

Demand pattern & trends

Demand Patterns

Time Series: The repeated observations of demand for a service or

product in their order of occurrence.

There are five basic patterns of most time series.

a.

Horizontal. The fluctuation of data around a constant mean.

b.

Trend. The systematic increase or decrease in the mean of the series over
time.

c.

Seasonal. A repeatable pattern of increases or decreases in demand,

depending on the time of day, week, month, or season.

d.

Cyclical. The less predictable gradual increases or decreases over longer

periods of time (years or decades).

e.

Random. The unforecastable variation in demand.

Demand Patterns
Horizontal

Seasonal

Trend

Cyclical

Historical Monthly Product Demand Consisting of a Growth

Trend, Cyclical Factor, and Seasonal Demand

Fundamentals of Operations
Management 4e

Exhibit 9.4
The McGraw-Hill Companies, Inc., 2003915

Common Types of Trends

Exhibit 9.5a

Fundamentals of
Operations Management

The McGraw-Hill Companies, Inc., 2003916

Common Types of Trends (contd)

Exhibit 9.5b

Fundamentals of
Operations Management

The McGraw-Hill Companies, Inc., 2003917

Designing the Forecast System

Deciding what to forecast

Level of aggregation.
Units of measure.

Choosing the type of forecasting method:

Qualitative methods
Quantitative methods

Deciding
What To Forecast
Few companies err by more than 5 percent when forecasting total

demand for all their services or products. Errors in forecasts for

individual items may be much higher.
Level of Aggregation: The act of clustering several similar
services or products so that companies can obtain more accurate
forecasts.
Units of measurement: Forecasts of sales revenue are not
helpful because prices fluctuate.
Forecast the number of units of demand then translate into sales

revenue estimates
Stock-keeping unit (SKU): An individual item or product that has an
identifying code and is held in inventory somewhere along the value chain.

Forecasting Methods
Qualitative Approaches
Quantitative Approaches

Qualitative Approaches
Usually based on judgments about causal factors that

underlie the demand of particular products or services

Do not require a demand history for the product or
service, therefore are useful for new products/services
Approaches vary in sophistication from scientifically
conducted surveys to intuitive hunches about future
events
The approach/method that is appropriate depends on a
products life cycle stage

Qualitative Methods
Educated guess

intuitive hunches

Executive committee consensus

Survey of sales force

Survey of customers
Historical analogy
Market research

scientifically conducted surveys

Quantitative Forecasting Approaches

Based on the assumption that the forces that generated

the past demand will generate the future demand, i.e.,

history will tend to repeat itself
Analysis of the past demand pattern provides a good
basis for forecasting future demand
Majority of quantitative approaches fall in the category
of time series analysis

Time Series Analysis

A time series is a set of numbers where the order or

sequence of the numbers is important, e.g., historical

demand
Analysis of the time series identifies patterns
Once the patterns are identified, they can be used to
develop a forecast

Components of Time Series

Trends are noted by an upward or downward sloping

line
Seasonality is a data pattern that repeats itself over the
period of one year or less
Cycle is a data pattern that repeats itself... may take
years
Irregular variations are jumps in the level of the series
due to extraordinary events
Random fluctuation from random variation or
unexplained causes

Seasonal Patterns
Length of Time
Before Pattern
Is Repeated
Year
Year
Year
Month
Week

Length of
Season
Quarter
Month
Week
Day
Day

Number of
Seasons
in Pattern
4
12
52
28-31
7

Exercise: For your product(s)/service(s), is there any demand pattern?

If yes, what is the patter and why? If no, why not?

Quantitative Forecasting Approaches

Linear Regression
Simple Moving Average
Weighted Moving Average

Exponential Smoothing (exponentially weighted moving

average)
Exponential Smoothing with Trend (double exponential
smoothing)

Long-Range Forecasts
Time spans usually greater than one year
Necessary to support strategic decisions about planning

products, processes, and facilities

Simple Linear Regression

Linear regression analysis establishes a relationship

between a dependent variable and one or more

independent variables.
In simple linear regression analysis there is only one
independent variable.
If the data is a time series, the independent variable is the
time period.
The dependent variable is whatever we wish to forecast.

Simple Linear Regression

Regression Equation

This model is of the form:

Y = a + bX
Y = dependent variable
X = independent variable
a = y-axis intercept
b = slope of regression line

Simple Linear Regression

Constants a and b

The constants a and b are computed using the following

equations:
a=

2
x
y- x xy

b=

n x2 -( x)2

n xy- x y
n x2 -( x)2

Simple Linear Regression

Once the a and b values are computed, a future value of

X can be entered into the regression equation and a

corresponding value of Y (the forecast) can be calculated.

Linear Regression

Dependent variable

Deviation,
Estimate of or error
Y from
regression
equation

Regression
equation:
Y = a + bX

Y = dependent variable
X = independent variable
a = Y-intercept of the line
b = slope of the line

Actual
value
of Y
Value of X used
to estimate Y

X
Independent variable

Example: College Enrollment

Simple Linear Regression

At a small regional college enrollments have grown

steadily over the past six years, as evidenced below. Use
time series regression to forecast the student
enrollments for the next three years.

Year
1
2
3

Students
Students
Enrolled (1000s) Year Enrolled (1000s)
2.5
4
3.2
2.8
5
3.3
2.9
6
3.4

Example: College Enrollment

Simple Linear Regression

x
y
x2
xy
1
2.5
1
2.5
2
2.8
4
5.6
3
2.9
9
8.7
4
3.2
16
12.8
5
3.3
25
16.5
6
3.4
36
20.4
Sx=21 Sy=18.1 Sx2=91 Sxy=66.5
a=

2
x
y- x xy

n x -( x)
2

b=

n xy- x y
n x2 -( x)2

Example: College Enrollment

Simple Linear Regression

91(18.1) 21(66.5)
a
2.387
2
6(91) (21)

6(66.5) 21(18.1)
b
0.180
105

Y = 2.387 + 0.180X

Example: College Enrollment

Simple Linear Regression

Y7 = 2.387 + 0.180(7) = 3.65 or 3,650 students

Y8 = 2.387 + 0.180(8) = 3.83 or 3,830 students
Y9 = 2.387 + 0.180(9) = 4.01 or 4,010 students
Note: Enrollment is expected to increase by 180
students per year.

Exercise
RCB manufacturers black-and-white television sets for

overseas market. Annual exports in thousands of units

are shown below for the past six years. Given this longterm decline in exports, forecast the expected number
of units to be exported for the next three years.

Year

Exports

Year

Exports

33

26

32

27

29

24

Causal model

Simple Linear Regression

Simple linear regression can also be used when the

independent variable X represents a variable other than

time.
In this case, linear regression is representative of a class
of forecasting models called causal forecasting models.

Example: Railroad Products Co.

Simple Linear Regression Causal Model

The manager of RPC wants to project the firms

sales for the next 3 years. He knows that RPCs longrange sales are tied very closely to national freight car
loadings. On the next slide are 7 years of relevant
historical data.
Develop a simple linear regression model between
RPC sales and national freight car loadings. Forecast
RPC sales for the next 3 years, given that the rail
industry estimates car loadings of 250, 270, and 300
million.

Example: Railroad Products Co.

Simple Linear Regression Causal Model

Year
1
2
3
4
5
6
7

RPC Sales
($millions)
9.5
11.0
12.0
12.5
14.0
16.0
18.0

Y = a + bX

??

Car Loadings
(millions)
120
135
130
150
170
190
220

Example: Railroad Products Co.

Year
1
2
3
4
5
6
7
8
9
10

RPC Sales
($millions)
9.5
11.0
12.0
12.5
14.0
16.0
18.0
?
?
?

Car Loadings
(millions)
120
135
130
150
170
190
220
250
270
300

Example: Railroad Products Co.

Simple Linear Regression Causal Model

x2

xy

120
135
130
150
170
190
220

9.5
11.0
12.0
12.5
14.0
16.0
18.0

14,400
18,225
16,900
22,500
28,900
36,100
48,400

1,140
1,485
1,560
1,875
2,380
3,040
3,960

1,115

93.0

185,425

15,440

Example: Railroad Products Co.

Simple Linear Regression Causal Model

185, 425(93) 1,115(15, 440)

a
0.528
2
7(185, 425) (1,115)
7(15, 440) 1,115(93)
b
0.0801
2
7(185, 425) (1,115)

Y = 0.528 + 0.0801X

??

Example: Railroad Products Co.

Simple Linear Regression Causal Model

Y8 = 0.528 + 0.0801(250) = $20.55 million

Y9 = 0.528 + 0.0801(270) = $22.16 million
Y10 = 0.528 + 0.0801(300) = $24.56 million
Note: RPC sales are expected to increase by $80,100 for
each additional million national freight car loadings.

Multiple Regression Analysis

Multiple regression analysis is used when there are

two or more independent variables.
An example of a multiple regression equation is:
Y = 50.0 + 0.05X1 + 0.10X2 0.03X3
where: Y = firms annual sales ($millions)
X1 = industry sales ($millions)
X2 = regional per capita income ($thousands)
X3 = regional per capita debt ($thousands)

Coefficient of Correlation (r)

The coefficient of correlation, r, explains the relative

importance of the relationship between x and y.

The sign of r shows the direction of the relationship.
The absolute value of r shows the strength of the
relationship.
The sign of r is always the same as the sign of b.
r can take on any value between 1 and +1.

Coefficient of Correlation (r)

Meanings of several values of r:

-1 a perfect negative relationship (as x goes up, y

goes down by one unit, and vice versa)
+1 a perfect positive relationship (as x goes up, y
goes up by one unit, and vice versa)
0 no relationship exists between x and y
+0.3 a weak positive relationship
-0.8 a strong negative relationship

Coefficient of Correlation (r)

r is computed by:

n xy x y

n x 2 ( x )2 n y 2 ( y )2

Example: Railroad Products Co.

Coefficient of Correlation

x2

xy

y2

120
135
130
150
170
190
220

9.5
11.0
12.0
12.5
14.0
16.0
18.0

14,400
18,225
16,900
22,500
28,900
36,100
48,400

1,140
1,485
1,560
1,875
2,380
3,040
3,960

90.25
121.00
144.00
156.25
196.00
256.00
324.00

1,115 93.0

185,425 15,440 1,287.50

Example: Railroad Products Co.

Coefficient of Correlation

7(15, 440) 1,115(93)

7(185, 425) (1,115)2 7(1,287.5) (93)2
r = .9829

a strong positive relationship

Seasonalized Time Series Regression

Analysis
Select a representative historical data set.
Develop a seasonal index for each season.
Use the seasonal indexes to deseasonalize the data.

Perform linear regression analysis on the deseasonalized

data.
Use the regression equation to compute the forecasts.
Use the seasonal indexes to reapply the seasonal patterns
to the forecasts.

Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis

An analyst at CPC wants to develop next years

quarterly forecasts of sales revenue for CPCs line of
Epsilon Computers. She believes that the most recent 8
quarters of sales (shown on the next slide) are
representative of next years sales.

Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis
Representative Historical Data Set

Year

Qtr.

($mil.)

Year

1
1
1
1

1
2
3
4

7.4
6.5
4.9
16.1

2
2
2
2

Qtr. ($mil.)

1
2
3
4

8.3
7.4
5.4
18.0

Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis
Compute the Seasonal Indexes (SI)

7.4
+ 8.3
15.7/2
7.85/9.25

Year
1
2
Totals
Qtr. Avg.
Seas.Ind.

Quarterly Sales
Q1
Q2 Q3
Q4
7.4
6.5 4.9 16.1
8.3
7.4 5.4 18.0
15.7 13.9 10.3 34.1
7.85 6.95 5.15 17.05
.849 .751 .557 1.843
SI for Q1

Total
34.9
39.1
74.0
9.25
4.000

74.0/8

Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis
Deseasonalize the Data

Year
1
2
7.4/0.849
8.3/0.849

Quarterly Sales
Q1
Q2
Q3
8.72
8.66
8.80
9.78
9.85
9.69
6.5/0.751

Q4
8.74
9.77

Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis
Perform Regression on Deseasonalized Data

Yr.

Qtr.

x2

xy

1
1
1
1
2
2
2
2

1
2
3
4
1
2
3
4

1
2
3
4
5
6
7
8

8.72
8.66
8.80
8.74
9.78
9.85
9.69
9.77

1
4
9
16
25
36
49
64

8.72
17.32
26.40
34.96
48.90
59.10
67.83
78.16

Totals

36

74.01

204

341.39

Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis
Perform Regression on Deseasonalized Data

204(74.01) 36(341.39)
a
8.357
2
8(204) (36)
8(341.39) 36(74.01)
b
0.199
2
8(204) (36)
Y = 8.357 + 0.199X

Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis
Compute the Deseasonalized Forecasts

Y9
Y10
Y11
Y12

= 8.357 + 0.199(9) = 10.148

= 8.357 + 0.199(10) = 10.347
= 8.357 + 0.199(11) = 10.546
= 8.357 + 0.199(12) = 10.745

Note: Average sales are expected to increase by

.199 million (about $200,000) per quarter.

Example: Computer Products Corp.

Seasonalized Times Series Regression Analysis
Seasonalize the Forecasts

Yr.

Qtr.

Seas.
Index

3
3
3
3

1
2
3
4

.849
.751
.557
1.843

Deseas.
Forecast

Seas.
Forecast

10.148
10.347
10.546
10.745

8.62
7.77
5.87
19.80

Assignment 1
You are a top consultant in a well known local company, Crystal Ball Sdn. Bhd,
that provides advice and assistance in forecasting. One of your client, a luxury car
manufacturer, has been in business for two and a half years and needs to estimate
future sales for the next four quarters. The client has provided you with the past data,
Firstly the company wants to know what method would you used to develop the
forecast. You need to justify your reason on the selected method.
Using your selected method, forecast the next four quarter sales. You need to
provide all relevant calculations and explanation. Evaluate the relationship between
the number of sales and the quarterly period based on your findings.
Useful formulas:
a = [ x2y - xxy ] [ nx2 (x)2 ]
Quarterly sales (number of
2
2
b = [ nxy - xy ] [ nx (x) ]
products)
r = [nxy - xy]
Year
{[ nx2 (x)2 ] [ ny2 (y)2 ]}
Q1
Q2
Q3
Q4
Y = a + bX
Season index, S.I = quarter ave./overall quarter ave. 1
32
Where:

x = independent variable values

y = dependent variable values
n = number of observations
a = vertical axis intercept
b = slope of the regression line
r = coefficient of correlation
Y = values of y that lie on the trend line Y = a + bX
X = values of x that lie on the trend line

49

72

114

41

55

88

135

44

60

Short range forecast

Short-Range Forecasts
Time spans ranging from a few days to a few weeks
Cycles, seasonality, and trend may have little effect
Random fluctuation is main data component

Short-Range Forecasting Methods

(Simple) Moving Average
Weighted Moving Average
Exponential Smoothing

Exponential Smoothing with Trend

Simple Moving Average

An averaging period (AP) is given or selected

The forecast for the next period is the arithmetic average

of the AP most recent actual demands

It is called a simple average because each period used to
compute the average is equally weighted
. . . more

Simple Moving Average

It is called moving because as new demand data

becomes available, the oldest data is not used

By increasing the AP, the forecast is less responsive to
fluctuations in demand (low impulse response and high
noise dampening)
By decreasing the AP, the forecast is more responsive to
fluctuations in demand (high impulse response and low
noise dampening)

Weighted Moving Average

This is a variation on the simple moving average where

the weights used to compute the average are not equal.

This allows more recent demand data to have a greater
effect on the moving average, therefore the forecast.
. . . more

Weighted Moving Average

The weights must add to 1.0 and generally decrease in

value with the age of the data.

The distribution of the weights determine the impulse
response of the forecast.

Example: Central Call Center

Moving Average

CCC wishes to forecast the number of incoming

calls it receives in a day from the customers of one of its
clients, BMI. CCC schedules the appropriate number of
telephone operators based on projected call volumes.
CCC believes that the most recent 12 days of call
volumes (shown on the next slide) are representative of
the near future call volumes.

Example: Central Call Center

Moving Average
Representative Historical Data

Day
1
2
3
4
5
6

Calls
159
217
186
161
173
157

Day
7
8
9
10
11
12

Calls
203
195
188
168
198
159

Example: Central Call Center

Moving Average

Use the moving average method with an AP = 3

days to develop a forecast of the call volume in Day 13.
F13 = (168 + 198 + 159)/3 = 175.0 calls

Example: Central Call Center

Weighted Moving Average

Use the weighted moving average method with an

AP = 3 days and weights of .1 (for oldest datum), .3, and
.6 to develop a forecast of the call volume in Day 13.
F13 = .1(168) + .3(198) + .6(159) = 171.6 calls

Note: The WMA forecast is lower than the MA forecast

because Day 13s relatively low call volume carries
almost twice as much weight in the WMA (.60) as it does
in the MA (.33).

Forecasting Error
For any forecasting method, it is important to measure

the accuracy of its forecasts.

Forecast error is the difference found by subtracting
the forecast from actual demand for a given period.
E t = Dt - F t
where
Et = forecast error for period t
Dt = actual demand for period t
Ft = forecast for period t

Monitoring Accuracy
Mean Absolute Deviation (MAD)

Sum of absolute deviation for n periods

MAD =
n
n

MAD =

Actual demand -Forecast demand

i=1

Moving Average Method

Exercise
a. Compute a three-week moving average forecast for
the arrival of medical clinic patients in week 4.
The numbers of arrivals for the past 3 weeks were:

Week

Patient
Arrivals

1
2
3

400
380
411

b. If the actual number of patient arrivals in week

4 is 415, what is the forecast error for week 4?
c. What is the forecast for week 5?

Example 13.2
Solution

450

The moving average method may involve the use of as many

periods of past demand as desired. The stability of the
demand series generally determines how many periods to
include.

Patient arrivals

430
410

390
370

Actual patient
arrivals
|
5

|
10

|
15
Week

|
20

|
25

|
30

Example 13.2

Solution continued
a.
Week
1
2
3
4
5

Arrivals Forecast
400
380
411
415
397
? 402

b.

Forecast error for week 4 is 18. It

is the difference between the
actual arrivals (415) for week 4
and the average of 397 that was
used as a forecast for week 4.
(415 397 = 18)

Forecast for week 4 is the

average of the arrivals for
weeks 1,2 and 3

F4 =

411 + 380 + 400

3

c.
Forecast for week 5 is the
average of the arrivals for
weeks 2,3 and 4
d. If the actual arrivals for week
5 is 410, what is the MAD for
these periods?

Week
1
2
3
4
5

Arrivals Forecast
400
380
411
415
397
410
402

MAD = (18 + 8) / 2 =

Error
?
18
8

Comparison of
3- and 6-Week MA Forecasts

Patient Arrivals

3-week moving
average forecast

6-week moving
average forecast

Actual patient arrivals

Week

QUIZ

Criteria for Selecting

a Forecasting Method
Cost
Accuracy
Data available

Time span
Nature of products and services
Impulse response and noise dampening

Criteria for Selecting

a Forecasting Method
Cost and Accuracy
There is a trade-off between cost and accuracy; generally,

more forecast accuracy can be obtained at a cost.

High-accuracy approaches have disadvantages:
Use more data
Data are ordinarily more difficult to obtain
The models are more costly to design, implement, and

operate
Take longer to use

Criteria for Selecting

a Forecasting Method
Cost and Accuracy
Low/Moderate-Cost Approaches statistical models,

historical analogies, executive-committee consensus

High-Cost Approaches complex econometric models,
Delphi, and market research

Criteria for Selecting

a Forecasting Method
Data Available
Is the necessary data available or can it be economically

obtained?
If the need is to forecast sales of a new product, then a
customer survey may not be practical; instead, historical
analogy or market research may have to be used.

Criteria for Selecting

a Forecasting Method
Time Span
What operations resource is being forecast and for what

purpose?
Short-term staffing needs might best be forecast with
moving average or exponential smoothing models.
Long-term factory capacity needs might best be predicted
with regression or executive-committee consensus
methods.

Criteria for Selecting

a Forecasting Method
Nature of Products and Services
Is the product/service high cost or high volume?
Where is the product/service in its life cycle?
Does the product/service have seasonal demand

fluctuations?

Criteria for Selecting

a Forecasting Method
Impulse Response and Noise Dampening
An appropriate balance must be achieved between:
How responsive we want the forecasting model to be to

changes in the actual demand data

Our desire to suppress undesirable chance variation or noise
in the demand data

Reasons for Ineffective Forecasting

Not involving a broad cross section of people
Not recognizing that forecasting is integral to business

planning
Not recognizing that forecasts will always be wrong
Not forecasting the right things
Not selecting an appropriate forecasting method
Not tracking the accuracy of the forecasting models

Some Specific Forecasting Data

Consumer Confidence Index
Consumer Price Index (CPI)
Gross Domestic Product (GDP)

Housing Starts
Index of Leading Economic Indicators
Personal Income and Consumption
Producer Price Index (PPI)
Purchasing Managers Index

Retail Sales

Wrap-Up: World-Class Practice

Predisposed to have effective methods of forecasting

because they have exceptional long-range business

planning
Formal forecasting effort
Develop methods to monitor the performance of their
forecasting models
Do not overlook the short run.... excellent short range
forecasts as well

Forecasting Techniques and Common Models

Exhibit 9.2a

Fundamentals of
Operations Management

The McGraw-Hill Companies, Inc., 20039123

Forecasting Techniques and Common Models

Exhibit 9.2b

Fundamentals of
Operations Management

The McGraw-Hill Companies, Inc., 20039124

Comparison of Forecasting Techniques

Fundamentals of
Operations Management

Exhibit 9.3
The McGraw-Hill Companies, Inc., 20039125

End of Chapter 3