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Chapter 3
Forecasting
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Chapter 3: Learning Objectives
You should be able to:
LO 3.1 List features common to all forecasts
LO 3.2 Explain why forecasts are generally wrong
LO 3.3 List elements of a good forecast
LO 3.4 Outline the steps in the forecasting process
LO 3.5 Summarize forecast errors and use summaries to make decisions
LO 3.6 Describe four qualitative forecasting techniques
LO 3.7 Use a naïve method to make a forecast
LO 3.8 Prepare a moving average forecast
LO 3.9 Prepare a weighted-average forecast
LO 3.10 Prepare an exponential smoothing forecast
LO 3.11 Prepare a linear trend forecast
LO 3.12 Prepare a trend-adjusted exponential smoothing forecast
LO 3.13 Compute and use seasonal relatives
LO 3.14 Compute and use regression and correlation coefficients
LO 3.15 Construct control charts and use them to monitor forecast errors
LO 3.16 Describe the key factors and trade-offs to consider when choosing a forecasting technique
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Forecast
Forecast – a statement about the future value of a
variable of interest
 We make forecasts about such things as weather, demand, and
resource availability
 Forecasts are important to making informed decisions
 Forecasting in both environment: Design and operations
 basic need for forecasting arises in estimating customer demand
for a firm’s products and services.
 Need aggregate estimates of demand as well as estimates for
individual products.
 long-term estimate of overall demand as well as a shorter-run
estimate of demand for each individual product or service.
 Short-term demand estimates for individual products are
necessary to determine daily or weekly management of the firm’s
activities such as scheduling personnel and ordering materials.
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Two Important Aspects of Forecasts
Expected level of demand
 The level of demand may be a function of some structural
variation such as trend or seasonal variation
Accuracy
 Related to the potential size of forecast error
Error = Actual(t) − Forecast(t)

where
t = Any given time period
Forecast Uses
 the difference between forecasting and planning.
 Planning is often in response to a forecast. A passive response
would be to reduce output because of a predicted decrease in
demand, while an active response would be to advertise in an
effort to offset the predicted decrease in demand.
 Plan the system
 Generally involves long-range plans related to:
 Types of products and services to offer
 Facility and equipment levels
 Facility location
 Plan the use of the system
 Generally involves short- and medium-range plans related to:
 Inventory management
 Workforce levels
 Purchasing
 Production
 Budgeting
 Scheduling
Features Common to All Forecasts
1. Techniques assume some underlying causal system that existed
in the past will persist into the future
2. Forecasts are not perfect
3. Forecasts for groups of items are more accurate than those for
individual items
4. Forecast accuracy decreases as the forecasting horizon increases
Poor forecasting leads to poor planning. This could result in offering

products and services that customers do not want. Poor forecasting
and planning would negatively affect budgeting and planning for
capacity, sales, production and inventory, labor, purchasing, energy
requirements, capital requirements, and materials requirements.
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Forecasts Are Not Perfect
Forecasts are not perfect:
Because random variation is always present, there will always
be some residual error, even if all other factors have been
accounted for.
Customers themselves may be unclear regarding what
they'd like to do versus what they'll actually do.
Which of the following is a potential shortcoming of using sales force opinions in
demand forecasting?
A. Members of the sales force often have substantial histories of working with and
understanding their customers.
B. Members of the sales force often are well aware of customers' future plans.
C. Members of the sales force have direct contact with consumers.
D. Members of the sales force can have difficulty distinguishing between what
customers would like to do and what they actually will do.
E. Customers often are quite open with members of the sales force with regard to
future plans. 3-7
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Elements of a Good Forecast
The forecast
 Should be timely
 Should be accurate (enable users to plan for possible errors )
 Should be reliable
 Should be expressed in meaningful units
 Should be in writing
 Technique should be simple to understand and use
 Should be cost-effective (The benefits should outweigh the
costs)
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Six Steps in the Forecasting Process
1. Determine the purpose of the forecast. This step will provide an
indication of the level of detail required in the forecast, the amount
of resources that can be justified, and the level of accuracy
necessary.
2. Establish a time horizon. The forecast must indicate a time interval,
keeping in mind that accuracy decreases as the time horizon increases.
3. Obtain, clean, and analyze appropriate data. Once obtained,
the data may need to be “cleaned” to get rid of outliers and
obviously incorrect data before analysis.
4. Select a forecasting technique.
5. Make the forecast.
6. Monitor the forecast errors. Monitor the forecast performance
and reexamine the method, assumptions, validity of data, and so
on; modify as needed; and prepare a revised forecast.
Forecast Accuracy and Control
Allowances should be made for forecast errors
 It is important to provide an indication of the extent to
which the forecast might deviate from the value of the
variable that actually occurs
Forecast errors should be monitored
 Error = Actual – Forecast
 If errors fall beyond acceptable bounds, corrective action
may be necessary
Forecast Accuracy Metrics
MAD 
 Actual t  Forecast t Mean Absolute Deviation
n (MAD) weights all errors evenly
  Actual t  Forecast t  2
Mean Square Error (MSE)
MSE 
n 1 weights errors according to their
squared values
Actualt  Forecast t
 Actual t
100
Mean Absolute Percent Error
MAPE 
n (MAPE) weights errors
according to relative error
Forecast Error Calculation
Actual Forecast (A-F)
Period
(A) (F) Error |Error| Error2 [|Error|/Actual]x100
1 107 110 -3 3 9 2.80%
2 125 121 4 4 16 3.20%
3 115 112 3 3 9 2.61%
4 118 120 -2 2 4 1.69%
5 108 109 1 1 1 0.93%
Sum 13 39 11.23%
n=5 n-1 = 4 n=5
MAD MSE MAPE
= 2.6 = 9.75 = 2.25%
Forecasting Approaches
1-Qualitative forecasting (Judgmental forecasts)
 Qualitative techniques permit the inclusion of soft information such as:
 Human factors
 Personal opinions
 Hunches
 These factors are difficult, or impossible, to quantify
2- Quantitative forecasting
 These techniques rely on hard data
 Quantitative techniques involve either the projection of historical data
or the development of associative methods that attempt to use causal
variables to make a forecast
 use equations that consist of one or more explanatory variables that can
be used to predict demand. For example, demand for paint might be
related to variables such as the price per gallon and the amount spent
on advertising, as well as to specific characteristics of the paint (e.g.,
drying time, ease of cleanup).
Qualitative Forecasts
Forecasts that use subjective inputs such as opinions from
consumer surveys, sales staff, managers, executives, and experts
 Executive opinions
A small group of upper-level managers may meet and collectively develop a
forecast
 Sales force opinions
Members of the sales or customer service staff can be good sources of
information due to their direct contact with customers and may be aware of
plans customers may be considering for the future
 Consumer surveys
Since consumers ultimately determine demand, it makes sense to solicit input
from them
Consumer surveys typically represent a sample of consumer opinions
 Other approaches
Managers may solicit 0pinions from other managers or staff people or outside
experts to help with developing a forecast.
The Delphi method is an iterative process intended to achieve a consensus
Forecasting Approaches
3- Time-Series Forecasts
Forecasts that project patterns identified in recent
time-series observations
 Time-series – a time-ordered sequence of observations
taken at regular time intervals
Assume that future values of the time-series can be
estimated from past values of the time-series
The data may be measurements of demand, earnings,
profits, shipments, accidents, output, precipitation,
productivity, or the consumer price index.
Can often be accomplished with a plot (Trend, seasonal
variations…etc)
Time-Series Behaviors
1. Trend refers to a long-term upward
or downward movement in the data.
2. Seasonality refers to short-term,
fairly regular variations generally
related to factors such as the
calendar or time of day.
3. Cycles are wavelike variations of
more than one year’s duration.
4. Irregular variations are due to
unusual circumstances such as
severe weather conditions, strikes,
or a major change in a product or
service. A demand forecast should be based
on a time series of past demand
5. Random variations are residual rather than unit sales. Sales would
variations that remain after all other not truly reflect demand if one or
behaviors
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Examples of Time series forecasting
 Trend
 Population shifts
 Changing income
 Seasonality
 Restaurants, service call centers, and theaters all experience seasonal demand
 Cycle
 Wavelike variations lasting more than one year
 These are often related to a variety of economic, political, or even agricultural
conditions
 Irregular variation
 Due to unusual circumstances that do not reflect typical behavior
 Labor strike
 Weather event
 Random Variation
 Residual variation that remains after all other behaviors have been accounted
for
Time-Series Forecasting - Naïve Forecast
Naïve forecast
 Uses a single previous value of a time series as the basis for a forecast
The forecast for a time period is equal to the previous time
period’s value
 Can be used with
A stable time series
Seasonal variations
Trend
 For data with trend, the forecast is equal to the last value of the series
plus or minus the difference between the last two values of the series. For
example, suppose the last two values were 50 and 53. The next forecast
would be 56:
Time-Series Forecasting - Averaging
These techniques work best when a series tends to vary
about an average
 Averaging techniques smooth variations in the data
 They can handle step changes or gradual changes in the level
of a series
 Techniques
1. Moving average
2. Weighted moving average
3. Exponential smoothing
Moving Average. One weakness of the naive method is that the forecast just traces the actual
data, with a lag of one period; it does not smooth at all. But by expanding the amount of
historical data a forecast is based on, this difficulty can be overcome. A moving average
forecast uses a number of the most recent actual data values in generating a forecast.
Moving Average
Technique that averages a number of the most recent
actual values in generating a forecast.
Example:
Compute a three-period moving average
forecast given demand for shopping carts
for the last five periods.
If actual demand in period 6 turns out to

be 38, the moving average forecast for
period 7 would be
3-20
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Moving Average (cont.)
As new data become available, the forecast is updated by
adding the newest value and dropping the oldest and then
re-computing the average
The number of data points included in the average
determines the model’s sensitivity
 Fewer data points used—more responsive (sensitive)
 More data points used—less responsive
Note how the moving average forecast lags

the actual values and how smooth the
forecasted values are compared with the actual
values.
FIGURE 3.3 A moving average forecast
tends to smooth and lag changes in the data
Weighted Moving Average
 The most recent values in a time series are given more weight in
computing a forecast
 The choice of weights, w, is somewhat arbitrary and involves some
trial and error
Ft  wt ( At )  wt 1 ( At 1 )  ...  wt  n ( At  n )
where
wt  weight for period t , wt 1  weight for period t  1, etc.
At  the actual value for period t , At 1  the actual value for period t  1, etc.
• Example: (a) 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.
• (b) If the actual demand for period 6 is 39, forecast demand for period 7 using the same
weights as in part a.
Exponential Smoothing
A weighted averaging method that is based on the previous
forecast plus a percentage of the forecast error ( α )
Ft  Ft 1   ( At 1  Ft 1 ) For example, suppose the previous
forecast was 42 units, actual demand
where was 40 units, and α = .10. The new
Ft  Forecast for period t forecast would be computed as
Ft 1  Forecast for the previous period follows:
Ft=42+.10(40-42)=41.8
 = Smoothing constant
At 1  Actual demand or sales from the previous period Then, if the actual demand turns out
to be 43, the next forecast would be:
Ft=41.8+.10(43-41.8)=41.92
The quickness of forecast adjustment to error is determined by the smoothing constant, α. The
closer its value is to zero, the slower the forecast will be to adjust to forecast errors (i.e., the
greater the smoothing).
Selecting a smoothing constant is basically a matter of judgment or trial and error, using
forecast errors to guide the decision. The goal is to select a smoothing constant that balances
the benefits of smoothing
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and when they occur.
Exercise: Compare the error performance of these three forecasting techniques
using MAD, MSE, and MAPE: a naive forecast, a two-period moving average, and
exponential smoothing with α = .10 for periods 3 through 11, using the data shown
Fill in the following table and calculate the MAD,MSE and MAPE
3-24
Linear Trend
A simple data plot can reveal the existence and nature of a
trend Ft  a  bt
where
Linear trend equation
Ft  Forecast for period t
For example, consider the trend a  Value of Ft at t  0
equation Ft = 45 + 5t. The value b  Slope of the line
of Ft when t = 0 is 45, and the t  Specified number of time periods from t  0
slope of the line is 5, which
means that, on the average, the
value of Ft will increase by five

units for each time period.
If t = 10, the forecast, Ft, is:
45 + 5(10) = 95 units.
Estimating Slope and Intercept
Cell phone sales for a California-based firm
Slope and intercept over the last 10 weeks are shown in the
can be estimated following table. Plot the data, and visually
from historical data check to see if a linear trend line would be
appropriate. Then determine the equation of
n ty   t  y the trend line, and predict sales for weeks 11
b
n t   t and 12.
2
2
a
 y  b t
or y  bt
n
where
n  Number of periods
y  Value of the time series
b = 7.51 and a = 699.40  The trend line is Ft = 699.40 + 7.51t,
Substituting values of t into this equation, the forecasts for the next two
periods (i.e., t = 11 and t = 12) are:
1. F11 = 699.40 + 7.51(11) = 782.01 3-26
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12 = 699.40 + 7.51(12) = 789.52
of McGraw-Hill Education
t Y t*Y t2
1 405 405 1
2 410 820 4
3 420 1,260 9
4 415 1,660 16
5 412 2,060 25
6 420 2,520 36
7 424 2,968 49
8 433 3,464 64
9 438 3,942 81
10 440 4,400 100
11 446 4,906 121
12 451 5,412 144
13 455 5,915 169
14 464 6,496 196
15 466 6,990 225
16 474 7,584 256
17 476 8,092 289
18 482 8,676 324
171 7,931 77,750 2,109
n  tY   t  Y 18(77,750)  171(7,931)
b   4.59
n  t 2  ( t ) 2 18(2,109)  (171) 2
 Y  b  t 7,931  4.59(171)
a   397.01
n 18
Y19 = 397.01 + (4.59)(19) = 484.22
Y20 = 397.01 + (4.59)(20) = 488.81
Y21 = 397.01 + (4.59)(21) = 493.40
There appears to be a long-term upward increasing trend in the data. If we use an

averaging technique, the forecast will underestimate when data values increase.
3-27
Trend-Adjusted Exponential Smoothing
The trend adjusted forecast consists of two
components TAFt +1  St  Tt
 Smoothed error where
 Trend factor
St  Previous forecast plus smoothed error
Tt  Current trend estimate
Alpha and beta are smoothing constants
Trend-adjusted exponential smoothing has the ability to
respond 
to changes in trend
TAFt +1  St  Tt
St  TAFt +  At  TAFt 
Tt  Tt1   TAFt  TAF t1  Tt1 
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Trend-Adjusted Exponential Smoothing (cont.)
Using the cell phone data, use trend-adjusted exponential
smoothing to obtain forecasts for periods 6 through 11, with α
TAFt +1  St  Tt
= .40 and β = .30.
St  TAFt +  At  TAFt 
Tt  Tt1   TAFt  TAFt1  Tt1 
 The initial estimate of trend is based on the net change of 28 for the three changes
from period 1 to period 4, for an average of 9.33. Notice that an initial estimate of
 values and that the starting forecast (period
trend is estimated from the first four
5) is developed using the previous (period 4) value of 728 plus the initial trend
estimate:
Starting forecast =
728 + 9.33 = 737.33
Unlike a linear trend line,
trend-adjusted smoothing has
the ability to adjust to
changes in trend.
The initial estimate of trend is based on
the net change of 30 for the three
periods from 1 to 4, for an average of
+10 units. Use  = .5 and  = .4.
Round values to two decimals.
Initial trend = (240 – 210)/3 = 10.00
3-30
Techniques for Seasonality Knowledge of seasonal
variations is an important
Seasonality – regularly repeating factor in retail planning and
movements in series values that can scheduling. Moreover,
seasonality can be an
be tied to recurring events important factor in capacity
 Expressed in terms of the amount that
planning for systems that
actual values deviate from the average must be designed to handle
value of a series peak loads
 Models of seasonality
 Additive
 Seasonality is expressed as a quantity
that gets added to or subtracted from the
time-series average in order to
incorporate seasonality
 Multiplicative
 Seasonality is expressed as a percentage
of the average (or trend) amount which
is then used to multiply the value of a
series in order to incorporate seasonality
Suppose that the seasonal relative for the
Seasonal Relatives quantity of toys sold in May at a store is
 Seasonal relatives: The seasonal 1.20. This indicates that toy sales for that
percentage used in the multiplicative month are 20 percent above the monthly
seasonally adjusted forecasting average.
model A seasonal relative of .90 for July indicates
 Using seasonal relatives that July sales are 90 percent of the
monthly average.
 To deseasonalize data
 Done in order to get a clearer A coffee shop owner wants to estimate
picture of the nonseasonal (e.g., demand for the next two quarters for hot
trend) components of the data chocolate. Sales data consist of trend
series and seasonality.
 Divide each data point by its 1.Quarter relatives are 1.20 for the first
seasonal relative quarter, 1.10 for the second quarter,
 To incorporate seasonality in a 0.75 for the third quarter, and 0.95 for
b) The forecast
trend values are: the fourth quarter. Use this
Period 9:1.Ft =Obtain
124 + 7.5(9) trend = 191.5
estimates for information to deseasonalize sales for
Period 10: Ft desired
= 124 + 7.5(10)periods using a trend
= 199.0 quarters 1 through 8.
equation
Period 9 is a first quarter and period 10 is a 2.Using the appropriate values of
2. Add
second quarter. seasonality
Multiplying eachby multiplying
trend value by quarter relatives and the equation Ft =
the appropriatethese
quarter trend estimates
relative results in: by the
corresponding seasonal relative 124 + 7.5t for the trend component, 3-32
Period 9:
LO 3.13 191.5(1.20)
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Period 10: 199.0(1.10) = 218.9 estimate demand for periods 9 and 10.
Computing Seasonal Relatives Using the Simple Average Method. The simple
average (SA) method is an alternative way to compute seasonal relatives. Each seasonal
relative is the average for that season divided by the average of all seasons. This method is
illustrated in Example 8B, where the seasons are days. Note that there is no need to
standardize the relatives when using the SA method.
3-33
Monitoring the Forecast
 Tracking forecast errors and analyzing them can provide useful insight
into whether forecasts are performing satisfactorily
 Sources of forecast errors:
 The model may be inadequate due to
a. omission of an important variable
b. a change or shift in the variable the model cannot handle
c. the appearance of a new variable
 Irregular variations may have occurred
 Random variation
 Control charts are useful for identifying the presence of non-random
error in forecasts
 Tracking signals can be used to detect forecast bias
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Control Chart Construction
1. Compute the MSE.
2. Estimate of standard deviation of the distributi on of errors
s  MSE
3. UCL : 0  z MSE
4. LCL : 0  z MSE
where z  Number of standard deviations from the mean
To construct a control chart, first compute the MSE. The square root
of MSE is used in practice as an estimate of the standard deviation
of the distribution of errors.
3-35
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Choosing a Forecasting Technique
Factors to consider Factors to consider
 Cost  Availability of forecasting software
 Accuracy  Time needed to gather and analyze
 Availability of data and prepare a forecast
historical data  Forecast horizon
Operations Strategy
 The better forecasts are, the more able organizations will
be to take advantage of future opportunities and reduce
potential risks
 A worthwhile strategy is to work to improve short-term forecasts
 Accurate up-to-date information can have a significant effect on
forecast accuracy:
 Prices
 Demand
 Other important variables
 Reduce the time horizon forecasts have to cover
 Sharing forecasts or demand data through the supply chain can
improve forecast quality
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Chapter 3

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Error = Actual(t) − Forecast(t)

Poor forecasting leads to poor planning. This could result in offering

2 125 121 4 4 16 3.20%

3 115 112 3 3 9 2.61%

4 118 120 -2 2 4 1.69%

5 108 109 1 1 1 0.93%

n=5 n-1 = 4 n=5

MAD MSE MAPE

= 2.6 = 9.75 = 2.25%

If actual demand in period 6 turns out to

Note how the moving average forecast lags

There appears to be a long-term upward increasing trend in the data. If we use an

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