Forecasting Forecasting

The Starting Point for All Planning

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Overview
q q q q q q

Introduction Qualitative Forecasting Methods Quantitative Forecasting Models How to Have a Successful Forecasting System Computer Software for Forecasting Forecasting in Small Businesses and Start-Up Ventures Wrap-Up: What World-Class Producers Do

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Demand Management

Independent demand items are the only items demand for which needs to be forecast q These items include:
q
q q

Finished goods and Spare parts

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Demand Management
Independent Demand
(finished goods and spare parts)

Dependent Demand
(components)

B(4)

C(2)

D(2)

E(1)

D(3)

F(2)

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Introduction Introduction
q

Demand estimates for independent demand products and services are the starting point for all the other forecasts in POM. Management teams develop sales forecasts based in part on demand estimates. Sales forecasts become inputs to both business strategy and production resource forecasts.

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Forecasting is an Integral Part Forecasting is an Integral Part of Business Planning of Business Planning
Inputs: Market, Economic, Other Forecast Method(s) Demand Estimates

Sales Forecast

Management Team

Business Strategy

Production Resource Forecasts

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Examples of Production Resource Forecasts

Forecast Horizon
Long-Range

Time Span
Years
q

Item Being Forecast

Product lines q Factory capacities q Planning for new products q Capital expenditures q Facility location or expansion q R&D Product groups Department capacities q Sales planning q Production planning and budgeting
q q

Units of Measure
Dollars, tons, etc.

Medium-Range

Months

Dollars, tons, etc.

Short-Range

Weeks

Specific product quantities q Machine capacities q Planning q Purchasing q Scheduling q Workforce levels q Production levels q Job assignments
q

Physical units of products

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Forecasting Methods

Qualitative Approaches q Quantitative Approaches

q

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Qualitative Forecasting Applications

Small and Large Firms

Technique
Managers Opinion Executives Opinion Sales Force Composite Number of Firms

Low Sales
40.7% 40.7% 29.6% 27

(less than $100M)

(more than $500M)

High Sales
39.6% 41.6% 35.4% 48

Source: Nada Sanders and Karl Mandrodt (1994) Practitioners Continue to Rely on Judgmental Forecasting Methods Instead of Quantitative Methods, Interfaces, vol. 24, no. 2, pp. 92-100. Note: More than one response was permitted.

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Qualitative Approaches
q

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

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Qualitative Methods Qualitative Methods

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Executive committee consensus Delphi method Survey of sales force Survey of customers Historical analogy Market research

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Quantitative Forecasting Approaches Quantitative Forecasting Approaches

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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

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Quantitative Forecasting Applications

Small and Large Firms

Technique
Moving Average Simple Linear Regression Naive Single Exponential Smoothing Multiple Regression Simulation Classical Decomposition Box-Jenkins Number of Firms

Low Sales
29.6% 14.8% 18.5% 14.8% 22.2% 3.7% 3.7% 3.7% 27

(less than $100M)

(more than $500M) 29.2 14.6 14.6 20.8 27.1 10.4 8.3 6.3 48

High Sales

Source: Nada Sanders and Karl Mandrodt (1994) Practitioners Continue to Rely on Judgmental Forecasting Methods Instead of Quantitative Methods, Interfaces, vol. 24, no. 2, pp. 92-100. Note: More than one response was permitted.

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Time Series Analysis Time Series Analysis

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q q

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

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Components of Time Series

Whats going on here?
x x x x x

Sales

x x x

xx x x xx x x x x x x x xxx x x x x x xxxx

x x

x x x

x x

Year

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Components of Time Series Components of Time Series

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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
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Actual Data & the Regression Line

160 140 Power Demand 120 100 80 60 40 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Year l Actual Data Linear (Actual Data)

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Seasonality Seasonality
Length of Time Before Pattern Is Repeated Year Quarter Year Month Year Week Month Week Month Day Week Day 7 Number of Length of Seasons Season in Pattern 4 12 52 4 28-31

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Eight Steps to Forecasting

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q q q q q q q

Determining the use of the forecast--what are the objectives? Select the items to be forecast Determine the time horizon of the forecast Select the forecasting model(s) Collect the data Validate the forecasting model Make the forecast Implement the results
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Quantitative Forecasting Approaches

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Linear Regression Simple Moving Average Weighted Moving Average Exponential Smoothing (exponentially weighted moving average) Exponential Smoothing with Trend (double smoothing)

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Simple Linear Regression Simple Linear Regression

q

q q

Relationship between one independent variable, X, and a dependent variable, Y. Assumed to be linear (a straight line) Form: Y = a + bX Y = dependent variable X = independent variable a = y-axis intercept b = slope of regression line
q q q q

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Simple Linear Regression Model

Yt = a + bx

0 1 2 3 4 5
q

(weeks)

b is similar to the slope. However, since it is calculated with the variability of the data in mind, its formulation is not as straight-forward as our usual notion of slope
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Calculating a and b

a = y - bx
xy - n(y)(x) x - n(x )
2 2

b=

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Regression Equation Example

Week 1 2 3 4 5

Sales 150 157 162 166 177

Develop a regression equation to predict sales based on these five points.

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Regression Equation Example

Week Week*Week Sales Week*Sales 1 1 150 150 2 4 157 314 3 9 162 486 4 16 166 664 5 25 177 885 3 55 162.4 2499 Average Sum Average Sum

xy - n( y)(x) = 2499 - 5(162.4)(3 ) = 63 = 6.3 b= 55 5(9) 10 x - n( x )

2 2

a = y - bx = 162.4 - (6.3)(3) = 143.5

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Regression Equation Example

y = 143.5 + 6.3t
180 175 170 165 160 155 150 145 140 135 1 2 3 4 5

Sales

Sales Forecast

Period
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Forecast Accuracy
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Accuracy is the typical criterion for judging the performance of a forecasting approach Accuracy is how well the forecasted values match the actual values

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Monitoring Accuracy Monitoring Accuracy

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Accuracy of a forecasting approach needs to be monitored to assess the confidence you can have in its forecasts and changes in the market may require reevaluation of the approach Accuracy can be measured in several ways Mean absolute deviation (MAD) Mean squared error (MSE)
q q

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Mean Absolute Deviation (MAD)

n

MAD =

Actual
i =1

demand - Forecast demand n

MAD =

(A - F )
i i i =1

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Mean Squared Error (MSE)

MSE = (Syx)2 Small value for Syx means data points tightly grouped around the line and error range is small. The smaller the standard error the more accurate the forecast. MSE = 1.25(MAD) When the forecast errors are normally distributed

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Example--MAD
Month 1 2 3 4 5 Sales 220 250 210 300 325 Forecast n/a 255 205 320 315

Determine the MAD for the four forecast periods

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Solution
Month 1 2 3 4 5 Sales 220 250 210 300 325 Forecast Abs Error n/a 255 5 205 5 320 20 315 10 40

MAD =

A
t=1

- Ft

40 = = 10 4
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Simple Moving Average

q q

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

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Simple Moving Average Simple Moving Average

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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) By decreasing the AP, the forecast is more responsive to fluctuations in demand (high impulse response)

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Simple Moving Average

Week 1 2 3 4 5 6 7 8 9 10 11 12

Demand 650 678 720 785 859 920 850 758 892 920 789 844

A t-1 + A t-2 + A t-3 +...+A t- n Ft = n

q

Lets develop 3-week and 6week moving average forecasts for demand. Assume you only have 3 weeks and 6 weeks of actual demand data for the respective forecasts

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Simple Moving Average

Week 1 2 3 4 5 6 7 8 9 10 11 12 Dem and 3-Week 6-Week 650 678 720 785 682.67 859 727.67 920 788.00 850 854.67 768.67 758 876.33 802.00 892 842.67 815.33 920 833.33 844.00 789 856.67 866.50 844 867.00 854.83
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Simple Moving Average

1000 900 Demand 800 700 600 500 1 2 3 4 5 6 7 8 9 10 11 12 We e k Demand 3-Week 6-Week

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Weighted Moving Average

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This is a variation on the simple moving average where instead of the weights used to compute the average being equal, they are not equal This allows more recent demand data to have a greater effect on the moving average, therefore the forecast . . . more

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Weighted Moving Average Weighted Moving Average

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The weights must add to 1.0 and generally decrease in value with the age of the data The distribution of the weights determine impulse response of the forecast

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Weighted Moving Average

Ft = w 1A t-1 + w 2 A t-2 + w 3A t-3 +. ..+w n A t-n
Week 1 2 3 4 Demand 650 678 720

Determine the 3-period n weighted moving average wi = 1 i=1 forecast for period 4 Weights (adding up to 1.0): t-1: .5 t-2: .3 t-3: .2
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Solution Week 1 2 3 4 Demand 650 678 720 Forecast

693.4

F4 = .5 (7 2 0 )+ . 7 8 )+6 5(0 ) 3 (6 .2
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Exponential Smoothing
q

The weights used to compute the forecast (moving average) are exponentially distributed The forecast is the sum of the old forecast and a portion of the forecast error Ft = Ft-1 + (At-1 - Ft-1 ) . . . more

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Exponential Smoothing Exponential Smoothing

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q q

The smoothing constant, , must be between 0.0 and 1.0 (excluding 0.0 and 1.0) A large provides a high impulse response forecast A small provides a low impulse response forecast

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Exponential Smoothing Example

Week 1 2 3 4 5 6 7 8 9 10 Demand 820 775 680 655 750 802 798 689 775
q

Determine exponential smoothing forecasts for periods 2 through 10 using =.10 and =.60.

Let F1=D1

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Exponential Smoothing Example

Week 1 2 3 4 5 6 7 8 9 10 Demand 820 775 680 655 750 802 798 689 775 0.1 820.00 820.00 815.50 801.95 787.26 783.53 785.38 786.64 776.88 776.69 0.6 820.00 820.00 820.00 817.30 808.09 795.59 788.35 786.57 786.61 780.77
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Effect of on Forecast

9 00 8 00 Demand 7 00 6 00 5 00 1 2 3 4 5 6 7 8 9 10 Week De man d 0.1 0.6

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Criteria for Selecting a Forecasting Method

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Cost Accuracy Data available Time span Nature of products and services Impulse response and noise dampening

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Reasons for Ineffective Forecasting Reasons for Ineffective Forecasting

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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 (think in terms of interval rather than point forecasts) Not forecasting the right things (forecast independent demand only) Not selecting an appropriate forecasting method (use MAD to evaluate goodness of fit) Not tracking the accuracy of the forecasting models
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How to Monitor and How to Monitor and Control a Forecasting Model Control a Forecasting Model
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Tracking Signal

Tracking signal =

(Actual demand - Forecast demand)

i =1

MAD

(A - F )
i i i =1

MAD

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Tracking Signal: What do you notice?

40 35 Sales 30 25 20 0 1 2 3 4 5 6 7 8 9 10 11 Pe riod

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Sources of Forecasting Data Sources of Forecasting Data

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Consumer Confidence Index Consumer Price Index Housing Starts Index of Leading Economic Indicators Personal Income and Consumption Producer Price Index Purchasing Managers Index Retail Sales

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Wrap-Up: World-Class Practice

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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 Use forecasting software with automated model fitting features, which is readily available today Do not overlook the short run.... excellent short range forecasts as well
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