Chapter 3: Forecasting

Forecast – a statement about the future value of a variable of interest.

o We make forecasts about such things as weather, demand, and resource availability
o Forecasts are important to making informed decisions
o The primary goal of OM is to match supply to demand
o Businesses make plans for future operations based on anticipated future demand

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
 A function of the ability of forecasters to correctly model demand, random variation, and
some unforeseen events

Forecast Uses
 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
BUSINESS FORECASTING IS MORE THAN PREDICTING DEMAND: PROFITS REVENUES
COSTS PRODUCTIVITY CHANGES PRICES AND AVAILABILITY OF ENERGY AND RAW
MATERIALS
FORECASTING S NOT AN EXACT SCIENCE

Features Common to All Forecasts

1. Techniques assume some underlying causal system that existed in the past will persist into the
future.
 THEREFORE, MUST BE CAREFUL BECAUSE OF CHANGES IN ELEMENTS
SUCH AS TAX INCREASES, PRICES OF COMPETING PRODUCTS CAN HAVE
IMPACT ON DEMAND, AND MAY NOT BE COVERED IN THE MODEL
2. Forecasts are not perfect: PRESENCE OF RANDOMNESS PRECLUDES A PERFECT
FORECAST
3. Forecasts for groups of items are more accurate than those for individual items BECAUSE
FORECASTING ERRORS AMONG ITEMS IN A GROUP USUALLY HAVE A CANCELLING
EFFECT
 4. Forecast accuracy decreases as the forecasting horizon increases
GENERALLY, SHORT RANGE FORECAST MUST CONTEND WITH FEWER
UNCERTAINTIES, AND SO TEND TO BE MORE ACCURATE

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.

Elements of a Good Forecast

The forecast:
 should be timely
 should be accurate: THIS WILL ENABLE USERS TO PLAN FOR POSSIBLE ERRORS
 should be reliable - CONSISTENT
 should be expressed in meaningful units
 should be in writing
 technique should be simple to understand and use
 should be cost-effective; BENEFITS OUTWEIGH COSTS

Steps in the Forecasting Process

1. Determine the purpose of the forecast: HOW IT WILL BE USED DETERMINES THE LEVEL
OF DETAILS
2. Establish a time horizon
3. Obtain, “clean”, and analyze appropriate data
4. Select a forecasting technique
5. Make the forecast
6. Monitor the forecast errors: ERRORS SHOULD BE MONITOREDE TO DETERMINE IF
THE FORECAST IS PERFORMING IN A SATISFACTORY MANNER

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

Forecasting Approaches:
A. Qualitative Forecasting qualitative techniques permit the inclusion of soft information such as:
 Human factors
 Personal opinions
 Hunches
 These factors are difficult, or impossible, to quantify
Quantitative Forecasting 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
 These techniques rely on hard data
 B. 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
 Part of long-range planning and new product development
 Brings knowledge, but has risk of one person’s opinion prevailing
 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
 May not distinguish between like to do and will do
 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

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

Time-Series Behaviors
PATTERNS THAT APPEAR WHEN WE CONDUCT TIME-SERIES FORECASTS:
 Trend
 Seasonality
 Cycles
 Irregular variations
 Random variation

Trend A long-term upward or downward movement in data

 Population shifts
 Changing income
 Cultural changes
Seasonality Short-term, fairly regular variations related to the calendar or time of day (weekly or daily)
 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
  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: demand last week 20 items; this week it will be 20 items
 Seasonal variations: last Ramadan 300 items; this Ramadan 300 items
 Trend: the forecast is equal to the last value of the series plus or minus the
difference between the last 2 values of the series

This method may sound simplistic, but it has its advantages:

1. Virtually no cost
2. Quick and easy to prepare because data analysis is nonexistent
3. Easily understandable

Averaging
These techniques work best when a series tends to vary about an average
 Averaging techniques smooth variations in the data
 Averaging techniques smooth fluctuations in a time series because the individual highs
and lows in the data offset each other when they are combined in an average; a forecast
based on an average thus tends to exhibit less variation than the original 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- Technique that averages a number of the most recent actual values in generating a
forecast.

 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
 More data points used-- less responsive
PROs: easy to compute and understand
CONs: all values in the average are weighed equally

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

Exponential Smoothing- A weighted averaging method that is based on the previous forecast plus a
percentage of the forecast error.

Linear Trend - A simple data plot can reveal the existence and nature of a trend.

Estimating slope and intercept- Slope and intercept can be estimated from historical data.

Techniques for Seasonality

Seasonality – regularly repeating movements in series values that can be tied to recurring events.
 Expressed in terms of the amount that actual values deviate from the average value of a series
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

Seasonal Relatives- The seasonal percentage used in the multiplicative seasonally adjusted forecasting
model. Using seasonal relatives:
 To deseasonalize data
 Done in order to get a clearer picture of the non-seasonal (e.g., trend) components of the
data series
 Divide each data point by its seasonal relative
 To incorporate seasonality in a forecast
 Obtain trend estimates for desired periods using a trend equation
 Add seasonality by multiplying these trend estimates by the corresponding seasonal
relative

Monitoring the Forecast- Tracking forecast errors and analyzing them can provide useful insight into
whether forecasts are performing satisfactorily.
 Sources of forecast errors:
1. 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
2. Irregular variations may have occurred
3. 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

Choosing a Forecasting Technique

Factors to consider:
 Cost
 Accuracy
 Availability of historical data
 Availability of forecasting software
 Time needed to gather and analyze data and prepare a forecast
 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