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INTRODUCTION TO OPERATIONS MANAGEMENT

CONTENTS

3.  Forecasting
Learning Objectives

What is forecasting and why is it important?

Understand the differences between qualitative and quantitative

forecasting.

Describe types of demand patterns exhibited in product demand.

Calculate forecasts using time series analysis and seasonal index.

 Determine forecast accuracy.

Forecasting is the process of making predictions of the future based on past and
present data. This is most commonly by analysis of trends. A commonplace example
might be estimation of some variable of interest at some specified future
date. Prediction is a similar, but more general term. Both might refer to formal
statistical methods employing time series, cross-sectional or longitudinal data, or
alternatively to less formal judgmental methods. Usage can differ between areas of
application: for example, in hydrology, the terms “forecast” and “forecasting” are
sometimes reserved for estimates of values at certain specific future times, while the
term “prediction” is used for more general estimates, such as the number of times
floods will occur over a long period.

Risk and uncertainty are central to forecasting and prediction; it is generally

considered good practice to indicate the degree of uncertainty attached to specific
forecasts. In any case, the data must be up to date in order for the forecast to be as
accurate as possible. In some cases, the data used to predict the variable of interest
is itself forecasted.[1]

As discussed in the previous chapter, functional strategies need to be aligned and

supportive to the higher level corporate strategy of the organization. One of these
functional areas is marketing. Creating marketing strategy is not a single event, nor
is the implementation of marketing strategy something only the marketing
department has to worry about.

When the strategy is implemented, the rest of the company must be poised to deal
with the consequences. An important component in this implementation is the
sales forecast, which is the estimate of how much the company will actually sell. The
rest of the company must then be geared up (or down) to meet that demand. In this
module, we explore forecasting in more detail, as there are many choices that can
be made in developing a forecast.

Accuracy is important when it comes to forecasts. If executives overestimate the

demand for a product, the company could end up spending money on
manufacturing, distribution, and servicing activities it won’t need. Data Impact, a
software developer, recently overestimated the demand for one of its new products.
Because the sales of the product didn’t meet projections, Data Impact lacked the
cash available to pay its vendors, utility providers, and others. Employees had to be
terminated in many areas of the firm to trim costs.

Underestimating demand can be just as devastating. When a company introduces a

new product, it launches marketing and sales campaigns to create demand for it.
But if the company isn’t ready to deliver the amount of the product the market
demands, then other competitors can steal sales the firm might otherwise have
captured. Sony’s inability to deliver the e-Reader in sufficient numbers made
Amazon’s Kindle more readily accepted in the market; other features then gave the
Kindle an advantage that Sony is finding difficult to overcome.

The firm has to do more than just forecast the company’s sales. The process can be
complex, because how much the company can sell will depend on many factors
such as how much the product will cost, how competitors will react, and so forth.
Each of these factors has to be taken into account in order to determine how much
the company is likely to sell. As factors change, the forecast has to change as well.
Thus, a sales forecast is actually a composite of a number of estimates and has to be
dynamic as those other estimates change.

A common first step is to determine market potential, or total industry-wide sales

expected in a particular product category for the time period of interest. (The time
period of interest might be the coming year, quarter, month, or some other time
period.) Some marketing research companies, such as Nielsen, Gartner, and others,
estimate the market potential for various products and then sell that research to
companies that produce those products.

Once the firm has an idea of the market potential, the company’s sales potential can
be estimated. A firm’s sales potential is the maximum total revenue it hopes to
generate from a product or the number of units of it the company can hope to sell.
The sales potential for the product is typically represented as a percentage of its
market potential and equivalent to the company’s estimated maximum market
share for the time period.  In your budget, you’ll want to forecast the revenues
earned from the product against the market potential, as well as against the
product’s costs.[2]

Forecasting Horizons
Long term forecasting tends to be completed at high levels in the organization. The
time frame is generally considered longer than 2 years into the future. Detailed
knowledge about the products and markets are required due to the high degree of
uncertainty.  This is commonly the case with new products entering the market,
emerging new technologies and opening new facilities. Often no historical data is
available.

Medium term forecasting tends to be several months up to 2 years into the future
and is referred to as intermediate term. Both quantitative and qualitative forecasting
may be used in this time frame.

Short term forecasting is daily up to months in the future. These forecasts are used
for operational decision making such as inventory planning, ordering and
scheduling of the workforce. Usually quantitative methods such as time series
analysis are used in this time frame.

Categories of Forecasting Methods

Qualitative Forecasting

Qualitative forecasting techniques are subjective, based on the opinion and

judgment of consumers and experts; they are appropriate when past data are not
available. They are usually applied to intermediate- or long-range decisions.

In the following, we discuss some examples of qualitative forecasting techniques:

Executive Judgement (Top Down)

Groups of high-level executives will often assume responsibility for the forecast. They
will collaborate to examine market data and look at future trends for the business.
Often, they will use statistical models as well as market experts to arrive at a forecast.

Sales Force Opinions (Bottom up)

The sales force in a business are those persons most close to the customers. Their
opinions are of high value. Often the sales force personnel are asked to give their
future projections for their area or territory. Once all of those are reviewed, they may
be combined to form an overall forecast for district or region.

Delphi Method

This method was created by the Rand Corporation in the 1950s. A group of experts
are recruited to participate in a forecast. The administrator of the forecast will send
out a series of questionnaires and ask for inputs and justifications. These responses
will be collated and sent out again to allow respondents to evaluate and adjust their
answers.  A key aspect of the Delphi method is that the responses are anonymous,
respondents do not have any knowledge about what information has come from
which sources. That permits all of the opinions to be given equal consideration. The
set of questionnaires will go back and forth multiple times until a forecast is agreed
upon.

Market Surveys

Some organizations will employ market research firms to solicit information from
consumers regarding opinions on products and future purchasing plans.

Quantitative Forecasting

Quantitative forecasting models are used to forecast future data as a function of

past data. They are appropriate to use when past numerical data is available and
when it is reasonable to assume that some of the patterns in the data are expected
to continue into the future. These methods are usually applied to short- or
intermediate-range decisions. Some examples of quantitative forecasting methods
are causal (econometric) forecasting methods, last period demand (naïve), simple
and weighted N-Period moving averages and simple exponential smoothing, which
are categorizes as time-series methods. Quantitative forecasting models are often
judged against each other by comparing their accuracy performance measures.
Some of these measures include Mean Absolute Deviation (MAD), Mean Squared
Error (MSE), and Mean Absolute Percentage Error (MAPE).

We will elaborate on some of these forecasting methods and the accuracy measure
in the following sections.[3]

Causal (Econometric) Forecasting Methods (Degree)

Some forecasting methods try to identify the underlying factors that might
influence the variable that is being forecast. For example, including information
about climate patterns might improve the ability of a model to predict umbrella
sales. Forecasting models often take account of regular seasonal variations. In
addition to climate, such variations can also be due to holidays and customs: for
example, one might predict that sales of college football apparel will be higher
during the football season than during the off-season.

Several informal methods used in causal forecasting do not rely solely on the output
of mathematical algorithms, but instead use the judgment of the forecaster. Some
forecasts take account of past relationships between variables: if one variable has, for
example, been approximately linearly related to another for a long period of time, it
may be appropriate to extrapolate such a relationship into the future, without
necessarily understanding the reasons for the relationship.

One of the most famous causal models is regression analysis. In statistical

modeling, regression analysis is a set of statistical processes for estimating the
relationships among variables. It includes many techniques for modeling and
analyzing several variables, when the focus is on the relationship between
a dependent variable and one or more independent variables (or ‘predictors’). More
specifically, regression analysis helps one understand how the typical value of the
dependent variable (or ‘criterion variable’) changes when any one of the
independent variables is varied, while the other independent variables are held
fixed.
 Figure 3.1: Example of regression analysis.

Common Forecasting Assumptions: 

1. Forecasts are rarely, if ever, perfect. It is nearly impossible to 100%

accurately estimate what the future will hold. Firms need to understand
and expect some error in their forecasts.
2. Forecasts tend to be more accurate for groups of items than for
individual items in the group. The popular Fitbit may be producing six
different models. Each model may be offered in several different
colours. Each of those colours may come in small, large and extra large.
The forecast for each model will be far more accurate than the forecast
for each specific end item.
3. Forecast accuracy will tend to decrease as the time horizon increases.
The farther away the forecast is from the current date, the more
uncertainty it will contain.
Demand Patterns

When we plot our historical product demand, the following patterns can often be
found:

Trend – A trend is consistent upward or downward movement of the demand. This

may be related to the product’s life cycle.

Cycle – A cycle is a pattern in the data that tends to last more than one year in
duration. Often, they are related to events such as interest rates, the political climate,
consumer confidence or other market factors.

Seasonal – Many products have a seasonal pattern, generally predictable changes in

demand that are recurring every year. Fashion products and sporting goods are
heavily influenced
Previous: by seasonality.
Operations Strategy and Competitiveness

Irregular variations – Often demand can be influenced by an event or series of Chain

Next: Supply
events that are not expected to be repeated in the future. Examples might include
an extreme weather event, a strike at a college campus, or a power outage.

Random variations – Random variations are the unexplained variations in demand

that remain after all other factors are considered. Often this is referred to as noise.

TREND CYCLICAL SEASONAL

Nov-Dec
Demand
Demand
Demand

irregularvariation
1уг

Time Time Time

Figure 3.2: Diagram of trend, cyclical, and seasonal demand patterns.

Time Series Methods

Time series methods use historical data as the basis of estimating future outcomes.
A time series is a series of data points indexed (or listed or graphed) in time order.
Most commonly, a time series is a sequence taken at successive equally spaced
points in time. Thus, it is a sequence of discrete-time data. Examples of time series
are heights of ocean tides, counts of sunspots, and the daily closing value of the Dow
Jones Industrial Average.

Time series are very frequently plotted via line charts. Time series are used in
statistics, signal processing, pattern recognition, econometrics, mathematical
finance, weather forecasting, earthquake prediction, electroencephalography,
control engineering, astronomy, communications engineering, and largely in any
domain of applied science and engineering which involves temporal measurements.
[4]

In the following, we will elaborate more on some of the simpler time-series methods
and go over some numerical examples.

Naïve Method
The simplest forecasting method is the naïve method. In this case, the forecast for
the next period is set at the actual demand for the previous period. This method of
forecasting may often be used as a benchmark in order to evaluate and compare
other forecast methods.

Simple Moving Average

In this method, we take the average of the last “n” periods and use that as the
forecast for the next period. The value of “n” can be defined by the management in
order to achieve a more accurate forecast. For example, a manager may decide to
use the demand values from the last four periods (i.e., n = 4) to calculate the 4-period
moving average forecast for the next period.

Example

Some relevant notation:

Dt = Actual demand observed in period t
Ft = Forecast for period t

Using the following table, calculate the forecast for period 5 based on a 3-period
moving average.
Period Actual Demand

1 42

2 37

3 34

4 40

Solution
Forecast for period 5 = F5 = (D4 + D3 + D2) / 3 = (40 + 34 + 37) / 3 = 111 / 3 = 37

Here is a video explaining simple moving averages.

https://www.linkedin.com/learning/forecasting-using-financial-
statements/simple-moving-average

Weighted Moving Average

This method is the same as the simple moving average with the addition of a weight
for each one of the last “n” periods. In practice, these weights need to be determined
in a way to produce the most accurate forecast. Let’s have a look at the same
example, but this time, with weights:

Example

Period Actual Demand Weight

1 42  

2 37 0.2

3 34 0.3

4 40 0.5

Solution
Forecast for period 5 = F5 = (0.5 x D4 + 0.3 x D3 + 0.2 x D2) = (0.5 x 40+ 0.3 x 34 + 0.2 x
37) = 37.6

Note that if the sum of all the weights were not equal to 1, this number above had to
be divided by the sum of all the weights to get the correct weighted moving
average.

Here is a video explaining weighted moving averages.

https://www.linkedin.com/learning/forecasting-using-financial-
statements/weighted-moving-average

Exponential Smoothing
This method uses a combination of the last actual demand and the last forecast to
produce the forecast for the next period. There are a number of advantages to using
this method.  It can often result in a more accurate forecast. It is an easy method
that enables forecasts to quickly react to new trends or changes. A benefit to
exponential smoothing is that it does not require a large amount of historical data.
Exponential smoothing requires the use of a smoothing coefficient called Alpha (α).
The Alpha that is chosen will determines how quickly the forecast responds to
changes in demand. It is also referred to as the Smoothing Factor.

There are two versions of the same formula for calculating the exponential
smoothing.

Here is version #1:

Ft = (1  – α) Ft-1 + α Dt-1

Note that α is a coefficient between 0 and 1

For this method to work, we need to have the forecast for the previous period. This
forecast is assumed to be obtained using the same exponential smoothing method.
If there were no previous period forecast for any of the past periods, we will need to
initiate this method of forecasting by making some assumptions. This is explained in
the next example.
Example

Period Actual Demand Forecast

1 42  

2 37  

3 34  

4 40  

5    

In this example, period 5 is our next period for which we are looking for a forecast. In
order to have that, we will need the forecast for the last period (i.e., period 4). But
there is no forecast given for period 4. Thus, we will need to calculate the forecast for
period 4 first. However, a similar issue exists for period 4, since we do not have the
forecast for period 3. So, we need to go back for one more period and calculate the
forecast for period 3. As you see, this will take us all the way back to period 1. Because
there is no period before period 1, we will need to make some assumption for the
forecast of period 1. One common assumption is to use the same demand of period 1
for its forecast. This will give us a forecast to start, and then, we can calculate the
forecast for period 2 from there. Let’s see how the calculations work out:

If α = 0.3 (assume it is given here, but in practice, this value needs to be selected
properly to produce the most accurate forecast)

Assume F1 = D1, which is equal to 42.

Then, calculate F2 = (1 – α) F1+ α D1 = (1 – 0.3) x 42 + 0.3 x 42 = 42

Next, calculate F3 = (1 – α) F2+ α D2 = (1 – 0.3) x 42 + 0.3 x 37 = 40.5

And similarly, F4 = (1 – α) F3+ α D3 = (1 – 0.3) x 40.5 + 0.3 x 34 = 38.55

And finally, F5 = (1 – α) F4+ α D4 = (1 – 0.3) x 38.55 + 0.3 x 40 = 38.985

 Period ActualDemand Forecast
42 42(assumed=D1)
2 37 (1-0.3)×4270.3×42=42
3 34 (1-0.3)×42÷0.3×37=40.5
40 (1-0.3)×40.5+0.3×34=38.55
5 (1-0.3)×38.55+0.3×40=38.985
Figure 3.3: Solution for Exponential Smoothing Version 1

Accessible format for Figure 3.3

Here is a video explaining exponential smoothing using EXCEL.

https://www.linkedin.com/learning/search?
keywords=exponential%20smoothing&u=2169170

Here is version #2: 

Ft = Ft-1 + α(Dt-1 – Ft-1)

Example
Assume you are given an alpha of 0.3, Ft-1 = 55

Figure 3.4: Solution for Exponential Smoothing Version 2

Accessible format for Figure 3.4

Seasonal Index
Many organizations produce goods whose demand is related to the seasons, or
changes in weather throughout the year. In these cases, a seasonal index may be
used to assist in the calculation of a forecast.

Example

Season Previous Sales Average Sales Seasonal Index

Winter 390 500 390 / 500 = .78

Spring 460 500 460 / 500 = .92

Summer 600 500 600 / 500 = 1.2

Fall 550 500 550 / 500 = 1.1

Total 2000    

Using these calculated indices, we can forecast the demand for next year based on
the expected annual demand for the next year.  Let’s say a firm has estimated that
next year annual demand will be 2500 units.

Avg. Sales /
Anticipated annual Seasonal New
Season Season
demand Factor Forecast
(2500/4)

.78 x 625 =
Winter   625 0.78
487.5

.92 x 625 =
Spring   625 0.92
575

1.2 x 625 =
Summer   625 1.2
750

1.1 x 625 =
Fall   625 1.1
687.5

  2500      

Forecast Accuracy Measures

In this section, we will calculate forecast accuracy measures such as Mean Absolute
Deviation (MAD), Mean Squared Error (MSE), and Mean Absolute Percentage Error
(MAPE). We will explain the calculations using the next example.

Example
The following actual demand and forecast values are given for the past four periods.
We want to calculate MAD, MSE and MAPE for this forecast to see how well it is
doing.
Note that Abs (et) refers to the absolute value of the error in period t (et).
Period Actual Demand Forecast et Abs (et) et2 [Abs (et) / Dt] x 100%
1 63 68
2 59 65
3 54 61
4 65 59

Here are what need to do:

Step 1: Calculate the error as et = Dt – Ft (the difference between the actual demand
and the forecast) for any period t and enter the values in the table above.

Step 2: Calculate the absolute value of the errors calculated in step 1 [i.e., Abs (et)],
and enter the values in the table above.

Step 3: Calculate the squared error (i.e., et2) for each period and enter the values in
the table above.

Step 4: Calculate [Abs (et) / Dt] x 100% for each period and enter the value under its
column in the table above.

Solution

Period Actual Demand Forecast et Abs (et) et2 [Abs (et) / Dt] x 100%

1 63 68 -5 5 25 7.94%

2 59 65 -6 6 36 10.17%

3 54 61 -7 7 49 12.96%

4 65 59 6 6 36 9.23%

Calculations for Accuracy Measures:

MAD = The average of what we calculated in step 2 (i.e., the average of all the
 absolute error values)

= (5 + 6 + 7 + 6) / 4 = 24 / 4 = 6

MSE = The average of what we calculated in step 3 (i.e., the average of all the
squared error values)

= (25 + 36 + 49 + 36) / 4 = 146/4 = 36.5

MAPE = The average of what we calculated in step 4

= (7.94% + 10.17% + 12.96% + 9.23%) / 4 = 40.3/4 = 10.075%

Here is a video on Mean Absolute Deviation using EXCEL

https://www.linkedin.com/learning/search?
keywords=mean%20absolute%20deviation%20&u=2169170

End of Chapter Problems

Problem #1

Below are monthly sales of light bulbs from the lighting store.
 Month Sales
Jan 255
Feb 298
Mar 357
Apr 319
May 360
June

.
Forecast sales for June using the following

1. Naïve method
2. Three- month simple moving average
3. Three-month weighted moving average using weights of .5, .3 and .2
4. Exponential smoothing using an alpha of .2 and a May forecast of 350.

Solution

1. 360
2. (357 + 319 + 360) / 3 = 345.3
3. 360 x .5 + 319 x .3 + 357 x .2 = 347.1
4. 350 + .2(360 – 350) = 352

Problem #2

Demand for aqua fit classes at a large Community Centre are as follows for the first
six weeks of this year.
 Week Demand
1 162
2 158
3 138
4 190
5 182
6 177
7

.
You have been asked to experiment with several forecasting methods.  Calculate the
following values:

1. a) Forecast for weeks 3 through week 7 using a two-period simple moving

average
2. b) Forecast for weeks 4 through week 7 using a three-period weighted moving
average with weights of .6, .3 and .1
3. c) Forecast for weeks 4 through week 7 using exponential smoothing. Begin
with a week 3 forecast of 130 and use an alpha of .3

Solution
Week Demand a) b) c)

1 162      

2 158      

(162 + 158) / 2 =
3 138   130 
160

(158 + 138) / 2 = 138 x .6 + 158 x .3 + 162 x 130 + .3 x (138 – 130) =

4 190
148 .1 = 146.4  132.4

(138 + 190) / 2 = 190 x .6 + 138 x .3 + 158 x 132.4 + .3 x (190 – 132.4)

5 182
164 .1 = 171.2 = 149.7

(190 + 182) / 2 = 182 x .6 + 190 x .3 + 138 x 149.7 + .3 x (182 –

6 177
186 .1 = 180 149.7) = 159.4 

(182 + 177) / 2 = 177 x .6 + 182 x .3 + 190 x 159.4 + .3 x (177 – 159.4)

7  
179.5 .1 = 179.8  = 164.7

Problem #3

Sales of a new shed has grown steadily from the large farm supply store. Below are
the sales from the past five years. Forecast the sales for 2018 and 2019 using
exponential smoothing with an alpha of .4. In 2015, the forecast was 360. Calculate a
forecast for 2016 through to 2020.
 Year Sales Forecast

2015 348 360

2016 372  

2017 311  

2018 371  

2019 365  

2020    

.
Solution

Year Sales Forecast

2015 348 360 

2016 372 360 + .4 x (348 – 360) = 355.2 

2017 311 355.2 + .4 x (372 – 355.2) = 361.9

2018 371 361.9 + .4 x (311 – 361.9) = 341.6

2019 365 341.6 + .4 x (371 – 341.6) = 353.3

2020   353.3 + .4 x (365-353.3) = 358.0

Problem #4

Below is the actual demand for X-rays at a medical clinic. Two methods of
forecasting were used. Calculate a mean absolute deviation for each forecast
method. Which one is more accurate?
Week Actual Demand Forecast #1 Forecast #2
1 48 50 50
2 65 55 56
3 58 60 55
4 79 70 85

Solution

Actual
Week Forecast #1 IerrorI Forecast #2 IerrorI
Demand

1 48 50 2 50 2

2 65 55 10 56 9

3 58 60 2 55 3

4 79 70 9 85 6

Mean Abs Mean Abs

    5.75 5
Deviation: Deviation: 

1. Wikipedia contributors. (2019). Forecasting. In Wikipedia, The Free Encyclopedia.

Retrieved November 4, 2019, from https://en.wikipedia.org/w/index.php?
title=Forecasting&oldid=933732816 ↵
2. Saylor Academy. (2012). Principles of Marketing. Forecasting. Retrieved on
November 4, 2019, from https://saylordotorg.github.io/text_principles-of-
marketing-v2.0/s19-03-forecasting.html ↵
3. Wikipedia contributors. (2019). Forecasting. In Wikipedia, The Free Encyclopedia.
Retrieved on November 4, 2019, from https://en.wikipedia.org/w/index.php?
title=Forecasting&oldid=933732816 ↵
4. Wikipedia contributors. (2019). Time series. In Wikipedia, The Free Encyclopedia.
Retrieved on November 4, 2019, from https://en.wikipedia.org/w/index.php?
title=Time_series&oldid=934671965 ↵
LICENSE

Introduction to Operations Management Copyright © by Mary Drane and Hamid

Faramarzi is licensed under a Creative Commons Attribution-NonCommercial 4.0
International License, except where otherwise noted.

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