MBA 512E

Operations Management

Forecasting
Dr. Partha Kumar Pandit
 What is Forecasting?
 Process of predicting
a future event
 Underlying basis of
all business decisions
 Production
 Inventory
 Personnel
 Facilities
Forecasting Time Horizons
 Short-range forecast
 Up to 1 year,
 Purchasing, job scheduling, workforce levels, job
assignments, production levels
 Medium-range forecast
 1 year to 3 years
 Sales and production planning, budgeting
 Long-range forecast
 3+ years
 New product planning, facility location, research
and development
 Distinguishing Differences
Medium/long range forecasts deal with more
comprehensive issues and support
management decisions regarding planning and
products, plants and processes
Short-term forecasting usually employs
different methodologies than longer-term
forecasting
Short-term forecasts tend to be more accurate
than longer-term forecasts
 Types of Forecasts
 Economic forecasts
 Address business cycle – inflation rate, money
supply, housing starts, etc.
 Technological forecasts
 Predict rate of technological progress
 Impacts development of new products
 Demand forecasts
 Predict sales of existing products and services
 Seven Steps in Forecasting
 Determine the use of the forecast
 Select the items to be forecasted
 Determine the time horizon of the forecast
 Select the forecasting model(s)
 Gather the data
 Make the forecast
 Validate and implement results
 Time Series Forecasting
 Set of evenly spaced numerical data
 Obtained by observing response variable at
regular time periods
 Forecast based only on past values, no other
variables important
 Assumes that factors influencing past and
present will continue influence in future
Time Series Components

Trend Cyclical

Seasonal Random
 Components of Demand
Trend
component
Demand for product or service

Seasonal peaks

Actual
demand

Average
demand over
Random four years
variation
| | | |
1 2 3 4
Year Figure 4.1
Trend Component
 Persistent, overall upward or downward
pattern
 Changes due to population, technology,
age, culture, etc.
 Typically several years duration
 Seasonal Component
 Regular pattern of up and down
fluctuations
 Due to weather, customs, etc.
 Occurs within a single year

Number of
Period Length Seasons
Week Day 7
Month Week 4-4.5
Month Day 28-31
Year Quarter 4
Year Month 12
Year Week 52
 Cyclical Component
 Repeating up and down movements
 Affected by business cycle, political, and
economic factors
 Multiple years duration
 Often causal or
associative
relationships

0 5 10 15 20
 Random Component
 Erratic, unsystematic, ‘residual’
fluctuations
 Due to random variation or unforeseen
events
 Short duration and
nonrepeating

M T W T F
 Forecasting Methods
 Qualitative Methods
 Quantitative Methods
Overview of Qualitative Methods
 Sales force composite
 Consumer Market Survey
 Jury of Executive opinion
 Delphi Method
 Sales Force Composite
 Each salesperson projects his or her
sales
 Combined at district and national levels
 Sales reps know customers’ wants
 Tends to be overly optimistic
 Consumer Market Survey
 Ask the consumer
 Find out the present demand of the
product
 Find out future demand of the product
 Make Forecast on survey
Jury of Executive Opinion
 Involves small group of high-level experts and
managers
 Group estimates demand by working together
 Combines managerial experience with
statistical models
 Relatively quick
 ‘Group-think’
disadvantage
 Delphi Method
 Iterative group process, Decision Makers
continues until (Evaluate
consensus is reached responses and
 3 types of participants make decisions)
 Decision makers
 Staff Staff
(Administering
 Respondents survey)

Respondents
(People who can make
valuable judgments)
 Quantitative Approaches
1. Naive approach

2. Moving averages
Time-Series
Models
3. Exponential smoothing

4. Trend projection
Associative
5. Linear regression Model
 Naive Approach
 Assumes demand in next
period is the same as
demand in most recent period
 e.g., If January sales were 68, then
February sales will be 68
 Sometimes cost effective and efficient
 Can be good starting point
 Moving Average Method
 MA is a series of arithmetic means
 Used if little or no trend
 Used often for smoothing
 Provides overall impression of data over time

∑ demand in previous n periods

Moving average = n
Moving Average Example
Actual 3-Month
Month Shed Sales Moving Average

January 10
February 12
March 13
April 16 (10 + 12 + 13)/3 = 11 2/3
May 19 (12 + 13 + 16)/3 = 13 2/3
June 23 (13 + 16 + 19)/3 = 16
July 26 (16 + 19 + 23)/3 = 19 1/3
Graph of Moving Average
Moving Average
Forecast
30 –
28 –
Actual Sales
26 –
24 –
Shed Sales

22 –
20 –
18 –
16 –
14 –
12 –
10 –
| | | | | | | | | | | |
J F M A M J J A S O N D
Weighted Moving Average
 Used when trend is present
 Older data usually less important
 Weights based on experience and intuition

∑ (weight for period n)

x (demand in period n)
Weighted = ∑ weights
moving average
 Weights Applied Period

Weighted Moving Average

3 Last month
2 Two months ago
1 Three months ago
6 Sum of weights

Actual 3-Month Weighted

Month Shed Sales Moving Average

January 10
February 12
March 13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 = 121/6
May 19 [(3 x 16) + (2 x 13) + (12)]/6 = 141/3
June 23 [(3 x 19) + (2 x 16) + (13)]/6 = 17
July 26 [(3 x 23) + (2 x 19) + (16)]/6 = 201/2
 Moving Average And
Weighted Moving Average
Weighted
moving
30 – average
25 –
Sales demand

20 – Actual
sales
15 –
Moving
10 – average

5 –
| | | | | | | | | | | |
Figure 4.2
J F M A M J J A S O N D
Exponential Smoothing
 Form of weighted moving average
 Weights decline exponentially
 Most recent data weighted most
 Requires smoothing constant ()
 Ranges from 0 to 1
 Subjectively chosen
 Involves little record keeping of past data
 Exponential Smoothing
t= Last period’s forecast
+ a (Last period’s actual demand
– Last period’s forecast)

Ft = Ft – 1 + a(At – 1 - Ft – 1)
where Ft = new forecast
Ft – 1 = previous forecast
a = smoothing (or weighting)
constant (0 ≤ a ≤ 1)
Exponential Smoothing Example
Predicted demand = 142 Flights
Actual demand = 153 Flights
Smoothing constant a = .20
Exponential Smoothing Example
Predicted demand = 142
Actual demand = 153
Smoothing constant a = .20

New forecast = 142 + .2(153 – 142)

Exponential Smoothing Example
Predicted demand = 142
Actual demand = 153
Smoothing constant a = .20

New forecast = 142 + .2(153 – 142)

= 142 + 2.2
= 144.2 ≈ 144
 Effect of
Smoothing Constants
Weight Assigned to
Most 2nd Most 3rd Most 4th Most 5th Most
Recent Recent Recent Recent Recent
Smoothing Period Period Period Period Period
Constant (a) a(1 - a) a(1 - a)2 a(1 - a)3 a(1 - a)4

a = .1 .1 .09 .081 .073 .066

a = .5 .5 .25 .125 .063 .031

 Impact of Different 
225 –
Actual a = .5
demand
200 –
Demand

175 –
a = .1
| | | | | | | | |
150 –
1 2 3 4 5 6 7 8 9
Quarter
 Impact of Different 
225 –
Actual a = .5
 Chose high values of
demand

when
200 – underlying average
Demand

is likely to change
175
Choose
– low values of 
when underlying average a = .1
is stable
| | | | | | | | |
150 –
1 2 3 4 5 6 7 8 9
Quarter
Choosing 
The objective is to obtain the most
accurate forecast no matter the
technique
We generally do this by selecting the model
that gives us the lowest forecast error

Forecast error = Actual demand - Forecast value

= At - Ft
Common Measures of Error
Mean Absolute Deviation (MAD)
∑ |Actual - Forecast|
MAD =
n

Mean Squared Error (MSE)

∑ (Forecast Errors)2
MSE =
n -1
Common Measures of Error

Mean Absolute Percent Error (MAPE)

n
∑100|Actuali - Forecasti|/Actuali
MAPE = i=1
n
Comparison of Forecast Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
Comparison of Forecast Error
∑ |deviations|
Rounded Absolute Rounded Absolute
MADActual
= Forecast Deviation Forecast Deviation
Tonnage n
with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1
For a =
180
.10 175 5.00 175 5.00
2 168 = 82.45/8
175.5 = 10.31
7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 For a =
175.50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 = 98.62/8
175.02 = 12.33
29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
Comparison of Forecast
∑ (forecast errors)
Error 2
Rounded Absolute Rounded Absolute
MSE = Actual Forecast Deviation Forecast Deviation
Tonnage n -1
with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1
For a 180
= .10 175 5.00 175 5.00
2 = 1,526.54/7
168 175.5 = 218.077
7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 For a =
175.50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205= 1,561.91/7
175.02 = 223.13
29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
Comparison of Forecast Error
n
∑100|deviation
Rounded i|/actualRounded
Absolute i Absolute
MAPE =Actual
i=1 Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 n a = .10 a = .50 a = .50
1
For a
180
= .10 175 5.00 175 5.00
2 168 = 44.75/8
175.5 = 5.59%
7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 For a175= .50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 = 54.05/8
175.02 =29.98
6.76% 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 218.07 223.13
Comparison of Forecast Error
Rounded Absolute Rounded Absolute
Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 218.07 223.13
MAPE 5.59% 6.76%
Comparison of MAD, MSE & MAPE

MAD weights all errors evenly

MSE weights errors according to their squared values
MAPE weights according to relative error

Compare these values with lowest one

Trend Projections
Fitting a trend line to historical data points to
project into the medium to long-range
Linear trends can be found using the least
squares technique
^
y = a + bx
^ where y = computed value of the variable to be
predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable
Least Squares Method
Values of Dependent Variable

Actual observation Deviation7

(y value)

Deviation5 Deviation6

Deviation3

Deviation4

Deviation1
(error) Deviation2
Trend line, y^ = a + bx

Time period Figure 4.4

Least Squares Method
Values of Dependent Variable

Actual observation Deviation7

(y value)

Deviation5 Deviation6

Deviation3
Least squares method minimizes the
sum of the squared errors (deviations)
Deviation4

Deviation1
Deviation2
Trend line, y^ = a + bx

Time period Figure 4.4

Least Squares Method
Equations to calculate the regression variables

^
y = a + bx

Sxy - nxy
b=
Sx2 - nx2

a = y - bx
Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
2001 1 74 1 74
2002 2 79 4 158
2003 3 80 9 240
2004 4 90 16 360
2005 5 105 25 525
2005 6 142 36 852
2007 7 122 49 854
∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063
x=4 y = 98.86

∑xy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
∑x2 - nx2 140 - (7)(4 )
2

a = y - bx = 98.86 - 10.54(4) = 56.70

Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
1999 1 74 1 74
2000 2 79 4 158
2001 The trend
3 line is 80 9 240
2002 4 90 16 360
^
2003 y5= 56.70 + 10.54x
105 25 525
2004 6 142 36 852
2005 7 122 49 854
Sx = 28 Sy = 692 Sx2 = 140 Sxy = 3,063
x=4 y = 98.86

Sxy - nxy 3,063 - (7)(4)(98.86)

b= 2 = = 10.54
Sx - nx2 140 - (7)(4 )
2

a = y - bx = 98.86 - 10.54(4) = 56.70

 Seasonal Variations In Data
Steps in the process:
1. Find average historical demand for each season
2. Compute the average demand over all seasons
3. Compute a seasonal index for each season
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the number of seasons, then
multiply it by the seasonal index for that season
Seasonal Index Example
Demand Average Average Seasonal
Month 2005 2006 2007 2005-2007 Monthly Index
Jan 80 85 105 90 94
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Apr 90 95 115 100 94
May 113 125 131 123 94
Jun 110 115 120 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
Seasonal Index Example
Demand Average Average Seasonal
Month 2005 2006 2007 2005-2007 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94
Mar 80 93 average
82 85 monthly demand
2005-2007 94
AprSeasonal90
index 95
= 115 average monthly
100 94
demand
May 113 125 131 123 94
Jun 110 115= 90/94
120 = .957 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
Seasonal Index Example
Demand Average Average Seasonal
Month 2005 2006 2007 2005-2007 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90 95 115 100 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 115 94 1.223
Jul 100 102 113 105 94 1.117
Aug 88 102 110 100 94 1.064
Sept 85 90 95 90 94 0.957
Oct 77 78 85 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
Seasonal Index Example
Demand Average Average Seasonal
Month 2005 2006 2007 2005-2007 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85Forecast for 2008
80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90 95Expected
115 annual demand
100 = 1,200 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 1,200 115 94 1.223
Jan 12 x .957 = 96
Jul 100 102 113 105 94 1.117
Aug 88 102 110 100 94 1.064
1,200
Sept 85 90Feb 95 90
x .851 = 85 94 0.957
12
Oct 77 78 85 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
Associative Forecasting
Used when changes in one or more independent
variables can be used to predict the changes in the
dependent variable

Most common technique is linear

regression analysis

We apply this technique just as we did in the

time series example
Associative Forecasting
Forecasting an outcome based on predictor
variables using the least squares technique

^
y = a + bx
^ where y = computed value of the variable to be
predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable though to predict the
value of the dependent variable
Associative Forecasting Example
Sales Local Payroll
($ millions), y ($ billions), x
2.0 1
3.0 3
2.5 4
2.0 2 4.0 –
2.0 1
3.0 –
3.5 7 Sales
2.0 –

1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
Associative Forecasting Example
Sales, y Payroll, x x2 xy
2.0 1 1 2.0
3.0 3 9 9.0
2.5 4 16 10.0
2.0 2 4 4.0
2.0 1 1 2.0
3.5 7 49 24.5
∑y = 15.0 ∑x = 18 ∑x2 = 80 ∑xy = 51.5

∑xy 51.5 - (6)(3)(2.5)

x = ∑x/6 = 18/6 = 3 b = - nxy = = .25
∑x2 - nx2 80 - (6)(3 )
2

y = ∑y/6 = 15/6 = 2.5 a = y - bx = 2.5 - (.25)(3) = 1.75

Associative Forecasting Example
^
y = 1.75 + .25x Sales = 1.75 + .25(payroll)

If payroll next year is

estimated to be $6 billion, 4.0 –
then:
3.25
3.0 –
Sales

Sales = 1.75 + .25(6) 2.0 –

Sales = $3,250,000
1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll