OPERATIONS MANAGEMENT

14e

WILLIAM J. STEVENSON
Rochester Institute of Technology

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1999

 CHAPTER THREE

CHAPTER THREE
FORECASTING

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1999

 Learning Objectives

After completing this chapter, you should be able to:

•List features common to all forecasts.
•Explain why forecasts are generally wrong.
•List the elements of a good forecast.
•Outline the steps in the forecasting process.
•Describe four qualitative forecasting techniques.
•Describe the key factors and trade-offs to consider when
choosing a forecasting technique
 3.1. Introduction

• A forecast is an estimate about the future value of a variable such

as demand.
• The better the estimate, the more informed decisions can be.
Some forecasts are long range, covering several years or more.
• Forecasts are a basic input in the decision processes of operations
management because they provide information on future
demand.
• The primary goal of operations management is to match supply
to demand.
 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
• Budgeting
3.2. Features common to all forecasts

• A wide variety of forecasting techniques are in use.

• In many respects, they are quite different from each other, as
you shall soon discover. Nonetheless, certain features are
common to all, and it is important to recognize them;
1. Forecasts are not perfect; actual results usually differ from
predicted values; the presence of randomness precludes a
perfect forecast. Allowances should be made for forecast
errors
2. Forecasts for groups of items tend to be more accurate
than forecasts for individual items because forecasting
errors among items in a group usually have a canceling
effect.
3. Forecast accuracy decreases as time horizon increases.
 3.3 Elements of a Good Forecast

Timely

it ve
c
ff e
Reliable Accurate t e
o s
C
se
f ul u
ng Written to
ni sy
e a Ea
M
3.4 Steps in the Forecasting Process

“The forecast”

Step 6 Monitor the forecast

Step 5 Make the forecast
Step 4 Gather and analyze data
Step 3 Select a forecasting technique
Step 2 Establish a time horizon
Step 1 Determine purpose of forecast
 3.5 approaches to forecasting

• There are two general approaches to forecasting:

qualitative and quantitative.
• Qualitative methods consist mainly of subjective inputs,
which often defy precise numerical description.
• Quantitative methods involve either the projection of
historical data or the development of associative models
that attempt to utilize causal (explanatory) variables to
make a forecast.
• Qualitative techniques permit inclusion of soft
information (e.g., human factors, personal opinions,
hunches) in the forecasting process.
• Those factors are often omitted or downplayed when
quantitative techniques are used because they are
difficult or impossible to quantify.
• Quantitative techniques consist mainly of analyzing
objective, or hard, data. They usually avoid personal
biases that sometimes contaminate qualitative methods.
In practice, either approach, or a combination of both
approaches, might be used to develop a forecast.
• The following pages present a variety of forecasting
techniques that are classified as judgmental, time-series, or
associative.

• Judgmental - uses subjective inputs (qualitative)

• Time series - uses historical data assuming the future will
be like the past (quantitative)

• Associative models - uses explanatory variables to predict

the future
 3.6 Judgmental Forecasts
(Qualitative)
•E xecutive opinions.
• Opinions of managers and staff

•Sales force.

•C onsumer surveys.

•D elphi method.
1. Executive Opinions
• A small group of upper-level managers (e.g., in
marketing, operations, and finance) may meet and
collectively develop a forecast.
• This approach is often used as a part of long-range
planning and new product development. It has the
advantage of bringing together the considerable
knowledge and talents of various managers.
• However, there is the risk that the view of one
person will prevail, and the possibility that diffusing
responsibility for the forecast over the entire group
may result in less pressure to produce a good
forecast
2. Sales force Opinions
• Members of the sales staff or the customer service staff are
often good sources of information because of their direct
contact with consumers.
• They are often aware of any plans the customers may be
considering for the future.
• There are, however, several drawbacks to using sales force
opinions.:
• The staff members may be unable to distinguish between what
customers would like to do and what they actually will do.
• The people are sometimes overly influenced by recent experiences.
• In addition, if forecasts are used to establish sales quotas, there will
be a conflict of interest because it is to the salesperson’s advantage
to provide low sales estimates.
3. Consumer Surveys
• The organizations seeking consumer input usually resort to consumer
surveys, which enable them to sample consumer opinions.
I. The obvious advantage of consumer surveys is that they can tap
information that might not be available elsewhere.
II. On the other hand, a considerable amount of knowledge and skill is
required to construct a survey, administer it, and correctly interpret the
results for valid information.
III. Surveys can be expensive and time-consuming.
IV. In addition, even under the best conditions, surveys of the general
public must contend with the possibility of irrational behavior patterns.
Along the same lines, low response rates to a mail survey should—but
often don’t— make the result suspect
I. If these and similar pitfalls can be avoided, surveys can produce useful
information
4. Other Approaches
• A manager may solicit opinions from a number of other
managers and staff people.
• Occasionally, outside experts are needed to help with a
forecast. Advice may be needed on political or
economic conditions in the country or a foreign country,
or some other aspect of importance with which an
organization lacks familiarity.
• Another approach is the Delphi method, an iterative
process intended to achieve a consensus forecast.
• This method involves circulating a series of
questionnaires among individuals who possess the
knowledge and ability to contribute meaningfully.
 Time Series Forecasts
(Quantitative)
• A time series is a time-ordered sequence of observations
taken at regular intervals (e.g., hourly, daily, weekly,
monthly, quarterly, annually). The data may be
measurements of demand, sales, earnings, profits, shipments,
accidents, output, precipitation, productivity, or the
consumer price index.
• Forecasting techniques based on time-series data are
made on the assumption that future values of the series
can be estimated from past values.
• Analysis of time-series data requires the analyst to identify
the underlying behavior of the series. This can often be
accomplished by merely plotting the data and visually
examining the plot.
• One or more patterns might appear: trends, seasonal
variations, cycles, or variations around an average
• In addition, there will be random and perhaps irregular
variations. These behaviors can be described as follows:
• Trend refers to a long-term upward or downward movement
in the data.
• Seasonality refers to short-term, fairly regular variations
generally related to factors such as the calendar or time of
day. Restaurants, and supermarkets, weekly and even daily
“seasonal” variations.
3. Cycles are wave like variations of more than one year’s
duration. These are often related to a variety of economic,
political, and even agricultural conditions.
4. Irregular variations are due to unusual circumstances
such as severe weather conditions, strikes, or a major
change in a product or service. Whenever possible, these
should be identified and removed from the data.
5. Random variations are residual variations that remain
after all other behaviors have been accounted for
 Forecast Variations
Figure 3-1

Irregular
variation

Trend

cycle
Cycles

90
89
88
Seasonal variations
 The Forecasting Techniques

• Naïve
• Simple Moving Average
• Weighted Moving Average
• Exponential Smoothing
• ES with Trend.
 Naïve Forecast

• Naive forecast : A forecast for any period that

equals the previous period’s actual value.
• Simple to use
• Virtually no cost
• Data analysis is nonexistent
• Easily understandable
• Cannot provide high accuracy
• For example, forecast for July = Actual for June
• Ft+1 = At
• FJul= AJun= 600
• Forecast Very Sensitive to Demand Changes; Good for stable
demand
• 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:
Techniques for Averaging
1. 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. The
moving average forecast can be computed using the
following equation:
• For example, MA3 would refer to a three-period moving
average forecast, and MA5 would refer to a five-period
moving average forecast.
• Compute a three-period moving average forecast given
demand for shopping carts for the last five periods.
Solution
 Points to Know on Moving Averages

• Pro: Easy to compute and understand

• Con: All data points were created equal
2. Weighted Moving Average
• A weighted average is similar to a moving average, except
that it typically assigns more weight to the most recent
values in a time series.
• For instance, the most recent value might be assigned a
weight of .40, the next most recent value a weight of .30, the
next after that a weight of .20, and the next after that a
weight of .10.
• Note that the weights must sum to 1.00, and that the heaviest
weights are assigned to the most recent values.
Example, Computing a Weighted Moving Average
•Given the following demand data,
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.

Period Demand
1 42
2 40
3 43
Solution 4 40
5 41
a. F6 = .10( 40 ) + .20( 43 ) + .30( 40 ) + .40( 41 ) = 41.0
b.F 7 = .10( 43 ) + .20( 40 ) + .30( 41 ) + .40( 39 ) = 40.2
3. Exponential Smoothing
• Exponential smoothing is a sophisticated weighted
averaging method that is still relatively easy to use and
understand.
• Each new forecast is based on the previous forecast plus a
percentage of the difference between that forecast and the
actual value of the series at that point. That is:
• The smoothing constant α represents a percentage of the
forecast error. Each new forecast is equal to the previous
forecast plus a percentage of the previous error. For
example, suppose the previous forecast was 42 units, actual
demand was 40 units, and α = .10. The new forecast would
be computed as follows:
• F t = 42 + .10(40 − 42 ) = 41.8
• Then, if the actual demand turns out to be 43, the next
forecast would be
• F t = 41.8 + .10(43 − 41.8 ) = 41.92
• An alternate form of Formula 3–3a reveals the weighting of the
previous forecast and the latest actual demand:
• F t = (1 − α) F t−1 + α A t−1 ......... (3–3b)
• For example, if α = .10, this would be
• F t = .90 F t−1 + .10 A t−1

• 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).
• Conversely, the closer the value of α is to 1.00, the greater the
responsiveness and the less the smoothing
This is illustrated in Figure 3.4B.
 Techniques for Trend
• Analysis of trend involves developing an equation that will
suitably describe trend (assuming that trend is present in the
data). The trend component may be linear, or it may not.
The discussion here focuses exclusively on linear trends
because these are fairly common.
 Linear Trend Equation Example
t y
Week t2 Sales ty
1 1 150 150
2 4 157 314
3 9 162 486
4 16 166 664
5 25 177 885

 t = 15 t2 = 55  y = 812  ty = 2499

(t)2 = 225
 Linear Trend Calculation

5 (2499) - 15(812) 12495 -12180

b = = = 6.3
5(55) - 225 275 - 225

812 - 6.3(15)
a = = 143.5
5

y = 143.5 + 6.3t
 Disadvantage of simple linear regression

1. Apply only to linear relationship with an independent

variable.
2. One needs a considerable amount of data to establish the
relationship ( at least 20).
3. All observations are weighted equally
 Forecast Accuracy
• Forecast error
difference between forecast and actual demand
•MAD
• mean absolute deviation
•MAPD
• mean absolute percent deviation
•Cumulative error
•Average error or bias
1. Mean Absolute Deviation (MAD)

 At - Ft 
MAD = n
where
t = period number
At = demand in period t
Ft = forecast for period t
n = total number of periods
= absolute value
 MAD Example

PERIOD DEMAND, At Ft ( =0.3) ( A t - F t) |A t - F t|

1 37 37.00 – –
2 40 37.00 3.00 3.00
3 41 37.90 3.10 3.10
4 37 38.83 -1.83 1.83
5 45 38.28 6.72 6.72
6 50 40.29 9.69 9.69
7 43 43.20 -0.20 0.20
8 47 43.14 3.86 3.86
9 56 44.30 11.70 11.70
10 52 47.81 4.19 4.19
11 55 49.06 5.94 5.94
12 54 50.84 3.15 3.15
557 49.31 53.39
  At - Ft 
MAD = n
53.39
=
11
= 4.85
Other Accuracy Measures

2. Mean absolute percent deviation (MAPD)

|At - Ft|
MAPD =
At
3. Cumulative error
E = et
4. Average error
et
(E )=
n
Comparison of Forecasts

FORECAST MAD MAPD E ( E)

Exponential smoothing (= 0.30) 4.85 9.6% 49.31 4.48
Exponential smoothing (= 0.50) 4.04 8.5% 33.21 3.02
(= 0.50, = 0.30)
 Forecast Control
• Tracking signal
• monitors the forecast to see if it is biased high
or low

(At - Ft) E
Tracking signal = =
MAD MAD
 Tracking Signal Values
DEMAND FORECAST, ERROR E = TRACKING
PERIOD At Ft At - Ft (At - Ft) MAD SIGNAL

1 37 37.00 – – – –
2 40 37.00 3.00 3.00 3.00 1.00
3 41 37.90 3.10 6.10 3.05 2.00
4 37 38.83 -1.83 4.27 2.64 1.62
5 45 38.28 6.72 10.99 3.66 3.00
6 50 40.29 9.69 20.68 4.87 4.25
7 43 43.20 -0.20 20.48 4.09 5.01
8 47 43.14 3.86 24.34 4.06 6.00
9 56 44.30 11.70 36.04 5.01 7.19
10 52 47.81 4.19 40.23 4.92 8.18
11 55 49.06 5.94 46.17 5.02 9.20
12 54 50.84 3.15 49.32 4.85 10.17
Tracking signal for period 3

TS3 = 6.10 = 2.00

3.05
 Sources of forecast errors
• The model may be inadequate.
• Irregular variation may be occur.
• The forecasting technique may be used incorrectly or the
results misinterpreted.
• There are always random variation in the data.
 End Notes
• The two most important factors in choosing a
forecasting technique:
• Cost
• Accuracy
• Keep it SIMPLE!
END