Forecasting

McGraw-Hill/Irwin
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 You should be able to:
1. List the elements of a good forecast
2. Outline the steps in the forecasting process
3. Describe at least three qualitative forecasting techniques
and the advantages and disadvantages of each
4. Compare and contrast qualitative and quantitative
approaches to forecasting
5. Describe averaging techniques, trend and seasonal
techniques, and regression analysis, and solve typical
problems
6. Explain three measures of forecast accuracy
7. Compare two ways of evaluating and controlling forecasts
8. Assess the major factors and trade-offs to consider when
choosing a forecasting technique

Instructor Slides 3-2

Forecast a statement about the future
value of a variable of interest
We make forecasts about such things as
weather, demand, and resource availability
Forecasts are an important element in making
informed decisions

Instructor Slides 3-3

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

Instructor Slides 3-4

1. Techniques assume some underlying causal
system that existed in the past will persist into
the future
2. Forecasts are not perfect
3. Forecasts for groups of items are more accurate
than those for individual items
4. Forecast accuracy decreases as the forecasting
horizon increases

Instructor Slides 3-5

The forecast
should be timely
should be accurate
should be reliable
should be expressed in meaningful units
should be in writing
technique should be simple to understand and use
should be cost effective

Instructor Slides 3-6

1. Determine the purpose of the forecast
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

Instructor Slides 3-7

Forecasters want to minimize forecast errors
It is nearly impossible to correctly forecast real-
world variable values on a regular basis
So, 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 accuracy should be an important
forecasting technique selection criterion
Error = Actual Forecast
If errors fall beyond acceptable bounds,
corrective action may be necessary

Instructor Slides 3-8

MAD
Actual t Forecast t MAD weights all errors
n evenly

Actual t Forecast t
2
MSE weights errors according
MSE to their squared values
n 1

Actual t Forecast t
Actualt
100
MAPE weights errors
MAPE
n according to relative error
Instructor Slides 3-9
 Actual Forecast (A-F)
Period
(A) (F) Error |Error| Error2 [|Error|/Actual]x100
1 107 110 -3 3 9 2.80%

2 125 121 4 4 16 3.20%

3 115 112 3 3 9 2.61%

4 118 120 -2 2 4 1.69%

5 108 109 1 1 1 0.93%

Sum 13 39 11.23%

n=5 n-1 = 4 n=5

MAD MSE MAPE

= 2.6 = 9.75 = 2.25%

Instructor Slides 3-10
 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

Instructor Slides 3-11

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

Instructor Slides 3-12

Trend
Seasonality
Cycles
Irregular variations
Random variation

Instructor Slides 3-13

Instructor Slides 3-14
Nave 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 periods value
Can be used with
a stable time series
seasonal variations
trend

Instructor Slides 3-15

These Techniques work best when a series
tends to vary about an average
Averaging techniques smooth variations in the
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

Instructor Slides 3-16

Technique that averages a number of the
most recent actual values in generating a
forecast n

At i
Ft MA n i 1
n
where
Ft Forecast for time period t
MA n n period moving average
At 1 Actual value in period t 1
n Number of periods in the moving average
Instructor Slides 3-17
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 models sensitivity
Fewer data points used-- more responsive
More data points used-- less responsive

Instructor Slides 3-18

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
Ft wt ( At ) wt 1 ( At 1 ) ... wt n ( At n )
where
wt weight for period t , wt 1 weight for period t 1, etc.
At the actual value for period t , At 1 the actual value for period t 1, etc.

Instructor Slides 3-19

A weighted averaging method that is based
on the previous forecast plus a percentage of
the forecast error
Ft Ft 1 ( At 1 Ft 1 )
where
Ft Forecast for period t
Ft 1 Forecast for the previous period
= Smoothing constant
At 1 Actual demand or sales from the previous period

Instructor Slides 3-20

Linear trend equation
Non-linear trends

Instructor Slides 3-21

A simple data plot can reveal the existence
and nature of a trend
Linear trend equation

Ft a bt
where
Ft Forecastforperiodt
a ValueofFt att 0
b Slopeoftheline
t Specifiednumberoftimeperiodsfromt 0

Instructor Slides 3-22

Slope and intercept can be estimated from
historical data
n ty t y
b
n t t
2
2

a
y b t
or y bt
n
where
n Numberofperiods
y Valueofthetimeseries

Instructor Slides 3-23
 The trend adjusted forecast consists of two
components
Smoothed error
Trend factor

TAFt +1 St Tt
where
St Previousforecastplussmoothederror
Tt Currenttrendestimate

Instructor Slides 3-24

Alpha and beta are smoothing constants

Trend-adjusted exponential smoothing has the
ability to respond to changes in trend

TAFt +1 St Tt
St TAFt + At TAFt
Tt Tt1 TAFt TAFt1 Tt1

Instructor Slides 3-25

 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

Instructor Slides 3-26

Instructor Slides 3-27
 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
nonseasonal (e.g., trend) components of the data
series
Divide each data point by its seasonal relative
To incorporate seasonality in a forecast
1. Obtain trend estimates for desired periods using a
trend equation
2. Add seasonality by multiplying these trend estimates
by the corresponding seasonal relative

Instructor Slides 3-28

 Cycles are similar to seasonal variations but are
of longer duration
Explanatory approach
Search for another variable that relates to, and leads,
the variable of interest
Housing starts precede demand for products and
services directly related to construction of new homes
If a high correlation can be established with a leading
variable, an equation can be developed that
describes the relationship, enabling forecasts to be
made

Instructor Slides 3-29

Associative techniques are based on the
development of an equation that
summarizes the effects of predictor
variables
Predictor variables - variables that can be
used to predict values of the variable of interest
Home values may be related to such factors as home
and property size, location, number of bedrooms, and
number of bathrooms

Instructor Slides 3-30

Regression - a technique for fitting a line to
a set of data points
Simple linear regression - the simplest form of
regression that involves a linear relationship
between two variables
The object of simple linear regression is to obtain
an equation of a straight line that minimizes the
sum of squared vertical deviations from the line
(i.e., the least squares criterion)

Instructor Slides 3-31

 yc a bx
where
yc Predicted (dependent) variable
x Predictor (independent) variable
b Slope of the line
a Value of yc when x 0 (i.e., the height of the line at the y intercept)
and
n xy x y
b

n x2 x
2

a
y b x
or y b x
n
where
n Number of paired observations
Instructor Slides 3-32
Standard error of estimate
A measure of the scatter of points around a
regression line
If the standard error is relatively small, the
predictions using the linear equation will tend to
be more accurate than if the standard error is
larger
y y
2
c
Se
n2
where
S e standard error of estimate
y y value of each data point
n number of data points
Instructor Slides 3-33
 Correlation, r
A measure of the strength and direction of relationship
between two variables
Ranges between -1.00 and +1.00

n xy x y
r
n x 2 x n y 2 y
2 2

r2, square of the correlation coefficient

A measure of the percentage of variability in the values
of y that is explained by the independent variable
Ranges between 0 and 1.00

Instructor Slides 3-34

1. Variations around the line are random
2. Deviations around the average value (the
line) should be normally distributed
3. Predictions are made only within the range
of observed values

Instructor Slides 3-35

Always plot the line to verify that a linear
relationship is appropriate
The data may be time-dependent.
If they are
use analysis of time series
use time as an independent variable in a multiple
regression analysis
A small correlation may indicate that other
variables are important

Instructor Slides 3-36

 Tracking forecast errors and analyzing them can provide
useful insight into whether forecasts are performing
satisfactorily
Sources of forecast errors
The model may be inadequate
Irregular variations may have occurred
The forecasting technique has been incorrectly
applied
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

Instructor Slides 3-37

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

Instructor Slides 3-38

 Reactive approach
View forecasts as probable future demand
React to meet that demand
Proactive approach
Seeks to actively influence demand
Advertising
Pricing
Product/service modifications
Generally requires either an explanatory model or a
subjective assessment of the influence on demand

Instructor Slides 3-39

 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

Instructor Slides 3-40