Forecasting Time Horizons

 Short-range forecast
 Up to 1 year, generally less than 3 months
 Purchasing, job scheduling, workforce
levels, job assignments, production levels
 Medium-range forecast
 3 months to 3 years
 Sales and production planning, budgeting
 Long-range forecast
 3+ years
 New product planning, facility location,
research and development
© 2006 Prentice Hall, Inc. 4–1
 Time Series Components

Trend Cyclical

Seasonal Random

© 2006 Prentice Hall, Inc. 4–2

 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
© 2006 Prentice Hall, Inc. 4–3
 Graph of Moving Average
Moving
30 –
Average
28 –
Forecast
26 – Actual
24 – Sales
Shed Sales

22 –
20 –
18 –
16 –
14 –
12 –
10 –
| | | | | | | | | | | |
J F M A M J J A S O N D

© 2006 Prentice Hall, Inc. 4–4

 Impact of Different 
225 –

Actual  = .5
200 – demand
Demand

175 –

 = .1
150 – | | | | | | | | |
1 2 3 4 5 6 7 8 9
Quarter

© 2006 Prentice Hall, Inc. 4–5

 Values of Dependent Variable
Least Squares Method

Actual observation Deviation7

(y value)

Deviation5 Deviation6

Deviation3

Deviation4

Deviation1
Deviation2
Trend line, y^ = a + bx

Time period Figure 4.4

© 2006 Prentice Hall, Inc. 4–6
 Values of Dependent Variable
Least Squares Method

Actual observation Deviation7

(y value)

Deviation5 Deviation6

Deviation3 Least squares method

minimizes the sum of the
Deviation
squared errors (deviations)
4

Deviation1
Deviation2
Trend line, y^ = a + bx

Time period Figure 4.4

© 2006 Prentice Hall, Inc. 4–7
 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
1999 1 74 1 74
2000 2 79 4 158
2001 3 80 9 240
2002 4 90 16 360
2003 5 105 25 525
2004 6 142 36 852
2005 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
∑x - nx
2 2 140 - (7)(4 2)

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

© 2006 Prentice Hall, Inc. 4–8
 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
1999 1 74 1 74
2000 2 79 4 158
2001The trend
3 line is 80 9 240
2002 4 90 16 360
2003 y^ 5= 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= = = 10.54
Sx - nx
2 2 140 - (7)(4 2)

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

© 2006 Prentice Hall, Inc. 4–9
 Least Squares Example
160 –
Trend line,
150 – y^ = 56.70 + 10.54x
140 –
Power demand

130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
50 –
| | | | | | | | |
1999 2000 2001 2002 2003 2004 2005 2006 2007
Year
© 2006 Prentice Hall, Inc. 4 – 10
 Associative Forecasting
Forecasting an outcome based on
predictor variables using the least squares
technique
y^ = a + bx

^ = computed value of the variable to

where y
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
© 2006 Prentice Hall, Inc. 4 – 11
 Associative Forecasting
Example
Sales Local Payroll
($000,000), y ($000,000,000), x
2.0 1
3.0 3
2.5 4 4.0 –
2.0 2
2.0 1 3.0 –
3.5 7 Sales
2.0 –

1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll

© 2006 Prentice Hall, Inc. 4 – 12

 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 - nxy 51.5 - (6)(3)(2.5)

x = ∑x/6 = 18/6 = 3 b=
∑x2 - nx2
= 80 - (6)(32) = .25

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

© 2006 Prentice Hall, Inc. 4 – 13

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

If payroll next year

4.0 –
is estimated to be
$600 million, then: 3.25
3.0 –
Sales
2.0 –
Sales = 1.75 + .25(6)
Sales = $325,000 1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
© 2006 Prentice Hall, Inc. 4 – 14
 Standard Error of the
Estimate
 A forecast is just a point estimate of a
future value
 This point is 4.0 –
actually the 3.25
mean of a 3.0 –
Sales
probability 2.0 –
distribution
1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
Figure 4.9
© 2006 Prentice Hall, Inc. 4 – 15
 Standard Error of the
Estimate

∑(y - yc)2
Sy,x =
n-2

where y = y-value of each data point

yc = computed value of the dependent
variable, from the regression
equation
n = number of data points

© 2006 Prentice Hall, Inc. 4 – 16

 Standard Error of the
Estimate
Computationally, this equation is
considerably easier to use

∑y2 - a∑y - b∑xy

Sy,x =
n-2

We use the standard error to set up

prediction intervals around the
point estimate

© 2006 Prentice Hall, Inc. 4 – 17

 Standard Error of the
Estimate
∑y2 - a∑y - b∑xy 39.5 - 1.75(15) - .25(51.5)
Sy,x = =
n-2 6-2

Sy,x = .306 4.0 –

3.25
3.0 –
Sales
The standard error
2.0 –
of the estimate is
$30,600 in sales 1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
© 2006 Prentice Hall, Inc. 4 – 18
 Correlation
 How strong is the linear
relationship between the
variables?
 Correlation does not necessarily
imply causality!
 Coefficient of correlation, r,
measures degree of association
 Values range from -1 to +1

© 2006 Prentice Hall, Inc. 4 – 19

 Correlation Coefficient
nSxy - SxSy
r=
[nSx2 - (Sx)2][nSy2 - (Sy)2]

© 2006 Prentice Hall, Inc. 4 – 20

 y
Correlation Coefficient y

n∑xy - ∑x∑y
r=
[n∑x 2 - (∑x)2][n∑y2 - (∑y)2]
(a) Perfect positive x (b) Positive x
correlation: correlation:
r = +1 0<r<1

y y

(c) No correlation: x (d) Perfect negative x

r=0 correlation:
r = -1
© 2006 Prentice Hall, Inc. 4 – 21
 Correlation
 Coefficient of Determination, r2,
measures the percent of change in
y predicted by the change in x
 Values range from 0 to 1
 Easy to interpret

For the Nodel Construction example:

r = .901
r2 = .81
© 2006 Prentice Hall, Inc. 4 – 22
 Multiple Regression
Analysis
If more than one independent variable is to be
used in the model, linear regression can be
extended to multiple regression to
accommodate several independent variables

y^ = a + b1x1 + b2x2 …

Computationally, this is quite

complex and generally done on the
© 2006 Prentice Hall, Inc.
computer 4 – 23
 Multiple Regression
Analysis
In the Nodel example, including interest rates in
the model gives the new equation:

y^ = 1.80 + .30x1 - 5.0x2

An improved correlation coefficient of r = .96

means this model does a better job of predicting
the change in construction sales

Sales = 1.80 + .30(6) - 5.0(.12) = 3.00

Sales = $300,000
© 2006 Prentice Hall, Inc. 4 – 24
 Monitoring and Controlling
Forecasts
Tracking Signal
 Measures how well the forecast is
predicting actual values
 Ratio of running sum of forecast errors
(RSFE) to mean absolute deviation (MAD)
 Good tracking signal has low values
 If forecasts are continually high or low, the
forecast has a bias error

© 2006 Prentice Hall, Inc. 4 – 25

 Monitoring and Controlling
Forecasts

Tracking RSFE
signal =
MAD

∑(actual demand in
period i -
forecast demand
Tracking in period i)
signal = (∑|actual - forecast|/n)

© 2006 Prentice Hall, Inc. 4 – 26

 Tracking Signal
Signal exceeding limit
Tracking signal
Upper control limit
+

0 MADs Acceptable
range

–
Lower control limit

Time

© 2006 Prentice Hall, Inc. 4 – 27

 Tracking Signal Example
Cumulative
Absolute Absolute
Actual Forecast Forecast Forecast
Qtr Demand Demand Error RSFE Error Error MAD

1 90 100 -10 -10 10 10 10.0

2 95 100 -5 -15 5 15 7.5
3 115 100 +15 0 15 30 10.0
4 100 110 -10 -10 10 40 10.0
5 125 110 +15 +5 15 55 11.0
6 140 110 +30 +35 30 85 14.2

© 2006 Prentice Hall, Inc. 4 – 28

 Tracking Signal Example
Tracking Cumulative
Absolute Absolute
Actual Signal
Forecast Forecast Forecast
Qtr (RSFE/MAD)
Demand Demand Error RSFE Error Error MAD

1 90-10/10
100= -1 -10 -10 10 10 10.0
2 95
-15/7.5
100= -2 -5 -15 5 15 7.5
3 115 0/10
100
= 0 +15 0 15 30 10.0
4 100-10/10
110= -1 -10 -10 10 40 10.0
5 125
+5/11110
= +0.5+15 +5 15 55 11.0
6 140
+35/14.2
110= +2.5
+30 +35 30 85 14.2

The variation of the tracking signal

between -2.0 and +2.5 is within acceptable
limits
© 2006 Prentice Hall, Inc. 4 – 29