MBA 2038

Operations Management

Forecasting

Nov 2011

Engr. Jovenal M. Arnaiz, PME,MMBM

Operations Management

Module 4: Forecasting

Learning Objectives
Identify or Define:
Forecasting & strategic importance Types of forecasts Time horizons

Approaches to forecasts
Moving averages Exponential smoothing

Trend projections
Regression and correlation analysis Measures of forecast accuracy

What is Forecasting?
Art and science of predicting a future event. Underlying basis of all business decisions
Production Inventory Personnel Facilities

??

Resource Planning

Sales and operations planning

Master production scheduling

Demand management

Front End

Detailed capacity planning

Detailed material planning

Material and capacity plans

Engine

Shop-floor systems

Supplier systems

Back end

Manufacturing Planning and Control System

Strategic Importance of Forecasting

Human Resources Hiring, training, laying off workers
Capacity Capacity shortages can result in undependable delivery, loss of customers, loss of market share Supply-Chain Management Good supplier relations and price advance

Forecasting Time Horizons

Long-range forecast

3+ years New product planning, facility location, research and development

Medium-range forecast

3 months to 3 years Sales and production planning, budgeting

Short-range forecast

Up to 1 year, generally less than 3 months Purchasing, job scheduling, workforce levels, job assignments, production levels

Influence of Product Life Cycle

Introduction Growth Maturity Decline

Introduction and growth require longer forecasts than maturity and decline As product passes through life cycle, forecasts are useful in projecting

Staffing levels Inventory levels Factory capacity

Product Life Cycle

Introduction
Product design and development critical Frequent product and process design changes Short production runs High production costs

Growth
Forecasting critical Product and process reliability Competitive product improvements and options Increase capacity Shift toward product focus

Maturity
Standardization Less rapid product changes more minor changes

Decline
Little product differentiation Cost minimization

OM Strategy/Issues

Optimum capacity
Increasing stability of process Long production runs Product improvement and cost cutting

Overcapacity in the industry

Prune line to eliminate items not returning good margin

Limited models
Attention to quality

Enhance distribution

Reduce capacity

Figure 2.5

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 product

Seven Steps in Forecasting

o o o

o o o o

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

The Realities!
Forecasts are seldom perfect
Most techniques assume an underlying stability in the system Product family and aggregated forecasts are more accurate than individual product forecasts

Forecasting Approaches
Qualitative Methods
Used when situation is vague and little data exist, i.e. new products, new technology Involves intuition, experience, e.g., forecasting sales on Internet

Quantitative Methods
Used when situation is stable and historical data exist, i.e. existing products, current technology Involves mathematical techniques, e.g., forecasting sales of color televisions

Overview of Qualitative Methods

Jury of executive opinion Delphi method Sales force composite

Consumer Market Survey

Nave

Overview of Quantitative Approaches

Moving averages

Exponential smoothing Trend projection

Time-Series Models

Associative Model

Linear regression

Time Series Forecasting

Set of evenly spaced numerical data Obtained by observing response variable at regular time periods Forecast based only on past values Assumes that factors influencing past and present will continue influence in future

Components of Demand
Trend component
Demand for product or service

Seasonal peaks

Actual demand Average demand over four years

| 3 | 4
Figure 4.1

Random variation
| 1 | 2 Year

Moving Average Method

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

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 moving average =

weights

Exponential Smoothing
New forecast = last periods forecast + a (last periods actual demand last periods 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)

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
^ = a + bX y where ^ = computed value of the variable to be y 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 (y value)
Deviation5 Deviation3 Deviation4 Deviation1

Deviation7

Deviation6

Deviation2

Trend line, y^ a + bx =

Time period

Figure 4.4

Least Squares Method

Values of Dependent Variable
Actual observation (y value)
Deviation5 Deviation3

Deviation7

Deviation6

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

Least Squares Method

Equations to calculate the regression variables
^ y = a + bX

b=

Sxy - nxy Sx2 - nx2

a = y - bx

Common Measures of Error

Mean Absolute Deviation (MAD)
MAD = |actual - forecast| n

Mean Squared Error (MSE)

(forecast errors)2 MSE = n

Mean Absolute Percent Error (MAPE)

n

100 |actuali - forecasti|/actuali MAPE =

i=1

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

Standard Error of the Estimate

(y - yc)2
n-2

Sy,x =
where

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

Standard Error of the Estimate

Computationally, this equation is considerably easier to use Sy,x = y2 - ay - bxy n-2

We use the standard error to set up prediction intervals around the point estimate

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

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

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

Monitoring and Controlling Forecasts

Tracking RSFE Signal = MAD

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

Tracking Signal
Signal exceeding limit Tracking signal + 0 MADs

Upper control limit

Acceptable range

Lower control limit Time

End of module 4