FORECASTING FUNDAMENTALS
Forecast: A prediction, projection, or estimate of some future activity, event, or
occurrence.
Types of Forecasts
- Economic forecasts
o Predict a variety of economic indicators, like money supply, inflation
rates, interest rates, etc.
- Technological forecasts
o Predict rates of technological progress and innovation.
- Demand forecasts
o Predict the future demand for a company’s products or services.
Since virtually all the operations management decisions (in both the strategic
category and the tactical category) require as input a good estimate of future
demand, this is the type of forecasting that is emphasized in our textbook and
in this course.
TYPES OF FORECASTING METHODS
Qualitative methods: These types of forecasting methods are based on
judgments, opinions, intuition, emotions, or personal experiences and are
subjective in nature. They do not rely on any rigorous mathematical computations.
Quantitative methods: These types of forecasting methods are based on
mathematical (quantitative) models, and are objective in nature. They rely
heavily on mathematical computations.
QUALITATIVE FORECASTING METHODS
Qualitative Methods
Executive Market Sales Force Delphi
Opinion Survey Composite Method
Approach in which Approach that uses Approach in which Approach in which
a group of interviews and each salesperson consensus
managers meet surveys to judge estimates sales in agreement is
and collectively preferences of his or her region reached among a
develop a forecast customer and to group of experts
assess demand
QUANTITATIVE FORECASTING METHODS
Quantitative Methods
Time-Series Models Associative Models
Time series models Associative models
look at past patterns (often called causal
of data and attempt models) assume that the
to predict the future variable being
based upon the forecasted is related to
underlying patterns other variables in the
contained within environment. They try
those data. to project based upon
those associations.
TIME SERIES MODELS
Model Description
Naïve Uses last period’s actual value as a forecast
Simple Mean (Average) Uses an average of all past data as a forecast
Uses an average of a specified number of the most
Simple Moving Average recent observations, with each observation receiving the
same emphasis (weight)
Uses an average of a specified number of the most
Weighted Moving Average recent observations, with each observation receiving a
different emphasis (weight)
A weighted average procedure with weights declining
Exponential Smoothing
exponentially as data become older
Technique that uses the least squares method to fit a
Trend Projection
straight line to the data
A mechanism for adjusting the forecast to accommodate
Seasonal Indexes
any seasonal patterns inherent in the data
Time series
a. Trend: Data exhibit a steady growth or decline over time.
b. Seasonality: Data exhibit upward and downward swings in a short to intermediate time
frame (most notably during a year).
c. Cycles: Data exhibit upward and downward swings in over a very long time frame.
d. Random variations: Erratic and unpredictable variation in the data over time with
no discernable pattern.
ILLUSTRATION OF TIME SERIES DECOMPOSITION
Hypothetical Pattern of Historical Demand
Demand
Time
TREND COMPONENT IN HISTORICAL DEMAND
Demand
Time
SEASONAL COMPONENT IN HISTORICAL DEMAND
Demand
Year 1 Year 2 Year 3 Time
CYCLE COMPONENT IN HISTORICAL DEMAND
Demand
Many years or decades Time
RANDOM COMPONENT IN HISTORICAL DEMAND
Demand
Time
Naïve method: The forecast for next period (period t+1) will be equal to this period's
actual demand (At).
Mean (simple average) method: The forecast for next period (period t+1) will be equal to the
average of all past historical demands.
Simple moving average method: The forecast for next period (period t+1) will be equal to
the average of a specified number of the most recent observations, with each observation
receiving the same emphasis (weight).
Weighted moving average method: The forecast for next period (period t+1) will be equal to a
weighted average of a specified number of the most recent observations.
Exponential smoothing method: The new forecast for next period (period t) will be
calculated as follows:
New forecast = Last period’s forecast + (Last period’s actual demand – Last period’s forecast)
(this box contains all you need to know to apply exponential smoothing)
Ft = Ft-1 + (At-1 – Ft-1) (equation 1)
Ft = At-1 + (1-)Ft-1(alternate equation 1 – a bit more user friendly)
Where is a smoothing coefficient whose value is between 0 and 1.
The exponential smoothing method only requires that you dig up two pieces of data to
apply it (the most recent actual demand and the most recent forecast).
An attractive feature of this method is that forecasts made with this model will include a
portion of every piece of historical demand. Furthermore, there will be different weights
placed on these historical demand values, with older data receiving lower weights. At first
glance this may not be obvious, however, this property is illustrated on the following page.
Trend projection method: This method is a version of the linear regression technique. It
attempts to draw a straight line through the historical data points in a fashion that comes as close
to the points as possible. (Technically, the approach attempts to reduce the vertical deviations of
the points from the trend line, and does this by minimizing the squared values of the deviations
of the points from the line). Ultimately, the statistical formulas compute a slope for the trend
line
(b) and the point where the line crosses the y-axis (a). This results in the straight line
equation Y = a + bX
Where X represents the values on the horizontal axis (time), and Y represents the values on the
vertical axis (demand)
