Operations

Management
Topic 2 – Forecasting

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 Learning outcomes

At the end of this lesson students should be able to :

1. Discuss the overview of forecasting techniques
2. Compare and contrast qualitative and quantitative
approaches to forecasting
3. Apply the naive, moving averages, weighted moving averages
and exponential smoothing methods.
4. Compute and analyze three measures of forecast accuracy;
MAD, MSE and MAPE

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 What is Forecasting?
1. Process of predicting a
future event Hmm…. you are
going to get an A for
2. Underlying basis of this subject. But!!!

all business decisions

 Production
 Inventory
 Personnel
 Facilities

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 Forecasting Time Horizons
1. Short-range forecast
 Up to 1 year, generally less than 3 months
 Purchasing, job scheduling, workforce levels, job
assignments, production levels
2. Medium-range forecast
 3 months to 3 years
 Sales and production planning, budgeting
3. Long-range forecast
 3+ years
 New product planning, facility location, research and
development

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 Seven Steps in Forecasting
1. Determine the use of the forecast
2. Select the items to be forecasted
3. Determine the time horizon of the
forecast
4. Select the forecasting model(s)
5. Gather the data
6. Make the forecast
7. Validate and implement results
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 Types of Forecasts
1. Economic forecasts
 Address business cycle – inflation rate, money
supply, housing starts, etc.
2. Technological forecasts
 Predict rate of technological progress
 Impacts development of new products
3. Demand forecasts
 Predict sales of existing products and services

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 Strategic Importance of Forecasting

1. Human Resources – Hiring, training, laying

off workers
2. Capacity – Capacity shortages can result in
undependable delivery, loss of customers,
loss of market share
3. Supply Chain Management – Good supplier
relations and price advantages

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 The Realities!

1. Forecasts are seldom perfect

2. Most techniques assume an underlying
stability in the system
3. Product family and aggregated forecasts
are more accurate than individual product
forecasts

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 Forecasting Methods
Generally there are two types of forecasting
methods; Qualitative and Quantitative
Methods
1. Qualitative methods are based on:
 judgment
 opinion
 past experience
 best guesses

2. Quantitative methods are based on:

 mathematical methods
 two traditional types; time series and regression

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

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 Forecasting Approaches
Quantitative Methods
 Used when situation is ‘stable’ and
historical data exist
 Existing products
 Current technology
 Involves mathematical techniques
 e.g., forecasting sales of color televisions

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 Overview of Quantitative
Approaches
1. Naive approach
2. Moving averages
3. Weighted Moving Averages Time-Series
Models
4. Exponential smoothing
5. Trend projection
Associative
6. Linear regression Model

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 Time Series Forecasting
 Set of evenly spaced numerical data
 Obtained by observing response variable at
regular time periods
 Forecast based only on past values, no
other variables important
 Assumes that factors influencing past and
present will continue influence in future

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 Time Series Components

Trend Cyclical

Seasonal Random

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 Components of Demand
Trend
component
Seasonal peaks
Demand for product or service

Actual
demand

Average demand
over four years
Random
variation
| | | |
1 2 3 4
Year Figure 4.1
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 Trend Component
1. Persistent, overall upward or
downward pattern
2. Changes due to population,
technology, age, culture, etc.
3. Typically several years duration

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 Seasonal Component
1. Regular pattern of up and down
fluctuations
2. Due to weather, customs, etc.
3. Occurs within a single year
Number of
Period Length Seasons
Week Day 7
Month Week 4-4.5
Month Day 28-31
Year Quarter 4
Year Month 12
Year Week
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 Cyclical Component
1. Repeating up and down movements
2. Affected by business cycle, political, and
economic factors
3. Multiple years duration
4. Often causal or
associative
relationships
0 5 10 15 20
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 Random Component
1. Erratic, unsystematic, ‘residual’
fluctuations
2. Due to random variation or unforeseen
events
3. Short duration and
non-repeating

M T W T F
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 Naive Approach
 Assumes demand in next
period is the same as
demand in most recent period
 e.g., If January sales were 68, then
February sales will be 68
 Sometimes cost effective and efficient
 Can be good starting point

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 Techniques for Averaging

1. Moving average
2. Weighted moving average
3. Exponential smoothing

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 Moving Average Method
1. MA is a series of arithmetic means
2. Used if little or no trend
3. Used often for smoothing
 Provides overall impression of data over
time

∑ demand in previous n periods

Moving average =
n
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 Moving Average Example
Actual 3-Month
Month Sales Moving Average
January 10
February 12
March 13
April 16 (10 + 12 + 13)/3 = 11 2/3
May 19 (12 + 13 + 16)/3 = 13 2/3
June 23 (13 + 16 + 19)/3 = 16
July 26 (16 + 19 + 23)/3 = 19 1/3

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 Graph of Moving Average

Moving
30 –
Average
28 –
Forecast
26 – Actual
24 – Sales
22 –
Sales

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

1. Used when trend is present

 Older data usually less important
2. Weights based on experience and
intuition

∑ (weight for period n)

Weighted x (demand in period n)
moving average = ∑ weights

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 Weights Applied Period
Weighted Moving Average
3 Last month
2 Two months ago
1 Three months ago
6 Sum of weights

Actual 3-Month Weighted

Month Sales Moving Average
January 10
February 12
March 13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 = 121/6
May 19 [(3 x 16) + (2 x 13) + (12)]/6 = 141/3
June 23 [(3 x 19) + (2 x 16) + (13)]/6 = 17
July 26 [(3 x 23) + (2 x 19) + (16)]/6 = 201/2

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 Moving Average And
Weighted Moving Average
Weighted
30 – moving
average
25 –
Sales demand

20 – Actual
sales
15 –
Moving
10 – average

5 –
| | | | | | | | | | | |
J F M A M J J A S O N D
Figure 4.2
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 Potential Problems With
Moving Average

1. Increasing n smoothens the forecast but

makes it less sensitive to changes
2. Do not forecast trends well
3. Require extensive historical data

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 Exponential Smoothing

1. Form of weighted moving average

 Weights decline exponentially
 Most recent data weighted most
2. Requires smoothing constant ()
 Ranges from 0 to 1
 Subjectively chosen
3. Involves little record keeping of past data

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 Exponential Smoothing
Remember This!!!!!!!!
New forecast = Last period’s forecast
+  (Last period’s actual demand
– Last period’s forecast)

Ft = Ft – 1 + (At – 1 - Ft – 1)

where Ft = new forecast

Ft – 1 = previous forecast
 = smoothing (or weighting)
constant (0 ≤  ≤ 1)
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 Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs

Actual demand = 153
Smoothing constant  = .20

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 Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs

Actual demand = 153
Smoothing constant  = .20

New forecast = 142 + .2(153 – 142)

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 Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs

Actual demand = 153
Smoothing constant  = .20

New forecast = 142 + .2(153 – 142)

= 142 + 2.2
= 144.2 ≈ 144 cars

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 Forecast Error

The objective is to obtain the most accurate

forecast no matter the technique; lowest
forecast error indicates better accuracy.

Forecast error = Actual demand - Forecast value

= At - Ft

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 Forecast Accuracy
(Common Measures of Error) – MAD #1
Error: difference between actual value and forecast
value
1. Mean Absolute Deviation (MAD)
 Average absolute error
{this value is computed by taking the sum of the absolute
values of the individual forecast errors and dividing by
the number of periods of data (n)}

∑ |Actual - Forecast|
MAD =
n

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 Forecast Accuracy
(Common Measures of Error)-MSE #2

2. Mean Squared Error (MSE)

 Average of squared error;
{ 2nd method of measuring overall forecast error; the
average of the squared differences between forecasted
and observed values}.

∑ (Actual - Forecast )2
MSE =
n

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 Forecast Accuracy
(Common Measures of Error)-MAPE #3

3. Mean Absolute Percent Error (MAPE)

 Average absolute percent error
{ the average of the absolute value difference betrween
the forecasted and the actual values; expressed in %}

n
MAPE = ∑100|Actuali - Forecasti|/Actuali

i=1 n

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 Common Measures of Error or
Forecast Accuracy
1) Mean Absolute Deviation (MAD)
∑ |Actual - Forecast|
MAD =
n
2) Mean Squared Error (MSE)
∑ (Actual - Forecast )2
MSE =
n
3) Mean Absolute Percent Error (MAPE)
n
MAPE = ∑100|Actuali - Forecasti|/Actuali

i=1 n
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 Examples 1
Demand for the last four months was:

Predict demand for July using each of these methods:

(A)
1) A 3-period moving average
2) exponential smoothing with alpha equal to .20 (use naïve to
begin).
(B)
3) If the naive approach had been used to predict demand for April
through June, what would MAD have been for those months?
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 Examples 1 (cont)
A) 1. (8+10+8)/3 = 8.67 (July Forecast)
2. Use naïve to begin
Month Demand Forecast
March 6 -
April 8 6
May 10 6 + 0.2(8 – 6) = 6.4
June 8 6.4 + 0.2(10 – 6.4) = 7.12
7.12 + 0.2(8 – 7.12) = 7.296

B)
Month March April May June
Demand 6 8 10 8
Naïve - 6 8 10
Absolute Error - 2 2 2
MAD = (2+2+2) /3 = 2
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 Example 2
Moving Average

Weekly sales of ten-grain bread at the local organic food market are in the
table below. Based on this data, forecast week 9 using a five-week moving
average.

Week 1 2 3 4 5 6 7 8

Sales 415 389 420 382 410 432 405 421

(382+410+432+405+421)/5 = 410.0

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 Examples 3
Exponential Smoothing & Forecast Accuracy measurement
Jim's department at a local department store has tracked the sales of a product
over the last ten weeks. Forecast demand using exponential smoothing with
an alpha (α) of 0.4, and an initial forecast of 28.0. Calculate MAD, MSE and
MAPE.
Period Demand
1 24
2 23
3 26
4 36
5 26
6 30
7 32
8 26
9 25
10 28
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 Examples 3 (cont)–
(Exponential Smoothing & Forecast accuracy)
Demand І At – FtІ ( At – Ft)2 100*І At – FtІ / At
Period Forecast Error
(Actual) І errorІ (error) 2 100 (І error І/actual)

1 24 28.00 -4 4 16 16.6 %
2 23 26.40 -3.40 3.40 11.56 14.78 %
3 26 25.04 0.96 0.96 0.92 3.69 %
4 36 25.42 10.58 10.58 111.94 29.39 %
5 26 29.65 -3.65 3.65 13.32 14.04%
6 30 28.19 1.81 1.81 3.28 6.03%
7 32 28.92 3.08 3.08 9.49 9.63 %
8 26 30.15 -4.15 4.15 17.22 15.96 %
9 25 28.49 -3.49 3.49 12.18 13.96%
10 28 27.09 0.91 0.91 0.83 3.25%
Total -1.36 36.03 196.74 127.33 %
Average -0.14 3.6 19.6 12.73 %
Bias MAD MSE MAPE

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 Let’s Recap
1. Discuss the overview of forecasting techniques
2. Compare and contrast qualitative and quantitative
approaches to forecasting
3. Apply the naive, moving averages, weighted moving averages
and exponential smoothing methods.
4. Compute and analyze three measures of forecast accuracy;
MAD, MSE and MAPE

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