Chapter 3 –Forecasting

Contents Introduction Overview of forecasting methods Qualitative Methods Quantitative Methods Measure of forecast accuracy

What is Forecasting? Forecasts are predictions, projections or estimates of future events or conditions in the environment in which an enterprise operates. Or Forecasts are estimates of occurrence, timing or magnitude of uncertain future events

?? What is Forecasting? Process of predicting a future event Underlying basis of all business decisions Production Inventory Personnel Facilities ??

What is Forecasting? The estimates can be Occurrence of an event Timing of happening Magnitude or volume The purpose of forecasting is to use the best available information to guide future activities toward organizational goals.

Forecasting can be used to determine Demand of product or service prices or costs Change of technology Competitors Interest rate Exchange rate Good forecasts enables managers to plan and budget for appropriate levels of personnel, raw materials, capitals, inventory and a lot of other variables. Forecasting is the basis for all planning and budgeting efforts.

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

Distinguishing Differences Medium/long range forecasts deal with more comprehensive issues and support management decisions regarding planning and products, plants and processes Short-term forecasting usually employs different methodologies than longer-term forecasting Short-term forecasts tend to be more accurate than longer-term forecasts

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

Company Strategy/Issues Drive-through restaurants Product Life Cycle Introduction Growth Maturity Decline Company Strategy/Issues Best period to increase market share R&D engineering is critical Practical to change price or quality image Strengthen niche Poor time to change image, price, or quality Competitive costs become critical Defend market position Cost control critical Internet search engines Sales Xbox 360 Drive-through restaurants CD-ROMs 3 1/2” Floppy disks LCD & plasma TVs Analog TVs iPods Figure 2.5

Product Life Cycle Introduction Growth Maturity Decline OM Strategy/Issues Product design and development critical Frequent product and process design changes Short production runs High production costs Limited models Attention to quality Forecasting critical Product and process reliability Competitive product improvements and options Increase capacity Shift toward product focus Enhance distribution Standardization Less rapid product changes – more minor changes Optimum capacity Increasing stability of process Long production runs Product improvement and cost cutting Little product differentiation Cost minimization Overcapacity in the industry Prune line to eliminate items not returning good margin Reduce capacity Figure 2.5

Types of Forecasts Economic forecasts Technological forecasts Address business cycle – inflation rate, money supply, etc. Technological forecasts Predict rate of technological progress Impacts development of new products Demand forecasts Predict sales of existing products and services

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 advantages

Seven Steps in Forecasting 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 New products New technology Involves intuition, experience e.g., forecasting sales on Internet

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

Overview of Qualitative Methods Jury of executive opinion Pool opinions of high-level experts, sometimes augment by statistical models Delphi method Panel of experts, queried iteratively

Overview of Qualitative Methods Sales force composite Estimates from individual salespersons are reviewed for reasonableness, then aggregated Consumer Market Survey Ask the customer

Jury of Executive Opinion Involves small group of high-level experts and managers Group estimates demand by working together Combines managerial experience with statistical models Relatively quick ‘Group-think’ disadvantage

Sales Force Composite Each salesperson projects his or her sales Combined at district and national levels Sales reps know customers’ wants Tends to be overly optimistic

Delphi Method Iterative group process, continues until consensus is reached 3 types of participants Decision makers Staff Respondents Decision Makers (Evaluate responses and make decisions) Staff (Administering survey) Respondents (People who can make valuable judgments)

Consumer Market Survey Ask customers about purchasing plans What consumers say, and what they actually do are often different Sometimes difficult to answer

Overview of Quantitative Approaches Naive approach Moving averages Exponential smoothing Trend projection Linear regression Time-Series Models Associative Model

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

Time Series Components Trend Cyclical Seasonal Random

Components of Demand Trend component Seasonal peaks Actual demand Demand for product or service | | | | 1 2 3 4 Year Seasonal peaks Actual demand Average demand over four years Random variation Figure 4.1

Trend Component Persistent, overall upward or downward pattern Changes due to population, technology, age, culture, etc. Typically several years duration

Seasonal Component Regular pattern of up and down fluctuations Due to weather, customs, etc. 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 52

Cyclical Component Repeating up and down movements Affected by business cycle, political, and economic factors Multiple years duration Often causal or associative relationships 0 5 10 15 20

Random Component Erratic, unsystematic, ‘residual’ fluctuations Due to random variation or unforeseen events Short duration and nonrepeating M T W T F

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

∑ demand in previous n periods Moving Average Method MA is a series of arithmetic means Used if little or no trend Used often for smoothing Provides overall impression of data over time Moving average = ∑ demand in previous n periods n

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

Graph of Moving Average Moving Average Forecast | | | | | | | | | | | | J F M A M J J A S O N D Shed Sales 30 – 28 – 26 – 24 – 22 – 20 – 18 – 16 – 14 – 12 – 10 – Actual Sales

Weighted Moving Average Used when trend is present Older data usually less important Weights based on experience and intuition Weighted moving average = ∑ (weight for period n) x (demand in period n) ∑ weights

Weighted Moving Average Weights Applied Period 3 Last month 2 Two months ago 1 Three months ago 6 Sum of weights Weighted Moving Average January 10 February 12 March 13 April 16 May 19 June 23 July 26 Actual 3-Month Weighted Month Shed Sales Moving Average [(3 x 16) + (2 x 13) + (12)]/6 = 141/3 [(3 x 19) + (2 x 16) + (13)]/6 = 17 [(3 x 23) + (2 x 19) + (16)]/6 = 201/2 10 12 13 [(3 x 13) + (2 x 12) + (10)]/6 = 121/6

Potential Problems With Moving Average Increasing n smooths the forecast but makes it less sensitive to changes Do not forecast trends well Require extensive historical data

Moving Average And Weighted Moving Average 30 – 25 – 20 – 15 – 10 – 5 – Sales demand | | | | | | | | | | | | J F M A M J J A S O N D Actual sales Moving average Figure 4.2

Exponential Smoothing Form of weighted moving average Weights decline exponentially Most recent data weighted most Requires smoothing constant () Ranges from 0 to 1 Subjectively chosen Involves little record keeping of past data

Exponential Smoothing New forecast = Last period’s forecast + a (Last period’s actual demand – Last period’s 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)

Exponential Smoothing Example Predicted demand = 142 Ford Mustangs Actual demand = 153 Smoothing constant a = .20

Exponential Smoothing Example Predicted demand = 142 Ford Mustangs Actual demand = 153 Smoothing constant a = .20 New forecast = 142 + .2(153 – 142)

Exponential Smoothing Example Predicted demand = 142 Ford Mustangs Actual demand = 153 Smoothing constant a = .20 New forecast = 142 + .2(153 – 142) = 142 + 2.2 = 144.2 ≈ 144 cars

Effect of Smoothing Constants Weight Assigned to Most 2nd Most 3rd Most 4th Most 5th Most Recent Recent Recent Recent Recent Smoothing Period Period Period Period Period Constant (a) a(1 - a) a(1 - a)2 a(1 - a)3 a(1 - a)4 a = .1 .1 .09 .081 .073 .066 a = .5 .5 .25 .125 .063 .031

Impact of Different  Actual demand a = .5 a = .1 225 – 200 – 175 – 225 – 200 – 175 – 150 – | | | | | | | | | 1 2 3 4 5 6 7 8 9 Quarter Demand Actual demand a = .5 a = .1

Impact of Different  225 – 200 – 175 – 150 – | | | | | | | | | 1 2 3 4 5 6 7 8 9 Quarter Demand Chose high values of  when underlying average is likely to change Choose low values of  when underlying average is stable Actual demand a = .5 a = .1

Choosing  The objective is to obtain the most accurate forecast no matter the technique We generally do this by selecting the model that gives us the lowest forecast error Forecast error = Actual demand - Forecast value = At - Ft

Common Measures of Error Mean Absolute Deviation (MAD) MAD = ∑ |Actual - Forecast| n Mean Squared Error (MSE) MSE = ∑ (Forecast Errors)2 n

Common Measures of Error Mean Absolute Percent Error (MAPE) MAPE = ∑100|Actuali - Forecasti|/Actuali n i = 1

Comparison of Forecast Error Rounded Absolute Rounded Absolute Actual Forecast Deviation Forecast Deviation Tonnage with for with for Quarter Unloaded a = .10 a = .10 a = .50 a = .50 1 180 175 5.00 175 5.00 2 168 175.5 7.50 177.50 9.50 3 159 174.75 15.75 172.75 13.75 4 175 173.18 1.82 165.88 9.12 5 190 173.36 16.64 170.44 19.56 6 205 175.02 29.98 180.22 24.78 7 180 178.02 1.98 192.61 12.61 8 182 178.22 3.78 186.30 4.30 82.45 98.62

Comparison of Forecast Error MAD = ∑ |deviations| n Rounded Absolute Rounded Absolute Actual Forecast Deviation Forecast Deviation Tonnage with for with for Quarter Unloaded a = .10 a = .10 a = .50 a = .50 = 82.45/8 = 10.31 For a = .10 1 180 175 5.00 175 5.00 2 168 175.5 7.50 177.50 9.50 3 159 174.75 15.75 172.75 13.75 4 175 173.18 1.82 165.88 9.12 5 190 173.36 16.64 170.44 19.56 6 205 175.02 29.98 180.22 24.78 7 180 178.02 1.98 192.61 12.61 8 182 178.22 3.78 186.30 4.30 82.45 98.62 = 98.62/8 = 12.33 For a = .50

Comparison of Forecast Error MSE = ∑ (forecast errors)2 n Rounded Absolute Rounded Absolute Actual Forecast Deviation Forecast Deviation Tonnage with for with for Quarter Unloaded a = .10 a = .10 a = .50 a = .50 = 1,526.54/8 = 190.82 For a = .10 1 180 175 5.00 175 5.00 2 168 175.5 7.50 177.50 9.50 3 159 174.75 15.75 172.75 13.75 4 175 173.18 1.82 165.88 9.12 5 190 173.36 16.64 170.44 19.56 6 205 175.02 29.98 180.22 24.78 7 180 178.02 1.98 192.61 12.61 8 182 178.22 3.78 186.30 4.30 82.45 98.62 MAD 10.31 12.33 = 1,561.91/8 = 195.24 For a = .50

Comparison of Forecast Error MAPE = ∑100|deviationi|/actuali n i = 1 Rounded Absolute Rounded Absolute Actual Forecast Deviation Forecast Deviation Tonnage with for with for Quarter Unloaded a = .10 a = .10 a = .50 a = .50 = 44.75/8 = 5.59% For a = .10 1 180 175 5.00 175 5.00 2 168 175.5 7.50 177.50 9.50 3 159 174.75 15.75 172.75 13.75 4 175 173.18 1.82 165.88 9.12 5 190 173.36 16.64 170.44 19.56 6 205 175.02 29.98 180.22 24.78 7 180 178.02 1.98 192.61 12.61 8 182 178.22 3.78 186.30 4.30 82.45 98.62 MAD 10.31 12.33 MSE 190.82 195.24 = 54.05/8 = 6.76% For a = .50

Comparison of Forecast Error Rounded Absolute Rounded Absolute Actual Forecast Deviation Forecast Deviation Tonnage with for with for Quarter Unloaded a = .10 a = .10 a = .50 a = .50 1 180 175 5.00 175 5.00 2 168 175.5 7.50 177.50 9.50 3 159 174.75 15.75 172.75 13.75 4 175 173.18 1.82 165.88 9.12 5 190 173.36 16.64 170.44 19.56 6 205 175.02 29.98 180.22 24.78 7 180 178.02 1.98 192.61 12.61 8 182 178.22 3.78 186.30 4.30 82.45 98.62 MAD 10.31 12.33 MSE 190.82 195.24 MAPE 5.59% 6.76%

Exponential Smoothing with Trend Adjustment When a trend is present, exponential smoothing must be modified Forecast including (FITt) = trend Exponentially Exponentially smoothed (Ft) + (Tt) smoothed forecast trend

Exponential Smoothing with Trend Adjustment Ft = a(At - 1) + (1 - a)(Ft - 1 + Tt - 1) Tt = b(Ft - Ft - 1) + (1 - b)Tt - 1 Step 1: Compute Ft Step 2: Compute Tt Step 3: Calculate the forecast FITt = Ft + Tt

Exponential Smoothing with Trend Adjustment Example Forecast Actual Smoothed Smoothed Including Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt 1 12 11 2 13.00 2 17 3 20 4 19 5 24 6 21 7 31 8 28 9 36 10 Table 4.1

Exponential Smoothing with Trend Adjustment Example Forecast Actual Smoothed Smoothed Including Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt 1 12 11 2 13.00 2 17 3 20 4 19 5 24 6 21 7 31 8 28 9 36 10 Step 1: Forecast for Month 2 F2 = aA1 + (1 - a)(F1 + T1) F2 = (.2)(12) + (1 - .2)(11 + 2) = 2.4 + 10.4 = 12.8 units Table 4.1

Exponential Smoothing with Trend Adjustment Example Forecast Actual Smoothed Smoothed Including Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt 1 12 11 2 13.00 2 17 12.80 3 20 4 19 5 24 6 21 7 31 8 28 9 36 10 Step 2: Trend for Month 2 T2 = b(F2 - F1) + (1 - b)T1 T2 = (.4)(12.8 - 11) + (1 - .4)(2) = .72 + 1.2 = 1.92 units Table 4.1

Exponential Smoothing with Trend Adjustment Example Forecast Actual Smoothed Smoothed Including Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt 1 12 11 2 13.00 2 17 12.80 1.92 3 20 4 19 5 24 6 21 7 31 8 28 9 36 10 Step 3: Calculate FIT for Month 2 FIT2 = F2 + T1 FIT2 = 12.8 + 1.92 = 14.72 units Table 4.1

Exponential Smoothing with Trend Adjustment Example Forecast Actual Smoothed Smoothed Including Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt 1 12 11 2 13.00 2 17 12.80 1.92 14.72 3 20 4 19 5 24 6 21 7 31 8 28 9 36 10 15.18 2.10 17.28 17.82 2.32 20.14 19.91 2.23 22.14 22.51 2.38 24.89 24.11 2.07 26.18 27.14 2.45 29.59 29.28 2.32 31.60 32.48 2.68 35.16 Table 4.1

Exponential Smoothing with Trend Adjustment Example | | | | | | | | | 1 2 3 4 5 6 7 8 9 Time (month) Product demand 35 – 30 – 25 – 20 – 15 – 10 – 5 – 0 – Actual demand (At) Forecast including trend (FITt) with  = .2 and  = .4 Figure 4.3

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 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 ^

Actual observation (y value) Least Squares Method Time period Values of Dependent Variable Deviation1 (error) Deviation5 Deviation7 Deviation2 Deviation6 Deviation4 Deviation3 Actual observation (y value) Trend line, y = a + bx ^ Figure 4.4

Actual observation (y value) Least Squares Method Time period Values of Dependent Variable Actual observation (y value) Deviation7 Deviation5 Deviation6 Deviation3 Least squares method minimizes the sum of the squared errors (deviations) Deviation4 Trend line, y = a + bx ^ Deviation1 Deviation2 Figure 4.4

Least Squares Method Equations to calculate the regression variables y = a + bx ^ b = Sxy - nxy Sx2 - nx2 a = y - bx

Least Squares Example Time Electrical Power Year Period (x) Demand x2 xy 2001 1 74 1 74 2002 2 79 4 158 2003 3 80 9 240 2004 4 90 16 360 2005 5 105 25 525 2005 6 142 36 852 2007 7 122 49 854 ∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063 x = 4 y = 98.86 b = = = 10.54 ∑xy - nxy ∑x2 - nx2 3,063 - (7)(4)(98.86) 140 - (7)(42) a = y - bx = 98.86 - 10.54(4) = 56.70

Least Squares Example The trend line is y = 56.70 + 10.54x ^ 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 Sx = 28 Sy = 692 Sx2 = 140 Sxy = 3,063 x = 4 y = 98.86 The trend line is y = 56.70 + 10.54x ^ b = = = 10.54 Sxy - nxy Sx2 - nx2 3,063 - (7)(4)(98.86) 140 - (7)(42) a = y - bx = 98.86 - 10.54(4) = 56.70

Least Squares Example Trend line, y = 56.70 + 10.54x ^ 160 – 150 – | | | | | | | | | 2001 2002 2003 2004 2005 2006 2007 2008 2009 160 – 150 – 140 – 130 – 120 – 110 – 100 – 90 – 80 – 70 – 60 – 50 – Year Power demand

Seasonal Variations In Data The multiplicative seasonal model can adjust trend data for seasonal variations in demand

Seasonal Variations In Data Steps in the process: Find average historical demand for each season Compute the average demand over all seasons Compute a seasonal index for each season Estimate next year’s total demand Divide this estimate of total demand by the number of seasons, then multiply it by the seasonal index for that season

Seasonal Index Example Jan 80 85 105 90 94 Feb 70 85 85 80 94 Mar 80 93 82 85 94 Apr 90 95 115 100 94 May 113 125 131 123 94 Jun 110 115 120 115 94 Jul 100 102 113 105 94 Aug 88 102 110 100 94 Sept 85 90 95 90 94 Oct 77 78 85 80 94 Nov 75 72 83 80 94 Dec 82 78 80 80 94 Demand Average Average Seasonal Month 2005 2006 2007 2005-2007 Monthly Index

Seasonal Index Example Jan 80 85 105 90 94 Feb 70 85 85 80 94 Mar 80 93 82 85 94 Apr 90 95 115 100 94 May 113 125 131 123 94 Jun 110 115 120 115 94 Jul 100 102 113 105 94 Aug 88 102 110 100 94 Sept 85 90 95 90 94 Oct 77 78 85 80 94 Nov 75 72 83 80 94 Dec 82 78 80 80 94 Demand Average Average Seasonal Month 2005 2006 2007 2005-2007 Monthly Index 0.957 Seasonal index = average 2005-2007 monthly demand average monthly demand = 90/94 = .957

Seasonal Index Example Jan 80 85 105 90 94 0.957 Feb 70 85 85 80 94 0.851 Mar 80 93 82 85 94 0.904 Apr 90 95 115 100 94 1.064 May 113 125 131 123 94 1.309 Jun 110 115 120 115 94 1.223 Jul 100 102 113 105 94 1.117 Aug 88 102 110 100 94 1.064 Sept 85 90 95 90 94 0.957 Oct 77 78 85 80 94 0.851 Nov 75 72 83 80 94 0.851 Dec 82 78 80 80 94 0.851 Demand Average Average Seasonal Month 2005 2006 2007 2005-2007 Monthly Index

Seasonal Index Example Jan 80 85 105 90 94 0.957 Feb 70 85 85 80 94 0.851 Mar 80 93 82 85 94 0.904 Apr 90 95 115 100 94 1.064 May 113 125 131 123 94 1.309 Jun 110 115 120 115 94 1.223 Jul 100 102 113 105 94 1.117 Aug 88 102 110 100 94 1.064 Sept 85 90 95 90 94 0.957 Oct 77 78 85 80 94 0.851 Nov 75 72 83 80 94 0.851 Dec 82 78 80 80 94 0.851 Demand Average Average Seasonal Month 2005 2006 2007 2005-2007 Monthly Index Forecast for 2008 Expected annual demand = 1,200 Jan x .957 = 96 1,200 12 Feb x .851 = 85 1,200 12

Seasonal Index Example 2008 Forecast 2007 Demand 2006 Demand 2005 Demand 140 – 130 – 120 – 110 – 100 – 90 – 80 – 70 – | | | | | | | | | | | | J F M A M J J A S O N D Time Demand

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 ^

Associative Forecasting Example Sales Local Payroll ($ millions), y ($ billions), x 2.0 1 3.0 3 2.5 4 2.0 2 3.5 7 4.0 – 3.0 – 2.0 – 1.0 – | | | | | | | 0 1 2 3 4 5 6 7 Sales Area payroll

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 3.5 7 49 24.5 ∑y = 15.0 ∑x = 18 ∑x2 = 80 ∑xy = 51.5 b = = = .25 ∑xy - nxy ∑x2 - nx2 51.5 - (6)(3)(2.5) 80 - (6)(32) x = ∑x/6 = 18/6 = 3 y = ∑y/6 = 15/6 = 2.5 a = y - bx = 2.5 - (.25)(3) = 1.75

Associative Forecasting Example y = 1.75 + .25x ^ Sales = 1.75 + .25(payroll) 4.0 – 3.0 – 2.0 – 1.0 – | | | | | | | 0 1 2 3 4 5 6 7 Sales Area payroll If payroll next year is estimated to be $6 billion, then: 3.25 Sales = 1.75 + .25(6) Sales = $3,250,000