McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 3 Forecasting

3-2 FORECAST:  A statement about the future value of a variable of interest such as demand.  Forecasting is used to make informed decisions.  Long-range  Short-range

3-3 Forecasts  Forecasts affect decisions and activities throughout an organization  Accounting, finance  Human resources  Marketing  MIS  Operations  Product / service design

3-4 AccountingCost/profit estimates FinanceCash flow and funding Human ResourcesHiring/recruiting/training MarketingPricing, promotion, strategy MISIT/IS systems, services OperationsSchedules, workloads Product/service designNew products and services Uses of Forecasts

3-5  Assumes causal system past ==> future  Forecasts rarely perfect because of randomness  Forecasts more accurate for groups vs. individuals  Forecast accuracy decreases as time horizon increases I see that you will get an A this semester. Features of Forecasts

3-6 Elements of a Good Forecast Timely Accurate Reliable Meaningful Written Easy to use

3-7 Steps in the Forecasting Process Step 1 Determine purpose of forecast Step 2 Establish a time horizon Step 3 Select a forecasting technique Step 4 Obtain, clean and analyze data Step 5 Make the forecast Step 6 Monitor the forecast “The forecast”

3-8 Types of Forecasts  Judgmental - uses subjective inputs  Time series - uses historical data assuming the future will be like the past  Associative models - uses explanatory variables to predict the future

3-9 Judgmental Forecasts  Executive opinions  Sales force opinions  Consumer surveys  Outside opinion  Delphi method  Opinions of managers and staff  Achieves a consensus forecast

3-10 Time Series Forecasts  Trend - long-term movement in data  Seasonality - short-term regular variations in data  Cycle – wavelike variations of more than one year’s duration  Irregular variations - caused by unusual circumstances  Random variations - caused by chance

3-11 Forecast Variations Trend Irregular variatio n Seasonal variations Figure 3.1 Cycles

3-12 Naive Forecasts Uh, give me a minute.... We sold 250 wheels last week.... Now, next week we should sell.... The forecast for any period equals the previous period’s actual value.

3-13  Simple to use  Virtually no cost  Quick and easy to prepare  Easily understandable  Cannot provide high accuracy Naïve Forecasts

3-14  Stable time series data  F(t) = A(t-1)  Seasonal variations  F(t) = A(t-n) Uses for Naïve Forecasts

3-15 Techniques for Averaging  Moving average  Weighted moving average  Exponential smoothing

3-16 Moving Averages  Moving average – A technique that averages a number of recent actual values, updated as new values become available.  Weighted moving average – More recent values in a series are given more weight in computing the forecast. F t = MA n = n A t-n + … A t-2 + A t-1 F t = WMA n = w n A t-n + … w n-1 A t-2 + w 1 A t-1

3-17 Simple Moving Average Actual MA3 MA5 F t = MA n = n A t-n + … A t-2 + A t-1

3-18 Exponential Smoothing Premise--The most recent observations might have the highest predictive value.  Therefore, we should give more weight to the more recent time periods when forecasting. F t = F t-1 +  ( A t-1 - F t-1 )

3-19 Exponential Smoothing  Weighted averaging method based on previous forecast plus a percentage of the forecast error  A-F is the error term,  is the % feedback F t = F t-1 +  ( A t-1 - F t-1 )

3-20 Example 3 - Exponential Smoothing

3-21 Picking a Smoothing Constant .1 .4 Actual

3-22 Common Nonlinear Trends Parabolic Exponential Growth Figure 3.5

3-23 Linear Trend Equation  F t = Forecast for period t  t = Specified number of time periods  a = Value of F t at t = 0  b = Slope of the line F t = a + bt t FtFt

3-24 Calculating a and b b = n(ty) - ty nt 2 - ( t) 2 a = y - bt n   

3-25 Linear Trend Equation Example

3-26 Linear Trend Calculation y = t a= (15) 5 = b= 5 (2499)- 15(812) 5(55)- 225 = =

3-27 Techniques for Seasonality  Seasonal variations  Regularly repeating movements in series values that can be tied to recurring events.  Seasonal relative  Percentage of average or trend  Centered moving average  A moving average positioned at the center of the data that were used to compute it.

3-28 Associative Forecasting  Predictor variables - used to predict values of variable interest  Regression - technique for fitting a line to a set of points  Least squares line - minimizes sum of squared deviations around the line

3-29 Linear Model Seems Reasonable A straight line is fitted to a set of sample points. Computed relationship

3-30 Linear Regression Assumptions  Variations around the line are random  Deviations around the line normally distributed  Predictions are being made only within the range of observed values  For best results:  Always plot the data to verify linearity  Check for data being time-dependent  Small correlation may imply that other variables are important

3-31 Forecast Accuracy  Error - difference between actual value and predicted value  Mean Absolute Deviation (MAD)  Average absolute error  Mean Squared Error (MSE)  Average of squared error  Mean Absolute Percent Error (MAPE)  Average absolute percent error

3-32 MAD, MSE, and MAPE MAD = Actualforecast   n MSE = Actualforecast )   n ( MAPE = Actualforecas t  n / Actual*100) 

3-33 MAD, MSE and MAPE  MAD  Easy to compute  Weights errors linearly  MSE  Squares error  More weight to large errors  MAPE  Puts errors in perspective

3-34 Example 10

3-35 Controlling the Forecast  Control chart  A visual tool for monitoring forecast errors  Used to detect non-randomness in errors  Forecasting errors are in control if  All errors are within the control limits  No patterns, such as trends or cycles, are present

3-36 Sources of Forecast errors  Model may be inadequate  Irregular variations  Incorrect use of forecasting technique

3-37 Tracking Signal Tracking signal = ( Actual - forecast ) MAD  Tracking signal –Ratio of cumulative error to MAD Bias – Persistent tendency for forecasts to be Greater or less than actual values.

3-38 Choosing a Forecasting Technique  No single technique works in every situation  Two most important factors  Cost  Accuracy  Other factors include the availability of:  Historical data  Computers  Time needed to gather and analyze the data  Forecast horizon

3-39 Operations Strategy  Forecasts are the basis for many decisions  Work to improve short-term forecasts  Accurate short-term forecasts improve  Profits  Lower inventory levels  Reduce inventory shortages  Improve customer service levels  Enhance forecasting credibility