Forecasting

Y.-H. Chen, Ph.D.

Production / Operations Management
International College
Ming-Chuan University

Forecasting Outline
Introduction
Forecasting

Process
Forecasting Methods
Forecast Accuracy and Control
Forecast Method Selection and Usage

Introduction

I see that you will

get an A this semester.

A forecast
is a statement of future,
is a basis for planning,
is not for forecasting demand only,
requires a skillful blending of art and science,
assumes that the underlying system will
continue to exist in the future, and
is rarely perfect.

Forecasting Process
The forecast

Step 6 Monitor the forecast

Step 5 Prepare the forecast
Step 4 Gather and analyze data
Step 3 Select a forecasting technique
Step 2 Establish a time horizon
Step 1 Determine purpose of forecast

Elements of A Good Forecast

The forecast horizon must cover the time necessary

to implement possible changes.
The degree of accuracy should be stated.
The forecast should be reliable; it should work
consistently.
The forecast should be expressed in meaningful
units.
The forecast should be in writing.
The forecast should be simply to understand and
use, or consistent with historical data intuitively.

Additional Properties

Forecasts for groups of

items tend to be more
accurate than forecasts for
individual items, because
forecasting errors among
items in a group usually
have a canceling effect.
Forecast accuracy
decreases as the time
period covered by the
forecast increases.

Timely

Reliable
ul
f
ng
i
n
ea
M

Accurate

Written

sy
a
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to

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us

Forecasting Methods
Basic

Methods

Judgmental Forecast
Statistical (Time Series) Forecast

Trend
Seasonality
Cycle
Association

Basic Forecasting Methods

Judgmental

Forecast
Statistical (Time Series) Forecast

Averaging
Weighted Moving Average
Exponential Smoothing

Judgmental Forecast
Executive opinions.

Mostly for long-range planning and introduction of new products. The view of one
person may prevail.

Direct customer contact composites.

Unable to distinguish between what customers would like to do and what they
will actually do.
Could overly influenced by recent sales experiences. Low sales could lead to
low estimates.
Conflict of interest. Low sales estimates lead to better sales performance.

Consumer survey or point-of-sales (POS) data.

Expensive and time-consuming.
Possible existence of irrational patterns.
Low response rates.

Opinions of managers and staff.

Delphi method (Rand Corp., 1948): Managers and staff complete a series of
questionnaires, each developed from the previous one, to achieve a consensus
forecast.
Technological forecasting. Long-term single-time forecasting. Data are costly to obtain.

Statistical (Time Series)

Forecast

It is extremely important to plot data and examine them before doing

any analysis or forecast. A demand forecast should be based on a time
series of past demand rather than sales or shipment.

Data patterns:
Trend
A long term upward or downward movement in data.
Seasonality
Short-term regular variations related to weather, holiday, or other factors.
Cycle
Wavelike variation lasting more than one year.
Irregular Variation
Caused by unusual circumstances, not reflective of typical behavior.
Random variation
Residual variation after all other behaviors are accounted for.

Data Patterns
Irregular
variation

Trend
Cycles

90
89
88
Seasonal variations

Simple Naive Forecast

Yt yt 1
No cost.
Quick and easy to prepare.
Easy to understand.
Can be applied to data with seasonality and trend

General Naive Forecast

Yt yt 1 ct

Weighted Moving Average

n

MAn

y
i 1

or MAn wi yi
i 1

Moving Average Example

a)

Compute a 3-period moving average

forecast given demand for shopping
carts for the last five periods.
43 40 41
MA3
41.33
3

b)

If the actual demand in period 6 turns out

to be 39, what would be the moving
average forecast for period 7?
MA3

40 41 39
40.00
3

Period
1
2
3
4
5
6
7

Demand
42
40
43
40
41
? 41.33 39
? 40.00

Weighted Moving Average

Example
a)

Compute a weighted average forecast using

a weight of .40 for the most recent period, .
30 for the next most recent, .20 for the next,
and .10 for the next.
Forecast .40( 41) .30(40) .20(43) .10(40) 41.0

b)

If the actual demand in period 6 turns out

to be 39, what would be the weighted
moving average forecast for period 7?
Forecast .40(39) .30(41) .20(40) .10(43) 40.2

Period
1
2
3
4
5
6
7

Demand
42
40
43
40
41
? 41.0 39
? 40.2

Properties of Weighted Moving

Average

Easy to compute and understand.

Moving average forecast lags and
smoothens the actual forecast.
The number of data points in the
average determines its sensitivity to
each new data point: the fewer the
data points in an average, the more
responsive the average tends to be.
Weights can be added to values in
the average to make the resulting
average more responsive to some
recent data points. However, weights
involve the use of trial-and-error to
find suitable weights.

Exponential Smoothing

Exponential smoothing is a weighted averaging method based

on previous forecast plus a percentage of its forecast error.

Yt yt 1 (d t 1 yt 1 )

Properties of Exponential
Smoothing

Commonly used values of

alpha range from 0.05 to
0.50. Low values are used
when the underlying average
tends to be stable; higher
values are used when the
underlying average is
susceptible to change.
Moving average or naive
forecast can be used to
generate starting forecast for
exponential smoothing.

Picking A Smooth Constant

Exponential Smoothing
Example
Use exponential smoothing to
develop a series of forecasts
for the data, and compute
(actual-forecast)=error for
each period.
a)
b)
c)

Use a smoothing factor of .10.

Use a smoothing factor of .40.
Plot the actual data and both
sets of forecasts on a single
graph.

Period (t)

Actual

42

40

43

40

41

39

46

44

45

10

38

11

40

12

Exponential Smoothing
Example
alpha=.10
Period (t)

Actual

Forecast

alpha=.40

Error

Forecast

Error

42.00

40.00

42.00

-2.00

42.00

-2.00

43.00

41.80

1.20

41.20

1.80

40.00

41.92

-1.92

41.92

-1.92

41.00

41.73

-0.73

41.15

-0.15

39.00

41.66

-2.66

41.09

-2.09

46.00

41.39

4.61

40.25

5.75

44.00

41.85

2.15

42.55

1.45

45.00

42.07

2.93

43.13

1.87

10

38.00

42.36

-4.36

43.88

-5.88

11

40.00

41.92

-1.92

41.53

-1.53

12

41.73

40.92

Forecasting Method Extension

Trend

Linear Trend
Trend-Adjusted Exponential Smoothing

Seasonality
Cycle
Association

Linear Trend

Yt a bt

Linear Trend Coefficients

b

t 1

t 1

t 1

n tyt t yt
n

n t

t 1

t 1

y
t 1

b t
t 1

y bt

Linear Trend Example

Calculate sales for a California-based
firm over the last 10 weeks are
shown in the table. Plot the data
and visually check to see if a linear
trend line would be appropriate.
Then, determine the equation of the
trend line, and predict sales for
weeks 11 and 12.

Week

Unit Sales

700

724

720

728

740

742

758

750

770

10

775

11

12

Linear Trend Example Solution

a. A plot suggests that a linear trend line would be appropriate.
b. For n=10, we have
10

t 55
t 1

10

385

t 1

10(41,358) 55(7,407) 6,195

7.51
10(385) 55(55)
825

7,407 7.51(55)
699.40
10

Thus, the trend line is yt=699.40+7.51t,

where t=0 for period 0.
c. By letting t=11 and t=12, we have

y11 699.40 7.51(11) 782.01

y12 699.40 7.51(12) 789.51

Seasonality

Cycle

Cycles are similar to

seasonal variations but of
longer duration, e.g., two to
six years between peaks.
It is difficult to project cycles
from past data, because
turning points are difficult to
identify.
A short moving average or a
naive approach may be of
some value.

Associative Forecasts

High correlation of a
forecast with leading
variables can be useful
in computing the
forecast.
The simple linear
regression is the
simplest and most
widely used method.

Y a bX

Simple Linear Regression

Coefficients

n
b

x y
i

i 1

i 1

y
i 1

x
i

x y

i 1

x
i 1

i 1
2

b xi
i 1

y bx

Simple Linear Regression

Example
Healthy Hamburgers has
a chain of 12 stores in
northern Illinois. Sales
figures and profits for
the stores are given in
the following table.
Obtain a regression line
for the data and predict
profit for a store
assuming sales of $10
million.

Sales, X

Profits, Y

(in millions of dollars)

7

0.15

0.10

0.13

0.15

14

0.25

15

0.27

16

0.24

12

0.20

14

0.27

20

0.44

15

0.34

0.17

Simple Linear Regression

Example: Data Plot

Simple Linear Regression

Example: Solution
x

xy

x^2

y^2

0.15

1.05

49

0.0225

0.10

0.20

0.0100

0.13

0.78

36

0.0169

0.15

0.60

16

0.0225

14

0.25

3.50

196

0.0625

15

0.27

4.05

225

0.0729

16

0.24

3.84

256

0.0576

12

0.20

2.40

144

0.0400

14

0.27

3.78

196

0.0729

20

0.44

8.80

400

0.1936

15

0.34

5.10

225

0.1156

0.17

1.19

49

0.0289

132

2.71

35.29

1796

0.7159

n xy x y

n x2 x

12(35.29) 132(2.71)
0.01593
12(1796) 132(132)

y b x

n
2.71 0.01593(132)

0.0506
12
Y 0.0506 0.01593 X
Y 0.2099 (million $) for X 10

An Important Measure of
Simple Linear Regression

Correlation measures the strength and direction of the

relationship between two variables.

+1, positive correlation.

-1, negative correlation.
0, zero correlation.

n xy x y

n x 2 x n y 2 y
2

The square of the correlation coefficient provides a

measure of how well a regression line fits the data. The
values ranges from 0 to 1.00.

[0.80,1.00], good fit.

[0.25,0.80), moderate fit.
[0.00,0.25), poor fit.

Simple Linear Regression and

Correlation Example
Sales of 19-inch color television sets and 3-month
lagged unemployment are shown in the table below.
Determine if unemployment levels can be used to
predict demand for 19-inch color TVs and, if so,
derive a predictive equation.
Period
Units sold

20 41

17

35

25 31

38

50

9 10
15

11

19 14

Unemployment % 7.2 4.0 7.3 5.5 6.8 6.0 5.4 3.6 8.4 7.0 9.0
(3-month lag)

Simple Linear Regression and

Correlation Example: Data Plot

Simple Linear Regression and

Correlation Example: Solution
x

xy

x^2

y^2

7.2

20

144.0

51.8

400

4.0

41

164.0

16.0

1681

7.3

17

124.1

53.3

289

5.5

35

192.5

30.3

1225

6.8

25

170.0

46.2

625

6.0

31

186.0

36.0

961

5.4

38

205.2

29.2

1444

3.6

50

180.0

13.0

2500

8.4

15

126.0

70.6

225

7.0

19

133.0

49.0

361

9.0

14

126.0

81.0

196

70.2

305

1750.8

476.3

9907

n xy x y

n x2 x

11(1750.8) 70.2(305)
6.91
11(476.4) 70.2(70.2)

y b x

n
305 ( 6.91)(70.2)

71.85
11
Y 71.85 6.91X
r

n xy x y

n x2 x n y 2 y
2

11(1750.8) 70.2(305)
11(476.4) (70.2) 2 11(9907) (305) 2

0.966

Linear Regression
Assumptions
No

patterns such as cycles or trends should

be apparent.
Deviations around the line should be
normally distributed.
Predictions are best being made within the
range of observed values.

Linear Regression Usage

Guidelines
Always

plot the data to verify that a linear

relationship is appropriate.
The data may be time-dependent. If patterns
appear, use analysis of time series or use
time as an independent variable as part of a
multiple regression analysis.
A small correlation may imply that other
variables are important.

Linear Regression Summary

Simple

linear regression applies only to linear

relationship with one independent variable.
One needs a considerable amount of data to
establish the relationship --- in practice, 20 or
more observations.
All observations are weighted equally.

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

Forecast Accuracy:
MAD & MSE
Actual forecast
MAD =
n
2

(Actual forecast)

MSE =
n-1
Example 10 (page 97).

Forecast Control
It is necessary to monitor forecast errors to ensure
that the forecast is performing adequately over
time. This is generally accomplished by comparing
forecast errors to predefined values, or action
limits.

Why Do We Need Forecast

Control?
The

omission of an important variable.

Appearance of a new variable.
A sudden or unexpected change in the
variable (causing by severe weather or other
nature phenomena, temporary shortage or
breakdown, catastrophe, or similar events).
Being used incorrectly.
Data being misinterpreted.
Random variation.

Forecasting Control Methods

Tracking

Signal
Control Chart

Forecast Control: Tracking

Signal

tracking signal

yt

MAD

MADt MADt 1 dt yt MADt 1

Forecast Control: Control

Chart

The control chart sets the limits as multiples of

the squared root of MSE.

Forecast Control: Control

Chart

s MSE

For a normal distribution, 95% of the errors fall within

+/-2s, and approximately 99.7% of the errors fall
within +/-3s. Errors fall outside these limits should be
regarded as evidence that corrective action is
needed.

Example 11 (Page 93).

Forecast Method Selection

Most important

Cost
Accuracy

Need to consider

Historical performance
Ability to respond to
change