Chapter Two

Forecasting
 Forecasting is the technique of estimating the
relevant future events and problems on the basis of
past and present behavior or happenings.
 The art and science of predicting future events
 The process of estimation the unknown situations.
 What should we produce, How much, and when ?
 In other words how can we determine the demand?
 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

Types of Forecast

1. Qualitative Forecasts

2. Quantitative Forecasts
Cont…
 1. Qualitative Methods

Type Characteristics Strengths Weaknesses

Executive A group of managers Good for strategic or One person's opinion
opinion meet & come up with new-product can dominate the
a forecast forecasting forecast

Market Uses surveys & Good determinant of It can be difficult to

research interviews to identify customer preferences develop a good
customer preferences questionnaire

Delphi Seeks to develop a Excellent for Time consuming to

method consensus among a forecasting long-term develop
group of experts product demand,
technological
2. Quantitative Forecasting Approaches

 Based on the assumption that the “forces” that

generated the past demand will generate the future
demand, i.e., history will tend to repeat itself

 Analysis of the past demand pattern provides a

good basis for forecasting future demand

 Majority of quantitative approaches fall in the

category of time series analysis
Cont…
 Time series Analysis

 A time series is a set of numbers where the order or

sequence of the numbers is important,
e.g., historical demand

 Assumptions of Time Series Models

•There is information about the past;
•This information can be quantified in the form of data
•The pattern of the past will continue into the future
 Components of Time Series

 Level (long term average) data fluctuates around a constant mean

 Trends are noted by an upward or downward sloping line
 Seasonality is a data pattern that repeats itself over the period of
one year or less
 Cycle is a data pattern that repeats itself... may take years
 Irregular variations are jumps in the level of the series due to
extraordinary events.
 Sudden, unpredictable changes in a time series due to
extraordinary or unusual events.
 Example Natural disaster
 Random fluctuations are small and unpredictable variations in
data that happen due to unexplained or random causes. Example
slight changes from usual sale
Techniques of Quantitative Methods
 1. Naive Approach

• Assumes demand in next period is the same as demand in

most recent period
• e.g., If May sales were 48, then June sales will be 48
 2. Moving Average Method

• Is a series of arithmetic means

• Used if little or no trend
Cont…
 3. Weighted Moving Average

• Used when trend is present

• Older data usually less important

• Weights based on experience and intuition

Cont…
Potential Problems With Moving Average

• Increasing n smooth's the forecast but makes

it less sensitive to changes

• Require extensive historical data

 4. Exponential Smoothing

• Form of weighted moving average

• Weights exponentially distribution

• Most recent data weighted most

• Requires smoothing constant (α)

• Ranges from 0 to 1
Cont…
 Exponential Smoothing Example

• Predicted demand = 142

• Actual demand = 153

•Smoothing constant α = .20 New forecast = 142 + .2(153 –142)

= 142 + 2.2

= 144.2 ≈ 144 cars

 Choosing α

• 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 value -Forecast value

= At-Ft
Common Measures of Error
Comparison of Forecast Error
Cont….
 5. Forecasting Trend

•Trend-adjusted exponential smoothing uses a three step process

• Step 1 - Smoothing the level of the series

S t  αA t  (1  α)(S t 1  Tt1 )
• Step 2 – Smoothing the trend

Tt  β(S t  S t1 )  (1  β)Tt1

• Forecast including the trend

FI T t  1  S t  Tt
 Example

Forecasting trend problem: a company uses exponential smoothing with

trend to forecast usage of its lawn care products. At the end of July the
company wishes to forecast sales for August. July demand was 62. The trend
through June has been 15 additional gallons of product sold per month.
Average sales have been 57 gallons per month. The company uses alpha +0.2
and beta +0.10. Forecast for August.
Smooth the level of the series:
S July  αA t  (1  α)(St1  Tt1 )  0.262 0.857  15  70
Smooth the trend:
TJuly  β(St S t1 )  (1 β)Tt1  0.170 57 0.915  14.8

Forecast including trend:

FITAugust  S t  Tt  70  14.8  84.8 gallons
 Associative model

The associative model (causal model) assumes that the

variable being forecasted is related to other variable in the
environment they try to project based up on those associations.

Example; 1. Simple Linear Regression

2. Multiple Regression
 1. Simple Linear Regression

 Establishes a relationship between one dependent

variable and one independent variables.
 If the data is a time series, the independent
variable is the time period.
 The dependent variable is whatever we wish
to forecast.
 Cont…

Regression Equation

Y = a + bX
Y = dependent variable
X = independent variable
a = y-axis intercept
b = slope of regression line
 Cont…
Constants a and b
The constants a and b are computed using the following equations:

a=
  y- x xy
x 2
n xy-  x y
b=
n  x -(  x)
2 2
n  x 2 -(  x)2
a  Y  bX
b  XY  nXY
 X  nX
2
2

• Once the a and b values are computed, a future value of X can be

entered into the regression equation and a corresponding value of Y
(the forecast) can be calculated.
 Example
At a regional university enrollments have grown
steadily over the past six years, as evidenced below.
Use time series regression to forecast the student
enrollments for the next three years.

Students Students
Year Enrolled (1000s) Year Enrolled (1000s)
1 2.5 4 3.2
2 2.8 5 3.3
3 2.9 6 3.4

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Example: College Enrollment

x y x2 xy
1 2.5 1 2.5
2 2.8 4 5.6
3 2.9 9 8.7
4 3.2 16 12.8
5 3.3 25 16.5
6 3.4 36 20.4
x=21 y=18.1 x2=91 xy=66.5

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 91(18.1)  21(66.5)
a  2.387
6(91)  (21)2
6(66.5)  21(18.1)
b  0.180
105

Y = 2.387 + 0.180X

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 Y7 = 2.387 + 0.180(7) = 3.65 or 3,650 students

Y8 = 2.387 + 0.180(8) = 3.83 or 3,830 students

Y9 = 2.387 + 0.180(9) = 4.01 or 4,010 students

Note: Enrollment is expected to increase by 180 students per year.

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 2. Multiple Regression

 Multiple regression analysis is used when there are

two or more independent variables.
 An example of a multiple regression equation is:
Y = 50.0 + 0.05X1 + 0.10X2 – 0.03X3
where: Y = firm’s annual sales ($millions)
X1 = industry sales ($millions)
X2 = regional per capita income ($thousands)
X3 = regional per capita debt ($thousands)

Reading Assignment for examples 46

 Coefficient of Correlation (r)

 The coefficient of correlation, r, explains the relative

importance of the relationship between x and y.
 The sign of r shows the direction of the relationship.
 The absolute value of r shows the strength of the
relationship.
 The sign of r is always the same as the sign of b.
 r can take on any value between –1 and +1.

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 Coefficient of Correlation (r)
 Meanings of several values of r:
-1 a perfect negative relationship (as x goes up, y
goes down by one unit, and vice versa)
+1 a perfect positive relationship (as x goes up, y
goes up by one unit, and vice versa)
0 no relationship exists between x and y
+0.3 a weak positive relationship
-0.8 a strong negative relationship
Coefficient of Correlation (r)
r is computed by:
 Example

 Coefficient of Correlation
x y x2 xy y2
120 9.5 14,400 1,140 90.25
135 11.0 18,225 1,485 121.00
130 12.0 16,900 1,560 144.00
150 12.5 22,500 1,875 156.25
170 14.0 28,900 2,380 196.00
190 16.0 36,100 3,040 256.00
220 18.0 48,400 3,960 324.00
1,115 93.0 185,425 15,440 1,287.50
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 Example:
 Coefficient of Correlation

7(15, 440)  1,115(93)

r
7(185, 425)  (1,115)2  7(1,287.5) (93) 2 

r = .9829

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