Chapter 4 B

Operations
Management
Forecasting
Chapter 4 - Part 2
4-1
Forecasting a Trend
Trend is increasing or decreasing pattern.
First, plot data to verify trend.
If trend exists, then moving averages and
exponential smoothing will always lag.
4-2
Plot Data
20
Actual
16
12
8
4
1
Period
4-3
Moving Averages for a Trend

Period Sales
1
8
2
11
3
13
4
15
5
19
6
MA
MA
Erro
r
10.67
13.00
15.67
4.33
6.00
?
MA = 3 period Moving Average

4-4
Trend Graph
20
Actual
16
MA Forecast
12
8
4
1
Period
4-5
Exponential Smoothing for a Trend

Period Sales
1
8
2
11
3
13
4
15
5
19
6
MA
10.67
13.00
15.67
MA
Erro
r
4.33
6.00
?
ES
11
11
12
13.5
16.25
ES
Error
3.0
5.5
?
MA = 3 period Moving Average

ES = Exponential Smoothing with =0.5 (F2=11)
4-6
Trend Graph
20
ES Forecast
Actual
16
MA Forecast
12
8
4
1
Period
4-7
Forecasting a Trend
Moving Averages and (simple) Exponential
Smoothing are always poor.
For a linear trend can use:
Exponential Smoothing with Trend Adjustment

(skip: pp. 90-92).
Linear Trend Projection (linear regression).
For non-linear trend can use:
Non-linear regression techniques.
4-8
Linear Trend Projection

Used for forecasting linear trend line.
PLOT TO VERIFY LINEAR RELATIONSHIP
Assumes linear relationship between

response variable, Y, and time, X.
Y = a + bX
a = y-axis intercept; b = slope
Estimated by least squares method.
Minimizes sum of squared errors.
4-9
Plot of X,Y Data

Values of Dependent Variable (Y)
Actual
observation
Time (x)
4-10
Least Squares
Actual
observation
Deviation
Deviation
Deviation
Deviation
Deviation
Deviation
Deviation
Y a bx
Time (x)
4-11
Point on
regression
line
Least Squares
Least squares line minimizes sum of squared
deviations.
This reduces large errors.
Similar to MSE.
Deviations around least squares line are

assumed to be random.
4-12
Least Squares Equations

Equation:
i a bx i
Y
n
Slope (p. 94):
x i y i nx y
b in
x i nx
i
Y-Intercept:
a y bx
4-14
Linear Trend Projection Example

Perio
d
1(x)
2
3
4
5
x=3
Sales
(y)
x2
1
8
8
4
11
22
39
9
13
60
16
15
25
19
95
y=13.2 xy=224 x2=55
224 5 3 13.2
b
2.6
2
55 5 3
4-15
xy
66
15
a 2.6 5.4
5
5
Linear Trend Projection Example

Period Sales
(x)
(y)
1
8
2
11
3
13
4
15
5
19
6
MA
10.67
13.00
15.67
MA
Err.
ES
ES
Err. TP
TP
Err.
11
11
4.33 12 3.0 15.8 -0.8
6.00 13.5 5.5 18.4 0.6
16.25
21.0
TP = Trend Projection: Y = 5.4 + 2.6x

4-16
Small errors!
Trend Graph
TP Forecast
20
ES Forecast
Actual
16
MA Forecast
12
8
4
1
Period
4-17
Models with Seasonality

Use if data exhibits seasonal patterns.
Daily, weekly, monthly, yearly.
Compute seasonal component.

Remove seasonality and forecast.
Factor in seasonal component.
See pages 96-100.
4-18
Associative Forecasting Methods

Identify Independent and dependent variable.
Dependent variable (y): Entity to be forecast (demand).
Independent variable (x): Used to predict (or explain)
dependent variable.
Determine relationship.
Plot data.
Consider time lags.
Calculate parameters.
Forecast.
Monitor.
4-19
Linear Regression
Linear relationship between dependent & explanatory
variables.
Example: Sales in month i (Yi ) depends on advertising in month i

(Xi ) (eg. number of ads)
Yi = a + b X i
Dependent variable (sales).
Independent variable
(number of ads).
Sales may also depend on advertising in previous months!
4-20
Least Squares
Actual
observation
Deviation
Deviation
Deviation
Deviation
Deviation
Deviation
Deviation
Y a bx
Values of Independent Variable (x)
4-21
Point on
regression
line
Linear Regression Equations

(same as before)
Equation:
i a bx i
Y
n
x i y i nx y
b i n
x i nx
Slope:
a y bx
Y-Intercept:
4-22
Interpretation of Coefficients
Slope (b):
Y changes by b units for each 1 unit increase in X.
If b = +2, then sales (Y) is forecast to increase by 2 for
each 1 unit increase in advertising (X).
Y-intercept (a):
Average value of Y when X = 0.
If a = 4, then average sales (Y) is expected to be 4
when advertising (X) is 0.
4-23
Least Squares
Plot data to verify linearity!
If curve is present, use non-linear regression.
Forecast only in (or near) range of observed

values!
May need future values of independent
variable to make forecast.
Example: Summer hotel demand may depend on

summer gasoline price.
4-24
Sales
Monthly Sales vs. Number of Ads
Number of TV ads per month
4-25
Least Squares Line
Sales
What is sales
forecast for
small number
of ads?
Y a bx
4-26
Forecasting Outside Range of

Observed Values is Unreliable
Sales
Forecast is for
negative sales!
Y a bx
4-27
Correlation
Answers: How strong is the linear relationship
between the variables?
Coefficient of correlation - r
Measures degree of association; ranges from -1 to +1
Coefficient of determination - r2
Amount of variation explained by regression equation.
Used to evaluate quality of linear relationship.

4-28
Sample Coefficient of Correlation
n x i yi x i yi

n
x
x
n
y
i
i
i
i
i
i
i
i
n
4-29
Coefficient of Correlation
r = +1
r = -1
Y
X
r = .89
r=0
Y
X
4-30
Guidelines for Selecting

Forecasting Model
You want to achieve:
No pattern or direction in forecast error.
Error = Actual - Forecast
Small forecast error.

Mean square error (MSE).
Mean absolute deviation (MAD).
Mean absolute percentage error (MAPE).
4-31
Pattern of Forecast Error

Desired Pattern
Trend Not Fully

Accounted for
Error
Error
Time
Time
4-32
Selecting Forecasting Model

Example
Youre a marketing analyst for Hasbro Toys. Youve forecast sales
with a linear regression model & exponential smoothing. Which
model do you use?
Linear Regression Exponential

Actual Model
Smoothing
Year
Sales
Forecast
1
2
3
4
5
1
1
2
2
4
0.6
1.3
2.0
2.7
3.4
4-33
Forecast (.9)
1.00
1.00
1.00
1.90
1.99
Linear Regression Model

Year
Yi
Fcast
Error
Error2
|Error|
1
2
3
4
5
Total
1
1
2
2
4
0.6
1.3
2.0
2.7
3.4
0.4
-0.3
0.0
-0.7
0.6
0.0
0.16
0.09
0.00
0.49
0.36
1.10
0.4
0.3
0.0
0.7
0.6
2.0
MSE = Error2 / n = 1.10 / 5 = 0.220

MAD = |Error| / n = 2.0 / 5 = 0.400
MAPE = [|Error|/Actual]/n = 1.2/5 = 0.24 = 24%
4-34
Exponential Smoothing Model

Year
Yi
1
2
3
4
5
Total
1
1
2
2
4
Fcast
1.00
1.00
1.00
1.90
1.99
Error
0.0
0.0
1.0
0.1
2.01
0.3
Error2
0.00
0.00
1.00
0.01
4.04
5.05
|Error|
0.0
0.0
1.0
0.1
2.01
3.11
MSE = Error2 / n = 5.05 / 5 = 1.01

MAD = |Error| / n = 3.11 / 5 = 0.622
4-35
Which is Better???
Linear Regression Model:
MSE = Error2 / n = 1.10 / 5 = 0.220
MAD = |Error| / n = 2.0 / 5 = 0.400
Exponential Smoothing Model:
MSE = Error2 / n = 5.05 / 5 = 1.01
MAD = |Error| / n = 3.11 / 5 = 0.622
4-36
Tracking Signal
Measures how well the forecast is predicting
actual values.
To use:
Calculate tracking signal each time period.

Ratio of running sum of forecast errors (RSFE) to mean absolute
deviation (MAD).
Plot tracking signal on graph.

Good tracking signal has low values.
Should be within upper and lower control limits (often

based on MAD).
4-37
Plot of a Tracking Signal

Signal exceeded limit
MAD
Upper control limit
0
-
Tracking signal
Acceptable range
Lower control limit
Time
4-38
Tracking Signal Equation

TS
RSFE
MAD
y i y i
i 1
MAD
4-39
(error )
MAD
Tracking Signal - Month 1

Mo Fcst
100
Act Error
RSFE
90
4-40
Cum
|Error|
MAD
TS

Mo Fcst
100
Act Error
RSFE
-10
-10
90
Cum
|Error|
MAD
TS
Error
Error==Actual
Actual--Forecast
Forecast
==90
90--100
100==-10
-10
RSFE
RSFE== Errors
Errors ==-10
-10
4-41

Mo Fcst
100
Act Error
RSFE
-10
-10
90
Cum
|Error|
MAD
10
Cum
Cum|Error|
|Error|== |Errors|
|Errors|
== 10
10
4-42
TS

Mo Fcst
100
Act Error
RSFE
-10
-10
90
Cum
|Error|
10
MAD
10.0
MAD
MAD== |Errors|/n
|Errors|/n
==10/1
10/1==10
10
4-43
TS

Mo Fcst
100
Act Error
RSFE
-10
-10
90
Cum
|Error|
10
TS
TS==RSFE/MAD
RSFE/MAD
==-10/10
-10/10==-1
-1
4-44
MAD
10.0
TS
-1

Mo Fcst
Act Error
RSFE
-10
-10
100
90
99
94
4-45
Cum
|Error|
10
MAD
10.0
TS
-1

Mo Fcst
Act Error
RSFE
-10
100
90
-10
99
94
-5
Cum
|Error|
10
MAD
10.0
Error
Error==Actual
Actual--Forecast
Forecast
==94
94--99
99==-5
-5
4-46
TS
-1

Mo Fcst
Act Error
RSFE
100
90
-10
-10
99
94
-5
-15
Cum
|Error|
10
MAD
10.0
RSFE
RSFE== Errors
Errors
==(-10)
(-10)++(-5)
(-5)==-15
-15
4-47
TS
-1

Mo Fcst
Act Error
RSFE
Cum
|Error|
100
90
-10
-10
10
99
94
-5
-15
15
MAD
10.0
Cum
CumError
Error== |Errors|
|Errors|
==10
10++55==15
15
4-48
TS
-1

Mo Fcst
Act Error
RSFE
Cum
|Error|
MAD
100
90
-10
-10
10
10.0
99
94
-5
-15
15
7.5
MAD
MAD== |Errors|/n
|Errors|/n
==15/2
15/2==7.5
7.5
4-49
TS
-1

Mo Fcst
Act Error
RSFE
Cum
|Error|
MAD
TS
100
90
-10
-10
10
10.0
-1
99
94
-5
-15
15
7.5
-2
TS
TS==RSFE/MAD
RSFE/MAD
==-15/7.5
-15/7.5==-2
-2
4-50

Mo Fcst
Act Error
RSFE
Cum
|Error|
MAD
TS
100
90
-10
-10
10
10.0
-1
99
94
-5
-15
7.5
-2
98
113
15
15
3
0
4-51
1
0
Tracking Signal - Months 4-6

Mo Fcst
Act Error
RSFE
Cum
|Error|
MAD
TS
100
90
-10
-10
10
10.0
-1
99
94
-5
-15
7.5
-2
98
113
15
105
95
-10
-10
104
119
15
110
140
30
35
15
3
0
4
0
5
5
8
5
4-52
1
0
10
-1
11
.45
14.2 2.47
Demand and Forecast

140
130
120
110
100
90
80
70
Forecast
Actual demand
4
Month
4-53
Tracking Signal
Tracking Signal
3
2
1
0
-1
-2
-3
0
4
Time
4-54
Tracking Signal Limits

Upper and lower limits depend on the product
being forecast.
98% of values should be within 3 MAD.
99.9% of values should be within 4 MAD.
Use smaller limits for high volume items.
For example: +2 MAD, -2 MAD
Patterns, even if within limits, indicate better

forecasts can be made.
4-55
Selecting Forecasting Model

Example - Revisited
Youre a marketing analyst for Hasbro Toys. Youve forecast sales
with a linear regression model & exponential smoothing. Which
model do you use?
Linear Regression Exponential

Actual Model
Smoothing
Year
Sales
Forecast
1
2
3
4
5
1
1
2
2
4
0.6
1.3
2.0
2.7
3.4
4-56
Forecast (.9)
1.00
1.00
1.00
1.90
1.99
Linear Regression Model

Tracking Signal
Year
Yi
Fcast
Error
1
2
3
4
5
1
1
2
2
4
0.6
1.3
2.0
2.7
3.4
0.4
-0.3
0.0
-0.7
0.6
4-57
MAD
0.4
0.35
0.233
0.35
0.40
TS
1.0
0.29
0.43
-1.71
0.0
Exponential Smoothing Model

Tracking Signal
Year
Yi
1
2
3
4
5
1
1
2
2
4
Fcast
1.00
1.00
1.00
1.90
1.99
4-58
Error
0.0
0.0
1.0
0.1
2.01
MAD
0.0
0.0
0.33
0.275
0.622
TS
0.0
0.0
3.0
4.0
5.0
Tracking Signals
Exponential Smoothing
Tracking Signal
3
2
1
0
-1
Linear Regression
-2
-3
0
4
Year
4-59
Forecasting in the Service Sector

Presents unusual challenges:
Large variability (during day, week, etc.).
Special need for short term forecasting.
Needs differ greatly as function of industry and

product.
Issues of holidays and calendar.
Examples: Staffing for hospitals, fast-food

restaurants, banking, etc.
4-60
Forecasting Summary
Determine purpose of forecast first.
Plot data.
Use several appropriate methods.
Continually monitor, evaluate and adjust
methods to improve forecasts.
4-61

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Operations

Moving Averages for a Trend

MA = 3 period Moving Average

Exponential Smoothing for a Trend

MA = 3 period Moving Average

Exponential Smoothing with Trend Adjustment

For non-linear trend can use:

Non-linear regression techniques.

Linear Trend Projection

PLOT TO VERIFY LINEAR RELATIONSHIP

Assumes linear relationship between

a = y-axis intercept; b = slope

Estimated by least squares method.

Minimizes sum of squared errors.

Plot of X,Y Data

Deviations around least squares line are

Least Squares Equations

Slope (p. 94):

Linear Trend Projection Example

Linear Trend Projection Example

TP = Trend Projection: Y = 5.4 + 2.6x

Models with Seasonality

Daily, weekly, monthly, yearly.

Compute seasonal component.

Associative Forecasting Methods

Consider time lags.

Example: Sales in month i (Yi ) depends on advertising in month i

Sales may also depend on advertising in previous months!

Linear Regression Equations

If curve is present, use non-linear regression.

Forecast only in (or near) range of observed

Example: Summer hotel demand may depend on

Monthly Sales vs. Number of Ads

Number of TV ads per month

Least Squares Line

Forecasting Outside Range of

Measures degree of association; ranges from -1 to +1

Amount of variation explained by regression equation.

Used to evaluate quality of linear relationship.

Sample Coefficient of Correlation

Guidelines for Selecting

Error = Actual - Forecast

Small forecast error.

Pattern of Forecast Error

Trend Not Fully

Selecting Forecasting Model

Linear Regression Exponential

Linear Regression Model

MSE = Error2 / n = 1.10 / 5 = 0.220

Exponential Smoothing Model

MSE = Error2 / n = 5.05 / 5 = 1.01

Calculate tracking signal each time period.

Plot tracking signal on graph.

Should be within upper and lower control limits (often

Plot of a Tracking Signal

Upper control limit

Tracking Signal Equation

Tracking Signal - Month 1

Tracking Signal - Month 1

Tracking Signal - Month 1

Tracking Signal - Month 1

Tracking Signal - Month 1