Operations Management

Forecasting

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

What is Forecasting?
Process of predicting a future event
Underlying basis of all business decisions

Sales will be $200 Million!

Production Inventory Personnel Facilities

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Types of Forecasts
Economic forecasts

Address business cycle, e.g., inflation rate, money supply etc.

Technological forecasts
Predict rate of technological progress Predict acceptance of new product

Demand forecasts

Predict sales of existing product

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Types of Forecasts by Time Horizon

Short-range forecast
Up to 1 year; usually less than 3 months Job scheduling, worker assignments

Medium-range forecast
3 months to 3 years Sales & production planning, purchasing, budgeting

Long-range forecast
3+ years

New product planning, facility location

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

What Do We Forecast - Aggregation

Clustering goods or services that have similar demand requirements and common processing, labor, and materials requirements:
Red shirts White shirts Blue shirts Big Mac Quarter Pounder Regular Hamburger

Shirts

What about Why units doof we measurement aggregate? ?

Pounds of Beef

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Realities of Forecasting
Forecasts are seldom perfect Most forecasting methods assume that there is some underlying stability in the system Both product family and aggregated product forecasts are more accurate than individual product forecasts

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Time Series Components

Trend Cyclical

Seasonal

Random

4-7 2001 by Prentice Hall,

PowerPoint presentation to accompany Operations Management, 6E (Heizer & Render)

Trend Component
Persistent, overall upward or downward pattern Due to population, technology etc. Several years duration
Response

Time
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

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

Response

Summer

Time
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Cyclical Component
Repeating up & down movements Due to interactions of factors influencing economy Usually 2-10 years duration
Cycle Response

Time

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Product Demand
Seasonal peaks Demand for product or service Trend component

Actual demand line

Random variation
Year 1 Year 2
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Average demand over four years

Year 3

Year 4
2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Forecasting Approaches
Qualitative Methods
Used when situation is vague & little data exist
New products New technology

Quantitative Methods
Used when situation is stable & historical data exist
Existing products Current technology

Involves intuition, experience

e.g., forecasting sales on Internet

Involves mathematical techniques

e.g., forecasting sales of color televisions

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Overview of Qualitative Methods

Jury of executive opinion

Pool opinions of high-level executives, sometimes augmented by statistical models Panel of experts, queried iteratively
Estimates from individual salespersons are reviewed for reasonableness, then aggregated Ask the customer
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Delphi method

Sales force composite

Consumer Market Survey

Jury of Executive Opinion

Involves small group of high-level managers

Group estimates demand by working together

Combines managerial experience with statistical models Relatively quick Group-think disadvantage

4-14 2001 by Prentice Hall,

PowerPoint presentation to accompany Operations Management, 6E (Heizer & Render) 1995 Corel Corp.

Sales Force Composite

Each salesperson projects their sales Combined at district & national levels Sales reps know customers wants Tends to be overly optimistic
4-15 2001 by Prentice Hall,

Sales

1995 Corel Corp.

PowerPoint presentation to accompany Operations Management, 6E (Heizer & Render)

Delphi Method
Iterative group process 3 types of people
Decision makers Staff Respondents

Staff (What will

sales be? survey)

(Sales will be 50!)

Decision (Sales?) Makers

Reduces group-think
(Sales will be 45, 50, 55)
4-16 2001 by Prentice Hall,

Respondents

PowerPoint presentation to accompany Operations Management, 6E (Heizer & Render)

Consumer Market Survey

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

How many hours will you use the Internet next week?

1995 Corel Corp.

4-17 2001 by Prentice Hall,

PowerPoint presentation to accompany Operations Management, 6E (Heizer & Render)

Overview of Quantitative Approaches

Nave approach Moving averages Exponential smoothing Trend projection Seasonal variation

Time-series Models

Linear regression
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Associative Models

2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

What is a Time Series?

Set of evenly spaced numerical data

Observing the response variable at regular time intervals

Forecast based only on past values

Assumes that factors influencing the past and present will continue to influence the future

Example
Year: Sales: 1999 78.7 2000 63.5 2001 89.7 2002 93.2 2003 92.1

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

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

Sometimes cost effective & efficient

1995 Corel Corp.

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Simple Moving Average

Forecast

Demand in Previous n
n
A t1 + A
t2

Periods

Ft

+A

t 3

+A

t4

Ft

A t 1 + A t 2 + A
3

t 3

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Weighted Moving Average

Forecast = (Weight for period n) (Demand in period n) Weights
t4

Ft
Ft

= .4A t1 + .3A t2 + .2A t3 + .1A

= .7A t1 + .2A t2 + .1A t3

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Exponential Smoothing Method

Form of weighted moving average

Weights decline exponentially Most recent data weighted most Ranges from 0 to 1 Subjectively chosen

Requires smoothing constant ()

Involves little record keeping of past data

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Exponential Smoothing
Forecast = (Demand last period) + (1 ) ( Last forecast)

Ft

= A t1 + (1 ) (F t1) = A t1 + F t1 F t1 = F t1 + (A t1 F t1)

Forecast =

Last forecast + (Last demand Last forecast)

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Exponential Smoothing with Trend Adjustment

Forecast = Exponentially smoothed forecast (Ft ) + Exponentially smoothed trend (Tt ) Tt = (Forecast this period Forecast last period) + (1- ) (Trend estimate last period)

= (Ft - Ft-1) + (1- )Tt-1

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Seasonal Variation
Quarter Year 1 Year 2 Year 3 Year 4

1 2 3 4
Total Average

45 335 520 100

1000 250

70 370 590 170

1200 300

100 585 830 285

1800 450

100 725 1160 215

2200 550

Actual Demand Seasonal Index = Average Demand Forecast for Year 5 = 2600
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45 250

= 0.18

2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Seasonal Variation
Quarter Year 1 Year 2 Year 3 Year 4

1 2 3 4

45/250 = 0.18 335/250 = 1.34 520/250 = 2.08 100/250 = 0.40

70/300 = 0.23 370/300 = 1.23 590/300 = 1.97 170/300 = 0.57

100/450 = 0.22 100/550 = 0.18 585/450 = 1.30 725/550 = 1.32 830/450 = 1.84 1160/550 = 2.11 285/450 = 0.63 215/550 = 0.39

Quarter 1 2 3 4

Average Seasonal Index (0.18 + 0.23 + 0.22 + 0.18)/4 = 0.20 (1.34 + 1.23 + 1.30 + 1.32)/4 = 1.30 (2.08 + 1.97 + 1.84 + 2.11)/4 = 2.00 (0.40 + 0.57 + 0.63 + 0.39)/4 = 0.50

Forecast 650(0.20) = 130 650(1.30) = 845 650(2.00) = 1300 650(0.50) = 325

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Overview of Quantitative Approaches

Nave approach Moving averages Exponential smoothing Trend projection Seasonal variation

Time-series Models

Linear regression
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Associative Models

2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Linear Regression
Factors Associated with Our Sales
Advertising
Pricing Competitors Economy Weather

Sales

Independent Variables
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Dependent Variable
2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Scatter Diagram
Sales (in $ hundreds of thousands)

Sales vs. Payroll

4

3
2 1

Now What?
0 1 2 3 4 5 6 7 8

0
Area Payroll (in $ hundreds of millions)
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Types of Forecasts by Time Horizon

Short-range forecast
Up to 1 year; usually less than 3 months Job scheduling, worker assignments

Time Series

Medium-range forecast
3 months to 3 years Sales & production planning, budgeting

Associative Qualitative

Long-range forecast
3+ years

New product planning, facility location

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Forecast Error

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Forecast Error
E t = A t Ft
3 +5

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Forecast Error - CFE

CFE Cumulative sum of Forecast Errors

CFE = Et
Positive errors offset negative errors Useful in assessing bias in a forecast

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Forecast Error - MSE

MSE Mean Squared Error

MSE = Et n

Accentuates large deviations

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Forecast Error - MAD

MAD Mean Absolute Deviation

MAD =

|Et |
n

Widely used, well understood measurement of forecast error

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Forecast Error - MAPE

MAPE Mean Absolute Percent Error

MAPE =

100

|Et | / At
n

Relates forecast error to the level of demand

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Forecast Error
Et = A t Ft

Et 2 MSE = Et
CFE =

n
MAD =

|Et |
n

MAPE = 100 |Et | / At n

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Monitoring & Controlling Forecasts

We need a TRACKING SIGNAL to measure how well the forecast is predicting actual values

TS = Running sum of forecast errors (CFE) Mean Absolute Deviation (MAD)

=

| Et | / n
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Et

Plot of a Tracking Signal

Signal exceeded limit

Upper control limit

Tracking signal CFE / MAD

0
Lower control limit Time

Acceptable range

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Forecasting in the Service Sector

Presents unusual challenges
special need for short term records needs differ greatly as function of industry and product issues of holidays and calendar unusual events

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Forecast of Sales by Hour for Fast Food Restaurant

20 15

10

0 +11-12

11-12 12-1 1-2 2-3

+1-2

+3-4

3-4 4-5 5-6

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+5-6

6-7 7-8 8-9 9-10 10-11

+7-8

+9-10

2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Factors to be considered in selecting a forecasting method

Cost and accuracy : In choosing a forecasting method a tradeoff may result between cost and accuracy .High accuracy models are more difficult to design operate and implement Statistical models , historic analogies , and executive committee consensus Low to moderate cost Econometric models , Delphi and market researchModerate to high In many situations simple and low cost forecasting methods tend to provide forecasts than that are as accurate as high cost methods

 Data available : The data that are available and relevant to forecasts is an important factor in choosing a forecasting method. Time span : The choice of the forecasting method is affected by the nature of the production resource Nature of product & service :Choice of a forecasting method is dependant on:

 High and cost : High or low Good or a service Product demand seasonal fluctuations Stage in the PLC :Growth /Maturity / decline

 Impulse Response and noise dampening: Degree of responsiveness required of the forecasting model to changes in the actual demand data Forecasting models differs in its impulse response and noise dampening abilities and the forecasting model chosen must fit the forecasting situation

How to monitor and control a forecasting method

Forecasts can be monitored and controlled by setting Upper and lower limits on how much the performance characteristics of a model can deteriorate before we change the parameters of the models Tracking Signal: Used for tracking the performance f a forecasting model TS = Algebraic sum of errors over n periods /Mean Absolute deviation over n periods

Sources of forecasting
Computer software for forecasting Forecast Pro Auto Box SAS SPSS SAP Forecasting software packages : Tailor made for the industry Management Consultants : Anderson Consulting , Booze Allen and Hamilton, BCG

Summary
Demand forecasts drive a firms plans Need to find the forecasting method(s) that best fit our pattern of demand no one right tool
- Production - Capacity - Scheduling

Track forecast error to determine if forecasting model requires change

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

- Qualitative methods e.g. customer surveys - Time series methods (quantitative) rely on historical demand to predict future demand - Associative models (quantitative) use historical data on independent variables to predict demand e.g. promotional campaign