Forecasting

BY: PRASAD PATIL B.E ( Mechanical Engg ) M.S( Industrial Engg ) Six Sigma Green Belt Certified Financial Planner (CFP) EMAIL ID: prasadpatil.dbit@gmail.com

Imagine ..

Lets assume that you are the Class Coordinator and you need to schedule the sessions for your classes
- What do you need to know to do this ?

Objectives of this Module

Identify or Define forecasting Types of forecast Time Horizons Approaches to Forecast

What is Forecasting ?

Process of predicting Future event It is the Basis for all BUSINES DECISIONS like - financing - Production - Man power recruitment - Facilities planning and Many more .

Sales will be $200 Million!

Forecasting
Forecasting is done for the purpose of Planning Performing Controlling Reacting Or It covers all the entities of P-D-C-A Cycle

P-D-C-A Cycle ???

Plan Do Check Act ( Also called DEMING Cycle )

Forecasting

Forecasts affect decisions and activities throughout an organization

Accounting, finance Human resources Marketing MIS Operations Product / service design

Uses of Forecasts
Accounting
Finance Human Resources Marketing MIS Operations Product/service design

Cost/profit estimates
Cash flow and funding Hiring/recruiting/training Pricing, promotion, strategy IT/IS systems, services Schedules, MRP, workloads New products and services

Benefits of Forecasting
Improved Forecasting
Better financial information Better marketing information Improved supply chain strategies Increased customer satisfaction Better allocation of resources Higher productivity Stability in planning Elimination of waste Higher flexibility

Enterprise Level

Operational Level

Steps in Forecasting
Underline the objective of forecasting
Determine the time horizon

Identify factors influencing forecasts

Determine apt forecasting technique

Validate and implement results

Types of Forecast
ECONOMICAL TECHNOLOGICAL DEMAND

Types of Forecast

ECONOMICAL TECHNOLOGICAL
Predict rate of technological progress Predict acceptance of new product

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

DEMAND

- Predict sales of existing product

Types of Forecast based on

TIME HORIZON
Short-Range

forecast Medium-range forecast Long-range forecast

Types of Forecast based on

TIME HORIZON
Short-Range

forecast
forecast

- Up to 1 year , less than 3 Months

Medium-range
3 Months to 3 years

Long-range
- 3 plus years

forecast

Differences ??

Medium/long range forecasts deal with more comprehensive issues and support management decisions regarding planning and products, plants and processes. Short-term forecasting usually employs different methodologies than longer-term forecasting Short-term forecasts tend to be more accurate than longer-term forecasts.

Steps in Forecasting

Product Demand ..Example

Seasonal peaks
Demand for product or service

Trend component

Actual demand line Average demand over four years

Random variation
Year 1 Year 2

Year 3

Year 4

Time Series Components

Trend (persistent) Seasonal (Regular pattern) Cyclical (repeating Up & down) Random (erratic,unsystematic)
Cycle

Mo., Qtr., Yr.

Summer

Mo., Qtr. Mo., Qtr., Yr.

Approach to Forecasting
QUALITATIVE METHODS QUANTITATIVE METHODS

Qualitative Methods..
Used when situation is vague & little data exist - New products - New technology Involves intuition, experience

e.g., forecasting sales on Internet

Quantitative Methods..
Used when situation is stable & historical data exist - Existing products - Current technology Involves mathematical techniques

e.g., forecasting sales of color televisions

Forecasting Methods..
* QUALITATIVE (judgement-based)
# Jury of Executive Opinion # Sales Force Composites # Delphi Method # Consumer Market Survey

* QUANTITATIVE ( Data-Based) # Time Series Models # Associative Models

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
1995 Corel Corp.

Sales Force Composite

Each salesperson projects his or her sales Combined at district & national levels Sales reps know customers wants Tends to be overly optimistic

Sales

1995 Corel Corp.

Delphi Method

Iterative group process 3 types of people

Decision Makers Staff (What will

sales be? survey) (Sales?) (Sales will be 50!)

Decision makers Staff Respondents

Reduces groupthink

(Sales will be 45, 50, 55)

Respondents

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.

Quantitative Forecasting Methods

Quantitative Forecasting
Time Series Models Associative Models

Moving Average

Exponential Smoothing

Trend Projection

Linear Regression

Time Series ?

Set of Evenly Spaces Numerical Data Based on Past Values Only

Eg: Year Income

1999 2000 2001 2002 2003 113 98 115 117 121

Time Series Components

Trend (persistent) Seasonal (Regular pattern) Cyclical (repeating Up & down) Random (erratic,unsystematic)
Cycle

Mo., Qtr., Yr.

Summer

Mo., Qtr. Mo., Qtr., Yr.

Moving Average Method

MA is a series of arithmetic means

Used if little or no trend

Used often for smoothing

Provides overall impression of data over time

Demand in Previous n Periods MA

n

Equation

Moving Average Example

Youre manager of a museum store that sells historical replicas. You want to forecast sales (000) for 2003 using a 3period moving average. 1998 4 1999 6 2000 5 2001 3 2002 7

Moving Average Solution

Time 1998 1999 2000 2001 2002 2003 Response Yi 4 6 5 3 7 NA Moving Total (n=3) NA NA NA 4+6+5=15 Moving Average (n=3) NA NA NA 15/3 = 5

Moving Average Solution

Time 1998 1999 2000 2001 2002 2003 Response Yi 4 6 5 3 7 NA Moving Total (n=3) NA NA NA 4+6+5=15 6+5+3=14 Moving Average (n=3) NA NA NA 15/3 = 5 14/3=4 2/3

Moving Average Solution

Time 1998 1999 2000 2001 2002 2003 Response Yi 4 6 5 3 7 NA Moving Total (n=3) NA NA NA 4+6+5=15 6+5+3=14 5+3+7=15 Moving Average (n=3) NA NA NA 15/3=5.0 14/3=4.7 15/3=5.0

Moving Average Graph

Sales 8 6 4 2
95 96 97 98 Year 99
Actual Forecast

00

Weighted Moving Average Method

Used when trend is present

Older data usually less important

Often lay between 0 & 1, & sum to 1.0

Weights based on intuition

Equation
(Weight for period n) (Demand in period n) Weights

WMA =

Actual Demand, Moving Average, Weighted Moving Average

35 30

Weighted moving average Actual sales

Sales Demand

25 20 15 10 5 0

Moving average
Fe b M ar A pr M ay Ju n Ju l A ug Se p O ct N ov D ec
Month

Ja

Disadvantages of Moving Average Methods

Increasing n makes forecast less sensitive to changes Do not forecast trend well Require much historical data

Quantitative Forecasting Methods

Quantitative Forecasting
Time Series Models Associative Models

Moving Average

Exponential Smoothing

Trend Projection

Linear Regression

Exponential Smoothing Method

Form of weighted moving average

Weights decline exponentially Most recent data weighted most

Requires smoothing constant ()

Ranges from 0 to 1 Subjectively chosen

Involves little record keeping of past data

Exponential Smoothing Equations

Ft = At - 1 + (1-)At - 2 + (1- )2At

-3

+ (1- )3At - 4 + ... + (1- )t1A 0

Ft = Forecast value At = Actual value = Smoothing constant

Ft = Ft-1 + (At-1 - Ft-1)

Use for computing forecast

Exponential Smoothing Example

During the past 8 quarters, the Port of Baltimore has unloaded large quantities of grain. ( = .10). The first quarter forecast was 175.. QuarterActual 1 2 3 4 5 6 7 8 9 180 168 159 175 190 205 180 182 ?

Find the forecast for the 9th quarter.

Exponential Smoothing Solution

Ft = Ft-1 + 0.1(At-1 - Ft-1)
Quarter 1 Actual 180 Forecast, F t ( = .10) 175.00 (Given) 175.00 +

2
3 4 5 6

168
159 175 190 205

Exponential Smoothing Solution

Ft = Ft-1 + 0.1(At-1 - Ft-1)
Quarter Actual 1 2 3 4 5 6 180 168 159 175 190 205 175.00 + .10(

Forecast, F t ( = .10)
175.00 (Given)

Exponential Smoothing Solution

Ft = Ft-1 + 0.1(At-1 - Ft-1)
Quarter Actual Forecast, Ft ( = .10)

1
2 3 4 5 6

180
168 159 175 190 205 175.00 + .10(180 -

175.00 (Given)

Exponential Smoothing Solution

Ft = Ft-1 + 0.1(At-1 - Ft-1)
Quarter Actual Forecast, Ft ( = .10)

1
2 3 4 5 6

180
168 159 175 190 205

175.00 (Given)
175.00 + .10(180 - 175.00)

Exponential Smoothing Solution

Ft = Ft-1 + 0.1(At-1 - Ft-1)
Quarter Actual 1 2 3 4 5 6 180 168 159 175 190 205

Forecast, Ft ( = .10)
175.00 (Given) 175.00 + .10(180 - 175.00) = 175.50

Exponential Smoothing Solution F = F + 0.1(A - F )

t t-1 t-1 t-1

Quarter 1 2 3 4 5 6

Actual 180 168 159 175 190 205

Forecast, F t ( = .10)
175.00 (Given) 175.00 + .10(180 - 175.00) = 175.50 175.50 + .10(168 - 175.50) = 174.75

Exponential Smoothing SolutionF = F + 0.1(A - F )

t t-1 t-1 t-1

Quarter Actual 1995 180

Forecast, F t ( = .10) 175.00 (Given)

1996
1997 1998

168
159 175

175.00 + .10(180 - 175.00) = 175.50

175.50 + .10(168 - 175.50) = 174.75 174.75 + .10(159 - 174.75)= 173.18

1999 2000

190 205

Exponential Smoothing Solution F = F + 0.1(A - F )

t t-1 t-1 t-1

Quarter Actual 1 2 3 4 5 6 180 168 159 175 190 205

Forecast, F t ( = .10)
175.00 (Given) 175.00 + .10(180 - 175.00) = 175.50 175.50 + .10(168 - 175.50) = 174.75 174.75 + .10(159 - 174.75) = 173.18 173.18 + .10(175 - 173.18) = 173.36

Exponential Smoothing Solution

Ft = Ft-1 + 0.1(At-1 - Ft-1)
Quarter Actual 1 180 Forecast, F t ( = .10) 175.00 (Given)

2
3 4 5 6

168
159 175 190 205

175.00 + .10(180 - 175.00) = 175.50

175.50 + .10(168 - 175.50) = 174.75 174.75 + .10(159 - 174.75) = 173.18 173.18 + .10(175 - 173.18) = 173.36 173.36 + .10(190 - 173.36) = 175.02

Exponential Smoothing Solution

Ft = Ft-1 + 0.1(At-1 - Ft-1)
Time Actual Forecast, F t ( = .10)

4
5 6 7 8 9

175
190 205 180

174.75 + .10(159 - 174.75) = 173.18

173.18 + .10(175 - 173.18) = 173.36 173.36 + .10(190 - 173.36) = 175.02 175.02 + .10(205 - 175.02) = 178.02

Exponential Smoothing Solution

Ft = Ft-1 + 0.1(At-1 - Ft-1)
Time Actual Forecast, F t ( = .10)

4
5 6 7 8 9

175
190 205 180

174.75 + .10(159 - 174.75) = 173.18

173.18 + .10(175 - 173.18) = 173.36 173.36 + .10(190 - 173.36) = 175.02 175.02 + .10(205 - 175.02) = 178.02 178.02 + .10(180 - 178.02) = 178.22 178.22 + .10(182 - 178.22) = 178.58

182 ?

Quantitative Forecasting Methods

Quantitative Forecasting
Time Series Models Associative Models

Moving Average

Exponential Smoothing

Trend Projection

Linear Regression

Exponential Smoothing with Trend Adjustment

Forecast including trend (FITt) = exponentially smoothed forecast (Ft) + exponentially smoothed trend (Tt)

Exponential Smoothing with Trend Adjustment

or
Ft = Last periods forecast + (Last periods actual Last periods forecast) Ft = Ft-1 + (At-1 Ft-1)

Tt = (Forecast this period - Forecast last period) + (1- )(Trend estimate last period or Tt = (Ft - Ft-1) + (1- )Tt-1

Exponential Smoothing with Trend Adjustment

Ft = exponentially smoothed forecast of the data series in period t Tt = exponentially smoothed trend in period t At = actual demand in period t = smoothing constant for the average = smoothing constant for the trend

If = 0.4 Calculate the Trend Adjusted Exponential Smoothing Forecast FIT for the given example

( Typically lies between 0.1 to 0.5 ) For Initial period , FIT = Ft

Comparing Actual and Forecasts

40 35 30 25
Demand

Actual Demand

20 15 10 5 0 1 2 3 4 5 Month 6 7 8 9 10

Forecast including trend

Smoothed Forecast Smoothed Trend

Quantitative Forecasting Methods

Quantitative Forecasting
Time Series Models Associative Models

Moving Average

Exponential Smoothing

Trend Projection

Linear Regression

Causal Models

Best known causal method is regression Independent variables Dependent variables

Simplest form Y = mX + c Where c = intercept m = slope

Causal Models
40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 1 2 3

(contd)

Regression Analysis for Demand Data y = 1549x + 8881.2 R = 0.2317

2

Demand (units)

10

11

12

Period (t) Demand Linear (Demand)

Causal Models

(contd)

R2 value Coefficient of determination

Proportion of observed variation that can be explained by the regression model

Value provides information regarding goodness-of-fit of the model Higher value of R2, more successful is the model in explaining the variation

Customizing Forecasting Methods

Forecasting is an art and science

One size does not fit all

One method can fit the data at hand, but may not forecast well Necessary to develop models that best explains the data

Principles of forecasting

Better processes yield better forecasts. Demand forecasting is being done in virtually every company. The challenge is to do it better than the competition. Better forecasts result in better customer service and lower costs, as well as better relationships with suppliers and customers. The forecast can and must make sense based on the big picture, economic outlook, market share, and so on. The best way to improve forecast accuracy is to focus on reducing forecast error. Bias is the worst kind of forecast error; strive for zero bias. Whenever possible, forecast at higher, aggregate levels. Forecast in detail only where necessary. Far more can be gained by people collaborating and communicating well than by using the most advanced forecasting technique or model.

Forecast Accuracy
Error - difference between actual value and predicted value Mean Absolute Deviation (MAD)

Average absolute error

Average of squared error Average absolute percent error

Mean Squared Error (MSE)

Mean Absolute Percent Error (MAPE)

MAD, MSE, and MAPE

MAD = Actual forecast

n
= ( Actual forecast)
2

MSE

n -1
( Actual foreca MAPE = st n / Actual*100)

MAD, MSE and MAPE

MAD
Easy to compute Weights errors linearly

MSE
Squares error More weight to large errors

MAPE

Puts errors in perspective

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