Operations

Management
Chapter 4 –
Forecasting

PowerPoint presentation to accompany

Heizer/Render
Principles of Operations Management, 7e
Operations Management, 9e
© 2008 Prentice Hall, Inc. 4–1
 What is Forecasting?
 Process of
predicting a future
event
 Underlying basis of
??
all business
decisions
 Production
 Inventory
 Personnel
 Facilities
© 2008 Prentice Hall, Inc. 4–2
 Forecasting Time Horizons
 Short-range forecast
 Up to 1 year, generally less than 3 months
 Purchasing, job scheduling, workforce
levels, job assignments, production levels
 Medium-range forecast
 3 months to 3 years
 Sales and production planning, budgeting
 Long-range forecast
 3+ years
 New product planning, facility location,
research and development
© 2008 Prentice Hall, Inc. 4–3
 Distinguishing 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

© 2008 Prentice Hall, Inc. 4–4

 Influence of Product Life
Cycle
Introduction – Growth – Maturity – Decline
 Introduction and growth require longer
forecasts than maturity and decline
 As product passes through life cycle,
forecasts are useful in projecting
 Staffing levels
 Inventory levels
 Factory capacity

© 2008 Prentice Hall, Inc. 4–5

 Product Life Cycle
Introduction Growth Maturity Decline
Best period to Practical to change Poor time to Cost control
Company Strategy/Issues

increase market price or quality change image, critical

share image price, or quality

R&D engineering is Strengthen niche Competitive costs

critical become critical
Defend market
position
CD-ROMs
Internet search engines
Analog TVs
Drive-through
LCD & plasma TVs restaurants

Sales iPods

3 1/2”
Xbox 360 Floppy
disks

Figure 2.5
© 2008 Prentice Hall, Inc. 4–6
 Product Life Cycle
Introduction Growth Maturity Decline
Product design Forecasting Standardization Little product
and critical Less rapid differentiation
development Product and product changes Cost
OM Strategy/Issues

critical process – more minor minimization

Frequent reliability changes Overcapacity
product and Competitive Optimum in the
process design product capacity industry
changes improvements Increasing Prune line to
Short production and options stability of eliminate
runs Increase capacity process items not
High production Shift toward Long production returning
costs product focus runs good margin
Limited models Enhance Product Reduce
Attention to distribution improvement capacity
quality and cost cutting

Figure 2.5
© 2008 Prentice Hall, Inc. 4–7
 Types of Forecasts
 Economic forecasts
 Address business cycle – inflation rate,
money supply, housing starts, etc.
 Technological forecasts
 Predict rate of technological progress
 Impacts development of new products
 Demand forecasts
 Predict sales of existing products and
services

© 2008 Prentice Hall, Inc. 4–8

 Strategic Importance of
Forecasting

 Human Resources – Hiring, training,

laying off workers
 Capacity – Capacity shortages can
result in undependable delivery, loss
of customers, loss of market share
 Supply Chain Management – Good
supplier relations and price
advantages

© 2008 Prentice Hall, Inc. 4–9

 Seven Steps in Forecasting
 Determine the use of the forecast
 Select the items to be forecasted
 Determine the time horizon of the
forecast
 Select the forecasting model(s)
 Gather the data
 Make the forecast
 Validate and implement results
© 2008 Prentice Hall, Inc. 4 – 10
 The Realities!

 Forecasts are seldom perfect

 Most techniques assume an
underlying stability in the system
 Product family and aggregated
forecasts are more accurate than
individual product forecasts

© 2008 Prentice Hall, Inc. 4 – 11

 Forecasting Approaches
Qualitative Methods
 Used when situation is vague
and little data exist
 New products
 New technology
 Involves intuition, experience
 e.g., forecasting sales on Internet

© 2008 Prentice Hall, Inc. 4 – 12

 Forecasting Approaches
Quantitative Methods
 Used when situation is ‘stable’ and
historical data exist
 Existing products
 Current technology
 Involves mathematical techniques
 e.g., forecasting sales of color
televisions

© 2008 Prentice Hall, Inc. 4 – 13

 Overview of Qualitative
Methods
 Jury of executive opinion
 Pool opinions of high-level experts,
sometimes augment by statistical
models
 Delphi method
 Panel of experts, queried iteratively

© 2008 Prentice Hall, Inc. 4 – 14

 Overview of Qualitative
Methods
 Sales force composite
 Estimates from individual
salespersons are reviewed for
reasonableness, then aggregated
 Consumer Market Survey
 Ask the customer

© 2008 Prentice Hall, Inc. 4 – 15

 Jury of Executive Opinion
 Involves small group of high-level experts
and managers
 Group estimates demand by working
together
 Combines managerial experience with
statistical models
 Relatively quick
 ‘Group-think’
disadvantage

© 2008 Prentice Hall, Inc. 4 – 16

 Sales Force Composite
 Each salesperson projects his or
her sales
 Combined at district and national
levels
 Sales reps know customers’ wants
 Tends to be overly optimistic

© 2008 Prentice Hall, Inc. 4 – 17

 Delphi Method
 Iterative group Decision Makers
(Evaluate
process, responses and
continues until make decisions)
consensus is
reached Staff
(Administering
 3 types of survey)
participants
 Decision makers
 Staff Respondents
(People who can
 Respondents make valuable
judgments)
© 2008 Prentice Hall, Inc. 4 – 18
 Consumer Market Survey

 Ask customers about purchasing

plans
 What consumers say, and what
they actually do are often different
 Sometimes difficult to answer

© 2008 Prentice Hall, Inc. 4 – 19

 Overview of Quantitative
Approaches
1. Naive approach
2. Moving averages
Time-Series
3. Exponential Models
smoothing
4. Trend projection
Associative
5. Linear regression Model

© 2008 Prentice Hall, Inc. 4 – 20

 Time Series Forecasting
 Set of evenly spaced numerical data
 Obtained by observing response
variable at regular time periods
 Forecast based only on past values,
no other variables important
 Assumes that factors influencing
past and present will continue
influence in future

© 2008 Prentice Hall, Inc. 4 – 21

 Time Series Components

Trend Cyclical

Seasonal Random

© 2008 Prentice Hall, Inc. 4 – 22

 Components of Demand
Trend
component
Demand for product or service

Seasonal peaks

Actual
demand

Average
demand over
Random four years
variation
| | | |
1 2 3 4
Year Figure 4.1
© 2008 Prentice Hall, Inc. 4 – 23
 Trend Component
 Persistent, overall upward or
downward pattern
 Changes due to population,
technology, age, culture, etc.
 Typically several years
duration

© 2008 Prentice Hall, Inc. 4 – 24

 Seasonal Component
 Regular pattern of up and
down fluctuations
 Due to weather, customs, etc.
 Occurs within a single year
Number of
Period Length Seasons
Week Day 7
Month Week 4-4.5
Month Day 28-31
Year Quarter 4
Year Month 12
Year Week 52
© 2008 Prentice Hall, Inc. 4 – 25
 Cyclical Component
 Repeating up and down movements
 Affected by business cycle, political,
and economic factors
 Multiple years duration
 Often causal or
associative
relationships

0 5 10 15 20
© 2008 Prentice Hall, Inc. 4 – 26
 Random Component
 Erratic, unsystematic, ‘residual’
fluctuations
 Due to random variation or
unforeseen events
 Short duration and
nonrepeating

M T W T F
© 2008 Prentice Hall, Inc. 4 – 27
 Naive Approach

 Assumes demand in next

period is the same as
demand in most recent period
 e.g., If January sales were 68, then
February sales will be 68
 Sometimes cost effective and
efficient
 Can be good starting point

© 2008 Prentice Hall, Inc. 4 – 28

 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

Moving average = n

© 2008 Prentice Hall, Inc. 4 – 29

 Moving Average Example
Actual 3-Month
Month Shed Sales Moving Average
January 10
February 12
March 13
April 16 (10 + 12 + 13)/3 = 11 2/3
May 19 (12 + 13 + 16)/3 = 13 2/3
June 23 (13 + 16 + 19)/3 = 16
July 26 (16 + 19 + 23)/3 = 19 1/3

© 2008 Prentice Hall, Inc. 4 – 30

 Graph of Moving Average
Moving
30 –
Average
28 –
Forecast
26 – Actual
24 – Sales
Shed Sales

22 –
20 –
18 –
16 –
14 –
12 –
10 –
| | | | | | | | | | | |
J F M A M J J A S O N D

© 2008 Prentice Hall, Inc. 4 – 31

 Weighted Moving Average

 Used when trend is present

 Older data usually less important
 Weights based on experience and
intuition

∑ (weight for period n)

Weighted x (demand in period n)
moving average = ∑ weights

© 2008 Prentice Hall, Inc. 4 – 32

 Weights Applied Period
Weighted Moving Average
3 Last month
2 Two months ago
1 Three months ago
6 Sum of weights

Actual 3-Month Weighted

Month Shed Sales Moving Average
January 10
February 12
March 13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 = 121/6
May 19 [(3 x 16) + (2 x 13) + (12)]/6 = 141/3
June 23 [(3 x 19) + (2 x 16) + (13)]/6 = 17
July 26 [(3 x 23) + (2 x 19) + (16)]/6 = 201/2

© 2008 Prentice Hall, Inc. 4 – 33

 Potential Problems With
Moving Average
 Increasing n smooths the forecast
but makes it less sensitive to
changes
 Do not forecast trends well
 Require extensive historical data

© 2008 Prentice Hall, Inc. 4 – 34

 Moving Average And
Weighted Moving Average
Weighted
30 – moving
average
25 –
Sales demand

20 – Actual
sales
15 –
Moving
10 – average

5 –
| | | | | | | | | | | |
J F M A M J J A S O N D
Figure 4.2

© 2008 Prentice Hall, Inc. 4 – 35

 Values of Dependent Variable
Least Squares Method

Actual observation Deviation7

(y value)

Deviation5 Deviation6

Deviation3

Deviation4

Deviation1
(error) Deviation2
Trend line, y^ = a + bx

Time period Figure 4.4

© 2008 Prentice Hall, Inc. 4 – 36
 Values of Dependent Variable
Least Squares Method

Actual observation Deviation7

(y value)

Deviation5 Deviation6

Deviation3 Least squares method

minimizes the sum of the
Deviation
squared errors (deviations)
4

Deviation1
Deviation2
Trend line, y^ = a + bx

Time period Figure 4.4

© 2008 Prentice Hall, Inc. 4 – 37
 Least Squares Method
Equations to calculate the regression variables

y^ = a + bx

Sxy - nxy
b=
Sx2 - nx2

a = y - bx

© 2008 Prentice Hall, Inc. 4 – 38

 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
2001 1 74 1 74
2002 2 79 4 158
2003 3 80 9 240
2004 4 90 16 360
2005 5 105 25 525
2005 6 142 36 852
2007 7 122 49 854
∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063
x=4 y = 98.86

∑xy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
∑x - nx
2 2 140 - (7)(4 2)

a = y - bx = 98.86 - 10.54(4) = 56.70

© 2008 Prentice Hall, Inc. 4 – 39
 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
1999 1 74 1 74
2000 2 79 4 158
2001The trend
3 line is 80 9 240
2002 4 90 16 360
2003 y^ 5= 56.70 + 10.54x
105 25 525
2004 6 142 36 852
2005 7 122 49 854
Sx = 28 Sy = 692 Sx2 = 140 Sxy = 3,063
x=4 y = 98.86

Sxy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
Sx - nx
2 2 140 - (7)(4 2)

a = y - bx = 98.86 - 10.54(4) = 56.70

© 2008 Prentice Hall, Inc. 4 – 40
 Least Squares Example
160 –
Trend line,
150 – y^ = 56.70 + 10.54x
140 –
Power demand

130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
50 –
| | | | | | | | |
2001 2002 2003 2004 2005 2006 2007 2008 2009
Year
© 2008 Prentice Hall, Inc. 4 – 41
 Associative Forecasting
Used when changes in one or more
independent variables can be used to predict
the changes in the dependent variable

Most common technique is linear

regression analysis

We apply this technique just as we did

in the time series example

© 2008 Prentice Hall, Inc. 4 – 43

 Associative Forecasting
Forecasting an outcome based on
predictor variables using the least squares
technique
y^ = a + bx
^ = computed value of the variable to
where y
be predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable though to
predict the value of the dependent
variable
© 2008 Prentice Hall, Inc. 4 – 44
 Associative Forecasting
Example
Sales Local Payroll
($ millions), y ($ billions), x
2.0 1
3.0 3
2.5 4 4.0 –
2.0 2
2.0 1 3.0 –
3.5 7 Sales
2.0 –

1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll

© 2008 Prentice Hall, Inc. 4 – 45

 Associative Forecasting
Example
Sales, y Payroll, x x2 xy
2.0 1 1 2.0
3.0 3 9 9.0
2.5 4 16 10.0
2.0 2 4 4.0
2.0 1 1 2.0
3.5 7 49 24.5
∑y = 15.0 ∑x = 18 ∑x2 = 80 ∑xy = 51.5

∑xy - nxy 51.5 - (6)(3)(2.5)

x = ∑x/6 = 18/6 = 3 b=
∑x2 - nx2
= 80 - (6)(32) = .25

y = ∑y/6 = 15/6 = 2.5 a = y - bx = 2.5 - (.25)(3) = 1.75

© 2008 Prentice Hall, Inc. 4 – 46

 Associative Forecasting
Example
y^ = 1.75 + .25x Sales = 1.75 + .25(payroll)

If payroll next year

4.0 –
is estimated to be
$6 billion, then: 3.25
3.0 –
Sales
2.0 –
Sales = 1.75 + .25(6)
Sales = $3,250,000 1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
© 2008 Prentice Hall, Inc. 4 – 47
 Standard Error of the
Estimate
 A forecast is just a point estimate of a
future value
 This point is 4.0 –
actually the 3.25
mean of a 3.0 –
Sales
probability 2.0 –
distribution
1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
Figure 4.9
© 2008 Prentice Hall, Inc. 4 – 48
 Standard Error of the
Estimate

∑(y - yc)2
Sy,x =
n-2

where y = y-value of each data point

yc = computed value of the dependent
variable, from the regression
equation
n = number of data points

© 2008 Prentice Hall, Inc. 4 – 49

 Standard Error of the
Estimate
Computationally, this equation is
considerably easier to use

∑y2 - a∑y - b∑xy

Sy,x =
n-2

We use the standard error to set up

prediction intervals around the
point estimate

© 2008 Prentice Hall, Inc. 4 – 50

 Standard Error of the
Estimate
∑y2 - a∑y - b∑xy 39.5 - 1.75(15) - .25(51.5)
Sy,x = =
n-2 6-2

Sy,x = .306 4.0 –

3.25
3.0 –
Sales
The standard error
2.0 –
of the estimate is
$306,000 in sales 1.0 –

| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
© 2008 Prentice Hall, Inc. 4 – 51
 Correlation
 How strong is the linear
relationship between the
variables?
 Correlation does not necessarily
imply causality!
 Coefficient of correlation, r,
measures degree of association
 Values range from -1 to +1

© 2008 Prentice Hall, Inc. 4 – 52

 Correlation Coefficient
nSxy - SxSy
r=
[nSx2 - (Sx)2][nSy2 - (Sy)2]

© 2008 Prentice Hall, Inc. 4 – 53

 y
Correlation Coefficient y

nSxy - SxSy
r=
[nSx 2 - (Sx)2][nSy2 - (Sy)2]
(a) Perfect positive x (b) Positive x
correlation: correlation:
r = +1 0<r<1

y y

(c) No correlation: x (d) Perfect negative x

r=0 correlation:
r = -1
© 2008 Prentice Hall, Inc. 4 – 54
 Correlation
 Coefficient of Determination, r2,
measures the percent of change in
y predicted by the change in x
 Values range from 0 to 1
 Easy to interpret

For the Nodel Construction example:

r = .901
r2 = .81
© 2008 Prentice Hall, Inc. 4 – 55
 Multiple Regression
Analysis
If more than one independent variable is to be
used in the model, linear regression can be
extended to multiple regression to
accommodate several independent variables

y^ = a + b1x1 + b2x2 …

Computationally, this is quite

complex and generally done on the
computer
© 2008 Prentice Hall, Inc. 4 – 56
 Multiple Regression
Analysis
In the Nodel example, including interest rates in
the model gives the new equation:

y^ = 1.80 + .30x1 - 5.0x2

An improved correlation coefficient of r = .96

means this model does a better job of predicting
the change in construction sales

Sales = 1.80 + .30(6) - 5.0(.12) = 3.00

Sales = $3,000,000
© 2008 Prentice Hall, Inc. 4 – 57
 Thank you

© 2008 Prentice Hall, Inc. 4 – 58