Lecture 8-9

FORECASTING

Dr. Muhammad Imran

NUST Business School, NUST
 What is Forecasting?
• Process of predicting future event
• Underlying basis of all business decisions

1.
2.
Production
Inventory
??
3. Personnel
4. Facilities
 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
 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
 Product Life Cycle
Introduction Growth Maturity Decline
Product design Forecasting Standardization Little product
and critical Fewer product differentiation
development Product and changes, more Cost
OM Strategy/Issues
critical process minor changes minimization
Frequent reliability Optimum Overcapacity
product and Competitive capacity in the
process design product industry
changes Increasing
improvements stability of Prune line to
Short production and options process eliminate
runs Increase capacity items not
Long production
High production Shift toward runs returning
costs product focus good margin
Product
Limited models Enhance improvement and Reduce
Attention to distribution cost cutting capacity
quality
 Forecasting Approaches
Qualitative Methods

Used when little data exist

1. New products
2. New technology
Involves intuition, experience
3. e.g., forecasting sales on Internet
 Qualitative Methods
Jury of executive opinion
Pool opinions of high-level experts, sometimes augment by statistical models)
Delphi method
Panel of experts, queried iteratively until consensus is reached
Sales force composite
Estimates from individual salespersons are reviewed for reasonableness, then
aggregated
Consumer Market Survey
Ask the customer
https://www.youtube.com/watch?v=GkazJtDO2Fg
 Quantitative Approaches

Used when situation is ‘stable’ and historical data exist

1. Existing products
2. Current technology
Involves mathematical techniques
3. e.g., forecasting sales of LCD televisions
 Quantitative Approaches

• Naive approach
• Moving averages time-series
models
• Exponential smoothing
• Trend projection associative
• Linear regression model
 Time Series Forecasting

Set of evenly spaced numerical data obtained by observing response

variable at regular time periods is called time series. e,g

• Humidity
• Temperature
• Fuel price
• Electricity price
 Time Series Components

Trend Cyclical

Seasonal Random
 Components of Demand
Trend
component

Demand for product or service Seasonal peaks

Actual demand
line

Average demand
over 4 years

Random variation
| | | |
1 2 3 4
Time (years)
 Trend Component

• Persistent, overall upward or downward pattern

• Changes due to population, technology, age, culture, etc.
• Typically several years duration
 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
 Cyclical Component
• Repeating up and down movements
• Affected by business cycle, political, and economic factors
• Multiple years duration

0 5 10 15 20
 Random Component

• Erratic, unsystematic, ‘residual’ fluctuations

• Due to random variation or unforeseen events
• Short duration and nonrepeating

M T W T F
 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

 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
 Moving Average Example

Actual 3-Month
Month Shed Sales Moving Average
January 10
10
12
February 12
13
March 13 (10 + 12 + 13)/3 = 11 2/3
April 16
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
 Graph of Moving Average
Moving
Average
30 –
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
 Weighted Moving Average

• Used when some trend might be 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
 Weights Applied Period
Weighted Moving Average
3
2
Last month
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
 Moving Average And
Weighted Moving Average
Weighted
moving
30 – average
25 –
Sales demand

20 – Actual
sales
15 –
Moving
10 – average

5 –
| | | | | | | | | | | |
J F M A M J J A S O N D
 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
 Exponential Smoothing

• Form of weighted moving average

1. Weights decline exponentially
2. Most recent data weighted most
• Requires smoothing constant ( )
1. Ranges from 0 to 1
2. Subjectively chosen
• Involves little record keeping of past data
 Exponential Smoothing

New forecast = Last period’s forecast

+ a (Last period’s actual demand
– Last period’s forecast)

Ft = Ft – 1 + a(At – 1 - Ft – 1)

where Ft = new forecast

Ft – 1 = previous forecast
a = smoothing (or weighting)
constant (0 ≤ a ≤ 1)
 Exponential Smoothing Example
In January, a car dealer predicted February demand for 142 Ford
Mustangs. Actual February demand was 153 autos. Using a
smoothing constant chosen by management of a = .20, the dealer
wants to forecast March demand using the exponential smoothing
model.

Predicted demand(t-1) = 142 Ford Mustangs

Actual demand (t-1)= 153
Smoothing constant a = .20
Exponential Smoothing Example

Predicted demand (t-1)= 142 Ford Mustangs

Actual demand = (t-1)153
Smoothing constant a = .20

New forecast (t) = 142 + .2(153 – 142)

Exponential Smoothing Example

Predicted demand = 142 Ford Mustangs

Actual demand = 153
Smoothing constant a = .20

New forecast = 142 + .2(153 – 142)

= 142 + 2.2
= 144.2 ≈ 144 cars
 Impact of Different 

225 –

Actual a = .5
demand
200 –
Demand

175 –
a = .1
| | | | | | | | |
150 –
1 2 3 4 5 6 7 8 9
Quarter
 Impact of Different 

225 –
Actual a = .5
• of  when
Choose high values demand
underlying
200 – average is likely to
Demand

change
175 – low values of  when
• Choose
underlying average is stable
a = .1
| | | | | | | | |
150 –
1 2 3 4 5 6 7 8 9
Quarter
 Choosing 

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 demand - Forecast value

= At - Ft
 Common Measures of Error

Mean Absolute Deviation (MAD)

∑ |Actual - Forecast|
MAD =
n

Mean Squared Error (MSE)

∑ (Forecast Errors)2
MSE =
n
 Common Measures of Error

Mean Absolute Percent Error (MAPE)

n
∑100|Actuali - Forecasti|/Actuali
MAPE = i=1
n
 Sample Example for forecasting error

During the past 8 quarters, the Port of Baltimore has unloaded

large quantities of grain from ships. The Port’s Operations
Manager wants to test the forecasting method exponential
smoothing to see how well the this method works in predicting
tonnage unloaded. He guesses that the forecast of grain unloaded
in the first quarter was 175 tons.
 Comparison of Forecast Error

Rounded Absolute Rounded Absolute

Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
 Comparison of Forecast Error

∑ |deviations|
Rounded Absolute Rounded Absolute
MADActual
= Forecast Deviation Forecast Deviation
Tonnage n
with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1
For a =180
.10 175 5.00 175 5.00
2 168 = 82.45/8
175.5 = 10.31
7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 For a =175
.50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 = 98.62/8
175.02 = 12.33
29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
 Comparison of Forecast Error
∑ (forecast
Rounded
errors) 2
Absolute Rounded Absolute
MSE = Actual Forecast Deviation Forecast Deviation
Tonnage n
with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1
For a =180
.10 175 5.00 175 5.00
2 = 1,526.54/8
168 175.5 = 190.82
7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 For a =175
.50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 = 1,561.91/8
205 175.02 = 195.24
29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
 Comparison of Forecast Error
n
∑100|deviation
Rounded i|/actuali Rounded
Absolute Absolute
MAPE =Actual
i=1 Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 n a = .10 a = .50 a = .50
1
For a180
= .10 175 5.00 175 5.00
2 168 = 44.75/8
175.5 = 5.59%
7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 For a175
= .50 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 = 54.05/8
175.02 = 6.76%
29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 190.82 195.24
© 2011 Pearson Education, Inc. publishing as Prentice Hall
 Comparison of Forecast Error

Rounded Absolute Rounded Absolute

Actual Forecast Deviation Forecast Deviation
Tonnage with for with for
Quarter Unloaded a = .10 a = .10 a = .50 a = .50
1 180 175 5.00 175 5.00
2 168 175.5 7.50 177.50 9.50
3 159 174.75 15.75 172.75 13.75
4 175 173.18 1.82 165.88 9.12
5 190 173.36 16.64 170.44 19.56
6 205 175.02 29.98 180.22 24.78
7 180 178.02 1.98 192.61 12.61
8 182 178.22 3.78 186.30 4.30
82.45 98.62
MAD 10.31 12.33
MSE 190.82 195.24
© 2011 Pearson Education, Inc. publishing as Prentice Hall
MAPE 5.59% 6.76%
Exponential Smoothing with Trend Adjustment

When a trend is present, exponential smoothing

must be modified to respond to trend

Forecast Exponentially Exponentially

including (FITt) = smoothed (Ft) + smoothed (Tt)
trend forecast trend
Exponential Smoothing with Trend Adjustment

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

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

Step 1: Compute Ft
Step 2: Compute Tt
Step 3: Calculate the forecast FITt = Ft + Tt
Example for Exponential Smoothing with Trend
Adjustment

A Portland manufacturer wants to forecast the demand for a pollution-

control equipment. Past data shows that there is an increasing trend.The
company assumes the initial forecast for month 1 was 11 units and the
trend over that period was 2 units. α = 0.2 β =0.4
 Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17
3 20
4 19
5 24 Step 1: Forecast for Month 2
6 21
7 31 F2 = aA1 + (1 - a)(F1 + T1)
8 28
9 36 F2 = (.2)(12) + (1 - .2)(11 + 2)
10 = 2.4 + 10.4 = 12.8 units
 Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80
3 20
4 19
5 24 Step 2: Trend for Month 2
6 21
7 31 T2 = b(F2 - F1) + (1 - b)T1
8 28
9 36 T2 = (.4)(12.8 - 11) + (1 - .4)(2)
10 = .72 + 1.2 = 1.92 units
 Exponential Smoothing with Trend
Adjustment Example

Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80 1.92
3 20
4 19
5 24 Step 3: Calculate FIT for Month 2
6 21
7 31 FIT2 = F2 + T2
8 28
9 36
FIT2 = 12.8 + 1.92
10 = 14.72 units
 Exponential Smoothing with Trend
Adjustment Example
Forecast
Actual Smoothed Smoothed Including
Month(t) Demand (At) Forecast, Ft Trend, Tt Trend, FITt
1 12 11 2 13.00
2 17 12.80 1.92 14.72
3 20 15.18 2.10 17.28
4 19 17.82 2.32 20.14
5 24 19.91 2.23 22.14
6 21 22.51 2.38 24.89
7 31 24.11 2.07 26.18
8 28 27.14 2.45 29.59
9 36 29.28 2.32 31.60
10 32.48 2.68 35.16
Exponential Smoothing with Trend
Adjustment Example
35 –
Actual demand (At)
30 –
Product demand

25 –

20 –

15 –

10 –
Forecast including trend (FITt)
with  = .2 and  = .4
5 –

0 – | | | | | | | | |
1 2 3 4 5 6 7 8 9
Time (month)
 Trend Projections
Fitting a trend line to historical data points to project into the medium
to long-range
Linear trends can be found using the least squares technique

y^ = a + bx
^ where y = computed value of the
variable to be predicted (dependent
variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable
 Least Squares Method

Actual observation
Values of Dependent Variable
Deviation7
(y-value)

Deviation5 Deviation6

Deviation3

Deviation4

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

Time period
 Least Squares Method

Actual observation
Values of Dependent Variable
Deviation7
(y-value)

Deviation5 Deviation6

Deviation3 Least squares method

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

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

Time period
 Least Squares Method

Equations to calculate the regression variables

y^ = a + bx

Sxy - nxy
b=
Sx2 - nx2

a = y - bx
 Least Squares Example
Time Electrical Power
Year Period (x) Demand (megawatt) x2 xy
2006 1 74 1 74
2007 2 79 4 158
2008 3 80 9 240
2009 4 90 16 360
2010 5 105 25 525
2011 6 142 36 852
2012 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)(42)

a ©=2011y Pearson
- bx Education,
= 98.86 - 10.54(4) = 56.70
Inc. publishing as Prentice Hall
 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
2003 1 74 1 74
2004 2 79 4 158
2005The trend3 line is 80 9 240
2006 4 90 16 360
2007 y^ =5 56.70 + 10.54x
105 25 525
2008 6 142 36 852
2009 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 ©=2011y Pearson
- bx Education,
= 98.86 - 10.54(4) = 56.70
Inc. publishing as Prentice Hall
 Least Squares Example
Trend line,
160 –
150 –
y^ = 56.70 + 10.54x
140 –
Power demand

130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
50 –
| | | | | | | | |
2006 2007 2008 2009 2010 2011 2012 2013 2014
YearHall
© 2011 Pearson Education, Inc. publishing as Prentice
 Least Squares Requirements

1. We always plot the data to insure a linear relationship

2. We do not predict time periods far beyond the database

3. Deviations around the least squares line are assumed to

be random and normally distributed.
 Seasonal Variations In Data

The multiplicative seasonal model

can adjust trend data for seasonal
variations in demand (jet skis, snow
mobiles)
 Seasonal Variations In Data
Steps in the process:

1. Find average historical demand for each season

2. Compute the average demand over all seasons
3. Compute a seasonal index for each season
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the number of seasons,
then multiply it by the seasonal index for that season
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012 Monthly Index
Jan 80 85 105 90 94
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Apr 90 95 115 100 94
May 113 125 131 123 94
Jun 110 115 120 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
© 2011 Pearson Education, Inc. publishing as Prentice Hall
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94
Mar 80 93 Average
82 85 monthly demand
2010-2012 94
Seasonal index
Apr 90 =95 115 Average monthly
100 94
demand
May 113 125 131 123 94
Jun 110 115= 90/94
120= .957 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
© 2011 Pearson Education, Inc. publishing as Prentice Hall
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90 95 115 100 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 115 94 1.223
Jul 100 102 113 105 94 1.117
Aug 88 102 110 100 94 1.064
Sept 85 90 95 90 94 0.957
Oct 77 78 85 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
© 2011 Pearson Education, Inc. publishing as Prentice Hall
 Seasonal Index Example
Demand Average Average Seasonal
Month 2010 2011 2012 2010-2012
Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 Forecast
85 for 2013
80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90Expected
95 annual demand
115 100 = 1,200 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 1,200 115 94 1.223
Jul 100 102 Jan 113 x .957 = 96 94
105 1.117
12
Aug 88 102 110 100 94 1.064
Sept 85 90 95 1,200 90 94 0.957
Feb x .851 = 85
Oct 77 78 85 12 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
© 2011 Pearson Education, Inc. publishing as Prentice Hall
 Seasonal Index Example
2013 Forecast
140 – 2012 Demand
130 – 2011 Demand
2010 Demand
120 –
Demand

110 –
100 –
90 –
80 –
70 –
| | | | | | | | | | | |
J F M A M J J A S O N D
Time
 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

 Associative Forecasting
Forecasting an outcome based on predictor variables using the least
squares technique

y^ = a + bx
^ where y = computed value of the
variable to 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
 Associative Forecasting Example

Sales Area Payroll

($ millions), y ($ billions), x
2.0 1
3.0 3
2.5 4
2.0 2 4.0 –
2.0 1
3.0 –

Sales
3.5 7
2.0 –

1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
 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= = = .25
∑x - nx
2 2 80 - (6)(32)

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

 Associative Forecasting Example

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

If payroll next year

is estimated to be $6 4.0 –
billion, then: 3.25
3.0 –

Nodel’s sales
Sales = 1.75 + .25(6) 2.0 –
Sales = $3,250,000
1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
 Standard Error of the Estimate
• A forecast is just a point estimate of a future value
• This point is actually the mean of a probability distribution

4.0 –
3.25
Nodel’s sales 3.0 –

2.0 –

1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
Standard Error of the Estimate

∑y2 - a∑y - b∑xy

Sy,x =
n-2

We use the standard error to set up

prediction intervals around the point
estimate
 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 –

Nodel’s sales
The standard error of
the estimate is 2.0 –
$306,000 in sales
1.0 –
| | | | | | |
0 1 2 3 4 5 6 7
Area payroll
 Prediction Intervals

The ranges or limits of a forecast are estimated by:

Upper limit = Y + t*Sy,x
Lower limit = Y - t*Sy,x
where
Y = forecasted value (point estimate)
t = number of standard deviations from the mean of the distribution
to provide a given probability of exceeding the limits through chance
syx = standard error of the forecast
 Prediction Intervals

Estimate the confidence interval for annual sales of next year

(remember payroll next year is estimated to be $6 billion) so that the
probability that the actual sales exceeding these limits will be
approximately equal to 0.05.

Sales = 1.75 + .25(6)

Sales = $3,250,000
 Prediction Intervals

Step 1: Compute the standard error of the forecasts, syx.

Step 2: Determine the appropriate value for t. n = 6, so degrees of
freedom = n – 2 = 4 level of significance = =.05. The Student’s t
Distribution Table show:

(tα/2=0.025) ) =2.78
 Prediction Intervals

Step 3: Compute upper and lower limits.

Upper limit = $3,250,000 + 2.78 * $306,000
=$4,100,680
Lower limit = $3,250,000 - 2.78 * $306,000
= $2,399,320
We are 95% confident the actual sales for next year will be between
$2,399,320 and $4,100,680.
 Correlation
• How strong is the linear relationship between the variables?
• Correlation does not necessarily imply causality!
• Coefficient of correlation, r, measures degree of association
1. Values range from -1 to +1

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

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

y y

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

r = 0© 2011 Pearson Education, Inc. publishing as Prentice Hall correlation:
r = -1
 Correlation
Coefficient of Determination, r2, measures the percent of change in y
predicted by the change in x
1. Values range from 0 to 1
2. Easy to interpret

For the Nodel Construction example:

r = .901
r2 = .81
 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 + b x + b x …
1 1 2 2

Computationally, this is quite complex and generally done on the

computer
 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
 Monitoring and Controlling
Forecasts
Tracking Signal

• Measures how well the forecast is predicting actual values

• Ratio of cumulative forecast errors to mean absolute deviation (MAD)
1. Good tracking signal has low values
2. If forecasts are continually high or low, the forecast has a bias error
Monitoring and Controlling Forecasts

Tracking Cumulative error

signal =
MAD

∑(Actual demand in
period i -
Forecast demand
Tracking in period i)
signal =
(∑|Actual - Forecast|/n)
 Tracking Signal

Signal exceeding limit

Tracking signal
Upper control limit
+

Acceptable
0 MADs range

– Lower control limit

Time
 Tracking Signal Example
Cumulative
Absolute Absolute
Actual Forecast Cumm Forecast Forecast
Qtr Demand Demand Error Error Error Error MAD

1 90 100 -10 -10 10 10 10.0

2 95 100 -5 -15 5 15 7.5
3 115 100 +15 0 15 30 10.0
4 100 110 -10 -10 10 40 10.0
5 125 110 +15 +5 15 55 11.0
6 140 110 +30 +35 30 85 14.2
 Tracking Signal Example
Cumulative
Tracking Absolute Absolute
Actual Signal
Forecast Cumm Forecast Forecast
Qtr (Cumm Error/MAD)
Demand Demand Error Error Error Error MAD

1 90-10/10
100= -1 -10 -10 10 10 10.0
2 95-15/7.5
100= -2 -5 -15 5 15 7.5
3 115 0/10100
= 0 +15 0 15 30 10.0
4 100-10/10
110= -1 -10 -10 10 40 10.0
5 125
+5/11110
= +0.5+15 +5 15 55 11.0
6 140
+35/14.2
110= +2.5
+30 +35 30 85 14.2

The variation of the tracking signal between -2.0 and +2.5 is within
acceptable limits
 One Company’s Rules for Changing the Smoothing
Constant (α )

Limits for Absolute Do not change Increase α by Increase α Increase α by

Tracking Signal 0.1 by 0.3 0.5

0 - 2.4 
2.5 - 2.9


3.0 - 3.9


Over 4 
 Forecasting in the Service Sector

Presents unusual challenges

• Special need for short term records
• Needs differ greatly as function of industry and
product
• Holidays and other calendar events
• Unusual events