March, 2017/18

By : Yinager.T

 Topics to be covered
 Introduction
 Importance of Forecasting
 Types of Forecasting
 Techniques of Forecasting
 Qualitative
 Quantitative

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Introduction to Forecasting
 A statement about the future value of a variable of
interest such as demand.
 Forecasting is a tool used for predicting future demand
based on past demand information.
 Forecasts affect decisions and activities throughout
an organization.
 Accounting, finance
 Human resources
 Marketing
 MIS
 Operations
 Product / service design

Importance of Forecasting
 More specifically, here are who and why they need to forecast:
 Marketing managers: use sales forecasts to determine optimal
sales force allocations set sales goals, and plan promotions and
advertising.
 Planning for capital investments: predictions about future
economic activity are required so that returns or cash inflows
accruing from the investment may be estimated.
 The personnel department requires a number of forecasts in
planning for human resources.
 Managers of nonprofit institutions and public administrators
also must make forecasts for budgeting purposes.
 Universities forecast student enrollments, cost of operations, and,
in many cases, the funds to be provided by tuition and by
government appropriations.
 The bank has to forecast: Demands of various loans and
deposits Money and credit conditions so that it can determine the
cost of money it lends.
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Importance of Forecasting
 Demand is not the only variable of interest to forecasters.
 Manufacturers also forecast worker absenteeism, machine
availability, material costs, transportation and production lead
times, etc.
 Besides demand, service providers are also interested in
forecasts of population, of other demographic variables, of
weather, etc.

Accounting Cost/profit estimates

Finance Cash flow and funding
Human Resources Hiring/recruiting/training
Marketing Pricing, promotion, strategy
MIS IT/IS systems, services
Operations Schedules, MRP, workloads
Product/service design New products and services
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Forecasting Range
 Short-range forecasts typically encompass the immediate future
and are concerned with the daily operations of a business firm,
such as daily demand or resource requirements. A short-range
forecast rarely goes beyond a couple months into the future.
 A medium-range forecast typically encompasses anywhere from
1 or 2 months to 1 year. A forecast of this length is generally more
closely related to a yearly production plan and will reflect such
items as peaks and valleys in demand and the necessity to secure
additional resources for the upcoming year.
 A long-range forecast typically encompasses a period longer
than 1 or 2 years. Long-range forecasts are related to
management's attempt to plan new products for changing
markets, build new facilities, or secure long-term financing. In
general, the further into the future one seeks to predict, the more
difficult forecasting becomes.

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Forecasting range
Short-range forecast
Quantitative
 Usually < 3 months methods
 Job scheduling, worker assignments Detailed
use of
Medium-range forecast system
 3 months to 2 years
 Sales/production planning

Long-range forecast
 > 2 years
Design
 New product planning of system

Qualitative
Methods

Principles of Forecasting
 Many types of forecasting models that differ in
complexity and amount of data & way they generate
forecasts:
 Forecasts rarely perfect because of randomness.
 Forecasts more accurate for groups vs. individuals.
 Forecast accuracy decreases as time horizon increases.

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Steps of Forecasting
1. Decide what needs to be forecasted.
 Level of detail, units of analysis & time horizon
required.
2. Evaluate and analyze appropriate data.
 Identify needed data & whether it’s available.
3. Select and test the forecasting model.
 Cost, ease of use & accuracy.
4. Generate the forecast.
5. Monitor forecast accuracy over time.

Forecasting Techniques
 Forecasting practice is based on a mix of qualitative and
quantitative methods. When planning occurs for innovative
products, little demand data are available for the product of
interest and the degree to which like product demand data are
similar is unknown. Thus a large amount of judgment is needed by
experts who can use their industry expertise to predict demand.
 Commodity-like products that are sold every day, on the other
hand, are much more suitable for quantitative models and need
very little judgment to forecast demand. Still, when knowledge of
certain events leads one to believe that future demand might not
track historical trends, some judgment may be warranted to make
adjustments in the models which use past data. In this case, a
heavy reliance on past data with adjustments based on expert
judgment should be the method used for forecasting.

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 Forecasting Techniques
 Qualitative methods – judgmental methods
 Forecasts generated subjectively by the forecaster
 Educated guesses
 Quantitative methods – based on mathematical modeling
 Forecasts generated through mathematical modeling

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Qualitative Forecasting Methods

 The qualitative (or judgmental) approach can be useful in formulating
short-term forecasts and can also supplement the projections based
on the use of any of the quantitative methods.
 Individual Expert: individual market experts can be hired to watch
for industry trends, perhaps even by geographic area, and might even
work with sales people to estimate future demand for products
 Executive Opinions/Group Consensus: The subjective views of
executives or experts from sales, production, finance, purchasing, and
administration are averaged to generate a forecast about future sales.
Usually this method is used in conjunction with some quantitative
method, such as trend extrapolation.
 Delphi Method: this method requires one person to administer and
coordinate the process and poll the team members (respondents)
through a series of sequential questionnaires.
 Consumer Surveys: Some companies conduct their own market
surveys regarding specific consumer purchases. Surveys may consist
of telephone contacts, personal interviews, or questionnaires as a
means of obtaining data.

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 Qualitative Methods
Type Characteristics Strengths W eaknesses
Executive A group of Good for strategic or One person's
opinion managers meet & new-product opinion can
come up with a forecasting dominate the
forecast forecast
Market Uses surveys & Good determinant It can be difficult
research interviews to of customer to develop a good
identify customer preferences questionnaire
preferences
Delphi Seeks to develop a Excellent for Time consuming
method consensus among a forecasting long- to develop
group of experts term product
demand,

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Quantitative Forecasting Techniques

 Quantitative analysis typically involves two approaches: causal
models and time-series methods.
 Causal/Regression Methods: Causal models establish a
quantitative link between some observable or known variable (like
advertising expenditures) with the demand for some product.
 Time Series Forecasting Methods: Time series forecasting
methods are based on analysis of historical data (time series: a set
of observations measured at successive times or over successive
periods). They make the assumption that past patterns in data can
be used to forecast future data points.
 Naïve or Projection
 Simple Moving Average
 Weighted Moving Average
 Exponential Smoothening

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Time Series Models
 Forecaster looks for data patterns as
 Data = historic pattern + random variation
 Historic pattern to be forecasted:
 Level (long-term average) – data fluctuates around a constant
mean
 Trend – data exhibits an increasing or decreasing pattern
 Seasonality – effects are similar variations occurring during
corresponding periods, e.g., December retail sales. Seasonal can
be quarterly, monthly, weekly, daily, or even hourly indexes.
 Cycle – are the long-term swings about the trend line. They are
often associated with business cycles and may extend out to
several years in length.
 Irregular variations - caused by unusual circumstances
 Random variations - caused by chance, cannot be predicted

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Time Series Patterns

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Time Series Models
 Projection: The easiest time series method simply
projects future demand based on the last period’s
demand. The forecast for the period t, Ft, is simply a
projection of previous period t-1 demand, At-1
 Ft=At-1
 E.g. If the actual demand of period t is 120, then the
forecast of the period t+1 is 120.
 This method, although easy to use, doesn’t make use of
data that is easily available to most managers; thus,
using more of the historical data should improve the
forecast. Averages of past demand might be more useful
and are discussed next.
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Time Series Model



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Time Series Model
 Simple Moving Average (A company sells storage shed, Determine
the forecast of January using 3 month simple moving average.)

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Forecasting Techniques


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Forecasting Techniques
 Weighted Moving Average: Consider the weights 3/6, 2/6,1/6 for
periods t-1, t-2 and t-3 respectively which are added to one. Determine
the forecast of January.

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Forecasting Techniques


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Forecasting Techniques
 Why use exponential smoothing?
 Uses less storage space for data
 More accurate
 Easy to understand
 Little calculation complexity
 There are simple accuracy tests

 The smoothing constant α expresses how much our forecast

will react to observed differences.
 If α is low: there is little reaction to differences.
 If α is high: there is a lot of reaction to differences.
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Forecasting Techniques
 Selecting Smoothening Constant (α):
 The exponential smoothing approach is easy to use and has been
applied successfully by banks, manufacturing companies.
wholesalers, and Other organizations.
 The appropriate value of the smoothing constant, α, however, can
make the difference between an accurate forecast and an inaccurate
forecast.
 In picking a value for the smoothing constant, the objective is to
obtain the most accurate forecast.
 Several values of the smoothing constant may be tried, and the one
with the lowest MAD could be selected. This is analogous to how
weights are selected for a weighted moving average forecast.
 Some forecasting software will automatically select the best
smoothing constant. QM for Windows will display the MAD that
would be obtained with values of α ranging from O to 1 in
measurements of 0.01.

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Forecasting Techniques
 Exponential smoothing: Main idea: The prediction of the future
depends mostly on the most recent observation, and on the error for
the latest forecast.
 To determine a forecast of a given period the forecast of the previous
period should be know .

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Forecasting Techniques
 Exponential smoothing: Main idea: The prediction of the future depends
mostly on the most recent observation, and on the error for the latest forecast.
 To determine a forecast of a given period the forecast of the previous period
should be know .

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 Selecting the Right Forecasting Model
1. The amount & type of available data
 Some methods require more data than others
2. Degree of accuracy required
 Increasing accuracy means more data
3. Length of forecast horizon
 Different models for 3 month vs. 10 years
4. Presence of data patterns
 Lagging will occur when a forecasting model meant for a level pattern is applied
with a trend

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Measuring Forecast Error

 Forecasts are never perfect
 Need to know how much we should rely on our
chosen forecasting method.
 Measuring forecast error:
E t  A t  Ft
 Note that:
 Over-forecasts = negative errors
 Under-forecasts = positive errors.
 Large values of negative or positive errors shows
there is bias in the forecast.

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 Measures of Forecast Error
 Mean Absolute Deviation (MAD)
 measures the total error in a forecast without regard to sign
 Cumulative Forecast Error (CFE)
 Also called running sum of forecast error (RSFE)
 Measures any bias in the forecast
 Mean Square Error (MSE)
 Penalizes larger errors

CFE   actual  forecast 

n
RSFE   (A
i 1
t  Ft )

 Ideal values =0 (i.e., no forecasting error)

Measuring Accuracy: Tracking signal

 The tracking signal is a measure of how often our

estimations have been above or below the actual
value. It is used to decide when to re-evaluate using a
model.
n
RSFE   (At  Ft )
RSFE
TS 
i 1 MAD
 Positive tracking signal: most of the time actual values are
above our forecasted values
 Negative tracking signal: most of the time actual values are
below our forecasted values

Usually 3 ≤ TS ≥ 8, out of this range investigate!

Measuring Forecast Accuracy and Error
Weighted (n=3,
Simple t-1=0.45, Exponential Exponential Exponential
S.N Actual Naïve
(n=3) t-2=0.35, (α=0.1) (α=0.5) (α=0.8)
t-3=0.2)
1 110 105 105 105
2 100 110.0 105.5 107.5 109.0
3 120 100.0 105.0 103.8 101.8
4 140 120.0 110.0 108.5 106.5 111.9 116.4
5 170 140.0 120.0 115.0 109.8 125.9 135.3
6 150 170.0 143.3 137.0 115.8 148.0 163.1
7 160 150.0 153.3 152.5 119.2 149.0 152.6
8 190 160.0 160.0 161.0 123.3 154.5 158.5
9 200 190.0 166.7 161.5 130.0 172.2 183.7
10 190 200.0 183.3 178.5 137.0 186.1 196.7
11 190.0 193.3 193.5 142.3 188.1 191.3
MAD 17.8 23.3 26.6 38.4 18.1 16.6
CFE 80.0 163.3 186.0 372.9 166.1 107.9
RMSE 58.3 74.5 81.8 141.5 72.5 61.1
TS 4.50 7.00 7.00 9.71 9.17 6.52

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Summary
 Three basic principles of forecasting are: forecasts are rarely
perfect, are more accurate for groups than individual items, and
are more accurate in the shorter term than longer time horizons.
 The forecasting process involves five steps: decide what to
forecast, evaluate and analyze appropriate data, select and test
model, generate forecast, and monitor accuracy.
 Forecasting methods can be classified into two groups: qualitative
and quantitative. Qualitative methods are based on the subjective
opinion of the forecaster and quantitative methods are based on
mathematical modeling.
 Time series models are based on the assumption that all
information needed is contained in the time series of data.
 Causal models assume that the variable being forecast is related
to other variables in the environment.

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Summary cont.
 There are four basic patterns of data: level or horizontal,
trend, seasonality, and cycles. In addition, data usually
contain random variation. Some forecast models used to
forecast the level of a time series are: naïve, simple mean,
simple moving average, weighted moving average, and
exponential smoothing. Separate models are used to
forecast trends and seasonality.
 Three useful measures of forecast error are mean absolute
deviation (MAD), mean square error (MSE) and tracking
signal.
 There are four factors to consider when selecting a model:
amount and type of data available, degree of accuracy
required, length of forecast horizon, and patterns present
in the data.

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