Meaning of forecasting

What is forecasting?
Forecasting is a tool used for predicting future demand based on
past and present demand information or data.

Educated Guessing
Underlying basis of all business decisions

 Production

 Inventory

 Personnel

 Facilities
example
 Predict the next number in the pattern:

a) 3.7, 3.7, 3.7, 3.7, 3.7, ?

b) 2.5, 4.5, 6.5, 8.5, 10.5, ?

c) 5.0, 7.5, 6.0, 4.5, 7.0, 9.5, 8.0, 6.5, ?

Answer
 Predict the next number in the pattern:

a) 3.7, 3.7, 3.7, 3.7, 3.7, 3.7

b) 2.5, 4.5, 6.5, 8.5, 10.5,12.5

c) 5.0, 7.5, 6.0, 4.5, 7.0, 9.5, 8.0, 6.5, 9.0

Why is forecasting important?
Demand for products and services is usually uncertain. Therefore
forecasting can be used for…
• Strategic planning (long range planning)
• Finance and accounting (budgets and cost) controls
• Marketing (future sales, new products) prediction
So, throughout in the day we forecast different things such as
weather, traffic, stock market, state of our company from different
perspectives.
Cont…

 practically every business attempt is based on forecasting.

 Not all of them are derived from sophisticated methods.

 However, “Best" educated guesses about future are more

valuable for purpose of Planning than no forecasts and hence
no planning.
What is forecasting all about?

Demand for Mercedes E Class We try to predict the

future by looking back
at the past

Predicted
demand
looking
Time back six
Jan Feb Mar Apr May Jun Jul Aug months
Actual demand (past sales)
Predicted demand
Some General Characteristics Of Forecasts
 Forecasts are not perfect; actual results usually differ from
predicted values
 Forecasts are more accurate for groups or families of items.

 Forecasts are more accurate for shorter time periods

 Every forecast should include an error estimate

 Forecasting is strictly concerned with future events only.

Forecasting techniques generally assume that the same underlying

causal system that existed in the past will continue to exist in the
future.
 REMEMBER: Forecasting is based on the assumption that the past
predicts the future! When forecasting, think carefully whether or not
the past is strongly related to what you expect to see in the future.
Some Important Questions
1. What is the purpose of the forecast?
2. Which system will use forecast?
3. How important is the past in estimating the future?

Answers will help determine time horizons, techniques, and

level of detail for the forecast.
 ELEMENTS OF A GOOD FORECAST
A properly prepared forecast should fulfill certain requirements:
Forecast should be timely
Forecast should be accurate
Forecast should be reliable
Forecast should be expressed in meaningful units
Forecast should be in writing
Forecasting technique should be simple to understand and use.
Forecast should be cost-effective
 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
 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 product
STEPS IN FORECASTING PROCESS

There are six basic steps in the forecasting process:

1. Determine the purpose of the forecast. How will it be used and

when will it be needed? This step will provide an indication of the level

of detail required in the forecast, the amount of resources

that can be justified, and the level of accuracy necessary.

2. Establish a time horizon. The forecast must indicate a time interval,

keeping in mind that accuracy decreases as the time horizon increases.

 Cont.
3. Obtain, clean, and analyze appropriate data. Obtaining the data
can involve significant effort. Once obtained, the data may need to be
“cleaned” to get rid of outliers and obviously incorrect data before
analysis.
4. Select a forecasting technique.
5. Make the forecast.
6. Monitor the forecast errors. The forecast errors should be
monitored to determine if the forecast is performing in a satisfactory
manner.
Types of forecasting Techniques
Qualitative (Judgmental) methods

Rely on subjective opinions from one or more experts.

Judgmental methods
Market research methods

Quantitative (Extrapolative ) methods

Rely on data and analytical techniques.

Time series methods
Casual methods
Qualitative forecasting methods
Qualitative techniques are the ones which apply knowledge of the
business, market, product and customer to make a judgment call on the
forecast. There are many qualitative techniques used in forecasting.
These techniques are primarily based on opinion, like

Grass Roots: deriving future demand by asking the person closest to

the customer.
Market Research: trying to identify customer habits; new product
ideas.
Panel Consensus: deriving future estimations from the synergy of a
panel of experts in the area.
Historical Analogy: identifying another similar market.
Delphi Method: similar to the panel consensus but with concealed
identities.
Quantitative forecasting methods
Time Series: A time series is a time-ordered sequence of
observations taken at regular intervals
e.g - hourly, daily, weekly, monthly, quarterly, annually).
The data may be measurements of demand, profits, shipments,
accidents, output, precipitation, productivity index.
Forecasting techniques based on time-series data are made on the
assumption that future values of the series can be estimated from
past values.
 Cont.
 Analysis of time-series data requires the analyst to identify
the underlying behavior of the series. This can often be
accomplished by merely plotting the data and visually
examining the plot. One or more patterns might appear:
trends, seasonal variations, cycles, or variations around an
average.
How should we pick our forecasting model?
1. Data availability
2. Time horizon for the forecast
3. Required accuracy
4. Required Resources
 Techniques for Averaging
 Historical data typically contain a certain amount of random
variation, or white noise, that tends to obscure systematic
movements in the data.

 Averaging techniques smooth fluctuations in a time series because

the individual highs and lows in the data offset each other when
they are combined into an average.

 Three techniques for averaging are described in this section:

1. Moving average.

2. Weighted moving average.

3. Exponential smoothing.
Moving average
 The moving average model uses the last t periods in order to
predict demand in period t+1.

 There can be two types of moving average models: simple

moving average and weighted moving average

 The moving average model assumption is that the most

accurate prediction of future demand is a simple (linear)
combination of past demand
Time series: simple moving average
In the simple moving average models the forecast value is

Ft+1 = At + At-1 + … + At-n

n

t is the current period.

Ft+1 is the forecast for next period
n is the forecasting horizon (how far back we look),
A is the actual sales figure from each period.
Example: forecasting sales at company A
company A sells bottled spring water

Month Bottles
Jan 1,325
Feb 1,353
Mar 1,305
Apr 1,275
May 1,210 What will
the sales be
Jun 1,195
for July?
Jul ?
What if we use a 3-month simple moving average?

AJun + AMay + AApr

FJul = = 1,227
3

What if we use a 5-month simple moving average?

FJul = AJun + AMay + AApr + AMar + AFeb = 1,268

5
 6-month simple moving average…

FJul = AJun + AMay + AApr + AMar + AFeb + AJan = 1,277

6

In other words, because we used equal weights, a slight downward

trend that actually exists is not observe

Weighted Moving Average.
A weighted average is similar to a moving average, except that it
typically assigns more weight to the most recent values in a time series.
For instance, the most recent value might be assigned a weight of .40,
the next most recent value a weight of .30, the next after that a weight of
.20, and the next after that a weight of .10.
Note that the weights must sum to 1.00,
For example: Given the following demand data,
a. Compute a weighted average forecast using a weight of .40 for the
most recent period,
.30 for the next most recent, .20 for the next, and .10 for the next.
b. If the actual demand for period 6 is 39, forecast demand for period 7
using the same weights as in part a.
How do we choose weights?
Note that if four weights are used, only the four most recent demands are
used to prepare the forecast.
The advantage of a weighted average over a simple moving average is
that the weighted average is more reflective of the most recent
occurrences.
 Exponential Smoothing (ES)
Main idea: The prediction of the future depends mostly on the most
recent observation, and on the error for the latest forecast.

Why use exponential smoothing?

1. Uses less storage space for data

2. Extremely accurate
3. Easy to understand
4. Little calculation complexity
5. There are simple accuracy tests
Exponential smoothing: the method
Assume that we are currently in period t. We calculated the
forecast for the last period (Ft-1) and we know the actual demand
last period (At-1) …

Ft  Ft1   ( At1  Ft1 )

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.

For example: suppose the previous forecast was 42 units, actual
demand was 40 units, and
=0.10. The new forecast
would be computed as follows:

Solution
Example: bottled water at Ambo

Month Actual Forecasted

Jan 1,325 1,370  = 0.2

Feb 1,353 1,361

Mar 1,305 1,359

Apr 1,275 1,349

May 1,210 1,334

Jun ? 1,309