Chapter Two: Forecasting

Introduction
A forecast is a statement about the future value of a variable such as demand. That is, forecasts
are predictions about the future. The better those predictions, the more informed decisions can
be. Forecasts are a basic input in the decision processes of operations management because they
provide information on future demand. The importance of forecasting to operations management
cannot be overstated. The primary goal of operations management is to match supply to demand.
Having a forecast of demand is essential for determining how much capacity or supply will be
needed to meet demand. For instance, operations needs to know what capacity will be needed to
make staffing and equipment decisions, budgets must be prepared, purchasing needs information
for ordering from suppliers, and supply chain partners need to make their plans.

Two aspects of forecasts are important. One is the expected level of demand; the other is the
degree of accuracy that can be assigned to a forecast (i.e., the potential size of forecast error).
The expected level of demand can be a function of some structural variation, such as a trend or
seasonal variation. Forecast accuracy is a function of the ability of forecasters to correctly model
demand, random variation, and sometimes unforeseen events.
Forecasts are made with reference to a specific time horizon. The time horizon may be fairly
short (e.g., an hour, day, week, or month), or somewhat longer (e.g., the next six months, the
next year, the next five years, or the life of a product or service). Short-term forecasts pertain to
ongoing operations. Long-range forecasts can be an important strategic planning tool. Long term
forecasts pertain to new products or services, new equipment, new facilities, or something else
that will require a somewhat long lead time to develop, construct, or otherwise implement.
Forecasts are the basis for budgeting, planning capacity, sales, production and inventory,
personnel, purchasing, and more. Forecasts play an important role in the planning process
because they enable managers to anticipate the future so they can plan accordingly.
Forecasts affect decisions and activities throughout an organization, in accounting, finance,
human resources, marketing, and management information systems (MIS), as well as in
operations and other parts of an organization.
2.1 Meaning of Forecasting
Forecasting is the process of estimating the occurrence, timing or magnitude of future event.
Forecasts are statements about future specifying the volume of sale to be achieved, material

Page 1
demand required, equipments and other inputs needed to meet the sales. They give operation
managers a rational basis for budgeting, capacity planning, sales, production and inventory,
Personnel and material management.
Forecasting is the basis of planning ahead even though the actual demand is quite uncertain thus,
it involves estimation of the future, and of particular interest here is the expected demand of
company’s product. Therefore, forecast of future demand is the link between company’s internal
expectations with outside environment that permits planning function to commence activities. A
popular definition of forecasting is that it is estimating the future demand of a product, service
and the resources necessary to produce an output.
2.2 Characteristics of forecasts
The following are the characteristics of forecasts:-
 Forecasting techniques generally assumes that the same underling causal system that
assisted in the past will continue to exist in the future.
 Forecasts are rarely perfect; actual results usually differ from predicted values.
 Forecasts for a group of items tends to be more accurate than forecasts for individual
item, because forecasting errors among items in a group usually are smaller than that of
individual items.
Forecast accuracy decreases as the time period covered by the forecast-time horizon increases.
2.3 Steps in the Process of Forecasting
There are five basic steps in the forecasting process.
1. Determine the purpose of the forecast that will provide an indication of:
a) The level of details required,
b) The amount of resources and
c) The desired level of accuracy.
2. Establish a time horizon that the forecast must cover, keeping in mind that accuracy
decreases as the length of the forecast period increases.
3. Select an appropriate forecasting technique particularly the quantitative models.
4. Gather and analyze the appropriate historical data and prepare the forecast. This requires
identifying all major assumptions that are made in conjunction with preparing and using
the forecast.

Page 2
 5. Monitor the forecast to check its validity. If it is unsatisfactory, reexamine the methods or
techniques, assumptions, validity of data, and make necessary adjustments to prepare a
revised forecast.
2.4 Uses of Forecast
Components, subassemblies or/enquired services that are part of the finished product may not
required formal forecast (i.e. not all materials required formal forecasts). Forecast should be used
for end items and services that have uncertain demand. The purpose of forecasting activities is
to make the best use of present information to guide decisions towards the objectives of the
organization in general. Accurate projections of future activity levels can minimize short-term
fluctuations in production and help balance workloads. This reduces hiring, firing and overtime
activities and helps maintain good labor relationship.
Good forecasts also help managers have appropriate level of materials available when needed.
By anticipating employment and materials needs, the forecasts enable managers to make better
use of facilities and deliver improved service to customers.
Generally, good forecast
 Improve employee relation
 Improve materials management
 Helps to have better use of capital and facilities and
 Improves customer’s service.
2.5 Types of Forecasting
There are two types of forecasting technique. These are:
1) Qualitative forecasting techniques
2) Quantitative forecasting techniques
Qualitative Approaches
Qualitative forecasting technique is a technique that is used when there is no historical data
available about past performance. These forecasting techniques are subjective and judgmental in
nature and most of the time they are based on opinion and expertise judgment. Qualitative
forecasting techniques rely on analysis of subjective inputs obtained from customers, sales
Person, managers and experts.
Forecasts based on judgment, experience or opinions are appropriate when:
Forecasts are prepared quickly in a short period of time,

Page 3
Available data may be obsolete or up to date information might not be available because of rapid
and continuous changes in the external environment such as economic and political conditions,
There is no historical data, like demand for a newly introduced product, and
The forecasting period is long range that past events will not repeat themselves in a similar
fashion.
There are four common types of qualitative forecasting techniques. These are:
Expert opinion method
 Sales opinion
 Consumer surveys
 Delphi technique
1. Expert Opinion methods
One of the most simple and widely used method of forecasting which consists of collecting
opinions and judgments of individuals who are expected to have the best knowledge of current
activities or future plans. This technique has its own advantages and disadvantage.
Advantage
 Decision is fast
 Responsibility and accountability is clear
 Brings together the considerable knowledge, experience, skill and talent of various
managers
 Managers (experts) will acquire experience that is obtained in the discussion.
Disadvantage
 Probably poor forecast (due to lack of experience)
 Domination by one or few manger
 Diffusing responsibility for the forecast over the entire group may result in less pressure
to produce a good forecast.
2. Sales force Opinions
In this method, the sales representatives are required to estimate the demand for each product and
the forecast of each sales representative is consolidated to prepare the overall forecast for the
company.
This forecasting technique has also its own advantages and disadvantages
Advantages

Page 4
  It can reset in quality forecast
 This pools together knowledge
 Can see from different approaches
Disadvantage
 Time taking decision
 Influenced by majority high stares persons
 Avoidance of responsibility
3. Consumer Surveys
This forecasting technique is based on the data which is collected from the consumers. Because it
is the consumers who ultimately determine demand, it seems important to solicit information
from them.
Advantage
 tap information that may not be available else where
 enhance the quality and accuracy of forecasts
Disadvantage
 Experience and knowledge is constructing
 Expensive and time consuming
4. Delphi Method
This is a qualitative method of forecasting which involves the development, distribution,
collection and analysis of series of questionnaires to get the views of expertise that are located at
different geographic areas to generate the forecast. A moderator compiles results and formulates
a new questionnaire that is again submitted to the same group of experts. The goal is to achieve a
consensus forecast.
Advantage
 The tendency of process loss is avoided/minimized
 No influence of the majority
Disadvantage
 It takes time to reach a consensus
 Difficult to coordination and interpretation.

Quantitative Forecasting Techniques

Page 5
Quantitative techniques consist of mainly analyzing objective or hard data. This usually avoids
personal biases that sometimes contaminate qualitative methods. It is based on actual historical
statistical data using mathematical and statistical methods to forecast demand. Thus, it is
objective and is also called statistical forecasting.
There are two types of quantitative forecasting techniques:
1) Time Series Analysis
2) Causal Methods
1) Time Series Analysis
A time series is a set of some variable (demand) overtime (e.g. hourly, daily, weekly, quarterly
annually). Time series analyses are based on time and do not take specific account of outside or
related factors.
Time series analysis is a time-ordered series of values of some variables. The variables value in
any specific time period is a function of four factors:
Trend c) Cycles
Seasonality d) Randomness
Trend – is a general pattern of change overtime. It represents a long time secular movement,
characteristic of many economic series.
Seasonality- refers to any regular pattern recurring with in a time period of no more than one
year. These effects are often related to seasons of the year.
Example:
Weather variations – sales of winter and summer
Vacations or holidays – air line travel, greeting card, visitors at tourists and resort centers.
Theaters demand on weekends
Daily variations: banks may over crowd during the afternoon.
Cycle – are long-term swings about the trend line and are usually associated with a business
cycle (phases of growth and decline in a business cycle).
Randomness – are sporadic effects due to chance and unusual occurrences.
Types of Time Series Analysis
A. Simple Moving average
A simple moving average is obtained by summing and averaging values from a given number of
periods repetitively, each time deleting the oldest value and adding the new value.

Page 6
 A t−1 + At−2 + A t−3 +.. .+ At−n
SMA = Ft = n
n
∑ A t −i
i=1
=
n
Where
SMA – simple moving average
Ft - Forecast for period t

At-i - Actual demand in period t-i

n - Number of periods (data points) in the moving average

Simple moving average is preferable if the demand for a product is neither growing nor declining
rapidly and also does not have any seasonal characteristics.
Example1: A food processor uses a moving average to forecast next month’s demand. Past
actual demand (in units) is shown in the following table

Month 1 2 3 4 5 6 7 8
Actual demand 105 106 110 110 114 121 130 128

Required
a. Compute a simple 5 month moving average to forecast demand for month 9
b. Find a simple 5 month moving average to forecast the demand for month 10 if the actual
demand for month 9 is 123.

Solution
128+130+121+114 +110
a) SMA9 = F9 = 5
= 120.6
Therefore, the forecasted demand for month 9 is 120.6.
123+128+130+ 121+ 114
b) SMA10 = F10 = 5 = 116/5 = 123.2

Therefore, the 5 month moving average forecasted demand for month 10 is 123.2.

Page 7
Note: In moving average, as each new actual value becomes available, the forecast is updated by
adding the newest value and dropping the oldest value and computing the average. Consequently
the ‘forecast’ moves by reflecting only the most recent values.
B) Weighted Moving average
In weighted moving average, the weight is given in such a way that more weight is given to the
most recent value in the time series. Weights can be percentages or any real numbers. In
weighted moving average, forecasts are calculated by:
Ft = WMA = W1At-1+W2.At-2+… +Wn.At-n
n
∑ A t−1 . W i
= i=1
Where
Ft =forecast in time t
WMA = weighted moving average
W = weight
A = Actual demand value

Example1: A department store may find that in a four month period the best forecast is derived
by using 40% of the actual demand for the most recent month, 30% two months ago, 20% of
three months ago and 10% of four months ago. The actual demands were as follows.

Month Month 1 Month 2 Month 3 Month 4

Demand 100 90 105 95
Required:
a. Compute weighted 4-month MA for month 5
WMA = 95x0.4+105x0.3+90x0.2+100x0.10
= 97.5 units
b. Suppose the demand for month 5 actually turned out to be 100. Compute forecast for month 6.
F6 =WMA = 0.4x100+0.30x95+0.2x105+0.1x90
F6 = 98.5 units.

Page 8
C) Simple Exponential Smoothing
The other type of time series forecasting method is simple exponential smoothing which weights
past data in an exponential manner so that most recent data carry more weight in the moving
average.
With simple exponential smoothing, the forecast is made up of the last period forecast plus a
portion of the difference between the last period actual demand and the last period forecast.

Mathematically
Ft = Ft-1 + (At-1 - Ft-1)
Where
Ft = Forecast for period t
Ft-1 = Forecast for the previous period
 = Smoothing constant (0<  <1)
At-1 = Actual demand for the previous period

The difference between the actual demand and the previous forecast (i.e. A t-1 – Ft-1) represents the
forecast error. As we observe from the equation, each forecast is simply the previous forecast
plus some correction for demand in the last period. Thus,
 If actual demand is above the last period forecast, the correction will be positive, and
 If the actual demand is below the last period forecast, the correction will be negative.
The smoothing constant,  actually dictates how much corrections will be made. It is a number
between 0 and 1, and it is used to compute the forecast.
Exponential smoothing is the most widely used of all forecasting techniques, because;
 Exponential forecasting models provide closer forecasts to actual demand.
 Formulating an exponential smoothing model is relatively easy.
 The user can easily understand the model
 It requires little computation
 It requires only three pieces of data
The most recent forecast
The actual demand of the previous period
The smoothing constant, 

Page 9
Example1: The production supervisor at a fiber board plant uses a simple exponential smoothing
technique ( = 0.2) to forecast demand. In April, the forecast was for 20 shipments, and the
actual demand was for 20 shipments. The actual demand in May and June was 25 and 26
shipments. Forecast the value for July.
Solution: First forecast the demand for May and June
Fmay = FApril +  (AApril –FApril)
= 20+0.2(20-20)
= 20
FJune = FMay +  (AMay –FMay)
= 20+0.2(25-20)
= 21
FJuly = FJune +  ( AJune – FJune)
= 21+0.2(26-21)
= 22
Therefore, the forecast for July is 22 shipments.
Trend equation
A linear trend equation has the form
Ft = at + b
Where : Ft = forecast for period t
a = slope of the line
b = value of Ft , at t = 0
t = specified number of time periods from t = 0

The coefficients of the line, a and b can be computed from historical data using these two
equations.
n . ∑ ty−Σt . Σy
2 2
a = n. Σt −( Σt )
Σy −aΣt
b= n

Example: Monthly demand for Wonji sugar factory over the past six months for sugar is given
below;

Page 10
 Month (in ‘000 tones) Sept. Oct Nov. Dec. Jan. Feb.
Actual demand 112 125 120 133 136 140
Required:
Obtain the trend equation?
Forecast the demand for the next two months?

Solution
First let’s find the values of the coefficients a and b.

n . Σ ty−Σt . Σy Σy−aΣt
2 2
a= n . Σt −( Σt ) , b= n
t t2 y ty
1 1 112 112
2 4 125 250
3 9 120 360
4 16 133 532
5 25 136 680
6 36 140 840
=21 91 766 2774

Now let’s compute a, and b

n . Σ ty−Σt . Σy 6 x 2774−21 x 766
2 2 2
a= n . Σt −( Σt ) = 6 x 91−(21) = 5.314
Σy−aΣt 766−5. 31 x 21
b= n = 6 = 109
a) The trend equation
Ft = Y = at + b
= 5.31t + 109
b) Forecast for the next two months (i.e. March and April)
Fmarch = F7 = 5.31(7) + 109
= 146,000 tones
FApril = F8 = 5.31 x 8 + 109 = 151,000 tones

Page 11
2) Casual Forecasting Methods
Casual forecasting techniques rely on identification of related variables that can be used to
predict values of the variable of interest (demand). Casual methods are used when historical data
are available and there is relationship between the factors to be forecasted.
Example
Real estate prices are usually related to
 Property location
 Square footage
Crop yield are related to
 Soil conditions
 Amounts and timings of water
 Fertilizer application
Types of Casual Methods of Forecasting
Regression and Correlation Methods
Regression and correlation techniques are means of describing the association between two or
more variables.
Regression: - It is concerned about the first two issues, i.e. Bringing out the nature of
relationship between any two variables.
Measuring the rate of change in one (the dependent) variable associated with a given change in
the other (independent) variable.
Regression means ‘dependence’ and involves estimating the value of a dependent variable, Y,
from an independent variable X.
Correlation: - is concerned about evaluating the strength of the relationship and quantifying the
closeness of such relationship.
Simple Linear regression and correlation
In simple linear regression, only one independent variable is used and the model takes the form
Y = a + bx
Where
Y = predicted (dependent) variable, demand
a = value of Y at X = 0

Page 12
 b = slope of the line

Note:
It is convenient to represent the values of the predicted variable on the Y-axis and values of the
predictor variable on the X-axis.
The coefficients a and b of the line are obtained by using the formula
n . Σ xy−Σx . Σy
2 2
b = n . Σx −(Σx )
Σy−bΣx
, or y − b x
a= n
n = Number of Period Observations
The correlation coefficient r, can be obtained by using the following formula and
coefficient of determination is r 2
n. Σ xy − Σx . Σy

Coefficient of correlation (r) = √[ n . Σx − ( Σx ) ] [ nΣy − ( Σy ) ]

2 2 2 2

Example: The general manager of a building materials production plant feels the demand for
plaster board shipments may be related to the number of constructions permits issued in the
country during the previous quarter. The manager has collected the data shown in the
accompanying table.

Construction permits Plaster board shipments

15 6
9 4
40 16
20 6

Page 13
 25 13
25 9
15 10
35 16
Required:
A. Derive a regression forecasting equation?
B. Determine plaster board demand when the number of construction permit is
30
35
40
C. Compute coefficient of determination (r 2) and coefficient of correlation (r), and interpret
the numbers
Solution
To derive the regression forecasting equation, first let’s find the values of the
Coefficients a and b

X Y XY X2 Y2
15 6 90 225 36
9 4 36 81 16
40 16 640 1600 256
20 6 120 400 36
25 13 325 625 139
25 9 225 625 81
15 10 150 225 100
35 16 560 1225 256
x=184 y=80 xy=2146 x2=5006  y2=950

n = 8 pairs of observation
n . Σ xy−Σx . Σy
2 2
b = n . Σx −(Σx )
8 x 2146 − 184 x 80
2
= 8 x 5006−(184)

Page 14
 2448
=0 . 39
= 6192
Σy− bΣx 80 − 0 . 39(184 )
a = n = 8 = 0.915
Thus, the regression equation is;
Y = a + bx
 Y = 0.915 + 0.395x

B) plaster board demand,

if no of permit = 30
Y = 0.915 + 0.395 (30) = 12.76
= 13 shipments
ii) if not of permit = 35
Y = 0.915 + 0.395 (35)
= 14.74
= 15 shipments
iii) if not of permit = 40
Y = 0.915 + 0.395 (40)
= 16.75
= 17 shipments
Coefficient of correlation and determination
n. Σ xy − Σx . Σy

Coefficient of correlation (r) = √[ n . Σx − ( Σx ) ] [ nΣy − ( Σy ) ]

2 2 2 2

8 x 2146− 184 x 80

r= √[ 8 x 5006 − ( 184) ] x [ 8 x 950 − ( 80 ) ]

2 2

2448
r = √ 2 ,430 , 400
r = 0.90  r2 = 0.81
Interpretation
* r = 0.81 means 81 percent of the total variation in plaster board shipments is explained by
construction permits. What remains is the coefficient of determination (i.e. 0.19). It indicates that 19%

Page 15
 of the total variation, which remains unexplained, is due to the factors other than the quantity of
shipments.

Note: Correlation coefficient, r is a number between -1 & 1.

Correlation coefficient can be positive, zero or negative.
r = 1  perfect positive relation.
r = 0 lack of any relationship between the two variables.
r =-1  perfect negative relationship.
Coefficient of correlation, r overstates the degree of relationship. Thus, we use coefficient of
determination, r2. Coefficient of determination, r2 ranges from 0 and 1, and it is a more objective
and definitive measure of the degree of relationship.

Page 16