CHAPTER TWO

FORECASTING

2.1. Meaning of Forecasting

Forecasts are estimates of the occurrence, timing or magnitude of future event. Forecasts are
statements about future specifying the volume of sale to be achieved or material demand required
and equipments, and other inputs needed to meet sale. 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 product, service and
the resources necessary to produce an output.

2.2. Characteristics of forecasts

The following are the characteristics of forecasts:-

1. Forecasting techniques generally assumes that the same underling causal system that
assisted in the past will continue to exist in the future.
2. Forecasts are rarely perfect; actual results usually differ from predicted values.
3. 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.
4. 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,

1
Materials Management (Forecasting)
 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.
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 give 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. They are:

2
Materials Management (Forecasting)
 1. Qualitative forecasting techniques
2. Quantitative forecasting techniques
1. 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 must be prepared quickly in a short period of time,
 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,
 Historical data cannot be available 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. They are:
A. Expert opinion method
B. Sales opinion
C. Consumer surveys
D. Delphi technique
A. 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.

3
Materials Management (Forecasting)
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.
B. 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
 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
C. 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
D. Delphi Method

4
Materials Management (Forecasting)
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
 Coordination and interpretation difficulty.

2. Quantitative Forecasting Techniques

Qualitative 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:
I. Time Series Analysis
II. Causal Methods
I. 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:
a) Trend c) Cycles
b) Seasonality d) Randomness
A) Trend – is a general pattern of change overtime. It represents a long time secular movement,
characteristic of many economic series.

5
Materials Management (Forecasting)
B) 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 crowded during the afternoon.
C) 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).
D) 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.

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.

6
Materials Management (Forecasting)
Example 1:
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 105 106 110 110 114 121 130 128
demand

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.
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

7
Materials Management (Forecasting)
 Ft =forecast in time t
WMA = weighted moving average
W = weight
A = Actual demand value

Example 1
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 our 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 110. Compute forecast for month 6.
F6 =WMA = 0.4x110+0.30x95+0.2x105+0.1x90
F6 = 102.5 units.
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 = F t-1 + (A t-1 - F t-1)
Where
Ft = Forecast for period t
Ft-1 = Forecast for the previous period
 = Smoothing constant (0<  <1)

8
Materials Management (Forecasting)
 A t-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 was above the last period forecast, the correction will be positive, and
 If the actual demand was 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, 
Example 1:
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 in May and June was 25 and 26 shipments. Forecast the value
for July.

Solution
First forecast the demand for May and June
F May = F April +  (A April –F April)
= 20+0.2(20-20)

9
Materials Management (Forecasting)
 = 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.
D) Trend equation
A linear trend equation has the form
Ft = at + b
Where : Ft = forecast for period t
a = scope 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
Month (in ‘000 Sept. Oct Nov. Dec. Jan. Feb.
tones)
Actual demand 112 125 120 133 136 140
Required:
a) Obtain the trend equation?

10
Materials Management (Forecasting)
 b) 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 2554

Now lets 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

11
Materials Management (Forecasting)
2. Causal Forecasting Methods
Causal 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 Causal Methods of Forecasting
Regression and Correlation Methods
Regression and correlation techniques are means of describing the association between two or
more variables. More specifically, regression and correlation methods are related to the
following issues
 Bringing out the nature of relationship between any two variables, say X and Y
 Measuring the rate of change in one (the dependent) variable associated with a given
change in the other (independent) variable.
 Evaluating the strength of the relationship and quantifying the closeness of such
relationship.
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.

12
Materials Management (Forecasting)
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
b = slope of the line

Note:
1. 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.
2. 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
3. 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.

13
Materials Management (Forecasting)
 Construction Plaster board shipments
permits
15 6
9 4
40 16
20 6
25 13
25 9
15 10
35 16

14
Materials Management (Forecasting)
Required:
a) Derive a regression forecasting equation?
b) Determine plaster board demand when the number construction permit is
i. 30
ii. 35
iii. 40
c) Compute coefficient of determination (r 2) and coefficient of correlation (r), and interpret the
numbers

15
Materials Management (Forecasting)
Solution
a) 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)
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

16
Materials Management (Forecasting)
 B) plaster board demand,
i) 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
C) 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 2= 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% of the total variation, which remains unexplained, is due to the factors other than the quantity
of shipments.

17
Materials Management (Forecasting)
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.

18
Materials Management (Forecasting)