CHAPTER III: FORECASTING

LESSON I: WHAT IS FORECASTING?

 A forecast is a prediction of future events for planning purposes. It is both the art and science
of predicting future events. It may involve taking historical data and projecting this data into the
future using some type of mathematical model.
 Forecasts are an important part of the operation manager’s role.
 Forecasting provides a basis for coordinating activities in various parts of the company.
 Forecasts are an important input to both long-term, strategic decision-making, as well as for
short-term planning for day-to-day operations.

IMPORTANCE OF FORECASTING

Forecasting is important for all of the functional areas of business:

 Finance uses long-term forecasts for capital planning and short-term forecasts for budgeting.
 Marketing produces sales forecasts for market planning and market strategy.
 Operations develops and uses forecasts for scheduling, inventory management, and long-term
capacity planning.
 Human Resource Management uses forecasts to estimate the need for employees.

LESSON II: FEATURES OF FORECAST

1. Forecasting techniques assume that the same basic or original system that existed in the past
will exist in the future.

2. Forecasts are rarely perfect.

3. Forecast accuracy decreases as the time horizon increases.

4. Forecasts for groups of items are more accurate than forecasts for individual items.

LESSON III: ELEMENTS OF A GOOD FORECAST

If a forecast is prepared properly, it should have the following elements:

Accuracy- Forecasts should be accurate within certain ranges, and these ranges should be known
and stated. Knowing the range or level of accuracy will help forecast users plan for errors and
provide a basis for comparing forecasts against actual results.

Timeliness- Forecasts have to be prepared well enough in advance of actual so that the information
contained in the forecast can be used in an effective manner. For example, a marketing program
cannot be implemented overnight. So, a forecast must be developed early enough to be used in
both the design and the implementation of the marketing program.

Reliability- As a characteristic of forecasts, reliability is more about consistency than accuracy. If

a forecast technique sometimes produces a good forecast and sometimes a poor one, the
technique is likely to leave users with the distinct impression that they could get burned anytime
they try the technique.

The forecasting technique must be simple to understand and use- It is axiomatic that no one
will use a forecasting technique that they do not understand. Users lack confidence in forecasts
based on sophisticated techniques; they do no understand if the technique is appropriate or what
its limitations might be.

Forecasts must be in useful units- Financial managers need forecasts in dollars. Production
planners need demand forecasts in units, particularly when I t comes time to scheduling equipment
and personnel. Each department in a business will need to have its forecasts expressed in the
units most useful for their planning requirements.

Forecasts must be in writing- There are two reasons for this: (1) a written forecast provides a
“hard-copy” basis for evaluating the effectiveness of the forecast once actual results are in and (2)
a written forecast increases the likelihood that everyone is using the same information – singing
from the same song sheet, so to speak.

LESSON IV: FORECASTING PROCESS

-STEPS IN THE FORECASTING PROCESS-

There are seven basic steps in the process of forecasting:

1. Determine the purpose of the forecast. How are you going to use the forecast and when
will you need it? Identifying the purpose and timing of the forecast will provide you with
some guidance as to the level of detail required in the forecast, the amount of resources
(time, dollars, and personnel) that should be invested in the forecast, and the level of
accuracy required.
2. Select the items to be forecast. Are you forecasting total demand, demand by
product/service group, or individual items?
3. Determine the time horizon for the forecast. Is it a short-, medium-, or long-term
forecast? The forecast must have a time limit, keeping in mind that forecast accuracy
decreases as the time period covered by the forecast increases.
4. Select the forecasting technique. This step is necessary in order to identify the data that
will be needed in order to build the forecast. A word of caution, however. Your choice of
technique carries with it certain assumptions about the data that will be used in the modest
selection of certain time series averaging techniques assumes that there is only random
variation in the data, not trend and/of seasonal variation. Remember, “fall in love with your
data, not your model!”
5. Gather the date needed to make the forecast. Before a forecast can be prepared, data
must be gathered and analyzed. Is the data consistent with the assumptions in the forecast
model? Is there enough data to support the technique? Are we missing data? These, and
other questions, need to be answered before we begin to forecast.
6. Make the Forecast. Forecasts should be monitored to see if they are performing in a
satisfactory manner. Monitoring forecasts means making sure that the model, the
assumptions, and the data are valid.

Approaches to Forecasting

There are two general approaches to forecasting: qualitative and quantitative. Qualitative
methods incorporate such factors as the decision maker’s intuition, personal opinions, personal
experiences, and value system in reaching a forecast. Qualitative methods use a variety of
mathematical models that rely on historical data and/or causal variables to forecast demand.

Forecasts Based on Time Series

Time series models attempt to predict the future by using historical data. These models make
the assumption that what happens in the future is a function of what has happened in the past. In
other words, time series models look back at what has happened over a period of time and use a
series of past data to make a forecast. Or, to phrase it more succinctly: “Time series forecasting
is like driving forward while looking in the rear-view mirror”.

This type of forecasting implies that future values are predicted only from past values and that
other variables that might influence demand are ignored.
 Analysis of time series data requires a forecaster to identify the underlying behavior of the
series. Graphing the data and visually examining the graph can often accomplish this. One of
more patterns might appear: trend, cycles, seasonal variation, and random variations. Once these
patterns have been identified, selection of the appropriate forecasting technique will follow.

Overview of Time Series Forecasting

A time series is based on a sequence of evenly spaced data points. The spacing between the
points could be daily, weekly, monthly, quarterly, and so on. Using this data to forecast implies that
future values are predicted (developed) only form past values. Other variables that might explain
demand are ignored. This does not endear time series modeling to marketers and economists.

Analyzing a time series means breaking down data into components and then project the
components into the future. Typically, there are four components: trend, cycles, seasonality, and
random variation.

Trend is the gradual upward or downward movement of data over time. A movement in trend may
be attributable to changes in demographics such as income, population, age distribution, or cultural
aspects.

Cycles are patterns in time series data that occur every several years. They are linked to business
cycles, which can have a length from as little as 2 years to as long as 10 years. The problem with
cycles is that their length is unpredictable and estimating the business cycle is difficult because they
are affected by political events.

Seasonality refers to short-term, regular variations in data. Seasonal variation involves patterns
of change within a year, and tends to be repeated from year to year. The patterns of change must
exhibit two characteristics:

Forecasting Methods for Time-Series Analysis We will study the following techniques for time-series
analysis in this section:

• Moving Average

• Weighted Moving Average

• Exponential Smoothing

• Seasonal Forecasting

• Trend Analysis

Moving Average- The moving average (MA) method supplies a forecast of future values based on
recent past history. MA is also called simple MA method. The latest n consecutive values, which are
observations of actual events such as daily, weekly, monthly, or yearly demand, are used in making a
forecast.

For example, if you want to forecast demand for April using n = 3, then the demands for last three
months, that is, January, February, and March, are needed. The forecast for April can then be calculated
as
January demand + February demand + March demand
3
Weighted Moving Average- The weighted moving average (WMA) method involves assigning a range
of percentages to different periods. A way to make forecasts more responsive to the most recent actual
occurrences (demand) is to use the weighted moving average (WMA) method. Just like the MA method,
the most recent n period are used in forecasting. However, each period is assigned a weight between
0 and 1. The total of all weights adds up to 1. The highest weight is assigned to the most recent period
and then the weights are assigned to the previous periods in the descending order of magnitude.

Suppose the number of periods used in forecasting n = 3 and the weights are 0.2, 0.3, and 0.5.
The highest weight (in this case 0.5) is assigned to the most recent period.

For example, the forecast for period 4 will be calculated Moving averages might be used to extrapolate
next events if the following occurs: there is no discernible cyclical pattern, and the system appears to
be generating a series of values such that the last set of values provides the best estimate of what will
be the next value. by using the weight 0.5 for period 3, 0.3 for period 2, and 0.2 for period 1.
MONTHLY SALES FORECAST CALCULATION
1 100 (F4= 0.2*(S1)+ 0.3*(S2)+ 0.5(S3)
2 80
3 90
4 110 89.00 (F4= 0.2*(100)+ 0.3*(80)+ 0.5(90)
5 100 98.00 (F4= 0.2*(80)+ 0.3*(90)+ 0.5(110)
6 110 101.00 (F4= 0.2*(100)+ 0.3*(80)+ 0.5(90)
7 100 107.00 (F4= 0.2*(100)+ 0.3*(80)+ 0.5(90)

Exponential Smoothing- Exponential smoothing is a technique that’s used to forecast time series
data by smoothing out fluctuations in the data.

An Example of ES Method (𝜶 = 0.2) (1-0.2=0.8)

MONTHLY SALES FORECAST CALCULATION
1 100 100 Ft= a (At)+(1-a) Ft
2 80 100 F2= 0.2 (100)+ 0.8(100)
3 90 96 F3= 0.2 (80)+ 0.8(100)
4 110 94.8 F4= 0.2 (90)+ 0.8(96)
5 100 97.84 F5= 0.2 (110)+ 0.8(94.8)
6 110 98.3 F6= 0.2 (100)+ 0.8(97.84)
7 100 100.64 F4= 0.2 (110)+ 0.8(98.3)

ES is a simpler method, requiring fewer calculations than WMA, which needs n weights and n
periods of data for each forecast estimate. ES needs only three pieces of data. Also, it can be more
effective because only one weight, alpha (α), has to be chosen.

SEASONAL FORECASTING

Step 1: Find average quarterly demand for each year. The total demand for each year is divided by four
(number of quarters in each year) to obtain the average demand in each year. Table 3.5 gives the
average demand for each quarter.
Step 2: Compute seasonal index (SI) for each quarter for each year. The seasonal index for a quarter
for a given year is obtained by dividing the demand in that quarter by the average quarterly demand for
that year. For example, the seasonal index for the winter quarter of year 2 is 1.090 which is obtained
by dividing 2420 (demand for the winter quarter in year 2) by 2221 (average quarterly demand for year
2). The seasonal indices for each quarter of each year are given in Table 3.6. The formulas to calculate
the seasonal indices are also given in this table.

Step 3: Calculate the average SI for each quarter. The next step is to find the average seasonal index
for each quarter which is simply the average of the seasonal indices calculated in step 2. Table 3.7
gives the average seasonal index for each quarter. For example

Step 4: Calculate the average quarterly demand for next year. In this step, we find the average quarterly
demand for the next year. The yearly demand estimate for next year is 2800. Therefore, the average
quarterly demand = 2800/4 = 700. This step is shown in Table 3.8.

The total demand for next year is given or determined by using an appropriate forecasting method.

Step 5: Forecast demand for quarters of next year. The quarterly demand for each quarter of next year
is obtained by multiplying the average demand by the SI for each quarter. Table 3.9 gives the forecast
of the quarterly demand of next year. For example, forecast for the Spring quarter (700 * 0.912 = 638),
where 700 is the average quarterly demand and 0.912 is the average SI for the Spring quarter.

In the above example, we have used year as the time period in which the seasons are
represented by quarters. The seasons could have been represented by months if the time series shows
variations by month. In some instances, the week could be the time period and the days could be the
“seasons” if the demand fluctuates on a daily basis. Restaurants are a good example of where the
demand fluctuates on a daily basis. Even hour of the day can be the “season” if the demand fluctuates
hourly in a given day, for example, the power generation requirement in a power utility or the number
of calls in a telephone company vary on an hourly basis.

TREND ANALYSIS- Trend analysis is a technique used in technical analysis that attempts to predict
future stock price movements based on recently observed trend data. Trend analysis uses historical
data, such as price movements and trade volume, to forecast the long-term direction of market
sentiment.

If the time series exhibits an increasing or decreasing trend, then the techniques discussed
above (MA, WMA, and ES) may not be appropriate for making a forecast. We perform a trend analysis
to make a forecast in this case. Consider the graphs given in Figure 3.6. The zigzag line shows the
demand for 10 periods. There is clearly an increasing trend. The trend analysis will fit a trend line
through these data to make forecast. The equation of the trend line is, Y = a + bX, where Y is the
demand forecast and X is the time period. X is the independent variable and Y is the dependent variable
since the demand depends on the time period. As X increases Y increases in an increasing trend. Y
will decrease as X increases in a decreasing trend.

Example: Consider the demand data for 10 periods given in Table 3.10. The Excel function gives b =
8.65 and a = 2.73. The forecast can now be made for any time period using these numbers. For
example, the forecast for period 6 (X = 6) will be F(6) = 2.73 + 6 * 8.65 = 54.63. Similarly, the forecast
for period 7 will be F(7) = 2.73 + 7 * 8.65 = 63.28. The forecast can be made for any future period.

PERIOD 1 2 3 4 5 6 7
DEMAND 11.38 20.03 28.68 37.33 45.98 54.63 63.28