FORECASTING

Prepared by: Jessie Rey F. Avenido

Learning Objectives:
After completing this chapter, the students should be able to:
• List features common to all forecasts.
• Explain why forecasts are generally wrong.
• List the elements of a good forecast.
• Outline the steps in the forecasting process.
• Describe four qualitative forecasting techniques.
• Use a naïve method to make a forecast.
• Prepare a moving average forecast.
• Prepare a weighted-average forecast.
Learning Objectives: (cont’d.)
After completing this chapter, the students should be able to:
• Prepare an exponential smoothing forecast.
• Prepare a linear trend forecast.
• Prepare a trend-adjusted exponential smoothing forecast.
• Compute and use seasonal relatives.
• Compute and use regression and correlation coefficients.
• Summarize forecast errors and use summaries to make decisions.
• Construct control charts and use them to monitor forecast errors.
• Describe the key factors and trade-offs to consider when choosing a forecasting
technique.
INTRODUCTION
Uses of Forecasts in Business
Organizations:
• Accounting
• Finance
• Human Resources
• Marketing
• MIS
• Operations
• Product/Service Design
Two uses for forecasts:
FEATURES COMMON TO ALL FORECASTS
• Forecasting techniques generally assume that the same underlying
causal system that existed in the past will continue to exist in the
future.
• Forecasts are not perfect.
• Forecasts for groups of items tend to be more accurate than forecasts
for individual items because forecasting errors among items in a
group usually have a canceling effect.
• Forecast accuracy decreases as the time period covered by the
forecast – the time horizon – increases.
ELEMENTS OF A GOOD FORECAST
FORECASTING
AND THE SUPPLY
CHAIN
• Inaccurate forecasts can lead
to shortages and excesses
throughout the supply chain.
• Inaccurate forecasts can result
in temporary increases and
decreases in orders to the
supply chain, which can be
misinterpreted by the supply
chain.
STEPS IN THE FORECASTING PROCESS
APPROACHES TO FORECASTING
APPROACHES TO FORECASTING (cont’d.)
• Judgmental forecasts rely on analysis of subjective inputs obtained
from various sources, such as consumer surveys, the sales staff,
managers and executives, and panel of experts.
• Time-series forecasts simply attempt to project past experience into
the future.
• Associative models use equations that consist of one or more
explanatory variables that can be used to predict demand.
 QUALITATIVE FORECASTS
EXECUTIVE OPINIONS
- A small group of upper-level managers (e.g. in marketing,
operations, and finance) may meet and collectively develop a
forecast.
- It has the advantage of bringing together the considerable
knowledge and talents of various managers
SALESFORCE OPINIONS
- Members of the sales staff or the customer service staff
are often good sources of information because of their direct
contact with consumers.
Drawbacks:
1. Staff members may be unable to distinguish between
what customers would like to do and what they actually will do.
2. These people are sometimes overly influenced by recent
experiences.
QUALITATIVE FORECASTS (cont’d.)
CONSUMER SURVEYS
- In some instances, every customer or potential customer
can be contacted.
- Organizations seeking customer input usually resort to
consumer surveys, which enable them to sample consumer
opinions.
- A considerable amount of knowledge and skill is required
to construct a survey, administer it, and correctly interpret the
results for valid information.
DELPHI METHOD
- An iterative process intended to achieve a consensus
forecast.
- Involves circulating a series of questionnaires among
individuals who possess the knowledge and ability to contribute
meaningfully.
- Useful for technological forecasting; that is, for assessing
changes in technology and their impact on an organization.
FORECASTS BASED ON TIME-SERIES
DATA
• 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, sales, earnings, profits,
shipments, accidents, output, precipitation, productivity, or the
consumer price 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.
• Analysis of time-series data requires the analyst to identify the
underlying behavior of the series.
• Can be accomplished by merely plotting the data and visually examining
the plot.
• Behaviors can be described as follows:
1. Trend refers to a long-term upward or downward
movement in the data.
2. Seasonality refers to short-term, fairly regular
variations generally related to factors such as the
calendar or time of day.
3. Cycles are wavelike variations of more than one
year’s duration.
4. Irregular variations are due to unusual
circumstances such as severe weather conditions,
strikes, or a major change in a product or service.
5. Random variations are residual variations that
remain after all the other behaviors have been
accounted for.
NAÏVE METHODS
• A naïve forecast uses a single previous value of a time series
as the basis of a forecast.
• Can be used with a stable series (variations around an
average), with seasonal variations, or with trend.
• With a stable series, the data point becomes the forecast for
the next period.
• With seasonal variations, the forecast for this “season” is
equal to the value of the series last “season.”
• For the data with trend, the forecast is equal to the last value
of the series plus or minus the difference between the last
two values of the series.
TECHNIQUES FOR AVERAGING
• Averaging techniques smooth variations in the data.
• Averaging techniques smooth variations in a time series
because the individual highs and lows in the data offset
each other when they are combined into an average.
• Averaging techniques generate forecast that reflect recent
values of a time series (e.g., the average value over the
several periods).
• 3 Techniques for Averaging:
a. Moving Average
b. Weighted Moving Average
c. Exponential Smoothing
Moving Average
• A moving average forecast uses a number of the most recent data
values in generating forecast.
• The moving average forecast can be computed using the following
equation:
Computing a Moving Average
• Compute a three-point moving average forecast given demand for
shopping carts for the last five periods.

Period Demand
1 42
2 40
3 43
4 40
5 41
Moving Average (cont’d.)
• Note that in a moving average, as each new actual values becomes
available, the forecast is updated by adding the newest value and
dropping the oldest and then recomputing the average.
• The moving average can incorporate as many data points as desired.
In selecting the number of periods to include, the decision maker
must take into account the number of data points in the average
determines its sensitivity to each new data point: The fewer the data
points in an average, the more sensitive (responsive) the average
tends to be.
Weighted Moving
Average
• A weighted average is similar to 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
a weight of .20, and the next after that a
weight of .10.
• Note that the weight must sum to 1.00
and that the heaviest weights are assigned
to the most recent values.
• Note that if four weights are used, only
the four most recent demands are used to
prepare the forecast.
Computing a Weighted Moving Average
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.
Period Demand
1 42
2 40
3 43
4 40
5 41
Exponential Smoothing
• Exponential smoothing is a sophisticated weighted
averaging method that is still relatively easy to use
and understand.
• Each new forecast is based on the previous forecast
plus a percentage of the difference between that
forecast and the actual value of the series at that
point. That is:
Next forecast = Previous forecast + α (Actual – Previous
forecast)

where (Actual – Previous forecast) represents the

forecast error and α is a percentage of the error.
TECHNIQUES FOR
TREND
• Analysis of trend involves developing an
equation that will suitably describe
trend (assuming that trend is present in
the data).
• There are two important techniques
that can be used to develop forecasts
when trend is present. One involves use
of a trend equation; the other is an
extension of exponential smoothing.
• Trend Equation A linear trend
equation has the form
Obtaining and Using a Trend Equation
Cell phone sales for a California-based firm over the last 10 weeks are
shown in the following table. Plot the data and visually check to see if a
linear trend line would be appropriate. Then, determine the equation
of the trend line, and predict sales for weeks 11 and 12.
Week Unit Sales
1 700
2 724
3 720
4 728
5 740
6 742
7 758
8 750
9 770
 • Sometimes called double
TREND- smoothing, which
differentiates it from
ADJUSTED exponential smoothing, which
EXPONENTIAL is appropriate only when data
vary around an average or
SMOOTHING have step or gradual changes.
• The trend-adjusted forecast
(TAF) is composed of two
elements – a smoothed error
and trend factor.
Problem:
Determine the forecast for period six using exponential smoothing with
trend adjustment if the forecast for period 1 is 11, and the trend is 2.
Use α = 0.20 and β = 0.40.

Period (t) Actual (At) Forecast (Ft) Trend (Tt) Forecast w/

Trend (FITt)
1 12 11 2
2 17
3 20
4 19
5 24
6
ASSOCIATIVE
FORECASTING
TECHNIQUE
• Associative techniques rely on identification of related variables that
can be used to predict values of the variable of interest.
• Examples:
a. Sales of beef may be related to the price per pound charged for
beef and the prices of substitutes such as chicken, pork, and
lamb.
b. Real estate prices usually related to property located and square
footage.
c. Crop yields are related to soil conditions and amounts and timing
of water and fertilizer applications.
• The essence of associative techniques is the development of an
equation that summarizes the effects of predictor variables.
Simple Linear Regression
• The simplest and most widely used form of regression involves linear relationship
between two variables.
• The object in linear regression is to obtain an equation of a straight line that
summarizes the sum of squared vertical deviations of data points from the line
(i.e., the least squares criterion).
• This least squares line has the equation
yc = a +bx
Where
yc = predicted (dependent) variable
x = predictor (independent) variable
b = slope of the line
a = value of yc when x = 0 (i.e., the height of the line at the y intercept)
 Simple
Linear
Regression
(cont’d.)
Determining the Regression
Equation
Example: Healthy Hamburgers has a chain of 12 stores in northern Illinois. Sales
figures and profits for the stores are given in the following table. Obtain a
regression equation for the data, and predict profit for a store assuming sales of
$10 million. Unit Sales,x Profits, y
(in $ millions) (in $ millions)
7 0.15
2 0.10
6 0.13
4 0.15
14 0.25
15 0.27
16 0.24
12 0.20
14 0.27
20 0.44
15 0.34
7 0.17
Simple Linear Regression (cont’d.)
• One indication of how accurate a prediction might be for a linear
regression line is the amount of scatter of the data points around the
line.
• If the data points tends to be relatively close to the line, predictions
using the linear equation will tend to be more accurate than if the
data points are widely scattered.
• The scatter can be summarized using the standard error of estimate.
Simple Linear Regression (cont’d.)
• Correlation – measures the strength and direction of relationship
between two variables.
• Correlation can range from -1.00 to +1.00.
• A correlation of +1.00 indicates that changes in one variable are
always matched by changes in the other; a correlation of -1.00
indicates that increases in one variable are matched by decreases in
the other; and a correlation close to zero indicates little linear
relationship between two variables.
• It can be computed using this equation:
Simple Linear Regression (cont’d.)
• The square of the correlation coefficients, r2, provides a measure of the
percentage of the variability in the values of y that is “explained” by the
independent variable.
• The possible values of r2 range from 0 to 1.00.
• The closer r2 is to 1.00, the greater the percentage of explained variation.
• A high value of r2, say .80 or more, would indicate that the independent
variable is a good predictor of values of the dependent variable.
• A low value, say 0.25 or less, would indicate a poor indicator, and a value
between .25 and .80 would indicate a moderate predictor.
Determining a
Regression Equation

• Sales of new houses and three-month lagged

unemployment are shown in the following
table. Determine if unemployment levels can
be used to predict demand for new houses
and, if so, derive a predictive equation.
PERIOD 1 2 3 4 5 6 7 8 9 10 11

Units Sold 20 41 17 35 25 31 38 50 15 19 14

Unemployment % 7.2 4.0 7.3 5.5 6.8 6.0 5.4 3.6 8.4 7.0 9.0
(three-month lag)
FORECAST ACCURACY
• Accuracy and control of forecasts is a vital aspect of forecasting, so
forecasters want to minimize forecast errors.
• Decision makers will want to include accuracy as a factor when
choosing among different techniques along with cost.
• Accurate forecasts are necessary for the success of daily activities of
every business organization.
• Forecasts are the basis for an organization’s schedules, and unless the
forecasts are accurate, schedules will be generated that may provide
for too few or too many resources, too little or to much output, the
wrong output, or the wrong timing of output, all of which can lead to
additional costs, dissatisfied customers, and headaches for managers.
FORECAST ACCURACY (cont’d.)
• When making periodic forecasts, it is important to monitor forecast
errors to determine if the errors are within reasonable bounds. If they
are not, it will be necessary to take corrective action.
• Forecast error is the difference between the value that occurs and the
value that was predicted for a given time period.
• Error = Actual – Forecast
• et = At – Ft
Where
t = Any given time period
Summarizing Forecast Accuracy
• Forecast accuracy is a significant factor when deciding among
forecasting techniques.
• Accuracy is based on the historical error performance of a forecast.
Choosing a Forecasting Technique
• Many different kinds of forecasting techniques are available, and no single
technique works best in every situation.
• When selecting a technique, the manager or analyst must take a number of
factors into consideration.
• The two most important factors are cost and accuracy.
• Other factors to consider in selecting a forecasting technique include the
availability of historical data; the availability of computer software; and the
time needed to gather and analyze data and to prepare the forecast.
• The forecast horizon is important because some techniques are more
suited to long-range forecasts while others work best for the short range.
Choosing a Forecasting Technique
(cont’d.)
• Moving averages and exponential smoothing are essentially short-
range techniques, because they produce forecast for the next period.
• Trend equations can be used to project over much longer time
periods.
• When using time-series data, plotting the data can be very helpful in
choosing an appropriate method.
Guide to selecting an appropriate forecasting method: