CH 3 Forecasting

Chapter 3:
Forecasting
3.1 Meaning and Use of Forecasting

3.2 Useful Forecasting Methods
3.1 Meaning and Use of Forecasting
Forecasts are vital to every business organization and for every significant
management decision. Forecasting is the basis of corporate long-run
planning. Forecasting is the art and science of predicting future events and
serves for developing an appropriate plan of a business.
In the functional areas of finance and accounting, forecasts provide the basis
for budgetary planning and cost control.
Marketing relies on sales forecasting to plan new products, compensate sales
personnel, and make other key decisions.
Production and operations personnel use forecasts to make periodic decisions
involving process selection, capacity planning, and facility layout, as well as
for continual decisions about production planning, scheduling, and inventory.
Uses of Forecasts
Accounting Cost/profit estimates
Finance Cash flow and funding
Human Resources Hiring/recruiting/training
Marketing Pricing, promotion, strategy, sales
MIS IT/IS systems, services
Operations Schedules, MRP, workloads
Product/service design New products and services

Steps in the Forecasting Process:
“The forecast”
Step 6: Monitor the forecast

Step 5: Prepare the forecast
Step 4: Gather and analyze data
Step 3: Select a forecasting technique
Step 2: Establish a time horizon
Step 1: Determine purpose of forecast
3.2 Useful Forecasting Methods
• Forecasting techniques:
– Qualitative and judgment method:- based on estimates and
opinions
– Naïve (time series) or quantitative/Extrapolative model:- based on
data related to past demand can be used to predict future demand
– Causal relationship (quantitative) or Explanatory model:- using
linear regression techniques
– Simulation :- dynamic models, usually computer-based
Qualitative Forecasting Methods
• Based upon managerial judgment when there is a lack of data or the data
were not reliable or relevant.
• Major methods:
– Grass root: Builds the forecast by adding successively from the bottom
or the person closest to the end user of the product.
– Delphi technique: It is a panel of group of experts with different level of
expertise and everyone has the same weight.
– Market surveys (research): panel, questionnaire, market test
– Life-cycles (historical) analogy: In forecasting new products, where an
existing product or generic product could be used as a model.
– Informed Judgment: group of individuals on experience, facts
– Panel consensus: by open meetings with free exchange of ideas
Quantitative/Time-Series Forecasting Methods
• Try to predict the future based on the past data
• To select forecasting model: time horizon, data availability, accuracy
required, size of forecasting budget, & qualified personnel are
considered.
• Components of time-series data:
– Trend – general direction (up or down)
– Seasonality – short term recurring cycles
– Cycle – long term business cycle
– Irregular variations – caused by unusual circumstances
– Random variations – caused by chance
• Decomposition of time-series
– Data are broken into the three components
• Moving Averages
• Exponential Smoothing
• Regression Analysis
Irregular
variation
Trend
Cycles
90
89
88
Seasonal variations
Moving Averages
• Moving average – combines demand data from several of the most
recent periods; their average being the forecast for next period.
n
 Ai
i=1
MAn
= n
or
Where,
Example 1:
• Weighted moving average – wants to use the moving average but does
not want to have all n periods equally weighted.
Where,
The sum of all the weights must equal one.
i.e.
Example 2:
Exponential Smoothing
• Include all past observations
• Weight recent observations much more heavily than very old observations:
0 1
weight
Decreasing weight given 
to older observations
(1)
(1)2
(1)3
today 
Simple Exponential Smoothing
Next forecast = previous forecast + (actual – previous forecast)
𝑭𝒕+𝟏 = 𝑭𝒕 +∝ (𝑨𝒕 − 𝑭𝒕 );
or
𝑭𝒕 = 𝑭𝒕−𝟏 +∝ (𝑨𝒕−𝟏 − 𝑭𝒕−𝟏 )
Where,
F = forecast of demand (both this period and next)
A = actual demand (this period)
t = time period
The value of the smoothing constant () is a choice. It determines how
much the calculation smoothes out the random variations. Its value can be
set between zero (0) and one (1).
Example 3:
By using the formula:
The sensitivity of forecast adjustment to error is determined by the smoothing
constant, . The closer its value to zero, the slower the forecast will be to adjust
to forecast errors (i.e., the greater the smoothing). Conversely, the closer the
value of  is to 1, the greater the sensitivity and the less the smoothing.
Forecast error
Forecast error for a period t is:
et =Actual demand (Dt) – Forecast (Ft)
The sources of forecast errors are:
• Model may be inadequate
• Irregular variations
• Incorrect use of forecasting technique
Elements of a good forecast:
1. The forecast should be timely – i.e. the forecasting horizon must
cover the time necessary to implement possible changes
2. The forecast should be accurate and the degree of accuracy should be
stated
3. The forecast should be reliable – i.e. it should work consistently
4. The forecast should be expressed in meaningful units – i.e. the choice
of units depends on user needs
5. The forecast should be in writing
6. The forecasting techniques should be simple to understand and use
Class Discussion 3:
Compare and contrast 'Forecasting', 'Planning' and 'Budgeting'

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Chapter 3:

3.1 Meaning and Use of Forecasting

Accounting Cost/profit estimates

Finance Cash flow and funding

Human Resources Hiring/recruiting/training

Marketing Pricing, promotion, strategy, sales

MIS IT/IS systems, services

Operations Schedules, MRP, workloads

Product/service design New products and services

Step 6: Monitor the forecast

The sum of all the weights must equal one.

Next forecast = previous forecast + (actual – previous forecast)

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