MODULE 4

Forecasting

OVERVIEW: Learning Objectives:

Most successful business uses different • Define and understand the nature and elements
forecasting methods in order to prepare their of a forecast
operations for the possible demand of their products • Outline the steps for forecasting
or services. By forecast, firms were able to plan and • Describe four qualitative forecasting techniques
estimate their future operations and were also able • Prepare forecasts using the different types and
to eliminate uncertainties in their planning activities. methods
Presented in this module are the different types,
approaches and techniques of forecasting.

4.1 Forecasts
Forecast is a statement about the future value of a variable of interest such as demand, it can also be referred as
predictions about the future. There are two aspects of forecasts. One is the expected level of demand; the other is the
degree of accuracy that can be assigned to a forecast. 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 may be short range or longe range.
Forecasts are used as basis for budgeting, planning capacity, sales, production and inventory, personnel, purchasing, and
more. Forecasts are important as it affect decisions and activities throughout the organization, in accounting, finance,
human resources, marketing, and management information systems, as well as in operations and other parts of an
organization. The specific use of forecasts are listed below:

Since the organizations rely on the forecasts, it is important that we make or come-up with a good and reliable forecast.
A properly prepared forecast should be timely, accurate, reliable, expressed in meaningful units, expressed in writing,
simple to understand and use, and must be cost-effective.

Steps in Forecasting:
1) Determine the purpose of the forecast. How will it be used and when will it be needed?
2) Establish a time horizon. The forecast must indicate a time interval, keeping in mind that accuracy decreases as
the time horizon increases.
3) Obtain, clean, and analyze appropriate data. Obtaining the data can involve significant effort.
 4) Select a forecasting technique.
5) Make the forecast.
6) Monitor the forecast errors. The forecast errors should be monitored to determine if the forecast is performing
in a satisfactory manner.

4.2 Forecast Accuracy

Accurate forecasts are necessary for the success of daily activities of every business organization. However, random
variables always exist that makes it hard for the forecast to be most accurate. In that sense, it is important to include an
indication of the extent to which the forecast might deviate from the value of the variable that actually occurs. This will
provide the forecast user with a better perspective on how far off a forecast might be. 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.

4.3 Approach to Forecasting

There are two approaches in forecasting, it can be quantitative method or qualitative method. Qualitative methods consist
mainly of subjective inputs, which often defy precise numerical description. It involves either the projection of historical
data or the development of associative models that attempt to utilize causal (explanatory) variables to make a forecast.
Quantitative consist mainly of analyzing objective, or hard, data. They usually avoid personal biases that sometimes
contaminate qualitative methods. In practice, either approach or a combination of both approaches might be used to
develop a forecast. Different types of forecasts include: Judgmental forecasts, Time-series forecasts, and Associative
models. Judgmental forecasts use subjective inputs such as opinions from consumer surveys, sales staff, managers,
executives, and experts, time-series forecasts project patterns identified in recent time-series observations, while
Associative model forecasting technique that uses explanatory variables to predict future demand.

4.3 Types of Forecasting

❖ Judgmental forecasts use subjective inputs such as opinions from consumer surveys, sales staff, managers, executives,
and experts.
• Executive Opinions
• Salesforce Opinions
• Consumer Surveys
• Other Approaches
▪ Delphi Method

❖ Time-series forecasts project patterns identified in recent time-series observations. A time series is a time-ordered
sequence of observations taken at regular intervals.
• Trend refers to a long-term upward or downward movement in the data.
• Seasonality refers to short-term, fairly regular variations generally related to factors such as the calendar or time
of day. Restaurants, supermarkets, and theaters experience weekly and even daily “seasonal” variations.
• Cycles are wavelike variations of more than one year’s duration. These are often related to a variety of economic,
political, and even agricultural conditions.
• Irregular variations are due to unusual circumstances such as severe weather conditions, strikes, or a major
change in a product or service.
• Random variations are residual variations that remain after all other behaviors have been accounted for.
 Naive Method
A naive forecast uses a single previous value of a time series as the basis of a forecast. This kind of forecast has
virtually no cost, quick and easy to prepare because data analysis is nonexistent, and is easily understandable. The
naive approach can be used with a stable series (variations around an average), with seasonal variations, or with trend.
In stable series, the last data point will be the forecast for the next period, in seasonal variations data of recent season
will be the forecast for the next season, and for the trend series 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

The existence of random variations arises due to relatively unimportant factors that can not be reliably
determined. Averaging are used to smoothen those variations present in the data that are used in forecasts.

▪ Moving average: A technique that averages a number of recent actual values, updated as new values become
available.
▪ Weighted average: Similar to a moving average, except that it typically assigns more weight to the most recent
values in a time series.
▪ Exponential smoothing: A weighted averaging method based on previous forecast plus a percentage of the
forecast error.

❖ Associative Model Forecasting rely on identification of related variables that can be used to predict values of the
variable of interest
• Simple Linear Regression
• Nonlinear and Multiple Regression Analysis

(Read illustrative examples of Forecasting techniques in Chapter 4 of operations Management by William Stevenson)

4.4 Monitoring Forecasts Error

Keeping track on forecast errors is useful in determining whether the forecasts provides satisfactory output. There
different reasons why forecasts errors exist and most of their sources are listed below:

1. The model may be inadequate due to the omission of an important variable, a change or shift in the variable that the
model cannot deal with (e.g., sudden appearance of a trend or cycle), or the appearance of a new variable (e.g., new
competitor).
2. Irregular variations may occur due to severe weather or other natural phenomena, temporary shortages or breakdowns,
catastrophes, or similar events.
3. Random variations. Randomness is the inherent variation that remains in the data after all causes of variation have
been accounted for. There are always random variations.

We can say that a forecast is satisfactory when it only contains errors of random variation. If they are not random, it is
necessary to investigate to determine which of the other sources is present and how to correct the problem. Techniques
in determination of randomness includes: control chart (a visual tool for monitoring forecast errors); and tracking signal
(relates the cumulative forecast error to the average absolute error).
 4.5 Choosing a forecasting technique

A number of considerations must be made in order to decide what technique should the manager use in forecasting. It is
important to note that not all forecasting techniques is applicable to all situations and conditions. In choosing a technique
cost and accuracy is of a great factor. It is important to weigh the balance or trade off of the cost that will be incurred in
order to arrive at an accurate forecast. The best forecast is not necessarily the most accurate or the least costly; rather, it
is some combination of accuracy and cost deemed best by management.

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
also important because some techniques are more suited to long-range forecasts while others work best for the short
range.

Reference used:

William J. Stevenson, Production Operations Management

Additional Readings:

Production Operations Management Chapter 3 by William J. Stevenson

Exercise 1
National Scan, Inc., sells radio frequency inventory tags. Monthly sales for a seven-month period were as follows:

a. Plot the monthly data on a sheet of graph paper.

b. Forecast September sales volume using each of the following:
(1) The naive approach.
(2) A five month moving average.
(3) A weighted average using .60 for August, .30 for July, and .10 for June.
(4) Exponential smoothing with a smoothing constant equal to .20, assuming a a March forecast of 19(000).
(5) A linear trend equation.
c. Which method seems least appropriate? Why? ( Hint: Refer to your plot from part a. )
d. What does use of the term sales rather than demand presume?

Exercise 2
The following equation summarizes the trend portion of quarterly sales of condominiums over a long cycle. Sales also
exhibit seasonal variations. Using the information given, prepare a forecast of sales for each quarter of next year (not this
year), and the first quarter of the year following that.

Exercise 3
A dry cleaner uses exponential smoothing to forecast equipment usage at its main plant. August usage was forecasted to
be 88 percent of capacity; actual usage was 89.6 percent of capacity. A smoothing constant of .1 is used.
a) Prepare a forecast for September.
b) Assuming actual September usage of 92 percent, prepare a forecast for October usage.