Chapter 2

Forcasting

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 Introduction
• Forecasting is a prelude to planning.
• Before making plans, an estimate must be
made of what conditions will exist over some
future period.
• The success of the business will then depend
on the accuracy of the forecasting process in
predicting the future demand.

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What to forecast?
Forecasting is estimating and predicting future
conditions and events. e.g.,
– Technology, - Products,
– Marketplace, - Customers,
– Competition and Economy,
– Global supply chains,
– Manpower, -Capital and
– Facilities.

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 Forecasting-Goals-Planning
• Forecasting is about predicting the future as accurately as
possible, given all the information available including
historical data and knowledge of any future events that
might impact the forecasts.
• Goals are what you would like to happen. Goals should be
linked to forecasts and plans, but this does not always occur.
Too often, goals are set without any plan for how to achieve
them, and no forecasts for whether they are realistic.
• Planning is a response to forecasts and goals. Planning
involves determining the appropriate actions that are
required to make your forecasts match your goals.

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 Definitions of forecasting
i. Forecasting is defined as the estimation of future activities
(type, quantity and quality of future work). This estimates
the basis to plan the future requirements for men,
machines, materials, time, money, etc.
ii. Forecasting is a systematic attempt to probe the future by
inference from known facts. The purpose is to provide
management with information on which it can base
planning decisions.
iii. Forecasts are predictions or estimates of change, if any in
characteristic economic phenomena which may affect ones
business plans.
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 2. …
Business forecasting refers to the statistical analysis
of the past and current movements in the given
time series so as to obtain clues about the future
pattern of the movements.
• Forecasting may be done in connection with sales,
production or any other type of business activities.
• Forecasting begins with the sales forecast and is
followed by production forecast and forecast for
probable costs, finance, purchases, profit or loss
etc.
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 Factors affecting the Demand
- General business and economic conditions.
-invention of new materials,
– fashion changes,
– policies of competitors,
– unseasonable weather,
– The firm’s own plans for advertising, promotion,
pricing, and product changes.
– threat of war and the general economic situation
expected in the country and foreign markets.

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 Purposes of Forecasting
• Set bounds for possibilities to help focus on
specifics
• Form basis for setting objectives
• Promote inter-group coordination
• Provide basis for resources allocation
(manpower, budget, facilities and business
relations - alliances, joint ventures)
• Induce innovation through forecasted needs

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 Steps to Forecast
• Identify critical success factors for achieving
company goals
• Determine forecasting horizon (short,
intermediate and long terms)
• Select forecasting techniques (e.g., trend
analysis, statistics, intuition, judgment)
• Predict future states and their probability of
occurrence

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 Demand Forecasting
• Forecasting product demand is crucial to any
supplier, manufacturer, or retailer.
• Forecasts of future demand will determine
the quantities that should be purchased,
produced, and shipped.
• Most manufacturers "make to stock" rather
than "make to order"

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 General Approaches to Forecasting
• All firms forecast demand, but it would be
difficult to find any two firms that forecast
demand in exactly the same way.
• Typically, businesses use relatively simple
forecasting methods that are often not based
on statistical modeling.
• However, the use of statistical forecasting is
growing and some of the most commonly
used methods are listed below.

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 Demand Over Time

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 Forecasting Methods
I. Naïve techniques - adding a certain
percentage to the demand for next year.
II. Opinion sampling - collecting opinions from
sales, customers etc.
III. Qualitative methods
IV. Quantitative methods

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 Qualitative Forecasting methods:
• Executive Committee Consensus:
• Knowledgeable executives from various
departments within the organization form a
committee charged with the responsibility of
developing a sales forecast. The committee
may use many inputs from all parts of the
organization and may have staff analysts
provide analysis as needed. This method is the
most common forecasting method.
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 Delphi Method
• This method is used to achieve consensus
within a committee. In this method executives
anonymously answer a series of questions on
successive rounds. Each response is fed back to
all participants on each round, and the process
is then repeated. As many as six round may be
required before consensus is reached on the
forecast. This method can result in forecasts
that most participants have ultimately agreed
to inspire of their initial disagreement.
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 Survey of sales force
• Estimates of the future regional sales are
obtained from individual members of the sales
force. These estimates are combined to form an
estimate of sales for all regions. Managers must
then transform this estimate into a sales forecast
to ensure realistic estimates. This is a popular
forecasting method for companies that have a
good communication system in place and that
have sales persons who sell directly to customers.

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 Survey of customers
• Estimates Estimates of the future sales are
obtained directly from customers. Individual
customers are surveyed to determine what
quantities of the firm’s products they intend to
purchase in future time period. A sales
forecast is determined by combining individual
customers’s responses. This method may be
preferred by companies that have relatively
few customers.

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 Historical Analogy
• This method ties the estimate of furure sales
of a product to knowledge of a similar
product’s sales. Knowledge of one product’s
sales during various stages of its product life
cycle is applied to the estimate of sales for a
similar product. This method may be
particularly useful in forecasting sales of new
products.

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 Market Research
• In market surveys, mail questionaries,
telephone interviews, or field interviews form
the basis for testing hypotheses about real
markets. In market tests, products marketed in
target regions or outlets are statistically
extrapolated to total markets. These methods
are ordinarily preferred for new products or
for existing products to be introduced in new
market segments.

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 Quantitative Methods of Forecasting

1. Causal –There is a causal relationship between

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 COLLECTION AND PREPARATION OF DATA
• Forecasts are usually based on historical data
manipulated in some way using either judgment or a
statistical technique. Thus, the forecast is only as
good as the data on which it is based. To get good
data, three principles of data collection are
important.
1. Record data in the same terms as needed for the
forecast.
2. Record the circumstances relating to the data.
3. Record the demand separately for different customer
groups.
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 Demand for a particular item over the past
year

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 Moving Averages
• One simple way to forecast is to take the average
demand for, say, the last three or six periods and
use that figure as the forecast for the next period.
• At the end of the next period, the first-period
demand is dropped and the latest-period
demand added to determine a new average to be
used as a forecast.
• This forecast would always be based on the
average of the actual demand over the specified
period.
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 Example - 1
• For example, suppose it was decided to use a
three-month moving average on the data
shown in Previous Figure.
• Our forecast for January, based on the
demand in October, November, and
December, would be:
(63 + 91 + 84)/3 = 79

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• Now suppose that January demand turned out to
be 90 instead of 79.
• The forecast for February would be calculated as:
[91 + 84 + 90]/3 = 88.
Problem: Demand over the past three months has
been 120, 135, and 114 units. Using a three month
moving average, calculate the forecast for the fourth
month.
Answer: ?
Actual demand for the fourth month turned out
to be 129. Calculate the forecast for the fifth month.

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 Demand Patterns
• If historical data for demand are plotted
against a time scale, they will show any shapes
or consistent patterns that exist.
• The pattern shows that actual demand varies
from period to period.
• There are four reasons for this:
Trend, Seasonality, Random variation, and
Cycle.

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 Stable Versus Dynamic Demand

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 Effect of Number of Months on
moving average method

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• If a five-period moving average is used, the
forecast for period 6 is
(1000 + 2000 + 3000 + 4000 + 5000)/5 = 3000.
• However, if a three-month moving average is
used, the forecast is
(3000 + 4000 + 5000) / 3 = 4000.
• The demand has no trend and is random.
• If a two month average is taken, the forecasts
for the third, fourth, fifth, and sixth months
are:
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• Forecast for third month = (2000 + 5000) / 2 =
3500.
• Forecast for fourth month = (5000 + 3000) / 2 =
4000.
• Forecast for fifth month = (3000 + 1000) / 2 =
2000.
• Forecast for sixth month = (1000 + 4000) / 2 =
2500.
• With a two-month moving average the forecast
reacts very quickly to the latest demand and thus
is not stable.
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 Applicability
• Moving averages are best used for forecasting products
with stable demand where there is little trend or
seasonality.
• Moving averages are also useful to filter out random
fluctuations.
• This has some common sense since periods of high
demand are often followed by periods of low demand.
• One drawback to using moving averages is the need to
retain several periods of history for each item to be
forecast.
• This will require a great deal of computer storage or
clerical effort.
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 Exponential Smoothing
• It is not necessary to keep months of history
to get a moving average because the
previously calculated forecast has already
allowed for this history.
• Therefore, the forecast can be based on the
old calculated forecast and the new data.
• In general, the formula for calculating the new
forecast is: New forecast = (α)latest demand +
(1 – α) previous forecast

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 EXAMPLE PROBLEM
• The weight given to latest actual demand is
called a smoothing constant and is
represented by the Greek letter alpha (α). It is
always expressed as a decimal from 0 to 1.0.
• The old forecast for May was 220, and the
actual demand for May was 190. If alpha (α)
is 0.15, calculate the forecast for June. If June
demand turns out to be 218, calculate the
forecast for July.

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 Answer
• June forecast = (0.15)(190) + (1 - 0.15)(220) =
215.5.
• July forecast = (0.15)(218) + (0.85)(215.5) =
215.9.
• If a trend exists, it is possible to use a slightly
more complex formula called double
exponential smoothing.

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 How to select a Forecasting Method
Though forecasts are usually wrong, still we
have to predict the demand. But, the following
factors are to be considered.
 Cost
 Accuracy
 Data available
 Time span
 Nature of products and services.

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Problem No. 1 : Given the following data, calculate
the three-month moving average forecasts for
months 4, 5, 6, and 7.
Month Demand Forecast
1 60
2 70
3 40
4 50
5 70
6 55
7

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Problem No. 2 : Using exponential smoothing,
calculate the forecasts for months 2, 3, 4, 5, and 6. The
smoothing constant is 0.2, and the old forecast for
month 1 is 245.
Month Actual Demand Forecast Demand
1 260
2 230
3 225
4 245
5 250
6

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