UNIT 3

FORECASTING
Weather forecasts are one of the many types of forecasts
used by some business organizations.
– Mega marts
– Medical Industry
– Clothing

Although some businesses simply rely on publicly

available weather forecasts, others turn to firms that
specialize in weather-related forecasts.
Many new car buyers have a thing or two in common. Once
they make the decision to buy a new car, they want it as
soon as possible.

The dealer who can correctly forecast buyer wants, and have
those cars available, is going to be much more successful.
So how does the dealer know how many cars of each type
to stock?
The answer is, the dealer doesn’t know for sure, but by
analyzing previous buying patterns, and perhaps making
allowances for current conditions, the dealer can come up
with a reasonable approximation of what buyers will want.
Forecasts help managers by reducing some of the uncertainty,
thereby enabling them to develop more meaningful plans.

A forecast is a statement about the future value of a variable

such as demand. That is, forecasts are predictions about
the future. The better those predictions, the more informed
decisions can be.
INTRODUCTION
Forecasts are the basis for budgeting, planning capacity,
sales, production and inventory, personnel, purchasing, and
more.
Forecasts play an important role in the planning process
because they enable managers to anticipate the future so
they can plan accordingly.

Forecasts affect decisions and activities throughout an

organization –
– Accounting
– Finance
– Human resources
– Marketing
– Management information systems (MIS)
– Other parts of an organization.
Here are some examples of uses of forecasts in business
organizations -
• Accounting. New product/process cost estimates, profit
projections, cash management.
• Finance. Equipment/equipment replacement needs, amount
of funding/borrowing needs.
• Human resources. Hiring activities, including recruitment,
interviewing, and training;
• Marketing. Pricing and promotion, business strategies.
• MIS. New/revised information systems, Internet services.
• Operations. Schedules, capacity planning, inventory
planning, outsourcing.
• Product/service design. Revision of current features,
design of new products or services.
In most of these uses of forecasts, decisions in one area have
consequences in other areas.

Therefore, it is very important for all affected areas to agree on

a common forecast.

Accurate forecasts can help managers plan tactics (e.g., offer

discounts, don’t offer discounts) to match capacity with
demand, thereby achieving high productivity.
There are two uses for forecasts. One is to help managers
plan the system, and the other is to help them plan the use
of the system.

Planning the system generally involves long-range plans

about the types of products and services to offer, what
facilities, where to locate, and so on.

Planning the use of the system refers to short-range and

intermediate- range planning, which involve tasks such as
planning inventory and workforce levels, planning
purchasing and production, budgeting, and scheduling.
FEATURES COMMON TO ALL FORECASTS

1. Assumes a causal system approach

2. Forecasts are not perfect

3. Forecasts for groups tend to be more accurate than

forecasts for individual items.

4. Forecast accuracy decreases as the time period covered by

the forecast increases.
FEATURES COMMON TO ALL FORECASTS
1. Forecasting techniques generally assume that the same
underlying causal system that existed in the past will
continue to exist in the future.
2. Forecasts are not perfect; actual results usually differ from
predicted values; Allowances should be made for forecast
errors.
3. 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.
4. Forecast accuracy decreases as the time period covered by
the forecast increases. Generally speaking, short-range
forecasts must contend with fewer uncertainties than
longer-range forecasts, so they tend to be more accurate.
ELEMENTS OF A GOOD FORECAST
1. Should be timely.

2. Should be accurate.

3. Should be reliable.

4. Expressed in meaningful units.

5. Should be in writing.

6. Techniques used should be simple to understand and

use.
7. Should be cost-effective.
ELEMENTS OF A GOOD FORECAST
1. The forecast should be timely. Usually, a certain amount of
time is needed to respond to the information contained in
a forecast.
2. The forecast should be accurate, and the degree of
accuracy should be stated.
3. The forecast should be reliable; A technique that
sometimes provides a good forecast and sometimes a
poor one will leave users with the uneasy feeling.
4. The forecast should be expressed in meaningful units.
5. The forecast should be in writing.
6. The forecasting technique should be simple to understand
and use.
7. The forecast should be cost-effective: The benefits should
outweigh the costs.
STEPS IN THE FORECASTING PROCESS
1. Determine the purpose of the forecast

2. Establish a time horizon

3. Obtain, clean, and analyze appropriate data

4. Select a forecasting technique

5. Make the forecast

6. Pass on the forecast results to the respective

departments for further action

7. Monitor the forecast

STEPS IN THE FORECASTING PROCESS

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. Once data

is obtained, the data may need to be “cleaned” to get rid of
outliers and obviously incorrect data before analysis.

4. Select a forecasting technique.

5. Make the forecast. Do analysis using mathematical
models.

6. Monitor the forecast. A forecast has to be monitored to

determine whether it is performing in a satisfactory
manner. If it is not, reexamine and prepare a revised
forecast.
APPROACHES TO FORECASTING
- Qualitative Approach
- Quantitative Approach

There are three general approaches to forecasting:

• Judgmental Forecasts

• Time-series Forecasts

• Associative Forecasts
Judgmental forecasts - are inputs obtained from various
sources, such as consumer surveys, the sales staff,
managers and executives, and panels of experts.

Time-series forecasts - Forecasts that project patterns

identified in recent time-series observations.

Associative model - Forecasting technique that uses

explanatory variables to predict future demand.
JUDGMENT AND OPINION

•Executive opinions (upper-level managers)

•Salesforce opinions

•Consumer surveys

•Opinions of experts

•Delphi method
FORECASTS BASED ON JUDGMENT AND OPINION

In situations where time is short forecast in solely based on

judgment and opinion.
Executive Opinions - A small group of upper-level managers
(e.g., in marketing, operations, and finance) collectively
develop a forecast. This approach is often used as a part of
long-range planning and new product development.
Sales force Opinions - Sales staff or the customer service
staff are often in direct contact with consumers. They are
often aware of any plans the customers may be considering
for the future.
Consumer Surveys - Because it is the consumers who
ultimately determine demand, it seems natural to solicit
input from them.
Delphi method
• An iterative process intended to achieve a consensus
forecast.
• This method involves circulating a series of questionnaires
among individuals who have the ability to contribute
meaningfully.
• Responses are kept anonymous, to obtain honest
responses and reduces the risk that one person’s opinion
will prevail.
FORECASTS BASED ON TIME-SERIES DATA
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, earnings,
profits, shipments, productivity, or the consumer price index.
• Time-series data are made on the assumption that future
values of the series can be estimated from past values.
• No attempt is made to identify variables that influence the
data
• These methods are widely used, often with quite satisfactory
results.
PATTERNS IN TIME-SERIES
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. Restaurants, supermarkets, and theaters experience
weekly and even daily “seasonal” variations.
3. 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.
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 other behaviors have been accounted for.
NAÏVE METHOD
Naïve forecast uses a single previous value of a time
series as the basis of a forecast.

Trend data
Techniques for Averaging

1. Moving average.

2. Weighted moving average.

3. Exponential smoothing.
1. Moving average - A moving average forecast uses a
number of the most recent actual data values in generating
a forecast.
EXAMPLE

SOLUTION
2. Weighted Moving Average.
• A weighted average is similar to a moving average, except
that it 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 that a weight of .20, and the next after that a
weight of .10.
• Note that the weights must sum to 1.00, and that the
heaviest weights are assigned to the most recent values.
EXAMPLE
3. Exponential Smoothing. In this type 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:
For example,
Suppose the previous forecast was 42 units,
Actual demand was 40 units,
and α= 0.10.
The new forecast would be computed as follows:
APPROACHES TO FORECASTING
- Qualitative Approach
- Quantitative Approach

There are three general approaches to forecasting:

• Judgmental Forecasts

• Time-series Forecasts – Naïve, Averages, Trend,

Seasonality, Cycles

• Associative Forecasts
TREND FORECASTS
Techniques for Trend – LINEAR TREND EQUATION
The trend component is a linear trend, which represents a
straight line.
A linear trend equation has the form

Ft = a + bt

This formula is used to develop forecasts when trend is

present.
1.
2. From the following graph, determine the equation of the linear trend
line for time-share sales for Glib Marketing, Inc.
Example 3: Cell phone sales for a firm over the last 10 years are shown in the
table.
a) Plot the data and check if a linear trend line would be appropriate.
b) Then determine the equation of trend line, and predict sales for weeks 11
and 12.
Solution:
The original data, the trend line, and the two projections
(forecasts) are shown on the following graph -
Example 4: Plot the data on a graph, and verify that a linear trend line is
appropriate. Develop the trend line equation and predict the next two values of
the series.
Techniques for Seasonality
Seasonal variations in time-series data are regularly
repeating upward or downward movements in series values
that can be tied to recurring events.
Examples –
Weather variations (e.g., sales of winter and summer sports
equipment)
Vacations or holidays (e.g., airline travel, greeting card sales,
visitors at tourist and resort centers)
Rush hour traffic occurs twice a day—incoming in the morning
and outgoing in the late afternoon.
Theaters and restaurants often experience weekly demand
patterns, with demand higher later in the week.
Banks may experience daily seasonal variations (heavier traffic
during the noon hour and just before closing)
• Knowledge of seasonal variations is an important factor in
retail planning and scheduling.

• Moreover, seasonality can be an important factor in

capacity planning for systems that must be designed to
handle peak loads (e.g., public transportation, electric
power plants, highways, and bridges).
Seasonal relatives
Seasonality in a time series are referred to as seasonal
relatives.

• First determine the forecast based on average or trend.

• Then multiply the seasonal relative to the forecast.
Example 1: The trend equation to estimate monthly demand is
Ft = 70 + 5 t, where t = 0 in June of last year. Seasonal
relatives are 1.10 for January, 1.02 for February, and .95 for
March. What demands should be predicted for January,
February and March this year and also next year?
Example 2:
Using the information given, prepare a forecast of sales for
each quarter of 2017 and the first quarter of 2018.
Ft = 40 – 6.5t + 2t2
where t = 0 at the fourth quarter of 2013.
Example 3:
Prepare a forecast for January, February, and March of next year.
Use Ft = 70 + 5t, where t = 0 in June last year. Seasonal relatives are
1.10 for January, 1.02 for February, and 0.95 for March.
Example 4:
Techniques for Cycles
Cycles are up-and-down movements similar to seasonal
variations but of longer duration—say, two to six years
between peaks.
Search for another variable that relates to, and leads, the
variable of interest.

• For example, the number of housing starts in a given month

often is an indicator of demand a few months later for
products and services directly tied to construction of new
homes (landscaping; sales of washers and dryers, carpeting,
and furniture; new demands for shopping, transportation,
schools).
APPROACHES TO FORECASTING

There are three general approaches to forecasting:

• Judgmental Forecasts

• Time-series Forecasts

• Associative Forecasts
Judgmental forecasts - are inputs obtained from various
sources, such as consumer surveys, the sales staff,
managers and executives, and panels of experts.

Time-series forecasts - Forecasts that project patterns

identified in recent time-series observations.

Associative model - Forecasting technique that uses

explanatory variables to predict future demand.
ASSOCIATIVE FORECASTING TECHNIQUES
Associative techniques rely on identification of related
variables that can be used to predict values of the variable
of interest.

The essence of associative techniques is the development of

an equation that summarizes the effects of predictor
variables.

Predictor variables – Variables that can be used to predict

values of the variable of interest.
Predictor variables – Variables that can be used to predict
values of the variable of interest.
Simple Linear Regression
Regression Technique for fitting a line to a set of points
(Least squares line).
Correlation between indicator and variable:
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.

A correlation close to zero indicates little relationship between

two variables.
The square of the correlation coefficient, r2, provides a
measure of the percentage of variability in the values of y
that is “explained” by the predictor variable x.
Regression analysis.
Example 1: The owner of a small hardware store has noted a
sales pattern for window locks that seems to parallel the
number of break-ins reported each week in the newspaper.
The data are:

a. Obtain a regression equation for the data.

b. Estimate average sales when the number of break-ins is 5.
c. Determine the correlation coefficient and interpret it.
FORECAST ACCURACY
Accuracy and control of forecasts is a vital aspect forecasting,
so forecasters want to minimize forecast errors.

Forecast error is the difference between the actual value that

and the value that was predicted for a given period.

Hence, Error = Actual - Forecast

et = At - Ft
CONTROLLING THE FORECAST
Tracking the forecast errors and analyzing them can
provide useful insight on whether or not forecast are
performing satisfactorily.
Measuring Forecasts Errors
Three commonly used measures –

1. The Mean Absolute Deviation (MAD) – is the average

absolute error.

2. The Mean Squared Error (MSE) – is the average of

squared errors.

3. The Mean Absolute Percent Error (MAPE) – is the

average absolute percentage error.
Forecast Accuracy - computation of MAD, MSE, and MAPE.
Example 1 :
Compute MAD, MSE, and MAPE for the following data –
Example 2:
The manager of a large manufacturer of industrial
pumps must choose between two alternative forecasting
techniques. Using MAD as a criterion, which technique has
the better performance record?
TRACKING SIGNAL:
• Each business has its forecast model to provide the
forecast.
• However, forecasters need to monitor a forecast to
determine when it might be advantageous to change or
update the model.
• A tracking signal provides a method for doing this by
quantifying bias.
 Demand Forecast

1 100 90

2 90 110

3 130 128

4 140 130

5 160 140
Values can be positive or negative.

A value of zero would be ideal.

Control limits of ±2 to ±4 are used for a range of acceptable

values of tracking signal.

Values outside this rage indicate that you should reevaluate

the model used.