Forecasting is the process of making predictions of the future based on past and present

data. This is most commonly by analysis of trends. A commonplace example might

be estimation of some variable of interest at some specified future date. Prediction is a
similar, but more general term. Both might refer to formal statistical methods
employing time series, cross-sectional or longitudinal data, or alternatively to less formal
judgmental methods. Usage can differ between areas of application: for example,
in hydrology, the terms “forecast” and “forecasting” are sometimes reserved for estimates of
values at certain specific future times, while the term “prediction” is used for more general
estimates, such as the number of times floods will occur over a long period.
Risk and uncertainty are central to forecasting and prediction; it is generally considered good
practice to indicate the degree of uncertainty attached to specific forecasts. In any case, the
data must be up to date in order for the forecast to be as accurate as possible. In some cases,
the data used to predict the variable of interest is itself forecasted. [1]
As discussed in the previous chapter, functional strategies need to be aligned and supportive
to the higher level corporate strategy of the organization. One of these functional areas is
marketing. Creating marketing strategy is not a single event, nor is the implementation of
marketing strategy something only the marketing department has to worry about.
When the strategy is implemented, the rest of the company must be poised to deal with the
consequences. An important component in this implementation is the sales forecast, which is
the estimate of how much the company will actually sell. The rest of the company must then
be geared up (or down) to meet that demand. In this module, we explore forecasting in more
detail, as there are many choices that can be made in developing a forecast.
Accuracy is important when it comes to forecasts. If executives overestimate the demand for
a product, the company could end up spending money on manufacturing, distribution, and
servicing activities it won’t need. Data Impact, a software developer, recently overestimated
the demand for one of its new products. Because the sales of the product didn’t meet
projections, Data Impact lacked the cash available to pay its vendors, utility providers, and
others. Employees had to be terminated in many areas of the firm to trim costs.
Underestimating demand can be just as devastating. When a company introduces a new
product, it launches marketing and sales campaigns to create demand for it. But if the
company isn’t ready to deliver the amount of the product the market demands, then other
competitors can steal sales the firm might otherwise have captured. Sony’s inability to
deliver the e-Reader in sufficient numbers made Amazon’s Kindle more readily accepted in
the market; other features then gave the Kindle an advantage that Sony is finding difficult to
overcome.
The firm has to do more than just forecast the company’s sales. The process can be complex,
because how much the company can sell will depend on many factors such as how much the
product will cost, how competitors will react, and so forth. Each of these factors has to be
taken into account in order to determine how much the company is likely to sell. As factors
change, the forecast has to change as well. Thus, a sales forecast is actually a composite of a
number of estimates and has to be dynamic as those other estimates change.
A common first step is to determine market potential, or total industry-wide sales expected in
a particular product category for the time period of interest. (The time period of interest
might be the coming year, quarter, month, or some other time period.) Some marketing
research companies, such as Nielsen, Gartner, and others, estimate the market potential for
various products and then sell that research to companies that produce those products.
Once the firm has an idea of the market potential, the company’s sales potential can be
estimated. A firm’s sales potential is the maximum total revenue it hopes to generate from a
product or the number of units of it the company can hope to sell. The sales potential for the
product is typically represented as a percentage of its market potential and equivalent to the
company’s estimated maximum market share for the time period. In your budget, you’ll
want to forecast the revenues earned from the product against the market potential, as well as
against the product’s costs.[2]
Forecasting Horizons
Long term forecasting tends to be completed at high levels in the organization. The time
frame is generally considered longer than 2 years into the future. Detailed knowledge about
the products and markets are required due to the high degree of uncertainty. This is
commonly the case with new products entering the market, emerging new technologies and
opening new facilities. Often no historical data is available.
Medium term forecasting tends to be several months up to 2 years into the future and is
referred to as intermediate term. Both quantitative and qualitative forecasting may be used in
this time frame.
Short term forecasting is daily up to months in the future. These forecasts are used for
operational decision making such as inventory planning, ordering and scheduling of the
workforce. Usually quantitative methods such as time series analysis are used in this time
frame.
Categories of Forecasting Methods
Qualitative Forecasting
Qualitative forecasting techniques are subjective, based on the opinion and judgment of
consumers and experts; they are appropriate when past data are not available. They are
usually applied to intermediate- or long-range decisions.
In the following, we discuss some examples of qualitative forecasting techniques:
Executive Judgement (Top Down)
Groups of high-level executives will often assume responsibility for the forecast. They will
collaborate to examine market data and look at future trends for the business. Often, they
will use statistical models as well as market experts to arrive at a forecast.
Sales Force Opinions (Bottom up)
The sales force in a business are those persons most close to the customers. Their opinions
are of high value. Often the sales force personnel are asked to give their future projections
for their area or territory. Once all of those are reviewed, they may be combined to form an
overall forecast for district or region.
Delphi Method
This method was created by the Rand Corporation in the 1950s. A group of experts are
recruited to participate in a forecast. The administrator of the forecast will send out a series
of questionnaires and ask for inputs and justifications. These responses will be collated and
sent out again to allow respondents to evaluate and adjust their answers. A key aspect of the
Delphi method is that the responses are anonymous, respondents do not have any knowledge
about what information has come from which sources. That permits all of the opinions to be
given equal consideration. The set of questionnaires will go back and forth multiple times
until a forecast is agreed upon.
Market Surveys
Some organizations will employ market research firms to solicit information from consumers
regarding opinions on products and future purchasing plans.
Quantitative Forecasting
Quantitative forecasting models are used to forecast future data as a function of past data.
They are appropriate to use when past numerical data is available and when it is reasonable
to assume that some of the patterns in the data are expected to continue into the future. These
methods are usually applied to short- or intermediate-range decisions. Some examples of
quantitative forecasting methods are causal (econometric) forecasting methods, last period
demand (naïve), simple and weighted N-Period moving averages and simple exponential
smoothing, which are categorizes as time-series methods. Quantitative forecasting models
are often judged against each other by comparing their accuracy performance measures.
Some of these measures include Mean Absolute Deviation (MAD), Mean Squared Error
(MSE), and Mean Absolute Percentage Error (MAPE).
We will elaborate on some of these forecasting methods and the accuracy measure in the
following sections.[3]
Causal (Econometric) Forecasting Methods (Degree)
Some forecasting methods try to identify the underlying factors that might influence the
variable that is being forecast. For example, including information about climate patterns
might improve the ability of a model to predict umbrella sales. Forecasting models often take
account of regular seasonal variations. In addition to climate, such variations can also be due
to holidays and customs: for example, one might predict that sales of college football apparel
will be higher during the football season than during the off-season.
Several informal methods used in causal forecasting do not rely solely on the output of
mathematical algorithms, but instead use the judgment of the forecaster. Some forecasts take
account of past relationships between variables: if one variable has, for example, been
approximately linearly related to another for a long period of time, it may be appropriate to
extrapolate such a relationship into the future, without necessarily understanding the reasons
for the relationship.
One of the most famous causal models is regression analysis. In statistical
modeling, regression analysis is a set of statistical processes for estimating the relationships
among variables. It includes many techniques for modeling and analyzing several variables,
when the focus is on the relationship between a dependent variable and one or
more independent variables (or ‘predictors’). More specifically, regression analysis helps one
understand how the typical value of the dependent variable (or ‘criterion variable’) changes
when any one of the independent variables is varied, while the other independent variables
are held fixed.

Common Forecasting Assumptions:

1. Forecasts are rarely, if ever, perfect. It is nearly impossible to 100% accurately
estimate what the future will hold. Firms need to understand and expect some error in
their forecasts.
2. Forecasts tend to be more accurate for groups of items than for individual items in the
group. The popular Fitbit may be producing six different models. Each model may be
offered in several different colours. Each of those colours may come in small, large
and extra large. The forecast for each model will be far more accurate than the forecast
for each specific end item.
3. Forecast accuracy will tend to decrease as the time horizon increases. The farther away
the forecast is from the current date, the more uncertainty it will contain.
Demand Patterns
When we plot our historical product demand, the following patterns can
often be found:

Trend – A trend is consistent upward or downward movement of the

demand. This may be related to the product’s life cycle.

Cycle – A cycle is a pattern in the data that tends to last more than one year
in duration. Often, they are related to events such as interest rates, the
political climate, consumer confidence or other market factors.

Seasonal – Many products have a seasonal pattern, generally predictable

changes in demand that are recurring every year. Fashion products and
sporting goods are heavily influenced by seasonality.

Irregular variations – Often demand can be influenced by an event or

series of events that are not expected to be repeated in the future.
Examples might include an extreme weather event, a strike at a college
campus, or a power outage.

Random variations – Random variations are the unexplained variations in

demand that remain after all other factors are considered. Often this is
referred to as noise.

Figure 3.2: Diagram of trend, cyclical, and seasonal demand patterns.

Time Series Methods

Time series methods use historical data as the basis of estimating future
outcomes. A time series is a series of data points indexed (or listed or
graphed) in time order. Most commonly, a time series is a sequence taken at
successive equally spaced points in time. Thus, it is a sequence of discrete-
time data. Examples of time series are heights of ocean tides, counts
of sunspots, and the daily closing value of the Dow Jones Industrial Average.
Time series are very frequently plotted via line charts. Time series are used
in statistics, signal processing, pattern recognition, econometrics,
mathematical finance, weather forecasting, earthquake prediction,
electroencephalography, control engineering, astronomy, communications
engineering, and largely in any domain of applied science and engineering
which involves temporal measurements.[4]

In the following, we will elaborate more on some of the simpler time-series

methods and go over some numerical examples.

Naïve Method
The simplest forecasting method is the naïve method. In this case, the
forecast for the next period is set at the actual demand for the previous
period. This method of forecasting may often be used as a benchmark in
order to evaluate and compare other forecast methods.

Simple Moving Average

In this method, we take the average of the last “n” periods and use that as
the forecast for the next period. The value of “n” can be defined by the
management in order to achieve a more accurate forecast. For example, a
manager may decide to use the demand values from the last four periods
(i.e., n = 4) to calculate the 4-period moving average forecast for the next
period.

Example

Some relevant notation:

Dt = Actual demand observed in period t
Ft = Forecast for period t

Using the following table, calculate the forecast for period 5 based on a 3-
period moving average.

Period Actual Demand

1 42

2 37

3 34

4 40

Solution
Forecast for period 5 = F5 = (D4 + D3 + D2) / 3 = (40 + 34 + 37) / 3 = 111 / 3 = 37
Weighted Moving Average
This method is the same as the simple moving average with the addition of a weight for each
one of the last “n” periods. In practice, these weights need to be determined in a way to
produce the most accurate forecast. Let’s have a look at the same example, but this time,
with weights:
Example

Actual
Period Weight
Demand

1 42

2 37 0.2

3 34 0.3

4 40 0.5

Solution
Forecast for period 5 = F5 = (0.5 x D4 + 0.3 x D3 + 0.2 x D2) = (0.5 x 40+ 0.3 x 34 + 0.2 x
37) = 37.6
Note that if the sum of all the weights were not equal to 1, this number above had to be
divided by the sum of all the weights to get the correct weighted moving average.
Exponential Smoothing
This method uses a combination of the last actual demand and the last forecast to produce
the forecast for the next period. There are a number of advantages to using this method. It
can often result in a more accurate forecast. It is an easy method that enables forecasts to
quickly react to new trends or changes. A benefit to exponential smoothing is that it does not
require a large amount of historical data. Exponential smoothing requires the use of a
smoothing coefficient called Alpha (α). The Alpha that is chosen will determines how
quickly the forecast responds to changes in demand. It is also referred to as the Smoothing
Factor.
There are two versions of the same formula for calculating the exponential smoothing.
Here is version #1:
Ft = (1 – α) Ft-1 + α Dt-1
Note that α is a coefficient between 0 and 1
For this method to work, we need to have the forecast for the previous period. This forecast
is assumed to be obtained using the same exponential smoothing method. If there were no
previous period forecast for any of the past periods, we will need to initiate this method of
forecasting by making some assumptions. This is explained in the next example.
Example
 Period Actual Demand Forecast

1 42

2 37

3 34

4 40

In this example, period 5 is our next period for which we are looking for a forecast. In order
to have that, we will need the forecast for the last period (i.e., period 4). But there is no
forecast given for period 4. Thus, we will need to calculate the forecast for period 4 first.
However, a similar issue exists for period 4, since we do not have the forecast for period 3.
So, we need to go back for one more period and calculate the forecast for period 3. As you
see, this will take us all the way back to period 1. Because there is no period before period 1,
we will need to make some assumption for the forecast of period 1. One common
assumption is to use the same demand of period 1 for its forecast. This will give us a forecast
to start, and then, we can calculate the forecast for period 2 from there. Let’s see how the
calculations work out:
If α = 0.3 (assume it is given here, but in practice, this value needs to be selected properly to
produce the most accurate forecast)
Assume F1 = D1, which is equal to 42.
Then, calculate F2 = (1 – α) F1+ α D1 = (1 – 0.3) x 42 + 0.3 x 42 = 42
Next, calculate F3 = (1 – α) F2+ α D2 = (1 – 0.3) x 42 + 0.3 x 37 = 40.5
And similarly, F4 = (1 – α) F3+ α D3 = (1 – 0.3) x 40.5 + 0.3 x 34 = 38.55
And finally, F5 = (1 – α) F4+ α D4 = (1 – 0.3) x 38.55 + 0.3 x 40 = 38.985

Here is version #2:

Ft = Ft-1 + α(Dt-1 – Ft-1)
Example
Assume you are given an alpha of 0.3, Ft-1 = 55

Seasonal Index
Many organizations produce goods whose demand is related to the seasons,
or changes in weather throughout the year. In these cases, a seasonal index
may be used to assist in the calculation of a forecast.

Example
Previous Average Seasonal
Season
Sales Sales Index

390 / 500
Winter 390 500
= .78

460 / 500
Spring 460 500
= .92

600 / 500 =
Summer 600 500
1.2

550 / 500 =
Fall 550 500
1.1

Total 2000

Using these calculated indices, we can forecast the demand for next year
based on the expected annual demand for the next year. Let’s say a firm
has estimated that next year annual demand will be 2500 units.
Avg. Sales /
Anticipated annual Seasonal
Season Season New Forecast
demand Factor
(2500/4)

.78 x 625 =
Winter 625 0.78
487.5

.92 x 625 =
Spring 625 0.92
575
 1.2 x 625 =
Summer 625 1.2
750

1.1 x 625 =
Fall 625 1.1
687.5

2500

Forecast Accuracy Measures

In this section, we will calculate forecast accuracy measures such as Mean
Absolute Deviation (MAD), Mean Squared Error (MSE), and Mean
Absolute Percentage Error (MAPE). We will explain the calculations using
the next example.

Example
The following actual demand and forecast values are given for the past four
periods. We want to calculate MAD, MSE and MAPE for this forecast to see
how well it is doing.
Note that Abs (et) refers to the absolute value of the error in period t (e t).

Period Actual Demand Forecast et Abs (et) et2 [Abs (et) / Dt] x 100%

1 63 68

2 59 65

3 54 61

4 65 59

Here are what need to do:

Step 1: Calculate the error as et = Dt – Ft (the difference between the actual

demand and the forecast) for any period t and enter the values in the table
above.

Step 2: Calculate the absolute value of the errors calculated in step 1 [i.e.,
Abs (et)], and enter the values in the table above.

Step 3: Calculate the squared error (i.e., et2) for each period and enter the
values in the table above.

Step 4: Calculate [Abs (et) / Dt] x 100% for each period and enter the value
under its column in the table above.

Solution
Period Actual Demand Forecast et Abs et2 [Abs (et) / Dt] x
 (et) 100%

-
1 63 68 5 25 7.94%
5

-
2 59 65 6 36 10.17%
6

-
3 54 61 7 49 12.96%
7

4 65 59 6 6 36 9.23%
Calculations for Accuracy Measures:
MAD = The average of what we calculated in step 2 (i.e., the average of all
the absolute error values)

= (5 + 6 + 7 + 6) / 4 = 24 / 4 = 6

MSE = The average of what we calculated in step 3 (i.e., the average of all
the squared error values)

= (25 + 36 + 49 + 36) / 4 = 146/4 = 36.5

MAPE = The average of what we calculated in step 4

= (7.94% + 10.17% + 12.96% + 9.23%) / 4 = 40.3/4 = 10.075%