CHAPTER TWO
FORECASTING
OUTLINE
Meaning and use of forecasting
Forecasting techniques
Meaning and use of forecasting
INTRODUCTION
A forecast is definite method of predicting future events
Forecasts are vital for every business organization and for
every significant management decisions
Forecasting is essential for a number of planning decisions
Forecasting is the bases of corporate long term decisions,
medium term decisions and short term decisions
Cont…
What is forecasting?
Forecasting is the art and science of predicting the future.
Forecasting is one input and to all types of business planning
and control
Marketing uses for planning products, promotion and pricing
Finance uses forecasting as an input for financial planning
Forecasting is an input for operation decisions on process
design, capacity planning and inventory
Strategic Importance of Forecasting
Human Resources – Hiring, training, laying off workers
Capacity – Capacity shortages can result in
undependable delivery, loss of customers, loss of market
share
Supply-Chain Management – Good supplier relations
and price advance
Seven Steps in Forecasting
1) Determine the use of the forecast
2) Select the items to be forecasted
3) Determine the time horizon of the forecast
4) Select the forecasting model(s)
5) Gather the data
6) Make the forecast
7) Validate and implement results
Classification of Forecasting Techniques
Forecasting Techniques
Forecasting depends on having enough historical data
to be able to describe the record in statistical terms.
There are basically two broad categories of forecasting
techniques.
1) Qualitative methods
2) Quantitative methods
Qualitative Methods
Qualitative methods of forecasting techniques are based upon judgment and
intuition and especially when sufficient information and data is not available.
When we have no historical data, statistical methods have no validity.
Used when situation is vague and little data exist
New products
New technology
Involves intuition, experience
e.g., forecasting sales on Internet
Cont…
There are different ways of forecasting future demand based
on qualitative methods.
1. The Delphi Methods
2. Jury of Executive Opinion
3. Market Survey
4. Opinions of Salesperson
5. Historical Analogy and Life Cycle Analysis
Historical Analogy and Life Cycle Analysis
Market survey can be supplemented by reference to the
performance of an ancestor of the product or service by applying
product life cycle analysis.
Most products pass through stages of introduction, growth,
maturity and decline.
Quantitative Methods
These techniques use statistical analysis and other
mathematical models to predict future events, primarily based
upon past activities.
Some of the typical techniques employed are:
i. Time Series Forecasting Method
ii. Causal Forecasting Methods
Time Series Forecasting Methods
A time series analysis is based on the assumption that past
activities are good indication of future activities.
It is usually tabulated or graphed to show the nature of the time
dependence.
The relative cost of this method is considered to be low.
Cont…
The following are some of the Time Series Forecasting
Methods.
1. Moving Averages
2. Weighted Moving Average
3. Exponential Moving Average
Naive Approach
Assumesdemand in next period is the same as
demand in most recent period
e.g., If May sales were 48, then June sales will be 48
Sometimes cost effective and efficient
1. Moving Averages
Random variations demand can be smoothed out by moving
averages which preserve the general pattern of the data.
A moving average is the average of values centered on the
period in question.
Where Ft= forecast
n = the chosen number of period
t = the time to be forecasted
D = the demand in the t-n period.
Moving Average Example
Simple Moving Average Problem (1)
2. Weighted Moving Average
Sometimes the forecaster wants to use a moving average but
does not want all n periods equally weighted.
A weighted moving average (WMA) allows for varying, not
equal, weighting of old demands:
WMA = Each period's times a weight, summed over all periods
in the moving average
Weighted Moving Average Problem (1)
Solution
Problem (2)
Solution
Exponential smoothing
In the previous methods of forecasting the major drawback is
the need to continually carry a large amount of historical data
Form of weighted moving average
Weights decline exponentially
Most recent data weighted most
Requires smoothing constant (α)
Ranges from 0 to 1
Subjectively chosen
Involves little record keeping of past data
Cont…
Exponential smoothing is the most used of all forecasting techniques.
It is well accepted for six major reasons
1. Exponential models are surprisingly accurate
2. Formulating an exponential model is relatively easy
3. The user can understand how the model works
4. Little computation is required to use the model
5. Computer storage requirements are small because of the limited use of
historical data
6. Tests for accuracy as to how well the model is performing are easy to compute
The equation for a single exponential smoothing forecasts simply
Exponential Smoothing Example
Predicted demand = 142 cars
Actual demand = 153
Smoothing constant α = .20
New forecast = 142 + .2(153 – 142)
= 142 + 2.2 = 144.2 ≈ 144 cars
Exponential Smoothing Problem 1
Solution
Exponential Smoothing Problem 2
A furniture manufacturing company produces different sizes of
cabinets and records the demand monthly. The following demand
data are for a specific cabinet model: January 60; February 55;
March 70. Using 56 as the forecast for January and a smoothing
constant of 0.20, what is the April sale? Is 0.20 a good choice as
a smoothing constant?
Solution
The April forecast is 60 units (fractional units should be rounded to be
realistic). And the given smoothing constant (0.20), recent demand is
not weighted heavily. This seems appropriate for this data. If demand
is unstable, a higher constant should be used.
Forecast Errors
In using the word error, we are referring to the difference
between the forecast value and what actually occurred
All forecasts contain some error
In discussing forecast errors, it is convenient to distinguish
between source of error and measurement of error
Several common terms used to describe the degree of error
Cont…
Forecasts are never perfect
Need to know how much we should rely on our chosen
forecasting method
Measuring forecast error
Note that over-forecasts = negative errors and under-
forecasts = positive errors
Exercise
The Instant Paper Clip Office Supply Company sells and delivers office
supplies to companies, schools, and agencies within a 50-mile radius of its
warehouse. The office supply business is competitive, and the ability to
deliver orders promptly is a big factor in getting new customers and
maintaining old ones. (Offices typically order not when they run low on
supplies, but when they completely run out. As a result, they need their
orders immediately.) The manager of the company wants to be certain that
enough drivers and vehicles are available to deliver orders promptly and that
they have adequate inventory in stock. Therefore, the manager wants to be
able to forecast the demand for deliveries during the next month. From the
records of previous orders, management has accumulated the following
data for the past 10 months:
a) Compute the monthly demand forecast for April through November
using a 3-month moving average.
b) Compute the monthly demand forecast for June through November
using a 5-month moving average.
c) Compute the monthly demand forecast for April through November
using a 3-month weighted moving average.
d) Use weights of 0.5, 0.33, and 0.17, with the heavier weights on the
more recent months.
e) Compute the mean absolute deviation for June through October for
each of the methods used. Which method would you use to forecast
demand for November?
Solution
Cont…
END OF CHAPTER TWO