FORECASTING

3
Intended Learning Outcomes
By the end of the learning experience, students must be able to:
1. List the elements of a good forecast.
2. Illustrate the steps in the forecasting process.
3. Compare and contrast qualitative and quantitative approaches to forecasting.
4. Describe at least three quantitative forecasting techniques and the advantages and
disadvantages of each.
5. Briefly discuss the factors in choosing forecasting techniques.
6. Briefly discuss the method of analysis using forecast information

ELEMENTS OF A GOOD FORECAST

A properly prepared forecast should fulfil certain requirements:

1. The forecast should be timely. Usually, a certain amount of time is needed to respond
to the information contained in a forecast. Hence, the forecasting horizon must cover
the time necessary to implement possible changes.
2. The forecast should be accurate and the degree of accuracy should be stated. This will
enable users to plan for possible errors and will provide a basis for comparing
alternative forecasts.
3. The forecast should be reliable; it should work consistently. A technique that
sometimes provides a good forecast and sometimes a poor one will leave users with the
uneasy feeling that they may get burned every time a new forecast is issued.
4. The forecast should be expressed in meaningful units. Financial planners need to know
how many dollars will be needed, production planners need to know how many units
will be needed, and schedulers need to know what machines and skills will be required.
The choice of units depends on user needs.
5. The forecast should be in writing. Although this will not guarantee that all concerned
are using the same information, it will at least increase the likelihood of it. In addition, a
written forecast will permit an objective basis for evaluating the forecast once actual
results are in.
6. The forecasting technique should be simple to understand and use. Users often lack
confidence in forecasts based on sophisticated techniques; they do not understand
either the circumstances in which the techniques are appropriate or the limitations of
the techniques. Misuse of techniques is an obvious consequence. Not surprisingly, fairly
crude forecasting techniques enjoy widespread popularity because users are more
comfortable working with them.

Features Common to All Forecasts

A wide variety of forecasting techniques are in use. Nonetheless, certain features are
common to all, such as:
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 rarely perfect; actual results usually differ from predicted values.
Allowances should be made for inaccuracies.
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 cancelling
effect.
4. Forecast accuracy decrease as the time period covered by the forecast – the time
horizon – increases. In general, short-range forecast must contend with fewer
uncertainties than longer-range forecasts, so they tend to be more accurate.

STEPS IN THE FORECASTING PROCESS

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There are six basic steps in the forecasting process:
1. Determine the purpose of the forecast. What is its purpose and when will it be needed?
This will provide an indication of the level of detail required in the forecast, the amount
of resources (personnel, computer time, dollars) that can be justified, and the level of
accuracy necessary.
2. Establish a time horizon. The forecast must indicate a time limit, keeping in mind that
accuracy decreases as the time horizon increases.
3. Select a forecasting technique.
4. Gather and analyze relevant data. Before a forecast can be prepared, data must be
gathered and analyzed. Identify any assumptions that are made in conjunction with
preparing and using the forecast.
5. Prepare the forecast. Use an appropriate technique.
6. Monitor the forecast. A forecast has to be monitored to determine whether it is
performing in a satisfactory manner. If it is not, re-examine the method, assumptions,
validity of data, and so on; modify as needed; and prepare a revised forecast.

APPROACHES TO FORECASTING

There are two general approaches to forecasting: qualitative and quantitative.

 Qualitative methods consist mainly of subjective inputs, which often defy precise
numerical description. Quantitative methods involve either the extension of
historical data or the development of associative models that attempt to utilize
causal (explanatory) variables to make a forecast.
 Quantitative techniques consist mainly of analyzing objective, or hard, data. They
usually avoid personal biases that sometimes contaminate qualitative methods. In
practice, either or both approaches might be used to develop a forecast.

a. Forecasts Based on Judgement and Opinion

Judgmental forecasts rely on analysis of subjective inputs obtained from various sources,
such as consumer surveys, the sales staff, managers and executives, and panels of experts.
1. Executive Opinions. A small group of upper-level managers (e.g., in marketing,
operations, and finance) may meet and collectively develop a forecast. This approach
is often used as a part of long-range planning and new product development.
2. Salesforce Opinions. The sales staff or the customer service staff is often a good
source of information because of their direct contact with consumers. They are often
aware of any plans the customers may be considering for the future.
3. Consumer Surveys. Because it is the consumers who ultimately determine demand, it
seems natural to solicit input from them. The obvious advantage of consumer
surveys is that they can tap information that might not be available elsewhere. On
the other hand, a considerable amount of knowledge and skill is required to construct
a survey, administer it, and correctly interpret the results for valid information.
Surveys can be expensive and time-consuming
4. Other Approaches. Another approach is the Delphi method which involves circulating
a series of questionnaires among individuals who possess the knowledge and ability
to contribute meaningfully. Responses are kept anonymous, which tends to
encourage honest responses and reduces the risk that one person's opinion will
prevail. Each new questionnaire is developed using the information extracted from
the previous one, thus enlarging the scope of information on which participants can
base their judgments. The goal is to achieve a consensus forecast. Thus, judgments
of experts or others who possess sufficient knowledge to make predictions are used.
b. Forecast Based on Time Series (Historical) Data
Some forecasting techniques simply attempt to project past experience into the future.
These techniques use historical or time series, data with the assumption that the future will
be like the past. A time series is a set of observations of a variable at regular intervals over
time.
 Forecasting techniques based on time series data are made on the assumption
that future values of the series can be estimated from past values.

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  Analysis of time series data requires the analyst to identify the underlying
behavior of the series. This can often be accomplished by merely plotting the
data and visually examining the plot.
The behaviors of time series can be described as follows:
 Trend refers to a long-term upward or downward movement in the data.
Ex. Population shifts, changing incomes, and cultural changes often account for
such movements.
 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. They do not reflect
typical behavior, and inclusion in the series can distort the overall picture.
Whenever possible, these should be identified and removed from the data.
 Random variations are residual variations that remain after all other behaviors
have been accounted for
1. Naïve Methods. A simple, but widely used approach to forecasting. A naive forecast
uses a single previous value of a time series as the basis of a forecast. The naive
approach can be used with a stable series (variations around an average), with seasonal
variations, or with trend.
i. With a stable series, the last data point becomes the forecast for the next
period. Thus, if demand for a product last week was 20 cases, the forecast for
this week is 20 cases.
ii. With seasonal variations, the forecast for this "season" is equal to the value of
the series last "season." For example, the forecast for demand for turkeys this
Thanksgiving season is equal to demand for turkeys last Thanksgiving; the
forecast of the number of checks cashed at a bank on the first day of the
month next month is equal to the number of checks cashed on the first day of
this month; and the forecast for highway traffic volume this Friday is equal to
the highway traffic volume last Friday.
iii. For data with trend, the forecast is equal to the last value of the series plus or
minus the difference between the last two values of the series. For example,
suppose the last two values were 50 and 53:

Advantages of this forecasting technique:

- It has virtually no cost.
- It is quick and easy to prepare
- It is easily understandable.
2. Techniques for Averaging. Averaging techniques generate forecasts that reflect recent
values of a time series (e.g., the average value over the last several periods). These
techniques work best when a series tends to vary around an average, although they
can also handle step changes or gradual changes in the level of the series. Three
techniques for averaging are described in this section:
i. Moving average. A moving average forecast uses a number of the most
recent actual data values in generating a forecast. The moving average
forecast can be computed using the following equation:
∑ ∑
MA = or
Where; ∑ = summation
X = Actual value in a period

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 n = Number of Periods in the moving average
MA = Moving Average
Sample Problem 3.1
Compute a three-period moving average forecast given demand for
shopping carts for the last five periods.
Period Age Demand
1 5 42
2 4 40
3 3 43
4 2 40 the 3 most recent demands
5 1 41

Solution:

MA6 = = 41.33
If actual demand in period 6 turns out to be 39, the moving average
forecast for period 7 would be:
MA7 = = 40.00
Note: In the moving average, as each new value becomes available, the forecast is
updated by adding the newest value and dropping the oldest and then re-computing the
average. Consequently, the forecast “moves” by reflecting only the most recent values.
ii. Weighted Moving Average. A weighted moving average (MAw) allows some
values to be emphasized by varying the weights assigned to each
component of the average. Weights can be either percentages or a real
number.
∑( )
MAWt = ∑
Where;
MWt = Weight Moving Average
Wt = Weights assigned to each component of the average
X = Actual value in a period
∑ = Summation
Sample Problem 3.2
Shipments (in tons) of welded tube by an aluminum producer are shown
below:
Year 1 2 3 4 5 6 7 8 9 10 11
Tons 2 3 6 10 8 7 12 14 14 18 19
a) Graph the data, and comment on the relationship.
b) Using a weight of 3 for the most recent data, 2 for the next, and
1 for the oldest, forecast shipments in year 12.

Solution
a)

The data points appear relatively linear.

∑( ) ( )( ) ( )( ) ( )( )
b) MAWt = ∑
= = 17.8 tons

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 iii. Exponential Smoothing. Exponential Smoothing is a sophisticated weighted
averaging method that is still relatively easy to use and understand. 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:
Next Forecast = Previous forecast + α (Actual – Previous forecast)
Where (Actual – Previous forecast) represents the forecast error and α is
a percentage of the error. More concisely,
Ft = Ft-1 + α (At-1 − Ft-1)
Where:
Ft = Forecast for period t
Ft-1 = Forecast for the previous period
α = Smoothing constant
At-1 = Actual value for the for previous period
For example, suppose the previous forecast was 42 units, actual demand
was 40 units, and α = .10. The new forecast would be computed as
follows:
Ft =42 + .10 (40 – 42) = 41.8
Then, if the actual demand turns out to be 43, the next forecast would
be:
Ft = 41.8 + .10 (43 – 41.8) = 41.92
Note: The quickness of forecast adjustment to error is determined by the smoothing
constant, α. The closer is value to zero, the slower the forecast will be to adjust to forecast
errors. Conversely, the closer the value of α is to 1.00, the greater the responsiveness and
the less the smoothing.
3. Techniques for Trend. Analysis of trend involves developing an equation that will
suitably describe trend (assuming that trend is present in the data). A simple plot of
the data can often reveal the existence and nature of a trend. The discussion here
focuses exclusively on linear trends because these are fairly common. There are two
important techniques that can be used to develop forecasts when trend is present.
i. Trend Equation. A linear trend equation has the form:
Yt = а+ bt.
where:
t = specified number of time periods from t = 0
yt = forecast for period t
а = value of y1 at t = 0
b= slope of the line

For example, consider the trend equation Yr = 45 + 5t. The value of Yr

when t = 0 is 45, and the slope of the line is 5, which means that, on the
average, the value of Yr will increase by five units for each time period. If

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 t = 10, the forecast, Yr, is 45 + 5(10) = 95 units. The equation can be
plotted by finding two points on the line. One can be found by
substituting some value of t into the equation (e.g., t = 10) and then
solving for Yr. The other point is a (i.e., Yr at t = 0). Plotting those two
points and drawing a line through them yields a graph of the linear trend
line. The coefficients of the line, a and b, can be computed from
historical data using these two equations:
∑ ∑ ∑
b= ∑ [∑ ]
∑ ∑
a= or ̅ – b ̅
where:
n = number of periods
y = value of the time series

Sample Problem 3.3:

Cell phone sales for a California- based firm over the last 10 weeks are
shown in the following table. Plot the data, and visually check to see if a
linear trend line would be appropriate. Then, determine the equation of
the trend line, and predict sales for weeks 11 and 12.
Week Unit Sales
1 700
2 724
3 720
4 728
5 740
6 742
7 758
8 750
9 770
10 775

a)

b)
Week (t) Y Ty
1 700 700
2 724 1,448
3 720 2,160
4 728 2,912
5 740 3,700
6 742 4,452
7 758 5,306
8 750 6,000
9 770 6,930
10 775 7,750

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 7,407 41,358
Compute the coefficients of the trend line:
∑ ∑ ∑
b= ∑ [∑ ]
( ) ( )
= ( ) ( )
= = 7.51
∑ ∑
а=
( )
= = 699.40
Thus, the trend line is yt = 699.40 + 7.51t, where t = 0 for period 0.
c) Substituting values of t into this equation, the forecasts for the next two
periods (i.e. t = 11 and t = 12) are:
y11 = 699.40 + 7.51(11) = 782.01
y12 = 699.40 + 7.51 (12) = 789.52
4. 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. Seasonality may refer to regular annual variations. The term seasonal
variation is also applied to daily, weekly, monthly, and other regularly recurring
patterns in data. Seasonality in a time series is expressed in terms of the amount that
actual values deviate from the average value of a series.
 If the series tends to vary around an average value, then seasonality is
expressed in terms of that average (or a moving average);
 if trend is present, seasonality is expressed in terms of the trend value. There
are two different models of seasonality: additive and multiplicative.
o In additive model, seasonality is expressed as a quantity (e.g., 20 units), which is
added or subtracted from the series average in order to incorporate seasonality.
o In the multiplicative model, seasonality is expressed as a percentage of the average
(or trend) amount (e.g., 1.10), which is then used to multiply the value of a series to
incorporate seasonality. The seasonal percentages in the multiplicative model are
referred to as seasonal relatives or seasonal indexes.
o Using Seasonal Relatives. Seasonal relatives are used in two different ways in
forecasting. These are:
1. To deseasonalize data is to remove the seasonal component from the
data in order to get a clearer picture of the non-seasonal (e.g., trend)
components. Deseasonalizing data is accomplished by dividing each
data point by its corresponding seasonal relative.
2. Incorporating seasonality in a forecast is useful when demand has both
trend (and average) and components. Incorporating seasonality can be
accomplished in this way:
 Obtain trend estimates for desired periods using a trend
equation.
 Add seasonality to the trend estimates by multiplying
(assuming a multiplicative model is appropriate) these trend
estimates by the corresponding seasonal relative.
Sample Problem 3.4
A furniture manufacturer wants to predict quarterly demand for
a certain loveseat for periods 15 and 16, which happen to be the
second and third quarters of a particular year. The series
consists of both trend and seasonality. The trend portion of
demand is projected using the equation yt = 124 +7.5t. Quarter
relatives are Q1 = 1.20, Q2 =1.10, Q3 = 0.75, and Q4 = 0.95. Use
this information to predict demand for periods 15 and 16.
Solution:
The trend values at t = 15 and t = 16 are:
y15 = 124 + 7.5(15) = 236.5
y16 = 124 + 7.5(16) = 244.0
Multiplying the trend value by the appropriate quarter relative
yields a forecast that includes both trend and seasonality. Given
that t = 15 is a second quarter and t = 15 is a third quarter, the
forecast are:

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 Period 15: 236.5(1.10) = 260.15
Period 16: 244.0(0.75) = 183.00
o Computing Seasonal Relatives. A commonly used method for representing the
trend portion of a time series involves a centered moving average. Centered
moving average is a moving average positioned at the center of the data that were
used to compute it.
Sample Problem 3.5
Assume the following time series data:

The three-period average is 42. 67. As a centered average, it is

positioned at period 2; the average is most representative of
theseries at that point. The ratio of demand at period 2 to this
centered average at period 2 is an estimate of the seasonal
relative at that point. Because the ratio is 46/42.67 = 1.08, the
series is about 8 percent above average at that point.

Sample Problem 3.6

The manager of a parking lot has computed daily relatives for the
number of cars per day in the lot. The computations are repeated
here (about three weeks are shown for illustration). A seven-
period centered moving average is used because there are seven
days (seasons) per week.

5. Techniques for Cycles. Cycles are up and down movements’ similar to seasonal
variations but of longer duration (two to six years between peaks). When cycles occur
in time series data, their frequent irregularity makes it difficult or impossible to project
from past data. A short moving average or a naive approach may be of some value,
although both will produce forecasts that cyclical movements by one or several
periods. If organization is able to establish a high correlation with a leading variable, it
can develop an equation that describes the relationship, enabling forecasts to be

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 made. It is important that a persistent relationship exists between the two variables.
Moreover, the higher the correlation, the better the chances that the forecast will be
on target.
c. Associative Forecasts. Associative models use equations that consist of one or more
explanatory variables that can be used to predict future demand. The essence of associative
techniques is the development of an equation that summarizes the effects of predictor
variables. The primary method of analysis is known as regression.
1. Simple Linear Regression. The simplest and most widely used form of regression
involves a linear relationship between two variables. The object in linear regression
is to obtain an equation of a straight line that minimizes the sum of squared vertical
deviations of data points from the line. This least squares line has the equation:
Yc = a + bx
where;
Yc =predicted (dependent) variable
x = predictor (independent) variable
b = slope of the line
a = value of Yc when x = 0 (i.e., the height of the line at the y intercept)

The coefficient a and b of the line are computed using these two equations:
(∑ ) (∑ ) (∑ )
b= (∑ ) (∑ )
∑ ∑
a= or ̅ - b ̅
where:
n = number of paired observations

Sample Problem 3.7

Healthy Hamburgers has a chain of 12 scores in northern Illinois. Sales figures
and profits for the stores are given in the following table. Obtain a regression
line for the data and predict profit for a store assuming sales of $10 million.

Sales, x (in millions of dollars) Profits, y (in millions of dollars)

$7 0.15
2 0.10
6 0.13
4 0.15
14 0.25
15 0.27
16 0.24
12 0.20
14 0.27
20 0.44
15 0.34
7 0.17

Solution:
a) Plot the data and decide if a linear model is reasonable.

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 *Conclusion: The linear model seems reasonable
b) Compute the quantities ∑ , ∑ , ∑ and ∑ . Calculations are shown
for these quantities in the table below. One additional calculation, ∑ ,
is included for later use.

Substituting into the equation, you find:

(∑ ) (∑ ) (∑ ) ( ) ( )
b= (∑ ) (∑ )
= ( ) ( )
= 0.01593
∑ (∑ ) ( )
a= = = 0.0506
Thus, the regression equation is Yc = 0.0506 + 0.01593x. For sales x = 10
(i.e., $10 million), estimated profit is Yc = 0.0506 + 0.01593(10) = 0.2099
or $209,900.
2. Correlation. This measures the strength and direction of relationship between two
variables. Correlation can be 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 the increase in one variable are matched by
decreases in the other, and a correlation between two variables can be computed
using the equation:
(∑ ) (∑ )(∑ )
r=
[√ (∑ ) (∑ ) ] [√ (∑ ) (∑ ) ]
The coefficient of determination r2 is the ratio of explained variation to total
variation.
∑( ̅)
r2 = ∑( ̅)
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 independent variable. The
possible values of r2 range from 0 to 1.00. The closer r2 is to 1.00, the greater the
percentage of explained variation. A high value of r2, say .80 or more, would
indicate that the independent variable is a good predictor of values of the

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 dependent variable. A low value, say .25 or less, would indicate a poor predictor,
and a value between .25 and .80 would indicate a moderate predictor.

Sample Problem 3.8:

A study to determine the correlation between plasterboard shipments X and
construction permits Y revealed the following:
∑x = 184; ∑y = 80; n = 8
∑x2 = 5,006; ∑xy2 = 950; ∑xy = 2,146
Compute the correlation coefficient.
(∑ ) (∑ )(∑ )
r=
[√ (∑ ) (∑ ) ] [√ (∑ ) (∑ ) ]
( ) ( )( )
r= = = 0.90
[√ ( ) ( ) ] [√ ( ) ( ) ] √

Summarizing the Forecast Accuracy

Forecast accuracy is a significant factor when deciding among forecasting alternatives.
Accuracy is based on the historical error performance of a forecast.
2 Commonly Used Measures for Summarizing Historical Error:
1. Mean Absolute Deviation (MAD). The average absolute forecast error.
∑( )
MAD =
2. Mean Squared Error (MSE). The average of squared forecast errors.
∑( )
MSE =
Sample Problem 3.9
Compute MAD and MSE for the following data.
(A-F)
Period Actual Forecast Error [Error] [Error]2
1 217 215 2 2 4
2 213 216 -3 3 9
3 216 215 1 1 1
4 210 214 -4 4 16
5 213 211 2 2 4
6 219 214 5 5 25
7 216 217 -1 1 1
8 212 216 -4 4 16
-2 22 76
Using the figures shown in the table,
∑| |
MAD = = = 2.75
∑
MSE = = = 10.86

Controlling the Forecast

Forecasts can be monitored using either tracking signals or control charts. A tracking signal
focuses on the ratio of cumulative forecast error to the corresponding value of MAD:
∑( )
Tracking Signal =
Tracking signal values are compared to predetermined limits based on judgment and
experience. They often range from ±3 to ±8; for the most part, we shall use limits of ±4, which
are roughly comparable to three standard deviation limits.
The control chart approach involves setting upper and lower limits for individual
forecast errors. The limits are multiples of the square root of MSE. This method assumes the
following:
1. Forecast errors are randomly distributed around a mean of zero.
2. The distribution of errors is normal.

CHOOSING A FORECASTING TECHNIQUE

Factors to consider in choosing forecasting techniques:
1) The two most important factors are cost and accuracy.

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 2) Other factors to consider in selecting a forecasting technique include the availability of
historical data; the availability of computers; the ability of decision makers to utilize
certain techniques; the time needed to gather and analyze data and to prepare the
forecast; and any prior experience with a technique.

USING FORECAST INFORMATION

A manager can take a reactive or a proactive approach to a forecast.
3. A reactive approach views forecasts as probable descriptions of future demand, and
a manager reacts to meet that demand (e.g., adjusts production rates, inventories,
the workforce).
4. A proactive approach seeks to actively influence demand (e.g., by means of
advertising, pricing, or product/service changes).
Computers play an important role in preparing forecasts based on quantitative data. Their use
allows managers to develop and revise forecasts quickly, and without the burden of manual
computations.
Note: Forecasts are the basis for many decisions. Clearly, the more accurate an organization's
forecasts, the better prepared it will be to take advantage of future opportunities and to reduce
potential risks. Maintaining accurate, up-to-date information on prices, demand, and other
variables can have a significant impact on forecast accuracy.

References
Stevenson, W.J. 2012. Operations Management. McGraw-Hill Companies Inc. New York, 11th
Edition
Stevenson, W.J. 2002. Operations Management. McGraw-Hill Companies Inc. New York, 7th
Edition
Kumar, A. S. & Suresh, N. 2009. Operations Management. New Age International (P) Limited,
Publishers. New Delhi.

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