Forecasting

What is Forecasting?
Process

of predicting a future event and it is

a mere guess.

It

is the estimating the future demand for

products and services are commonly referred
as a sales forecast

Underlying

Production
Inventory
Personnel
Facilities

basis of all business decisions:

NEED OF DEMAND FORECASTING

New

facility planning
Production planning
Workforce scheduling
Financial planning

Forecasts by Time Horizon

Short-range

forecast

Up

to 1 year (usually less than 3 months)

Job scheduling, worker assignments, plan
for purchasing
Medium-range

forecast

months to 3 years
Sales & production planning, budgeting
Long-range
3

forecast

years, or more
New product planning, facility location

Types of Forecasts
Economic

forecasts

Address

the future business conditions

(e.g., inflation rate, money supply, etc.)

Technological

forecasts

Predict

the rate of technological progress

Predict acceptance of new products
Demand
Predict

forecasts
sales of existing products

Features of demand forecasting

It

generally assume the same underlying

reasons
Forecasts are rarely perfect
Forecast for group items will be more
perfect than the individual items
Forecast accuracy decreases as the
time period covered by the forecast

Seven Steps in Forecasting

Determine

the purpose of the forecast

Select the items to be forecasted
Determine the time horizon of the
forecast
Select the forecasting model(s)
Gather the data
Make the forecast
Validate and implement results

Objectives of demand forecasting

Short range objectives

Formulation of production strategy and
policy
Formulation of pricing policies
Planning and control of sales
Financial planning

Objectives of demand forecasting

Medium or Long range objectives

Long range planning for production

capacity
Labour requirements
Restructuring the capital structure

Forecasting Approaches
Qualitative Methods
Used

when situation is
vague & little data
exist
New products
New technology

Involves

intuition,
experience
e.g., forecasting sales on
Internet

Quantitative Methods
Used

when situation
is stable & historical
data exist
Existing products
Current technology

Involves

mathematical
techniques
e.g., forecasting sales of
color televisions

Qualitative Methods
Jury

of executive opinion

Pool

opinions of high-level executives, sometimes

augment by statistical models

Delphi

method or judge mental method

Panel

Sales

of experts, queried iteratively

force composite

Estimates

from individual salespersons are

reviewed for reasonableness, then aggregated

Consumer
Ask

(Market research) Survey

the customer

Quantitative Approaches
Time series model(Trend, Seasonality, Cycles)

Naive

approach
Moving average
Exponential smoothing
Casual models
Trend projection
Linear regression analysis

Time Series Models

Set of evenly spaced numerical data

Forecast based only on past values

Obtained by observing response variable at

regular time periods
Assumes that factors influencing past and
present will continue influence in future

Example
Year: 1998 1999 2000 2001 2002
Sales: 78.7 63.5 89.7 93.2 92.1

Time Series Components

Trend

Cycle

Seasonal

Random

Trend Component
Persistent,

overall upward or downward

pattern
Due to population, technology etc.
Several years duration

Seasonal Component
Regular

pattern of up & down

fluctuations
Due to weather, customs, etc.
Occurs within 1 year

Cyclical Component
Repeating

up & down movements

Due to interactions of factors influencing
economy
Can be anywhere between 2-30+ years
duration

Random Component
Erratic,
Due

unsystematic, residual fluctuations

to random variation or unforeseen events

Union

strike

Tornado

Short

duration & non-repeating

1.Naive Approach
Assumes

demand in next period is equal to

the actual demand in most recent period
e.g.,

If May sales were 48, then June sales

will be 48

Sometimes

cost effective & efficient

2.Moving Average Method

Moving average uses a number of most recent

historical actual data values to generate a forecast.

MA is a series of arithmetic means

Used if little or no trend
Used often for smoothing
Provides overall impression of data over time
Equation:

Demand in Previous n Periods

MA
n

example
Forecast

demand for 4 months

d1+d2+d3 *4
3

3.Exponential Smoothing Method

It requires only three items of data this

periods forecast, the actual demand for
this period and which is referred to as a
smoothing constant and having value
between 0 and 1

Next periods forecast = This period forecast +

{this periods actual dd this periods
forecast}

Exponential Smoothing
Equations

Ft

= Ft-1 + (At-1 - Ft-1)

Ft = forecast for this period

Ft-1 =

forecast

for the previous period

At-1= Actual demand for the previous period

Smoothing constant (0 to 1)

Linear Trend Projection

Used

for forecasting linear trend line

Assumes relationship between
response variable, Y, and time, X, is a
linear function
Yi a bX i
Estimated by least squares method
Minimizes

sum of squared errors

Correlation
Answers:

how strong is the linear

relationship between the variables?
Coefficient of correlation Sample
correlation coefficient denoted r
Range:

-1 < r < 1
Measures degree of association
Used

mainly for understanding

Linear regression analysis

The

demand or sales forecast is a

dependent variable and other factors are
independent variables

Factors to be considered in the

selection of forecasting method
Cost

and accuracy
Data available
Time span
Nature of products and services
Impulse response and noise dampening

Selecting a Forecasting Model

You

want to achieve:

No

pattern or direction in forecast error

Error

= (Yi - Y^ i) = (Actual - Forecast)

Seen

in plots of errors over time

Smallest
Mean

forecast error

Absolute Deviation (MAD), or Mean

Absolute Percentage Error (MAPE)
Mean Squared Error (MSE)

Which Model Is Best So Far?

The

Nave model has both the lowest

MAD (1.91) and MSE (4.45) of the first
five models tested
Therefore, the Nave model is the best
However, it may be that one model has
the lowest MAD or MAPE and another
model has the lowest MSE

So Which Model Do You Choose?

If

you only require the forecast with the

smallest average deviation, choose the
model with the smallest MAD or MAPE
However, if you have a low tolerance for
large deviations choose the model with
the smallest MSE