Lecture-4: Forecasting

What is forecasting?

Forecasting is the art & science of predicting future events. It may involve taking
historical data & projecting them into the future with some sort of mathematical
model. It may be a subjective or intuitive prediction. Or it may involve a
combination of these- that is, a mathematical model adjusted by a managers good
judgment.

Uses of forecast:

Leadership requires ability to recognize a problem before it becomes an
emergency. Up-to-date and accurate forecasts can facilitate the identification of
problems. The inventory manager, materials manager and the warehouse
manager have to forecast their future activities and make their plans. The top
management is interested in forecasting for operating budget, capital budgets,
cash inflows & outflows and planning diversification & expansion.

The personnel officer is interested in manpower planning and promotion aspects
of the executive in future. The production manager is interested in scheduling the
production on the basis of the sales forecasts. The materials manager is
interested in the forecasts of prices and quantities as well as in materials planning.
Accuracy of Forecasts:

Robust common sense, intrinsic analytical skills and high IQ are prerequisites for
any forecast. The accuracy of forecasts depends on the method used, factors
considered, and the period for which the forecast is made.

Successful forecasts are based on subjective experience, knowledge, skills,
expertise and judgment of the executive. Therefore, it is advantageous to use
more than one method to improve the accuracy.

The factors influencing forecasts, include social, economical, political, religious,
ethnic, fiscal, governmental, natural, macro, micro and technological aspects. The
macro factors comprise influencing business forecasts policy aspects such as
credit regulations, taxation policies, budgetary policies, export/ import policies,
industrial licensing policies, deficit financing, and inflation. The micro level policies
cover the market share, promotion expenses, advertising, research/ development
aspects, cost/ pricing aspects, motivation, management information system, and
criticalityavailabilityreliability of an item. These factors can be classified as
controllable/ uncontrollable or as tangible and intangible factors
SWOT Analysis and 7s Approach:
Strength and weakness are analyzed with respect to the factors internal to
the organization. The opportunities and threat are the effects external to the
company. These can be analyzed by the 7 S approach of the Harvard-
Boston group. This approach looks at every aspect from the following view
points:

a) super ordinate goals,
b) strategies,
c) structure,
d) systems,
e) skills,
f) staffing, and
G) styles of management.

For example , an effective forecasting ability can be used to reduce the threat
of fluctuating prices. Ideally, SWOT analysis has to be done separately for
the department, company, industry, nation and international scene, both for
the key raw material and the important finished goods.

The Ranging of Forecasting/ Forecasting Time Horizons:

Forecast is usually classified by the future time horizon that it covers. Time
horizons fall into three categories:

1. Short-range forecast: This forecast has a time span of up to one
year but is generally less than three months. It is used for planning,
purchasing, job scheduling, workforce level, job assignments, and
production levels.

2. Medium-range forecast: A medium-range, or intermediate,
forecast generally spans from 3 months to 3 years. It is useful in
sales planning, production planning and budgeting, cash budgeting,
and analyzing various operating plans.

3. Long-range forecast: Generally 3 years or more in time span,
long-range forecasts are used in planning for new products, capital
expenditures, facility location or expansion, and research and
Types of Forecasting:
Organizations use three major types of forecasts in planning future operations:
1. Economic forecasts: address the business cycle by predicting
inflation rates, money supplies, housing starts, and other
planning indicators.

2. Technological forecasts: are concerned with rates of
technological progress, which can result in the birth of exciting
new products, requiring new plants and equipment.

3. Demand forecasts: are projections of demand for a companys
products or services. These forecasts also called Sales
forecasts, drive a companys production, capacity, and
scheduling systems and serve as inputs of financial,
marketing, and personnel planning.

Economical & technological forecasting are specialized techniques that
may fall outside the role of the operations manager. The emphasis will
therefore, be given on demand forecasting throughout the session.


Steps in the Forecasting System
There are 7 Steps

1. Objectives i.e. to determine the use of the forecast, say to estimate demand
forecast- Purpose of the forecast.

2. Select the items to be forecasted. A company may produce many products.
Demand forecast by families (or groups).

3. Determine the time horizon of the forecasts: Is it short, medium, or long term?
Then develops it into monthly, quarterly, or for 12-month sales projections.

4. Select forecasting model varieties of statistical methods or models like moving
average, exponential smoothing, regression analysis etc.

5 Gather data needed to make the forecast- say creating a database to monitor
sales of each product.

6. Make the forecast.

7. Validate and implement the result- Forecasts are reviewed in sales, marketing,
finance and production departments to make sure that the model, assumptions
and data are valid. Forecasts are then used to schedule material, equipment and
personnel at each plant.
Limitations of Forecast:
1. Forecasts are seldom perfect. All factors determining the
forecasts can not be included in the real life.

2. Forecasts should be periodically reviewed due to changes
in its underlying factors.

3. Most forecasting technique assumes that there is certain
underlying stability, so some firms have automated
predictions using computerized system.

4. Both product family and aggregated forecasts are more
accurate than the individual product forecast.


Methods of Forecasting:

A large number of forecasting techniques with varying degrees of
complexity have been devised in the recent past. But there are two
general approaches to forecasting:

a. Subjective/qualitative: Forecasts that incorporate such
factors as the decision-makers intuitions, emotions,
personnel experiences, and value system. I also depend
upon individual judgments.

b. Objective/quantitative Forecast that employ one or more
mathematical models that rely on historical data and/or
causal variables to forecast demand.
In practice, a combination of the two is usually most
effective.

a. Subjective/Qualitative methods:
Four types
1. Visionary Forecast: The top management either as an individual or as a small
team fixes the forecast on an ad hoc basis, usually at 10% more than the last
year. This team is called the Jury of Executive Opinion. The forecast uses
personal insights, judgments, thumb rules and if possible, works out different
future scenarios. The forecasts are particularly useful for long range, new product
sales and forecasts of margins. Luck plays a crucial role in any forecast.

2. Panel Consensus: Panel Consensus is based on the assumption that several
experts can arrive at a better forecast than one person. In the marketing field, this
method is known as Sales Force Composite, where the individual salesmen
send the sales forecast of each product to the regional headquarters.

3. Market Research/ Consumer Market Survey: This process involves the
collection of information from a representative sample of possible consumers
through a carefully structured questionnaire, on the utilization of the companys
products. Considerable amount of information on market data is needed before
coming to a conclusion on the forecasts. A case in point is the opinion polls
conducted during the pre-elections period.

4. Delphi Method: A Forecasting technique using a group process that allows experts
to make forecasts. There may be 3 different types of participants in the Delphi
method: decision makers, staff personnel and respondents. Decision makers usually
consist of a group of 5 to 10 experts who will be making actual forecasts. Staff
personnel assist decision makers prepare, distribute, collect and summaries
questionnaire. Respondents are a group of people, often located in different place,
give judgment.

b. Objective/ Quantitative method:
Five quantitative forecasting methods, all of which use historical data, will be
discussed here. They fall into two broad categories:

(i) Time-series analysis
A forecasting technique that uses a series of past data to make a forecast. The
time are evenly spaced say weekly, monthly, yearly etc. Example: weekly
sales of Level Brothers Bangladesh Ltd. The analysis can be conducted in 04
different ways:
1. Naive approach:
A forecasting technique that assumes demand in the next period is equal
to demand in the most recent period. Ex. Grameen Phone has sold 68 cellular
phones in the last month (January) and Grameen has forecasted that in this
month (February) will also have a sales of 68 units. For some products line
it has been found that this approach of forecasting is the most cost-effective
and efficient.
2. Moving averages: A forecasting method that uses an average of the n
most recent periods of data to forecast the next period.
demand in previous n periods
Moving average= n
Where, n= nos. of period in the moving average.

Problem: to be solved
When a detectable trend and pattern is present, weight can be used to
place more emphasis on recent values. This practice makes forecasting
techniques more responsive to changes because more recent periods
may be more heavily weighted. For example, if the latest month or period is
weighted too heavily, the forecast might reflect a large unusual change in
the demand or sales pattern too quickly.
A weighted moving average may be expressed mathematically as-

(weight for period n) (demand in pen)
Weighted moving average = (weights)

Both simple and weighted moving averages are effective in smoothing
out sudden fluctuations in the demand pattern in order to provide
stable estimates.


Exponential Smoothing: A weighted moving average forecasting technique in which
data points are weighted by an exponential function. It involves very little record keeping
of past data. The basic exponential formula can be shown as follows:
New forecast = last periods forecast + (last periods actual demand - last periods
forecast)

where is a weight, or smoothing constant, chosen by the forecaster, that has a value
between 0 and 1. This equation can be also written as---
Ft= Ft-1 + (A t-1 - Ft-1 )
Where,
Ft = New forecast, Ft-1 = Previous forecast, A t-1 = Previous periods actual demand
and = smoothing (weighting) constant (0 1)

The latest estimate of demand is equal to our old estimate adjusted by a fraction of the
difference between the last periods actual demand and the old estimate.

Selecting the Smoothing Constant:
The exponential smoothing approach is easy to use, and it has been successfully
applied in virtually every type of business. However, the appropriate value of the
smoothing constant , can make the difference between an accurate forecast and an
inaccurate forecast. The overall accuracy of a forecasting model can be determined by
comparing the forecasted values for past known periods with the actual or observed
demand for those periods. The forecast error is defined as


Forecast error= demandforecast

Mean Absolute Deviation: MAD is a measure of the overall forecast error for a
model. This value is computed by taking the sum of the absolute values of the
individual forecast errors and dividing by the number of periods of data (n):
(Forecast errors)
MAD= n

4. Trend Projections: A time-series forecasting method that fits a trend line to a
series of historical data points and then projects the line into the future for
forecasts. Example: The steady increase of cost of living, recorded by the
consumer price index (CPI), is an example of long term trend.

5. Linear Regression Analysis: A straight-line mathematical model to describe
the functional relationships between independent and dependent variables.

This regression functionally relates sales to other economic, competitive or
internal variables. It estimates an equation using the least square technique of
minimising the total square of deviations of the observed and expected value.
The relationships are primarily analyzed statistically although any relationship
should be selected for testing on a rational ground. The usual equation is

y = a + bx,
y is the dependent variable or the forecast,
x is the influencing independent variable.
a = (y bx) is the intercept on the y-axis and
b = (xy nxy) / (xi nx2). Computer programs are available for complex
situations involving more influential variables or non-linear equations to forecast by
the regression method.

Thus, the analytical techniques are applied to indicate the forecast for the total
business as for the individual item, by identifying any peculiarities or sudden
changes in trends or patterns. This information is then incorporated into the details
of the item forecasts with adjustments, considering the smoothing mechanisms,
seasonal, executive judgment and other influencing factors.

6.Correlation Analysis
The forecaster has to identify the influencing variables like disposable income and
sales on the forecasted variable. The correlation analysis measures the strength of
the relationship between two or more variables. The value of correlation coefficient
lies between -1 and +.1, the positive values indicating that there is a tendency for
the second variable to increase with the increases in the first. The scatter diagram,
or a plot of the two variables in a graph sheet, gives some idea of the nature of
relationship to be considered. This may be a straight line or a curve and the extent
may be positive or negative.

Example 1:
Storage shed sales at Donnas Garden Supply are shown in the middle column of
the table below. A month moving average appears on the right.
Month Actual Shed Sales 3- Month Moving Average
January 10
February 12
March 13
(10+12+13)/3=11.66
April 16 (12+13+16)/3=13.66
May 19 (13+16+19)/3=16
June 23 (16+19+23)/3=19.33
July 26 (19+23+26)/3=22.66
August 30 (23+26+30)/3=26.33
September 28 (26+30+28)/3=28
October 18 (30+28+18)/3=25.33
November 16 (28+18+16)/3=20.66
December 14
Thus, we see that the forecast for December is 20.66. To project the demand for
sheds in the coming January, we sum the October, November, and December sales
and divided by 3: January forecast = (18+16+14)/3= 16.