CHAPTER II – FORECASTING

INTRODUCTION

The success of an organization depends on how well the organization sees the future environment which
is full of risks and uncertainties. In order to make prediction about the future, we must use the past and
present data. These data helps in minimizing risk and/or uncertainties about the future. Forecasting is a
introduction to planning. Before making plans, an estimate must be made of what conditions will exist
over some future period. How estimates are made, and with what accuracy, is another matter, but little
can be done without some form of estimation. Every day managers make decisions without knowing
what will happen in the future. They order inventory without knowing what sales will be, purchase new
equipments despite uncertainty about demands for product, and make investments without knowing
what profit will be. Managers are always trying to make better estimate of what will happen in the future
in the face of uncertainty. Making good estimates is the main purpose of forecasting.
What forecasting is?
Forecasting is the art and science of predicting future events. It involves estimation of the occurrence,
timing, and magnitude of uncertain future events or levels of activities. Forecasting may involves taking
historical data and projecting them into the future with some sort of mathematical model. It may be a
subjective or intuitive prediction. In some conditions it may involves the combination of both
mathematical data and manager’s perception. Successful forecasting requires blending art and science.
Experience, judgment, and technical expertise will all play a role in a successful forecasting. The
purpose of forecasting activities is to make use of the best available present information to guide future
activities towards systems goal.
2.1. Why Forecasting?
There are many circumstances and reasons, but forecasting is inevitable in developing plans to satisfy
future demand. Most firms cannot wait until orders are actually received before they start to plan what to
produce. Customers usually demand delivery in reasonable time, and manufacturers must anticipate
future demand for products or services and plan to provide the capacity and resources to meet that
demand. Firms that make standard products need to have saleable goods immediately available or at
least to have materials and subassemblies available to shorten the delivery time. Firms that make-to-
order cannot begin making a product before a customer places an order but must have the resources of
labor and equipment available to meet demand.
Many factors influence the demand for a firm’s products and services. Although it is not possible to
identify all of them, or their effect on demand, it is helpful to consider some major factors:
 General business and economic conditions.
 Competitive factors.
 Market trends such as changing demand.
 The firm’s own plans for advertising, promotion, pricing, and product changes.
2.2. Features of Good Forecasting
To be a good forecast; one organizations’ forecast system should be:
 Timely
 Accurate and the degree of accuracy should be stated clearly
 Reliable (consistent)
 Expressed in a meaningful terms
 In a written form
 Simple to understand and use
Principles of Forecasting
Forecasts have four major characteristics or principles. An understanding of these will allow us to make
more effective use of forecasts. They are simple and, to some extent, common sense.

1. Forecasts are rarely perfect, actual results usually differ from predicted values. Forecasts attempt
to look into the unknown future and, except by sheer luck, will be wrong to some degree. Errors
are inevitable and must be expected.
2. Forecasts are more accurate for families or groups. The behavior of individual items in a group is
random even when the group has very stable characteristics. For example, the marks for
individual students in a class are more difficult to forecast accurately than the class average.
High marks average out with low marks. This means that forecasts are more accurate for large
groups of items than for individual items in a group.
3. Forecasts are more accurate for nearer time periods. The near future holds less uncertainty than
the far future. Most people are more confident in forecasting what they will be doing over the
next week than a year from now. As someone once said, tomorrow is expected to be pretty much
like today.
 4. Forecasting techniques generally assume that the same underlying causal systems that existed in
the past will continue to exist in the future.
Advantages of Good Forecast
 it assures improved materials management system in a given organization
 better use of capital and finance may be created
 assures improved customer service
 enhances improved employee relation
 it may also served as starting point for budgeting
2.3. Steps in Forecasting Process
1. Determine the purpose of forecast
2. Establish a time horizon
3. Select a forecasting technique
4. Prepare a forecast
5. Monitor the forecast

2.4. Types of Forecasting/Forecasting Techniques

There are many forecasting methods, but they can usually be classified into two categories:
a. Qualitative b. Quantitative
1. Qualitative Forecasting

Qualitative techniques are projections based on judgment, intuition, and informed opinions. By their
nature, they are subjective. Such techniques are used to forecast general business trends and the potential
demand for large families of products over an extended period of time. As such, they are used mainly by
senior management. Production and inventory forecasting is usually concerned with the demand for
particular end items, and qualitative techniques are seldom appropriate. These methods are used
primarily when there is no data available.
Some of the common qualitative methods of forecasting are:
i. Delphi method
This method involves judgment. It is an interactive group process and employs a group of experts, not
an oracle to obtain forecasts. The experts are usually not known to each other and their interaction takes
place through a coordinator. The other participants in the delphi process are the staffs who are involved
in collecting and analyzing data. The respondents are the subjects whose judgment is being sought.
 ii. Sales force composite
In this method sales force members will be asked to estimate the likely sales in their respective areas.
The estimates are then received to ensure that they are realistic. Finally, the estimates are combined at
the district, regional and national level to obtain the overall forecast.
iii. Consumer Panel Survey
Under this method consumers are questioned about their purchase plan in a consumer panel. The aim of
this method is to forecast product and service demand on the basis of subjective judgment of consumer
purchase. These are typically used to forecast long rage and new product sales. It can help not only in
preparing a forecast but also in improving the design and planning for new product. There is one basic
assumption to this model. i.e. the consumer in the panel are the representatives of the ultimate/final
purchasers.
2. Quantitative Forecasting

In opposite to qualitative approach, quantitative models are objective in their very nature and they
employ numerical information. This model includes time series model and causal models.
A. Time series models.
The time series models attempt to predict the future values using the historical data. Here the demand
forecast is done on the basis of the past demand value. This prediction is based on the premise that the
future is a function of what has happen in the past. In other words, they look at what has happened over
a period of time and use a series of past data to make a forecast. If we are predicting weekly sales of an
automobile, we use the past weekly sales for automobile in making forecast.
 Decomposition of time series
Time series analysis involves decomposing the past data in to components and then projecting them
forward. A time series has four components.
 Trend :- Over a long period, time series will have an overall tendency either to move upwards or
downwards, though the actual movement will not be regular.
 Seasonality :- The fluctuation occurs periodically, the movements recurring within a definite
period may be every month or every Week
 Cyclical movement:- The cyclic variations as an index in decomposition method occur as short-
period changes and periodic variations. These variations may be regular or irregular. They are
 caused by business cycles. For example, the sales of company may be high because the level of
economic performance may be high.
 Random Variation:- These variations are erratic and irregular and are usually caused by some
unpredictable reason. They follow no discernible pattern, so they can not be predictable.
The most commonly used time series models are:
a. Naive forecast : the simplest way to forecast is to assume that the forecast in the next period
will be equal to demand in the most recent period.
Eg. If the actual demand for October is 45 unit, the forecasted demand for Nonmember will be
45 unit.
b. Simple Moving Averages
The simple moving average method uses the average of the most recent n data values in the time series
as the forecast for the next period. Mathematically, the simple moving average is expressed as:

Simple Moving Average =

∑ demands∈privious n periods
n

Example:
Example:
The demand for product A is observed for 10 months & it is given below:
below:

Month Demand ( in unit)

1 420
2 380
3 456
4 412
5 429
6 366
7 392
8 440
9 452
10 396

Question:
What is the forecast for month 11 using a 3 month moving average & 4 month
Month moving average methods ?
Solution:
A three month moving average can be obtained by adding the demand during the past three months &
dividing the sum by three, with each passing month the recent month data is added by dropping the old
to get new forecast.

 By using three months moving average, the demand in month 11 will be;

396 + 452 +440 = 429 units

3
 When a four months moving average is used, the forecast of month 11 will be
420 units.

Which can be obtained as follows:

392 + 440 + 452 + 396 = 420 units
4

c. Weighted moving average

In the simple moving average method, each observation in the time series receives the same weight.
When detectable trend or pattern is percent, weight can be used to place more emphasis on recent
values. One possible variation known as weighted moving average; involves selecting different weights
for each data value and then computing a weighted mean as the forecast. In most cases, the most recent
observation receives the greater weight, and the weight decrease for the older data values. This practice
makes forecasting technique more responsive to changes because most recent period may be more
heavily weighted.

Mathematically it can be expressed as:

Weighted Moving Average =

∑ ( weight for period ¿n)(demand ∈ period n) ¿
∑ weights
For example, using cotton demand in textile manufacturing company let us illustrate the computation of
3-months weighted moving average.
Assume Weight applied Period

3 ……………………… Last month

2………………………... Two months ago

1………………………… Three months ago

Forecast for this month =

3 X dd . At last month+ 2 X dd . At two months ago+1 X dd . At three months ago

6 ∑ of the weights

Month Time series value 3- month weighted moving average forecast

1 17
2 21
3 19
4 23 (3X19) + (2X21) + (1X17) = 116/6 =19.33
5 18 (3X23) + (2X19) + (1X21) = 128/6 =21.33
6 16
7 20
8 18
9 22