Wsu,CBE,Mgt 2017

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. Inorder 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
aintroduction 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:

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 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
 itassures improved materials management system in a given organization
 better use of capital and finance may be created

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 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

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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
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.

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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
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 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 = 420units
420units

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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 appliedPeriod

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

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Trend Projections
In this method, a trend line is fitted to the given time series data and then projections are made in to the
future by using this line. The trend line may be linear or curvilinear in nature. In-order to obtain the
trend line, the historical data are plotted on the graph, representing time scales on X- axis. Then a line is
drown through these points in such a way that the sum of deviations above & below the line are equal.

The sum of the squares of these vertical deviations is minimum. In essence the trend line is drowning
based on the principle of least square. Such a line is represented by;

y = bx +a

where:
y = is the trend line to be predicted
b = the slope of the trend line
a – the y intercept
x – independent variable (in this case time)
So far the trend line the value of b & a can be obtained as follows

∑ xiyi−n ( x )( y )
b= ∑ xi2−n( x )2
a= y−b( x)
Example:
Consider the following demand pattern of ABC Company for iron ore.

Year Demand for iron sheet in ‘000 tons

1989 13
1990 17
1991 16
1992 16
1993 21
1994 20
1995 20
1996 23
1997 25
1998 24

Required: 1999 25

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A. Forecast the demand of the iron sheet for the year 2000 for ABC Company. Using 1984 as base year.

B. Forecast the demand of the iron sheet for the year 2000 for ABC Company. Using 1997 as base year.

Solution:

Here by using the square method we can develop the estimating (regression) equation.

By using the last square method we can develop the line of the best fit.

y = bx +a

The line of the best fit always passes through the two points X & Y i.e. ( X , Y ).

Now to develop the equation of the line we need to have a base year to see the deviation of others from
it. Most of the time the base year is the middle observation. In the case of even observations we use the
mean of the two middle observations as base year by multiplying the mean by any number. For simplicity
in calculation.

When we use 1994 as a base year.

Year Xi yi xiyi xi2

1989 -5 13 -65 25
1990 -4 17 -68 16
1991 -3 16 -48 19
1992 -2 16 -32 4
1993 -1 21 -21 1
1994 0 20 0 0
1995 1 20 20 1
1996 2 23 46 4
1997 3 25 75 9
1998 4 24 96 16
1999 5 25 125 25
xi = 0 yi = 220 xiyi = 128  xi2 = 110

The equation of the estimating line,

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When the base year is 1994  x = 0. The value of b &a for trend line can be obtained as follows:

b = 128 –11(0)(20) = 128 =1.1636

110 – 11(0)2 110
a = y – b( x )
20 – 1.1636(0) = 20
(y = bx + a)

The trend linear equation will be;

y= 1.1636x + 20
Therefore, the forecast for the year 2000 will be as follows;
x= 6 (because it is six years after the base year 1994
y= 1.1636(6) + 20
y= 26.9816 tons of iron sheet

B. Causal Models of Forecasting

The causal model considers two types of variables the dependent and independent variables. E.g., the
sales of a company are depend on & is related to the price changed.
* By using regression analysis it is possible to develop a statistical relation ship b/n the dependent and
independent variables.
Simple regression analysis;
It is used when there is one independent variable/ explanatory variable. Here an estimate of the
dependent variable is made corresponding to a given value of the independent variable by putting their
relationship in the form of regression line. Like the tend projection, the regression line is obtained by
plotting paired observations of x and y variables. The regression line is then represented by the following
equation.
y = a +bx where,
a- y intersect of the regression line
b- slope of the regression line
x- the independent variable
y- the predicted value of the dependent variable

b= ∑xy – n x y
∑ x 2 - n x2

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a= y–bx

Here parameter b is also called the regression coefficient.

Parameter a and b of the trend line drown on the principle of vast square are obtained using the following
pairs of normal equations.
∑y = na + b∑x
∑xy = a∑x + bx2
b= ∑xy – n x y
∑ x 2 - n x2

a= y–bx Here
∑y –Summation of the value of the dependent variable
∑x – Summation of the value of the independent variable
∑xy –Summation of moderate of x and corresponding y value
∑x2 – Sum of the square of the value of the independent variable
n- Number of date points

When the values of x are stated in the above equation we are going to consider the time sale associated
with the year of projections.
Illustration on Regression analysis
Consider a large firm organization engaged in producing barely. The organization feels that the demand
for its product (barely) is dependent or related to the number. of cans of beer of 1 liter consumed every
year in a certain locality. To establish the demand forecast for its product, the organization has collected
the following historical data of hectares of land that had been sawn & the number. of quintals of barely
harvested.

Year Consumption of beer in ‘000 of liters Demand for barely in ‘000 of quintals
1990 36 54
1991 26 30

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1992 12 28
1993 40 48
1994 24 36
1995 18 30
1996 30 38
1997 30 46
1998 14 16
1999 34 42

Required:
If the numbers of liters of beer to be consumed in the coming period is 48000 litters (orders already
received from clients). Forecast the number of quintals of barely that could be demanded in the year
2000.
Solution:
Solution:
The first step is regression analysis is to identity the dependent and independent variables usually denoted
by x and y respectively. In this illustration the dependent variable is barely and the independent variable
is beer.
Bear (x) Barely (y) x2 xy
36 54 1296 1944
26 30 676 780
12 28 144 336
40 48 1600 1120
24 36 576 864
18 30 324 540
30 38 900 1140
30 46 900 1380
14 16 196 224
34 42 1156 1424
∑xi = 264 ∑yi = 368 ∑xi =7768 ∑yi = 10556

x = ∑x = 264 =26.4
n 10

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y = ∑y = 368 =36.8
n 10

b= 10556 – 10(26.4)(36.8) = 840.8 = 1.05

7768 – 10(26.4)2 798.4

a= 36.8 – (1.05)(26.4) = 9.08

∴ y = 1.05x + 9.08

The demand for barely is in the year 2000 = 1.05 (48000) + 9.08 = 50.4 tons of quintals.

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