Forecasting

A forecast is an estimate of what is likely to happen in the future.It is both the art and science of predicting
future events. It may involve taking historical data and projecting this data into the future using some type
of mathematical model. It may be a judgmental prediction, based on subjective considerations or intuition.
Or, it may involve a combination of quantitative analysis adjusted by a manager’s judgment.
People make and use forecasts all the time, both in their jobs and in everyday life. In everyday life, they
forecast answers and then make decisions based on their forecasts. Typical questions they may ask are: "Can
I make it across the street before that car comes?" "How much food and drink will I need for the party?"
"Will I get the job?" "When should I leave to make it to class, the station, the bank, the interview, ... , on
time?" To make these forecasts, they may take into account two kinds of information. One is current factors
or conditions. The other is past experience in a similar situation. Sometimes they will rely more on one than
the other, depending on which approach seems more relevant at the time. In recent years, no business
function has grown as rapidly as the forecasting function. More and more businesses now recognize that
forecasts are the key to good decision making.
Forecasting for business purposes involves similar approaches. In business, however, more formal methods
are used to make forecasts and to assess forecast accuracy. Forecasts are the basis for budgeting and
planning for capacity, sales, production and inventory, personnel, purchasing, and more. Forecasts play an
important role in the planning process because they enable managers to anticipate the future so they can
plan accordingly.

Importance of Forecasting
Good forecasts are important in all aspects of a business:
 Finance
Finance uses long-term forecasts to estimate needs for capital and to evaluate capital projects. Short-term
forecasts are used in finance to prepare certain budgets such as cash budgets.

 Marketing
Marketing produces sales forecasts for use in the development of marketing plans and for the
implementation of marketing strategy.

 Human Resources
Human Resources use forecasts to estimate the need for employees. Hiring, training, and the layoff of
workers all depend on anticipated demand. If a firm hires additional workers on extremely short notice, the
amount of training declines and quality suffers.

 Operations
Operations develop and use forecasts for decisions regarding scheduling, inventory replenishment, and long-
term capacity planning. Forecasting is particularly important for capacity planning, because when capacity is
inadequate, resulting shortages result in unreliable delivery schedules. Loss of customers, and loss of market
share, on the other hand, when excess capacity is built, costs increased.
 Types of Forecasts
There are three major types of forecasts: demand forecasts, technological forecasts, and economic forecasts.

 Demand Forecasts. These are projections (estimates) of demand for a company’s products or services.
These forecasts, often called sales forecasts, which drive a company’s marketing, financial, operations,
and personnel planning.

 Technological Forecasts. These are concerned with rates of change in technology, which can result in
the development of new products or services, requiring new plants and equipment.

 Economic Forecasts. These speak to economic cycles by predicting inflation rates, employment rates,
money supply, housing starts, and other economic indicators.

Uses for forecasts

There are two uses for forecasts. One is to help businesses plan their system and the other is to help them
plan the use of the system. Planning the system involves long-term planning about products and services to
offer, facilities and equipment to have, where to locate and so on. Planning the use of the system is linked
to short-and intermediate-term planning, which includes planning about inventory, work-force levels,
scheduling, purchasing, and budgeting.
Business forecasting is about more than predicting demand. Forecasts are used to predict financial
outcomes such as revenues, costs, and profit prices, productivity changes, interest rates, availability of
inputs, changes in key economic indicators, and prices of stocks. Keep in mind, however, that the concepts
and techniques apply equally well to other variables.

Features Common to All Forecasts

A wide variety of forecasting techniques are in use. In many respects, they are quite different from each
other, as you shall soon discover. Nonetheless, certain features are common to all, and it is important to
recognize them.

 Forecasting techniques assume that the same underlying system that existed in the past will continue to
exist in the future. This “stable” system is assumed to exist for all forecasting techniques, and it is
important to recognize that any unplanned events can wreak havoc with the system and the forecasts
that come from it.

 Forecasts are rarely, if ever, perfect, actual results differ from predicted values. No one is ever able to
predict precisely how a large number of factors will impact on the variable we wish to forecast. There is
no more humbling experience available to the forecaster than the development of forecasts based on
the assumption of perfect knowledge – only to have these forecasts blow up in the face of the
forecaster.

 Forecast accuracy decreases as the forecast horizon increases. As the time period covered by a forecast
increase, there are more opportunities for unplanned events to impact on the forecast. Short-term
forecasts simply don’t allow enough time for things to go wrong; consequently, they tend to be more
accurate than long-term forecasts.

 Forecasts for groups of items are more accurate that forecasts for individual items because forecasting
errors among items in a group tend to cancel each other out. Forecasts of total demand developed by
financial planners will have smaller errors than the sum of errors created by forecasting item-by-item
demand, where errors are in full view and cannot cancel out each other.
 Elements of a Good Forecast
If a forecast is prepared properly, it should have the following elements:

1) Accuracy:The forecast should be accurate.Forecasts should be accurate within certain ranges, and
these ranges should be known and stated. Knowing the range or level of accuracy will help forecast
users plan for errors and provide a basis for comparing forecasts against actual results.
2) Timely:The forecast should be timely.Forecasts have to be prepared well enough in advance of actual
so that the information contained in the forecast can be used in an effective manner. For example, a
marketing program cannot be implemented overnight. So, a forecast must be developed early enough
to be used in both the design and the implementation of the marketing program.

3) Reliability:The forecast should be reliable.As a characteristic of forecasts, reliability is more about

consistency than accuracy. If a forecast technique sometimes produces a good forecast and sometimes
a poor one, the technique is likely to leave users with the distinct impression that they could get burned
anytime they try the technique.

4) Simple to understand and use:The forecasting technique should be simple to understand and use.It
is understood that no one will use a forecasting technique that they do not understand. Users lack
confidence in forecasts based on sophisticated techniques; they do no understand if the technique is
appropriate or what its limitations might be.

5) Meaningful units:The forecast should be expressed in meaningful units.Financial managers need

forecasts in dollars. Production planners need demand forecasts in units, particularly when I t comes
time to scheduling equipment and personnel. Each department in a business will need to have its
forecasts expressed in the units most useful for their planning requirements.

6) In writing:The forecast should be in writing.There are two reasons for a forecast to be in writing: (1) a
written forecast provides a “hard-copy” basis for evaluating the effectiveness of the forecast once
actual results are in and (2) a written forecast increases the likelihood that everyone is using the same
information – singing from the same song sheet, so to speak.

Steps in the Forecasting Process

There are seven basic steps in the process of forecasting:
1. Determine the purpose of the forecast:How are you going to use the forecast and when will you
need it.Identifying the purpose and timing of the forecast will provide you with some guidance as to the
level of detail required in the forecast, the amount of resources (time, dollars, and personnel) that
should be invested in the forecast, and the level of accuracy required.

2. Select the items to be forecast:Are you forecasting total demand, demand by product/service group,
or individual items?

3. Determine the time horizon for the forecast:Is it a short-, medium-, or long-term forecast? The
forecast must have a time limit, keeping in mind that forecast accuracy decreases as the time period
covered by the forecast increases.

4. Select the forecasting technique:This step is necessary in order to identify the data that will be
needed in order to build the forecast. A word of caution, however. Your choice of technique carries
with it certain assumptions about the data that will be used in the modest selection of certain time
 series averaging techniques assumes that there is only random variation in the data, not trend and/of
seasonal variation. Remember, “fall in love with your data, not your model!”

5. Gather the date needed to make the forecast:Before a forecast can be prepared, data must be
gathered and analyzed. Is the data consistent with the assumptions in the forecast model? Is there
enough data to support the technique? Are we missing data? These, and other questions, need to be
answered before we begin to forecast.
6. Prepare the forecast:Forecasts should be monitored to see if they are performing in a satisfactory
manner. Monitoring forecasts means making sure that the model, the assumptions, and the data are
valid.
7. Monitor the results:The forecast results should be monitored to determine if the forecast is
performing in a satisfactory manner. If it is not, reexamine the method,
assumptions, validity of data, and so on; modify as needed; and prepare a revised forecast.

Approaches to Forecasting

Forecasting

Quantitative Qualitative

Time Series Associative Executive

Models Models Opinions

Salesforce
Naive Techniques Techniques Techniques Simple Multiple
Forecast for Averaging for Trend for Seasonality Linear Regression Linear Regression Opinions

Consumer
Simple Trend Trend and Seasonal
Moving Average Exponential Smoothing Exponential Smoothing Surveys
Weighted
Moving Average
Trend
Projection
Trend
Projection
Market
Research
Simple
Exponential Smoothing
Market
Surveys

Market
Tests

Delphi
Method

There are two general approaches to forecasting: quantitative and qualitative

Qualitative methods incorporate such factors as the decision maker’s intuition, personal opinions, personal
experiences, and value system in reaching a forecast.
Quantitative methods use a variety of mathematical models that rely on historical data and/or causal
variables to forecast demand.

The following points present a variety of forecasting techniques that are classified as judgmental, time-series
and associative.

 Forecasts Based on Judgment: Judgmental forecasts rely on analysis of subjective inputs from a
variety of sources including customer surveys, sales staff, managers, and panels of experts. Frequently,
these sources provide insights that cannot be obtained by any other means.
 Forecasts Based on Time Series Data: A time series is a sequence of evenly spaced date points.Some
forecasting techniques use historical, or time series data, with the assumption that the future will be
like the past. Examples might include weekly sales of a running shoe, quarterly earnings of a stock, daily
shipments of a beer, and annual consumer price indices.

 Associative Forecasts: Associative models use equations that consist of one or more explanatory
variables that can be used to predict future demand. For example, demand for personal computers
might be related to such variables as price, competitor’s price, the amount spent on advertising, and
general economic conditions.

QUALITATIVE FORECASTS
Forecasts Based on Judgment
Qualitative forecasting methods are usually based on judgment about the factors that underlie the sales of
particular products or services and on opinions about the relative likelihood of theses factors being present
in the future. These methods may involve different levels of sophistication, ranging from scientifically
conducted consumer surveys to intuitive hunches about future events.

Executive Opinions. A forecasting method in which the opinions and experience of one or more managers
are used to produce a forecast. Knowledgeable executives from various departments in an organization form
a committee charged with the responsibility of developing a sales forecast. The committee may use many
inputs from all parts of the organization. Such forecasts tend to be compromise forecasts, not reflecting the
extremes that could be present had they been prepared by individuals.

Sales Force Opinions. Forecasts compiled from estimates of demand made by members of a company’s
sales force.Estimates of future regional sales are obtained from individual members of the sales force. These
estimates are combined to form an estimate of sales for all regions. Management then transforms this
estimate into s sales forecast, using judgment to ensure realistic estimates. This is a popular forecasting
method is a company has a good communication system in place and has salespeople who sell directly to
customers.

Consumer Surveys. A forecasting method that seeks input from customers regarding future purchasing
plans for existing products or services.Estimates of future sales are obtained directly from customers.
Individual customers are surveyed to determine what quantities of the firm’s products they intend to
purchase in each future time period. A sale forecast is determined by combining individual customer’s
responses. Companies that have relatively few customers may prefer this method.

Market Research. This method tests hypothesis about new products or services or new markets for
existing products or services.In market surveys, mail questionnaires, telephone interviews, or field
interviews from the basis for testing hypotheses about real markets. In market tests, product marketed on
target regions or outlets are statistically extrapolated to total markets. These methods are preferred for
new products or for existing products to be introduced into new markets.

Delphi Method. A forecasting technique using a group process that allows experts to make forecasts.This
method is used to achieve consensus within a committee. Under this method, management anonymously
answers a series of questions in successive rounds. Each response is fed back to all participants on each
round, and the process is then repeated. As many a six rounds may be required before consensus is reached
on the forecast. This method can result in forecasts that most participants ultimately agree to in spite of any
initial disagreement.
 QUANTITATIVE FORECASTS

Forecasts Based on Time Series Data

Time series models attempt to predict the future by using historical data. These models make the
assumption that what happens in the future is a function of what has happened in the past. In other words,
time series models look back at what has happened over a period of time and use a series of past data to
make a forecast. Or, to phrase it more succinctly: “Time series forecasting is like driving forward while
looking in the rear-view mirror”.
This type of forecasting implies that future values are predicted only from past values and that other
variables that might influence demand are ignored.
Analysis of time series data requires a forecaster to identify the underlying behavior of the series.
Analyzing a time series means breaking down data into components and then project the components into
the future. Typically, there are five components: trend, cycles, seasonality, and random variation.

 Trend: Trend is the gradual upward or downward movement of data over time. A movement in trend
may be attributable to changes in demographics such as income, population, age distribution, or
cultural aspects.

 Cycle: Cycles are patterns in time series data that occur every several years. They are linked to
business cycles, which can have a length from as little as 2 years to as long as 10 years. The problem
with cycles is that their length is unpredictable and estimating the business cycle is difficult because
they are affected by political events.

 Seasonality: Seasonality refers to Short-term, fairly regular variations that are generally related to
weather factors or to human-made factors such as holidays.Seasonal variation involves patterns of
change within a year, and tends to be repeated from year to year.

 Irregular variations: 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
their inclusion in the series can distort the overall picture. Whenever possible, these should be
identified and removed from the data.

 Random variations: Random variations are “glitch” in the data caused by chance and unusual
situations. They have no pattern, so they cannot be predicted. They also serve to remind us that the
future is not perfectly predictable.

1.Naive Forecasts
A forecast that assumes that demand in the next period will be equal to demand in the most recent period.A
simple, but widely used approach to forecasting is the naive approach. A naïve forecast assumes that
demand in the next period will be equal to demand in the most recent period. The naive approach can be
used with a stable series (random variation only), with seasonal variation, or with trend.
Stable Series: If the data series has only random variation, the last data point becomes the forecast for the
next period. For example, if demand for a product last month was 950 units, the forecast for this month is
950 units
Seasonal Variation. For seasonal data, the forecast for this “season” is equal to the value of the series last
“season”. For example, the forecast of demand for a particular toy this Christmas is equal to the demand for
the toy last Christmas.

Trend. For data with trend, the forecast is equal to the last value of the data series plus or minus the
difference between the last two values of the series. For example, suppose the last two values of a series
were 125 and 140:
Change From
Period Actual Previous Value Forecast

t–1 125
t 140 15
t+1 140 + 15 = 155

This forecast, then, is 140 + 15, or 155.

2. Techniques for Averaging

These are techniques that are useful for data that has only random variation.Averaging techniques smooth
variations in the data and leave only “real” variations, such as changes in the demand. As a practical matter,
however, it is usually impossible to distinguish between these two kinds of variations, so the best one can
hope for is that the small variations are random and the large variations are “real”.
Averaging techniques generate forecasts that reflect recent values of a time series.These techniques work
best when a data series tends to vary around in average; i.e., when the primary fluctuation in the data is due
to random variation. However, these techniques can also handle step changes or gradual changes in the
level of the series.
There are three popular averaging techniques:
1. Simple moving average
2. Weighted moving average
3. Simple exponential smoothing
 Moving Average
A technique that uses a number of historical data values to generate a forecast.
Involves finding a series of successive averages by dropping the first data value in the series and adding the
last data value.
Useful for data without trend, seasonality, or cycles.
A key decision involves selecting the number of periods that will be included in the average.
The larger the number of periods, the greater the smoothing; the smaller the number of periods, the quicker
the forecast reacts to changes in the data.
 Weighted Moving Average:
Weighted Moving Average is a model that applies different “weights” to each value in the moving average
calculations.In certain situations, it may be desirable to apply unequal weights to the historical data. When
an apparent trend or pattern is present, weights can be used to place more emphasis on recent values. This
practice makes forecasting more responsive to changed because more recent periods are more heavily
weighted.
 Simple Exponential Smoothing
Simple exponential smoothing is a variation of the weighted moving average model in which data points are
weighted by an exponential function, which declines, as the data gets older. The simple exponential
smoothing function can be shown as:
New forecast = alpha (current demand) + (1-alpha)(current forecast)

Ft+1 = aAt + (1 – a)Ft

Where Ft+1 = forecast for next period
a = smoothing constant (0 < a < 1)
At = current period’s actual demand
Ft = current period’s forecast