Forecasting

Definition of Forecasting

A planning tool that helps management in its attempts to cope with the uncertainty of the future, relying mainly on data from the past

and present and analysis of trends.

Forecasting is the process of projecting the values of one or more variables into the future.

Accurate forecasts are needed throughout the value chain, and

are used by all functional areas of the organization, including accounting, finance, marketing, operations, and distribution.

Forecasts are used to predict profits, revenues, costs, productivity changes, prices, availability of energy and raw materials, interest rates, movements of key economic indicators (GDP, Inflation , etc.

Looking into future trends

Elements of good Forecast

Timely

Reliable

Accurate

Written

Sources of Data

Primary Sources:

Data collected through surveys, interviews of

experts.

Secondary sources: Historical data available with the company.

Other sources: intuition and judgment

Demand pattern

Time Series: It is a set of observations measured at successive points in time or over successive periods of time.

There are five basic patterns of most time series. a. Horizontal. The fluctuation of data around a constant mean. b. Trend. The systematic increase or decrease in the mean of the

series over time.

c. Seasonal. A repeatable pattern of increases or decreases in demand, depending on the time of day, week, month, or season. d. Cyclical. The less predictable gradual increases or decreases over longer periods of time (years or decades). e. Random. The unforecastable variation in demand.

Linear and non-linear pattern

Seasonal patterns are characterized by repeatable periods of ups and downs over short periods of time.

Cyclical patterns are regular patterns in a data series that take place over long periods of time.

Irregular variation

Trend

Cycles
90 89 88 Seasonal variations

Methods of Forecasting

Judgmental Forecasts: rely on subjective inputs (Qualitative) obtained from various

sources such as consumer surveys, sales staff, managers,

executives and panel of experts.

Time-series forecasts: Attempts to project past experience in future. Use of historical data with the assumption that future will be like past.

Associative Models:
Use equations that consists of one or more explanatory variables that can be used to predict demand.

Judgment Forecasting methods

Sales force estimates: The forecasts that are compiled from estimates of future demands made periodically by members of a companys sales force.

Executive opinion: A forecasting method in which the opinions, experience, and technical knowledge of one or more managers are summarized to arrive at a single forecast.

Market research: A systematic approach to determine external consumer interest in a service or product by creating and testing

hypotheses through data-gathering surveys.

Delphi method: A process of gaining consensus from a group of experts while maintaining their anonymity.

Time series Methods

Naive forecast: A time-series method whereby the forecast for the next period equals the demand for the current period, or Forecast = Dt

Simple moving average method: A time-series method used to

estimate the average of a demand time series by averaging the demand for the n most recent time periods. It removes the effects of random fluctuation and is most useful when demand has no pronounced trend or seasonal influences.

Example of Moving Average Method

We will use the following customerarrival data in this moving average application:

F5

D4 D3 D2 790 810 740 780 3 3

780 customer arrivals

F6

D5 D4 D3 805 790 810 801.667 3 3

802 customer arrivals

Weighted moving average method: A time-series

method in which each historical demand in the average can have its own weight; the sum of the weights equals

1.0.

Ft+1 = W1Dt + W2Dt-1 + + WnDt-n+1

F5 W1D4 W2 D3 W3D2 0.50790 0.30810 0.20740 786

786 customer arrivals

F6 W1D5 W2D4 W3D3 0.50805 0.30790 0.20810 801.5

802 customer arrivals

Exponential smoothing method: A sophisticated weighted moving average method that calculates the average of a time series by giving recent demands more weight than earlier demands. Ft+1 = (Demand this period) + (1 )(Forecast calculated last period) = Dt + (1)Ft Or an equivalent equation: Ft+1 = Ft + (Dt Ft )

Where alpha (is a smoothing parameter with a value between 0 and 1.0

Exponential smoothing is the most frequently used

formal forecasting method because of its simplicity and the small amount of data needed to support it.

Example Exponential smoothing

Reconsider the medical clinic patient arrival data. It is now the end of week 3. a. Using = 0.10, calculate the exponential smoothing forecast for week 4. Ft+1 = Dt + (1-)Ft F4 = 0.10(411) + 0.90(390) = 392.1 b. What is the forecast error for week 4 if the actual demand turned out to be 415? Week Arrivals E4 = 415 - 392 = 23 c. What is the forecast for week 5? F5 = 0.10(415) + 0.90(392.1) = 394.4
1 2 3 4 5 400 380 411 415 ?

Trend-adjusted exponential smoothing method: The method for incorporating a trend in an exponentially smoothed forecast.
With this approach, the estimates for both the average and the trend are smoothed, requiring two smoothing constants. For each period, we calculate the average and the trend.
Ft+1 = At +Tt
where At = Dt + (1 )(At-1 + Tt-1) Tt = (At At-1) + (1 )Tt-1 At = exponentially smoothed average of the series in period t Tt = exponentially smoothed average of the trend in period t = smoothing parameter for the average = smoothing parameter for the trend Dt = demand for period t Ft+1 = forecast for period t + 1

Associative methods are used when historical data are

available and the relationship between the factor to be forecasted and other external or internal factors can be identified.

Associative Forecasting Techniques

Linear regression: A causal method in which one variable

(the dependent variable) is related to one or more independent

variables by a linear equation.

Dependent variable: The variable that one wants to forecast. Independent variables: Variables that are assumed to affect the dependent variable and thereby cause the results

observed in the past.

The following are sales and advertising data for the past 5 months for brass door hinges. The marketing manager says that next month the company will spend $1,750 on advertising for the product. Use linear regression to develop an equation and a forecast for this product.

Month 1 2 3 4 5

Sales (000 units) 264 116 165 101 209

Advertising (000 $) 2.5 1.3 1.4 1.0 2.0

We use the computer to determine the best values of a, b, the correlation coefficient (r), the coefficient of determination (r2), and the standard error of the estimate (syx). a = 8.135 b = 109.229X r = 0.98 r2 = 0.96 syx= 15.603

Example of regression
300 Sales (thousands of units) 250 200

Y = a + bX
Y = 8.135 + 109.229X a = 8.135 b = 109.229X r = 0.98 r2 = 0.96 syx= 15.603

150
100 50

| | | | 1.0 1.5 2.0 2.5 Advertising (thousands of dollars)

Forecast for Month 6: X = $1750, Y = 8.135 + 109.229(1.75) = 183,016

The End

Demand forecasting is being done in virtually every

company. The challenge is to do it better than the

competition.

Better forecasts result in better customer service and lower costs, as well as better relationships with suppliers

and customers.