INTRODUCTION TO FORECASTING

Making good estimates is the main purpose of forecasting. Every day, operations managers make decisions with uncertain
outcomes. No one can see the future to know what sales will be, what will break, what new equipment will be needed, or
what investments will yield. Yet those decisions need to be made and executed to move the firm forward.

What is Forecasting?

Forecasting is the art and science of predicting what will happen in the future. Sometimes that is determined by a
mathematical method; sometimes it is based on the intuition of the operations manager. Most forecasts and end decisions are
a combination of both.

Forecasting is conducted by what are referred to as time horizons.

FEATURES COMMON TO ALL FORECASTS

A wide variety of forecasting techniques are in use. In many respects, they are quite different from each other.

1. Forecasting techniques generally assume that the same underlying casual system that existed in the past will continue
to exist in the future.
2. Forecasts are rarely perfect; actual results usually differ from predicted values.
3. Forecasts for groups of items tend to be more accurate than forecasts for individual items because forecasting errors
among items in a group usually have a canceling effect.
4. Forecast accuracy decreases as the time period covered by the forecast- the time horizon- increases.

ELEMENTS OF A GOOD FORECAST

1. The forecast should be timely.

2. The forecast should be accurate and the degree of accuracy should be stated.
3. The forecast should be reliable, it should work consistently.
4. The forecast should be expressed in meaningful units.
5. The forecast should be in writing.
6. The forecast technique should be simple to understand and use.
7. The forecast should be cost-effective.
* The definition of cost effective is something that is a good value, where the benefits and usage are worth at least what
is paid for them.

STEPS IN THE FORECASTING PROCESS

1. Determine the purpose of the forecast.

2. Establish a time horizon.
* Time horizon is the estimated length of time for a plan, program, or project to complete, an endeavor to succeed,
an investment to yield returns, an obligation to become due, a right to mature, etc.
3. Select a forecasting technique.
4. Gather and analyze relevant data.
5. Make the forecast.
6. Monitor the forecast.

APPROACHES TO FORECASTING

There are two general approaches to forecasting: qualitative and quantitative.

Judgmental forecasts rely on analysis of subjective inputs obtained from various sources, such as consumer surveys,
the sales staff, managers and executives, and panels of experts.

Qualitative methods include:

1. Jury of executive opinion. This is based on the inputs and decisions of high-level experts or management.

2. Delphi method. Decision makers, staff, and respondents all meet to develop the forecast. Every shareholder in the process
provides input.

3. Sales force composite. Each sales person provides an individual estimate which is reviewed for realism by management,
and then combined for a big picture view.
4. Consumer market survey. This is surveying the prospective customer base to determine demand for existing products and
can also be used for new products.

As these methods are based mostly on instinct, experience and human input, be cautious of excessive optimism.

Quantitative methods are in two categories. Time-series models predict by assuming the future is a function of the
past. Associative models uses similar historical data inputs and then includes other external variables such as advertising
budget, housing, competitor's prices and more.

Time series forecasts simply attempt to project past experience into the future. These techniques use historical data
with the assumption that the future will be like the past. Associative models use equations that consist of one or more
explanatory variables that can be used to predict future demand.

FORECAST BASED ON JUDGMENT AND OPINION

Executive Opinions

A small group of upper-level managers may meet and collectively develop a forecast. This approach is often used as a
part of long-range planning and new product development. It has the advantage of bringing together the considerable knowledge
and talents of various managers. However, there is the risk that the view of one person will prevail, and the possibility that
diffusing responsibility for the forecast over the entire group may result in less pressure to produce a good forecast.

Salesforce Opinions

The sales staff or the customer service staff is often a good source of information because of their direct contact with
customers. They are often aware of any plans the customer may be considering for the future. There are, however, several
drawbacks to this approach. (*Drawback is a feature that renders something less acceptable; a disadvantage or problem.) One
is that they may be unable to distinguish between what customers would like to do and what they actually will do. Another is
that these people are sometimes overly influence by recent experiences. Thus after several prior of low sales, their estimates
may tend to become more pessimistic. After several periods of good sales, they may tend to be too optimistic. In addition, if
forecasts are used to establish sales quotas, there will be a conflict of interest because it is to the sales person’s advantage to
provide low sales estimates.

Consumer Surveys

Because it is the consumers who ultimately determine demand, it seems natural to solicit input from them. In some
instances, every customer or potential customer can be contacted. However, there are usually too many customers or no way to
identify all potential customers. Therefore, organizations seeking consumer input usually resort to consumer surveys, which
enable them to sample customer opinions. The obvious advantage to consumer surveys is that they can tap information that
might not be available elsewhere. On the other hand, a considerable amount of knowledge and skill is requires to construct a
survey, administer it and correctly interpret the results for valid information.

Other Approaches

A manager may solicit opinions from a number of other managers and staff people. Occasionally, outside experts are
needed to help with a forecast. Advice may be needed on political or economic conditions. Another approach is the Delphi
Method. It involves a series of questionnaires among individuals who possess the knowledge and ability to contribute
meaningfully. Responses are kept anonymous, which tends to encourage honest responses and reduces the risk that one person’s
opinion will prevail. Each new questionnaire is developed using the information extracted from the previous one, thus enlarging
the scope of information on which participants can base their judgments. The goal is to achieve a consensus forecast.
(*Concensus – general agreement.)

FORECASTS CASED ON TIME SERIES DATA

A time series is a time-ordered sequence of observations taken at regular intervals. The may be measured of demand,
earning profits, shipments, accidents, output, precipitation, productivity, and the consumer price index. It is based on the
assumption that future values of the series can be estimated from past values. Although no attempt is made to identify variables
that influence the series, these methods are widely used, often with quite satisfaction.

Analysis of time series data requires the analyst to identify the underlying behavior of the series. This can often be
accomplished by merely plotting the data and visually examining the plot. One or more patterns might appear: trends, seasonal
variations, cycles or variations around an average.

1. Trend refers to a long-term upward or downward movement in the data.

2. Seasonality refers to short-term, fairly regular variations generally related to factors such as the calendar to time of
day.
3. Cycles are wavelike variations more than one year’s duration.

4. Irregular variations are due to unusual circumstances such as severe weather conditions, strikes or a major change in
a product or service.
5. Random variations are residual variations that remain after all other behaviors have been accounted for.

A Naïve forecast uses a single previous value of a time series as the basis of a forecast. The naïve approach can be
used with a stable series, with seasonal variations, or with trend. With a stable series, the last data point becomes the forecast
for the next period.

TECHNIQUES FOR AVERAGING

Historical data typically contain a certain amount of random variation, or white noise that tends to obscure systematic
movements in the data. This randomness arises from the combined influence of many relatively unimportant factors.

A Moving Average forecast uses a number recent actual data values in generating a forecast.
 Weighted Average is similar to a moving average, except that it assigns more weight to the most recent values in a
time series. More recent values in a series are given more weight in computing a forecast.

Exponential Smoothing is a sophisticated weighted averaging method that is still relatively easy to use and understand.
Each new forecast is based on the previous forecast plus a percentage of the difference between that forecast and the actual
value of the series at that point.

*Alpha is the smoothing constant for the level of the series. The limits of this value are zero and one. Usually, a value between
0.1 and 0.3 are used. As the value gets closer to one, more and more weight is given to recent observations.
TECHNIQUES FOR TREND

Analysis of trend involves developing an equation that will suitably describe trend. The trend component may be linear
or it may not. A simple plot of the data often can reveal the existence and nature of a trend. A linear trend equation has the form
F1 = a + bt.

A variation of simple exponential smoothing can be used when a time series exhibits a linear trend. It is called trend-
adjusted exponential smoothing or, sometimes, double smoothing, to differentiate it from simple exponential smoothing which
is appropriate only when data vary around an average or have step or gradual changes. If a series exhibits trend, and simple
smoothing is used on it, the forecasts will all lag the trend: if the data are increasing, each forecast will be too low: if decreasing,
each forecast will be too high.

TECHNQUES FOR SEASONALITY

Seasonal variations in time series data are regularly repeating upward or downward movements in series values that
can be recurring events. Seasonality may refer to regular variations. Familiar examples of seasonality are weather variations
and vacations or holidays. The term seasonal variations is also applied to daily, weekly, monthly, and other regularly recurring
patterns in data.

Seasonality in a time series is express in terms of the amount that actual values deviate from the average value of a
series. If the series tends to vary around an average value, then seasonality is expressed in terms of that average; if trend is
present, seasonality is expressed in terms of the trend value.

USING SEASONAL RELATIVES

Seasonal relatives are used in two different ways in forecasting. One was is to deseasonalize data; the other way is to
incorporate seasonality in a forecast.

To deseasonalize data is to remove the seasonal component from the data in order to get a clearer picture of the
nonseasonal components. Incorporating seasonality in a forecast is useful when demand has both trend and seasonal
components.

COMPUTING SEASONAL RELATIVES

A commonly used method for representing the trend portion of a time series involves a centered moving average.
Computations and the resulting values are the same as those for a moving average forecast. However, the values are not
projected as in a forecast; instead, they are positioned in the middle of the periods used to compute the moving average.

TECHNIQUE FOR CYCLES

Cycles are up and down movements similar to seasonal variations but longer duration— say, two to six years between
peaks. When cycles occur in time series data, their frequent irregularity makes it difficult or impossible to project them from
past data because turning points are difficult to identify.

ASSOCIATIVE FORECASTING TECHNIQUES

Associative techniques rely on identification of related variables that can be used to predict values of the variable of
interest. The essence of associative techniques is the development of an equation that summarizes the effects of predictor
variables. The primary method of analysis is known as regression. A brief overview of regression should suffice to place this
approach into perspective relative to the other forecasting approaches.

SIMPLE LINEAR REGRESSION

The simplest and most widely used for of regression involves a linear relationship between two variables. The object
in linear regression is to obtain an equation of a straight line that minimizes the sum of squared vertical deviations of data points
from the line.

Correlations measure the strength and direction of relationship between two variables. Correlation can range from -
1.00 + 1.00. A correlation of +1.00 indicates that changes in one variable are always match by changes in the other, a correlation
of -1.00 indicates that increases in one variable are match by decreases in the other, and a correlation close to zero indicates
little linear relationship between two variables.

CURVILINEAR and MULTIPLE REGRESSION ANALYSIS

Simple linear regression may prove inadequate to handle certain problems because a linear model is inappropriate or
because more than one predictor variable is involved. When nonlinear relationships are present, you should employ curvilinear
regression; models that involve more than one predictor require the use of multiple regression analysis. The computations lent
themselves more to computers than to hand calculation. Multiple regression forecasting substantially increases data
requirements. In each case, it is necessary to weigh the additional cost and effort against potential improvements in accuracy
of predictions.

ACCURACY and CONTROL OF FORECASTS

Accuracy and control is a vital aspect of forecasting. The complex nature of most real-world variables makes it almost
impossible to correctly predict future values of those variables on a regular basis. Consequently, it is important to include an
indication of the extent to which the forecast might deviate from the variable that actually occurs. This will provide the forecast
user with a better perspective on how far off a forecast might be.

Forecast error is the difference between the value that occurs and the value was predicted for a given time period.

CONTROLLING the FORECAST

Because forecast errors are the rule rather than the exception, there will be a succession of forecast errors. Tracking the
forecast errors and analyzing them can provide useful insight on whether or not forecasts are performing satisfactorily.

There are a variety of possible sources of forecast errors, including the following:

1. The model may be inadequate due to the omission of an important variable, a change or shift in the variable that the
model cannot deal with, the appearance of a new variable.
2. Irregular variations may occur due to severe weather or other natural phenomena, temporary shortages or breakdowns,
catastrophes, or similar events.
3. The forecasting technique may be used incorrectly or the results misinterpreted.
4. There are always random variations in the data. Randomness is the inherent variation that remains in the data after all
causes of variation have been accounted for.

CHOOSING A FORECASTING TECHNIQUE

Many different kinds of forecasting techniques are available, and no single technique works best in every situation.
When selecting a technique for a given situation, the manager or analyst must take a number of factors into consideration.

Other factors to consider in selecting a forecasting technique include the availability of historical data; the availability
of computer software; the availability of decision makers to utilize certain techniques; the time needed to gather and analyze
data and to prepare the forecast; and any prior experience with a technique. The forecast horizon is important because come
techniques are more suited to long-range forecasts while other works best for the short-range. (*Time horizon - Estimated
length of time for a plan, program, or project to complete, an endeavor to succeed, an investment to yield returns, an obligation
to become due, a right to mature, etc.)

The two most important factors are cost and accuracy. Generally speaking, the higher accuracy, the higher the cost, so
it is important to weigh cost-accuracy trade-offs carefully. The best forecast is not necessarily the most accurate or the least
costly; rather, it sis me combination of accuracy and cost deemed best by management.

USING FORECAST INFORMATION

A manager can take a reactive or a proactive approach to a forecast. A reactive approach views forecasts as probable
of future demand, and a manager reacts to meet that demand. Conversely, a proactive approach seeks to actively influence
demand.

Generally speaking, a proactive approach requires either an explanatory model, or a subjective assessment of the
influence on demand. It is possible that a manager might take two forecasts one to predict what will happen under the status
quo and a second one based on a “what if” approach, if the results of the status quo forecast are unacceptable. (*The status
quo is the current state of things.)

COMPUTER IN FORECASTING

Computer play an important role in preparing forecasts based on quantitative data. Their use allows managers to
develop and revise forecasts quickly, and without the burden of manual computations. There is a wide range of software
packages available for forecasting. There are templates for moving averages, exponential smoothing, linear trend equation,
trend-adjusted exponential smoothing, and simple linear regression.