Forecasting

According to the International Institute of Forecasters (IIF), the field of

forecasting is concerned with approaches to determining what the
future holds. It is also concerned with the proper presentation and use
of forecasts. The terms “forecast,” “prediction,” “projection,” and
“prognosis” are typically used interchangeably. Forecasts may be
conditional. That is, if policy A is adopted then X will occur. Often
forecasts are made for future values of a time-series; for example, the
likely demand for skimmed milk. The field of forecasting includes the
study and application of judgment as well as of quantitative or
statistical methods.[1]

Richard San Juan explained Forecasting from an Entrepreneurial point

of view as “Forecasting is the process by which companies and
organizations analyze relevant data and graphs to determine how best to
proceed in business decisions for the future.” This valuable tool can be
used to evaluate the future of the business as a whole, the future of an
existing or potential product, and the future of the particular market
sector in which the company is a part of.[2]

Forecasting models are used to predict future aspects of business

operation.[3] They include averages, moving averages, weighted
moving averages, exponential smoothing (EXPOSM), linear trend
models, and simple and multiple regression models.

Forecasting techniques are used by managers to plan future capacity

to meet market demand and to procure the needed inputs to produce
this demand at optimum costs.[4]

Forecasting is a collection of mostly statistical and/or judgmental

procedures which aim at predicting the future based on the available
information and/or data (These processes may include activities such
as data collection, data pre-processing and preliminary data analysis,
forecasting method selection, which also involves model selection,
model fitting, and diagnostic checking, and control in a forecasting
system in use). In such processes, forecasting has lots of potentials for
strategic level managers including revealing system dynamics,
problem determination, predicting, monitoring, and control. [5]

Accurate forecasting is significant for numerous reasons. First, it

enables management to adjust and refine its operations at the
appropriate time in order to maximize the greatest benefit. Moreover,
forecasting assists in preventing losses by taking in all relevant
information and making proper judgment decisions. Organizations that
are able to demonstrate high quality and accurate forecasts are more
likely to reach their benchmarks and strategic objectives. Forecasting
is also essential when it comes to the subject of developing new
products, because it gives management an idea on whether or not it
has a good chance of being successful. Forecasting prevents the
company from wasting time and money developing, manufacturing,
and marketing a product that will ultimately fail.[2]

Forecasting in relation to planning:

Forecasting is concerned with what the future will look like, while
planning is concerned with what it should look like as explained by the
International Institute of Forecasters (IIF). “One would usually start by
planning. The planning process produces a plan that is, along with
information about the situation, an input to the forecasting process. If
the organization does not like the forecasts generated by the
forecasting process, it can generate other plans until a plan is found
that leads to forecasts of acceptable outcomes. Of course, many
organizations take a shortcut and merely change the forecast.”[1]

Fig1:
Forecasting as an integral
part of business
[6]
planning
Importance of Forecasting
According to Norman Gaither and Greg Frazier[6], some of the reasons
why forecasting is necessary in Operations Management are:

New Facility Planning – It can take 5 years to design and build a new
factory or design and implement a new production process.

Production Planning – Demand for products vary from month to

month and it can take several months to change the capacities of
production processes.

Workforce Scheduling – Demand for services (and the necessary

staffing) can vary from hour to hour and employees weekly work
schedules must be developed in advance.

In their book “Introduction to Time Series Analysis and Forecasting”,

Montgomery, Jennings & Kulahci[7] tackled the issue of the importance
of using forecasting as follows by saying that the reason that
forecasting is so important is that prediction of future events is a
critical input into many types of planning and decision making
processes, with application to areas such as the following:

1. Operations Management. Business organizations routinely

use forecasts of product sales or demand for services in
order to schedule production, control inventories, manage the
supply chain, determine staffing requirements, and plan
capacity. Forecasts may also be used to determine the mix of
products or services to be offered and the locations at which
products are to be produced.

2. Marketing. Forecasting is important in many marketing

decisions. Forecasting sales response to advertising
expenditures, new promotions, or changes in pricing polices
enable businesses to evaluate their effectiveness, determine
whether goals are being met, and make adjustments.

3. Finance and Risk Management. Investors in financial assets

are interested in forecasting the returns from their investments.
These assets include but are not limited to stocks, bonds, and
commodities; other investment decisions can be made relative to
forecasts of interest rates, options, and currency exchange rates.
Financial risk management requires forecasts of the volatility of
asset returns so that the risks associated with investment
portfolios can be evaluated and insured, and so that financial
derivatives can be properly priced.
 4. Economics. Governments, financial institutions, and policy
organizations require forecasts of major economic variables,
such as gross domestic product, population growth,
unemployment, interest rates, inflation, job growth, production,
and consumption. These forecasts are an integral part of the
guidance behind monetary and fiscal policy and budgeting plans
and decisions made by governments. They are also instrumental
in the strategic planning decisions made by business
organizations and financial institutions.

5. Industrial Process Control. Forecasts of the future values of

critical quality characteristics of a production process can help
determine when important controllable variables in the process
should be changed, or if the process should be shut down and
overhauled. Feedback and feed forward control schemes are
widely used in monitoring and adjustment of industrial processes
and predictions of the process output are an integral part of
these schemes.

6. Demography. Forecasts of population by country and regions

are made routinely, often stratified by variables such as gender,
age, and race. Demographers also forecast births, deaths, and
migration patterns of populations. Governments use these
forecasts for planning policy and social service actions, such as
spending on health care, retirement programs, and antipoverty
programs. Many businesses use forecasts of populations by age
groups to make strategic plans regarding developing new
product lines or the types of services that will be offered.

Forecasting as a Strategic Decision-Making

Tool
Surviving in highly competitive markets and adapting to new states
require both strategic thinking and utilizing all the available
information about the future, as well as that about the present.[5]
Nevertheless, the information required about the future may not
always be readily available. Even though it is possible to obtain a part
of those data and/or information (e.g. inflation figures, growth
forecasts, exchange rates) from external sources, firms mostly produce
and obtain the required data (e.g. the amount of future stocks, cash
flows, market shares) themselves within their own bodies. Moreover,
firms, themselves, may also have to produce some of the external data
needed (e.g. inflation rates and exchange rates) for themselves, which
could normally be obtained from external providers otherwise. [5]
Strategic management is applied in three different levels: Corporate,
business, and functional levels.[8] In fact, the functional level
management is the main management unit where the strategies in a
company are put into action. In strategy formation, the business and
corporate level managers need and use the information being fed from
the functional level. Forecasting activities can take place anywhere in
these three levels based on the managerial needs and forecasting
problems. However, as we get from top to bottom of managerial levels,
the more intensive and more frequent forecasting function is utilized.
[5]

On the other hand, strategic decisions mainly focus on creating

‘competitive advantages’ and differ from other daily or operational
decisions from several aspects. Some of the characteristics of strategic
decisions are that (i) they are made less frequently than (e.g. daily)
operational decisions; (ii) they are generally more costly (in terms of
the decision-making process e.g. may require longer time and more
money, and the alternative costs) to make compared to other type of
decisions; (iii) the consequences may be too severe for the firm; (iv) it
generally requires background work and longer time to make; (v) they
may normally require more and detailed information (e.g. data and
(full) analysis of the situations, which may not be a pre-condition for
ordinary daily decisions). The decisions such as market segmentation,
new product development, application of new manufacturing process,
selection of a new distribution channel, and application of a new
marketing mix, all can be considered as strategic decisions. Similarly,
the major decisions directed at obtaining substantial cost reductions
can significantly contribute to gaining competitive advantages and,
that is why, can be considered as a strategic type. More specifically,
forecasting of costs, market share, sales, inventory, cash flows,
dividends, stock prices, and capacity requirements, which are only
some of the internal utility areas, besides interest rates, inflation rates,
and growth rates of economy, which are some of the external utility
areas, all are closely related to strategic decision-making in one way or
another. [5]

The operation of the forecasting function, in this sense, is an inter-

departmental activity and, therefore, the development of forecasts
(e.g. sales or market potential) should be done by the inclusion of
several parties (e.g. market research manager, sales manager, and
production manager in a company). This is particularly important for
especially if the forecasts are used for strategic (e.g. marketing)
planning, integration, and realization of those strategic plans.[5]

Integration of forecasting system to management activities is

particularly important in utilizing the potential of forecasting, which has
two main dimensions: (i) the production of the desired forecasts and
(ii) putting them into use. As the first one is related to the forecasting
function, the second one is related to the managerial decision
processes. As with any other decision tools, a failure in utilizing it will
make it difficult to achieve the desired objectives, especially if a
particular decision is heavily based on the information from the
forecasting system such as the decisions regarding manufacturing
capacity planning based on sales forecasts).

In a survey of expert opinions on cash flow forecasting in British

companies[9], the author has found the variety of forecasts performed
(e.g. sales, costs, revenue, inventory, capital expenditures, working
capital, and other types of forecasts) were mainly for planning
purposes in addition to monitoring and control. The study also pointed
out the multi-purpose character of forecasting, which supports this
idea.

According to Palot[5], the potential uses of forecasting in

strategic decision processes can be stated as follows:

Goal Setting: Strategic planning requires input and the forecasting

system in a company provides the underlying input necessary for the
underlying process. Strategic managers can base their plans on these
inputs in determining more realistic and attainable goals. In other
words, forecasts can be taken as benchmarks for determining what are
(are not) possible and achievable goals in a managerial decision
context.

Firm Performance: The information produced by the forecasting

system is ready-to-use material for measuring the firm performance
and whether the predetermined strategic goals are achieved. Hence,
forecasting can be used as a performance evaluation and a monitoring
device in assessing the success of strategic plans. Assume that
company X forecasted its market share to be 25% in a 3 years’ time
and determined all its strategies to attain this market share. At the end
of the 3 years period, strategic management could easily use market
share forecast as a benchmark for evaluating to what extent it
achieved its objectives or how well it performed during these last 3
years, so that it can refine its strategies.

Strategy Formulation: Strategy formulation is one of the key

processes in strategic management. Broad range of forecasting
processes provides with company managers the relevant information
from procedural and analytical designs so that the outcomes from
various scenarios can be investigated and taken as a ground for such
processes and activities. This would give managers the opportunity to
make more realistic assumptions in their plans and projections and
determine alternative strategies concerning different outcomes of
forecast results for the scenarios being considered.

Flow of information and data from bottom-to-top (functional level to

business level and business level to corporate level) is one of the major
inputs in strategic management. Without this information and data
flow from functional level, for instance, to business level managers are
unlikely to formulate business strategies. Also, without such input,
business level managers might choose a strategy that the company
does not have the operational and functional resources to attain.[7] The
same is valid for corporate level managers.

Strategy Implementation: Strategy implementation is another key

process in strategic management. The attainability and consistency of
strategic objectives are particularly significant for strategic
management levels. The strategic objectives expressed in clear and
objective figures are the key elements in strategy implementation.
Good communication between strategic managers at all levels is a
prerequisite for achieving these objectives, which requires clear,
concrete, and understandable messages. Forecasts produced, in this
sense, are a major part of the messages in the communication
between both different levels of strategic and operational managers,
and among themselves, as well.

The same as in the strategy formulation, without the flow of

information (and data) from the top level to the functional level, the
opposite of above, the functional level managers would not know what
strategic objectives are pre-determined; in turn, what the functional
level objectives should accordingly be, what functional decisions to
make, and what tools to use for monitoring and control purposes. In
other words, without concrete strategic goals accompanied by
figures, which are made more concrete and visible by
forecasts, it would be too difficult to implement the strategies
determined.

It was also suggested by Palot[5] that forecasting can be used in two

different ways for strategic purposes:
1. For the realization of strategic decisions in functional and
operational levels (e.g. short-term operational forecasts which
should normally be the basic guide in running the business’ daily
operations).
2. For planning strategic decisions directly (e.g. medium term and
long term capacity forecasts based on market potential).
Medium or longer term forecasts can directly be considered for
strategic planning purposes mainly because they have to consider
economic, political, social, demographic, and other relevant external
(or internal) characteristics. Good sales forecasts start from forecasting
of the general state of an economy, and goes to forecasting of the
specific industry and then to the market potential and sales for a
specific period of time. Within these processes, it is expected that
various scenarios are considered and a different set of forecasts for
each scenario is produced. Here, strategic thinking is an integral part
of forecasting for different scenarios and the end product is a set of
information obtained from such processes, made ready to be used for
strategic purposes.

The forecasting function is related to the strategic management

context as follows: Strategic decisions are long-term in nature. Long-
term decisions are riskier than short-term decisions due to an increase
in the uncertainty in the long-term. The higher the increase in
uncertainty, the more the managers’ need for information for strategic
decision-making. In principle the longer the time horizon is, the higher
the planning requirements are (e.g. capacity planning) in companies. It
is obvious that in such situations the information requirement by
management increases dramatically, especially, if the intention is to
make strategic decisions, which makes forecasting central to strategic
decision-making. Cost considerations are another factor that forces
strategic managers to consider forecasting. A forecasting activity with
a high accuracy may be needed especially in major planning and
investment decisions based on the forecasts of market potential or
sales where high costs are incurred (e.g. plant expansion and new
facilities construction). The size of the costs or financial resources to be
invested may make firms utilize the forecasting function in making a
ground for such decisions.

Selection of forecasting methods

The choice of a forecasting technique is significantly influenced by the
stage of the product life cycle and sometimes by the firm or industry
for which decision is being made. [10]

In the beginning of the product life cycle, relatively small expenditures

are made for research and market investigation. During the first phase
of product introduction, these expenditures start to increase. In the
rapid growth stage, considerable amounts of money are involved in the
decisions; therefore, a high level of accuracy is desirable. After the
product has entered the maturity stage, the decisions are more
routine, involving marketing and manufacturing. These are important
considerations when determining the appropriate sales forecast
technique.[10]

After evaluating the particular stages of the product and determining

firm and industry life cycle, a further probe is necessary. Instead of
selecting a forecasting technique by using whatever seems applicable,
decision makers should determine what is appropriate. Some of the
techniques are quite simple and rather inexpensive to develop and
use, whereas others are extremely complex, require significant
amounts of time to develop, and may be quite expensive. Some are
best suited for short-term projections, whereas others are better
prepared for intermediate or long-term forecasts.

According to Shim & Siegel [10], what technique or techniques to select

depends on the following criteria:
- What is the cost associated with developing the forecasting
mode compared with potential gains resulting from its use? The
choice is one of the benefit-cost tradeoff.
- How complicated are the relationships that are being
forecasted?
- Is it for short- or long-term purposes?
“Short-term staffing needs might best be forecast with moving
average or exponential smoothing models. On the other hand,
long-term factory capacity needs might best be predicted with
regression or executive-committee consensus methods.”[6]

- How much accuracy is desired?

According to Gaither & Frazier [6], High-accuracy approaches
have disadvantages:
 Use more data
 Data are ordinarily more difficult to obtain
 The models are more costly to design, implement,
and operate
 Take longer to use
- Is there a minimum tolerance level of errors?
- How much data are available? Techniques vary in the amount
of data they require. “If the need is to forecast sales of a new
product, then a customer survey may not be practical; instead,
historical analogy or market research may have to be used.”[6]

Types of Forecasting
Despite the wide range of problem situations that require forecasts,
there are only two broad types of forecasting techniques—qualitative
methods and quantitative methods.[7]

Qualitative forecasting techniques are often subjective in nature

and require judgment
on the part of experts. Qualitative forecasts are often used in situations
where there is little or no historical data on which to base the forecast.
An example would be the introduction of a new product, for which
there is no relevant history. In this situation the company might use
the expert opinion of sales and marketing personnel to subjectively
estimate product sales during the new product introduction phase of
its life cycle. Sometimes qualitative forecasting methods make use of
marketing tests, surveys of potential customers, and experience with
the sales performance of other products (both their own and those of
competitors). However, although some data analysis may be
performed, the basis of the forecast is subjective judgment. Perhaps
the most formal and widely known qualitative forecasting technique is
the Delphi Method. This technique was developed by the RAND
Corporation in 1967.[7] It employs a panel of experts who are assumed
to be knowledgeable about the problem. The panel members are
physically separated to avoid their deliberations being impacted either
by social pressures or by a single dominant individual. Each panel
member responds to a questionnaire containing a series of questions
and returns the information to a coordinator. Following the first
questionnaire, subsequent questions are submitted to the panelists
along with information about the opinions of the panel as a group. This
allows panelists to review their predictions relative to the opinions of
the entire group. After several rounds, it is hoped that the opinions of
the panelists converge to a consensus, although achieving a consensus
is not required and justified differences of opinion can be included in
the outcome.

Quantitative forecasting techniques make formal use of historical

data and a fore- casting model. The model formally summarizes
patterns in the data and expresses a statistical relationship between
previous and current values of the variable. Then the model is used to
project the patterns in the data into the future. In other words, the
forecasting model is used to extrapolate past and current behavior into
the future. There are several types of forecasting models in general
use. The three most widely used are regression models, smoothing
models, and general time series models.
1. Regression models make use of relationships between the
variable of interest and one or more related predictor variables.
Sometimes regression models are called causal forecasting
models, because the predictor variables are assumed to
 describe the forces that cause or drive the observed values of
the variable of interest. An example would be using data on
house purchases as a predictor variable to forecast furniture
sales. The method of least squares is the formal basis of most
regression models.

2. Smoothing models typically employ a simple function of

previous observations to provide a forecast of the variable of
interest. These methods may have a formal statistical basis, but
they are often used and justified heuristically on the basis that
they are easy to use and produce satisfactory results.

3. General time series models employ the statistical properties

of the historical data to specify a formal model and then
estimate the unknown parameters of this model (usually) by
least squares.

Forecast Error
The form of the forecast can be important. We typically think of a
forecast as a single number that represents our best estimate of the
future value of the variable of interest. Statisticians would call this a
point estimate or point forecast. Now these forecasts are almost
always wrong; that is, we experience forecast error. Consequently, it is
usually good practice to accompany a forecast with an estimate of how
large a forecast error might be experienced. One way to do this is to
provide a prediction interval (PI) to accompany the point forecast. The
PI is a range of values for the future observation, and it is likely to
prove far more useful in decision making than a single number.

Forecast Horizon and Forecast Interval

The forecast horizon is the number of future periods for which
forecasts must be produced. The horizon is often dictated by the
nature of the problem. For example, in production planning, forecasts
of product demand may be made on a monthly basis. Because of the
time required to change or modify a production schedule, ensure that
sufficient raw material and component parts are available from the
supply chain, and plan the delivery of completed goods to customers
or inventory facilities, it would be necessary to forecast up to three
months ahead. The forecast horizon is also often called the forecast
lead time.

The forecast interval is the frequency with which new forecasts are
prepared. For example, in production planning, we might forecast
demand on a monthly basis, for up to three months in the future (the
lead time or horizon), and prepare a new forecast each month. Thus
the forecast interval is one month, the same as the basic period of
time for which each forecast is made. If the forecast lead time is
always the same length, T periods, and the forecast is revised each
time period, then we are employing a rolling or moving horizon
forecasting approach. This system updates or revises the forecasts for
T −1 of the periods in the horizon and computes a forecast for the
newest period T. This rolling horizon approach to forecasting is widely
used when the lead time is several periods long.

Steps in the Forecasting Process

There are six basic steps in the forecasting process [10]:

1- Determine the what any why of the forecast and what will be
needed. This will indicate the level of details required in the
forecast (e.g., forecast by region, forecast by product), the
amount of resources (e.g. computer hardware and software,
manpower) that can be justified, and the level of accuracy
desired.
2- Establish a time horizon, short-term or long-term. More
specifically, project for the next year or next 5 years, etc.
3- Select a forecasting method.
4- Gather the data and develop a forecast.
5- Identify any assumptions that had to be made in preparing the
forecast and using it.
6- Monitor the forecast to see if it is performing in a manner
desired. Deveop an evaluation system for this purpose. If not
return to step1.

Criticism of Forecasting
It should be mentioned that there also exist some opposing views
about the use of forecasting in strategic planning and operations
management. The claims are based on the idea that while certain
repetitive patterns (e.g. seasonal) may be predictable, the forecasting
of discontinuities including technological breakthroughs and price
increases is “practically impossible.” Therefore, according to
Makridakis et al.’s opinion, ““very little, or nothing” can be done other
than to be prepared, in a general way, to …react quickly once a
discontinuity has occurred”.”[11]

Some Reasons for Ineffective Forecasting[6]

- Not involving a broad cross section of people
- Not recognizing that forecasting is integral to business planning
- Not recognizing that forecasts will always be wrong
- Not forecasting the right things
- Not selecting an appropriate forecasting method
- Not tracking the accuracy of the forecasting models
References:
[1] International Institute of forecasters (IIF):
http://www.forecastingprinciples.com

[2] Richard San Juan for Gaebler Ventures:

http://www.gaebler.com/Forecasting.htm

[3] Anderson, D., Sweeney, D., and Williams, T., 2002. An Introduction
to Management Science: Quantitative Approaches to Decision Making,
tenth edition, South-Western Publishing Company, Cincinnati, Ohio.

[4] Jack A. Fuller, C. Lee Martinec, Operations Research And

Operations Management: From Selective Optimization To System
Optimization, Journal of Business & Economics Research – July 2005
Volume 3, Number 7, pp11-14

[5] Polat, Cihat Forecasting as a Strategic Decision-Making Tool: A

Review and Discussion with Emphasis on Marketing Management,
European Journal of Scientific Research, 2008 Volume 20 Number 2,
pp.419-442

[6] Gaither and Frazier, Operations Management 9th edition, 2001,

South-Western.

[7] Douglas C. Montgomery, Cheryl L. Jennings, and Murat Kulahci,

Introduction to Time Series Analysis and Forecasting, John Wiley &
Sons, Inc.

[8] Hill, Charles W. L. and Jones, G. R. (1992), Strategic Management:

An Integrated Approach (2nd Ed.), USA: Houghton Mifflin Company

[9] Polat, Cihat (2003), The Role of Forecasting and Its Potential for
Functional Management: A Review from the Value-Chain Perspective,
Ankara Üniversitesi Siyasal Bilgiler Fakültesi Dergisi (white paper)
[10] Jae K. Shim, Joel G. Siegel, Operations Management, 1999,
Barron’s Educational Series, Inc. ISBN: 0-7641-0510-8

[11] Hogarth, R. and Makridakis, S., “The value of decision making in a

complex environment: an experimental approach”, Management
Science, 1981, Vol. 27 No. 1, pp. 93-107