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1  P a g e
Chapter 3: Forecasting
Definition: Forecasting is a statement about the future. It is estimating future event (variable), by
casting forward past data. Past data are systematically combined in predetermined way to obtain the
estimate. Forecasting is not guessing or prediction.
Forecasting help managers to:
• Plan the system
• Plan the use of system
Forecasts affect decisions and activities throughout an organization
• Accounting, finance
• Human resources
• Marketing
• MIS
• Operations
• Product / service design
Accounting Cost/profit estimates
Finance Cash flow and funding
Human Resources Hiring/recruiting/training
Marketing Pricing, promotion, strategy
MIS IT/IS systems, services
Operations Schedules, MRP, workloads
Product/service design New products and services
Common features of forecasting:
1. Forecasting is rarely perfect (deviation is expected).
2. All forecasting techniques assume that there is some degree of stability in the system, and
“what happened in the past will continue to happen in the future”.
3. Forecasting for a group of items is more accurate than the forecast for individuals.
4. Forecasting accuracy increases as time horizon increases.
Elements of good forecast:
1. Timely: Forecasting horizon must cover the time necessary to implement possible changes.
2. Reliable: It should work consistently.
3. Accurate: Degree of accuracy should be stated.
4. Meaningful: Should be expressed in meaningful units. Financial planners should know how many
dollars needed, production should know how many units to be produced, and schedulers need to
know what machines and skills will be required.
5. Written: to guarantee use of the same information and to make easier comparison to actual
results.
6. Easy to use: users should be comfortable working with forecast.
Types of forecast by time:
• Shortrange (days – weeks – months): Job scheduling, work assignments
o Time spans ranging from a few days to a few weeks.
o Cycles, seasonality, and trend may have little effect.
o Random fluctuation is main data component.
• Medium term (12 years): Sales, production
• Long range forecast (> 2years): change location
o Time spans usually greater than one year.
o Necessary to support strategic decisions about planning products, processes,
and facilities.
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2  P a g e
Example of sales forecast:
Months Forecast of
Sales
Actual Sales Error Squared
Error = E
2
1 10 8 2 4
2 8 12 4 16
3 11 7 4 16
4 14 16 2 4
5 10 8 2 4
Total 14 44
Forecast accuracy:
• Total absolute deviation (TAD)= 14
• Mean absolute deviation (MAD)= ∑ (Actualforecast)/n = 14/5 = 2.8
• Total Squared Error (TSE) = 44
• Mean Square Error (MSE)= 44/5 = 8.8
Steps in forecast development:
1. Determine purpose of forecast.
2. Establish a time horizon: time limit, accuracy decreases with shorter durations.
3. Select forecasting technique.
4. Gather and analyze data.
5. Prepare the forecast
6. Monitor forecast.
Methods of forecast:
1. Quantitative (based on time series data):
Time series data: a time ordered sequence of observation taken at regular intervals over time.
Patterns resulting from plotting of these data are:
a. Trend: A longterm upward or downward movement in data.
b. Seasonality: Shortterm regular variations related to calendar or time of day.
c. Cycle: Wavelike variation lasting more than one year.
d. Random variations: residual variations after all other behaviors are accounted for.
e. Irregular variations: caused by irregular circumstances, not reflective of typical
behavior.
Naïve forecast: The forecast for any period equals the previous period’s actual value.
• Simple to use.
• Virtually no cost.
• Quick and easy to prepare (no data analysis required).
• Easily understandable.
• Cannot provide high accuracy.
• Can be a standard for accuracy and cost. Q: is the increased accuracy of another
method worth the additional cost?
• Can be applied in stable demand (moving around average), seasonal, and trend
Examples:
1. Sales of air conditioning units next July, will be the same as the sales in last July.
(Seasonal)
2. Highway traffic next Tuesday will be the same as last Tuesday (stable, moving around
average).
3. If the last 2 actual values were 50 and 53, the next will be 56 (trend).
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3  P a g e
2. Qualitative methods: (based on judgment and opinion)
1. Jury of executives: opinions of high level executives
2. Sales force composite: estimates from sales individuals are reviewed for
reasonableness (may tend to make under estimates), then aggregated.
3. Consumer market survey: Asking the customers may give best forecasts but it is
higher in cost, difficult to apply.
4. Delphi method:
(a) Panel of experts queried.
(b) Chosen experts to participate should be of a variety of knowledgeable people in
different areas (finance, marketing, production etc). They are unknown to any one,
except for the coordinator.
(c) Through questionnaire the coordinator obtains estimates from all participants.
(d) Coordinator summarizes results and redistributes them to participants along with
appropriate new questions.
(e) Summarize again and refine forecasts and develop new question.
Differences between qualitative and quantitative
Qualitative Methods Quantitative Methods
Uses when situation is vague Used in stable situations
and little data available Historical data available
New products Existing products
New technology Current technology
Involves mathematical techniques
Example: forecasting newly introduced
online sales
Example: sales of color TVs
Lnear regresson anayss:
• Establishes a relationship between a dependent varabe and one or more independent variables.
• In simple linear regression analysis there is only one independent variable.
• If the data is a time series, the independent variable is the time period.
• The dependent variable is whatever we wish to forecast. (e.g. sales)
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4  P a g e
kegresson Lquaton
Y
Delta Y
Delta X
a
X
¥ = a + b k
Y = dependent variable (example: Company Sales)
X = independent variable (example: time periods, sales of other related company)
a = Yaxis intercept
b = Slope of regression line = delta Y/ delta X
• Constants a and b:
o The constants a and b are computed using the following equations:
Or, Σy=na+bΣx a= (Σy – bΣx)/n
Σxy=aΣx+bΣx
2
o Once the a and b values are computed, a future value of X (tme, or saes of other eated
product) can be entered into the regression equation and a corresponding value of Y (the
forecast) can be calculated.
• Lxampe: Coege Lnroment
At a small regional college enrollments have grown steadily over the past six years, as evidenced
below. Use time series regression to forecast the student enrollments for the next three years.
Students Students
Year Enrolled (s) Year Enrolled (s)
. .
. .
. .
x y x
xy
. .
. .
. .
. .
. .
. .
1ota 21 18Ŧ1 91 66Ŧ5
2
2 2
x y x xy
a =
n x ( x)
∑ ∑ ∑ ∑
∑ ∑
2 2
xy x y
b =
n x ( x)
n
∑ ∑ ∑
∑ ∑
b = Deta ¥ / Deta k = 5ope
Example: b= . means that for
every one unit increase in X , .
unit will increase in Y
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5  P a g e
Y = . + .X
Y
= . + .() = . or , students
Y
= . + .() = . or , students
Y
= . + .() = . or , students
Eote: Enrollment is expected to increase by students per year.
Coeffcent of Correaton (r)
• The coefficient of correlation, r, explains the relative importance of the relationship between x
and y.
• The sign of r shows the direction of the relationship.
• The absolute value of r shows the strength of the relationship.
• The sign of r is always the same as the sign of b.
• r can take on any value between –1 and +1.
• Meanings of several values of r:
 a perfect negatve relationship (as x goes up, y goes down by one unit, and vice
versa)
+ a perfect postve relationship (as x goes up, y goes up by one unit, and vice versa)
no relationship exists between x and y
+. a weak postve relationship
. a strong negatve relationship
Lquaton:
Lxampe: karoad Þroducts CoŦ
X (sales) Y (profit) x
Xy y
. , , .
. , , .
. , , .
. , , .
. , , .
. , , .
. , , .
1,115 93Ŧ0 185,425 15,440 1,287Ŧ50
r = .
2
91(18.1) 21(66.5)
2.387
6(91) (21)
a
−
= =
−
6(66.5) 21(18.1)
0.180
105
b
−
= =
2 2
7(15, 440) 1, 115(93)
7(185, 425) (1, 115) 7(1, 287.5) (93)
r
−
=
− −
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6  P a g e
5easonazed 1me 5eres kegresson Anayss
• Select a representative historical data set.
• Develop a seasonal index for each season.
• Use the seasonal indexes to deseasonalize the data.
• Perform linear regression analysis on the deseasonalized data.
• Use the regression equation to compute the forecasts.
• Use the seasonal indexes to reapply the seasonal patterns to the forecasts.
• Seasonalized Times Series Regression Analysis
An analyst at CPC wants to develop next year’s quarterly forecasts of sales revenue for CPC’s line of
Epsilon Computers. She believes that the most recent quarters of sales (shown on the next slide) are
representative of next year’s sales.
• Representative Historical Data Set
¥ear CtrŦ ($mŦ) ¥ear CtrŦ ($mŦ)
. .
. .
. .
. .
1Ŧ Compute the 5easona Indexes
2Ŧ Deseasonaze the Data
Quarterly Sales ( = actual quarter sales / seasonality index)
¥ear
C1 C2 C3 C4
. . . .
. . . .
Eotice that results have no seasona varatons.
3Ŧ Þerform kegresson on Deseasonazed Data
X y x
xy
. .
. .
. .
. .
. .
. .
. .
. .
1ota 36 74Ŧ01 204 341Ŧ39
¥ear C1 C2 C3 C4 1ota
. . . . . (year)
. . . . . (y)
1otas 15Ŧ7 13Ŧ9 10Ŧ3 34Ŧ1 74Ŧ0
Qtr. Avg. . . . . 9Ŧ25
5easŦ IndŦ = Q.average/9Ŧ25 Ŧ849 Ŧ751 Ŧ557 1Ŧ843 .
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7  P a g e
Y = . + .X
4Ŧ Compute the Deseasonazed Iorecasts
Y
= . + .() = .
Y
= . + .() = .
Y
= . + .() = .
Y
= . + .() = .
Eote: Average sales are expected to increase by . million (about ,) per quarter.
. 5easonaze the Iorecasts: (= deseaonalized forecasts x seasonality index)
Yr. Quarter Index Deseasonalized
Forecast
5easonazed
Iorecast
. . 8Ŧ62
. . 7Ŧ77
. . 5Ŧ87
. . 19Ŧ80
Movng Average
Technique that averages a number of recent actual values, updated as new values become available. It
can be calculated using the following equation:
F
t
= MA
n
= Σ A
i
/ n
Where: Eumber of periods=n
Actual values in period
i
= A

Moving Average = MA
Index corresponds to period = 
Forecast for time period
t
= I
t
Lxampe: MA
refers to a threeperiod moving average forecast, and MA
would refer to a five period
moving average forecast.
Calculate three perod moving average for:
Period Demand
42
40
43
40
41
F
= (++) / = .
If actual demand in period turns out to be 39, so
F
= (++39) / = .
Note that: the forecast s updated by addng the newest actua vaue and droppng the odestŦ
Advantage of movng average: Easy to use and to compute.
Dsadvantage: values in the average are weighted equally. For example, in a ten period moving average
each the same weight of /, the oldest has an equal value to the most recent.
2
204(74.01) 36(341.39)
a 8.357
8(204) (36)
−
= =
−
2
8(341.39) 36(74.01)
b 0.199
8(204) (36)
−
= =
−
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8  P a g e
Weghted movng average:
More recent values in a series are given more weght in computing a forecast.
Lxampe:
The weight of most recent value = ., next most recent weight = ., next = ., and next= ..
1ota weghts aways = 1Ŧ In the last example: forecast of period will be:
F
= . () + .() + .() + .() =
If actual demand of period is 39. Forecast of period will be:
F
= .() + .() + .() + .() = .
Advantage: more reflective of the most recent occurrences.
Lxponenta 5moothng:
Weighted averaging method based on previous forecast plus a percentage (α) of the forecast error.
Eext forecast = Previous forecast + α ( Actual – Previous forescast)
Where (Actual – Previous forecast) = forecast error, α is a percentage of the error.
F
t
= F
t
+ α (A
t
– F
t
)
Where,
F
t
= Forecast for period t
F
t
= Forecast for previous period
α = Smoothing constant
A
t
= Actual demand or sales for the previous period.
Lxampe: If the previous forecast was units, actual demand was units, and α = .. The new
forecast would be:
F
t
= + . () = .
Then if the actual demand turns out to be , the next forecast would be:
F
t
= . + . (.) = .
Þerod Actua
Demand
Iorecast Lrror Iorecast Lrror
   
 . 
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
α = 0Ŧ10 α = 0Ŧ40
keaton between the smoothng constant and response to error:
• Exponential smoothing is one of the most widely used techniques in forecasting.
• The quickness of the forecast adjustment to error is determined by the smoothing constant α.
• The closer the value of α to zero, the slower the forecast will respond to error more smoothing.
• The closer the value of α to ., the greater the forecast will respond to error less smoothing.
• Smoothing means that values are less variable smooth curve
• To choose the best forecasting method Calculate forecasts and choose method with least MAD.
So, steps will be: make forecasting by various methods calculate MAD for each method
method with the least MAD is the best. (n exam queston) Eotice that
. MA
means start by calculating F
.
. If F
is not given assume that F
=A
(if F
is given, don’t use it in calculation of MAD in MA)
. In calculation of MAD to compare accuracy, use same periods.