Forecasting: Its importance and limitations

Types of the forecast

There are two types of forecasting: (1) point forecast, and (2)
prediction interval forecast.
Point Forecast: A point forecast is a single number that
represents our best prediction of the actual value of the variable
being forecasted.

Prediction Interval Forecast: A prediction interval forecast

is an interval or range of numbers that is calculated so that
we are very confident that the actual value will be
contained in the interval.

Forecasting Methods
There are many forecasting methods that can be used to predict
future events. These methods can be divided into two basic
types: Qualitative methods and Quantitative methods.

Qualitative Forecasting Methods

Qualitative forecasting techniques are used when historical data
are limited or not available at all. These methods are usually
based on the opinions of experts to predict future events
subjectively. These methods are required when new product is
being introduced. To forecast sales for the new product, a
company must rely on expert opinion, which can be supplied by
members of its sales force and market research team. There are
some commonly used qualitative forecasting techniques. They
are also called Judgmental forecasting methods:
1)Subjective curve fitting: In predicting sales of the new
product, it is convenient to consider “product life cycle.”
This life cycle consist of three stages: a) growth (requires
S-curve), b) maturity, and c) decline. The subjective
construction of such curve is difficult and requires a great
deal of expertise and judgment.
2)Delphi method: The Delphi method assumes that the panel
members are recognized experts in the field of interest, and
assumes combined knowledge of panel members may
produce predictions. Each participant is asked to respond a
questionnaire and return it to panel coordinator.
3)Time-independent Technological comparison: In this
method, which is often used in predicting technological
change, changes in one area are predicted by monitoring
changes that take place in another area. The forecaster tries
to determine a pattern of change in one area, often called
primary trend, which he believes will result in new
developments in some other area.
Quantitative Forecasting Method
Quantitative forecasting methods are used when historical data
are available. Quantitative methods can be grouped in two
kinds: Univariate models and Casual models.
Univariate models: These models predict future values of the
variable of interest solely on the basis of the historical pattern
(time series) of that variable, assuming that the historical pattern
will continue. Univariate models are most useful when
conditions are expected to remain the same; they are not very
useful in forecasting the impact of changes in management
policies, e.g. increase in price or advertising expenditures.
Univariate models include – Time series regression, classical
decomposition, exponential smoothing, and the Box-Jenkins
methodology.
Casual models: These models predict future values of the
variable of interest based on relationship between that variable
to be forecasted and the other variables. That is, the relationship
between dependent variable to be forecasted and the other
independent variables. The use of casual models involves the
identification of other variables that are related to the variable to
be predicted.
In business world, casual models are advantageous because they
allow management to evaluate the impact of various alternative
policies. For example, management might wish to predict how
various price structures and levels of advertising expenditures
will affect sales. On the other hand, casual models are difficult
to develop. Moreover, the ability to predict the dependent
variable depends on the ability of the forecaster to accurately
predict future values independent variables.
Choosing a Forecasting Technique
Forecasts are generated for points in time that may be a number
of days, weeks, months, quarters, or years in the future. The
forecaster must consider the following factors when choosing the
forecasting technique:
1. The time frame, i.e. immediate, short term, medium, or long
term
2. The pattern of data, i.e. the four components of time series
(T, C, S, I)
3. The cost of forecasting, i.e. cost of developing the model
must be considered
4. The accuracy desired, i.e. some situation forecast limit as
much as 20% error as acceptable and in some situations
forecast error cannot be more than 1%.
5. The availability of data, i.e. the quantity of available data
6. The ease of operation and understanding, i.e. if the
manager does not have confidence in the technique used
in predictions, then the predicted values will not be used
in the decision making process.