Lesson 2- Forecasting

Forecast – a statement about the future value of a variable of interest

* We make forecasts about such things as weather, demand, and resource availability
* Forecasts are an important element in making informed decisions
Two Important Aspects of Forecasts
a. Expected level of demand -The level of demand may be a function of some structural variation
such as trend or seasonal variation
b. Accuracy is related to the potential size of forecast error

Features Common to All Forecasts

a. Techniques assume some underlying causal system that existed in the past will persist into the
future
b. Forecasts are not perfect
c. Forecasts for groups of items are more accurate than those for individual items
d. Forecast accuracy decreases as the forecasting horizon increases

Elements of a Good Forecast

The forecast should be:
a. timely
b. accurate
c. reliable
d. expressed in meaningful units
e. in writing
f. simple to understand and use
g. cost effective

Steps in the Forecasting Process

a. Determine the purpose of the forecast
b. Establish a time horizon
c. Select a forecasting technique
d. Obtain, clean, and analyze appropriate data
e. Make the forecast
f. Monitor the forecast

Forecast Accuracy and Control

a. Forecasters want to minimize forecast errors
b. It is nearly impossible to correctly forecast real-world variable values on a regular basis
c. it is important to provide an indication of the extent to which the forecast might deviate from
the value of the variable that actually occurs
d. Forecast accuracy should be an important forecasting technique selection criterion
e. Forecast errors should be monitored
Error = Actual – Forecast
If errors fall beyond acceptable bounds, corrective action may be necessary
Forecasting Approaches
a. Qualitative Forecasting
Qualitative techniques permit the inclusion of soft information such as human factors, personal
opinions, hunches. These factors are difficult, or impossible, to quantify
b. Quantitative Forecasting
Quantitative techniques involve either the projection of historical data or the development of
associative methods that attempt to use causal variables to make a forecast. These techniques
rely on hard data

Judgmental Forecasts
Forecasts that use subjective inputs such as opinions from consumer surveys, sales staff,
managers, executives, and experts
Examples: Executive opinions, Salesforce opinions, Consumer surveys, Delphi method

Time-Series Forecasts
Forecasts that project patterns identified in recent time-series observations

Time-series - a time-ordered sequence of observations taken at regular time intervals

Assume that future values of the time-series can be estimated from past values of the time-
series

Time-Series Behaviors
Trend -A long-term upward or downward movement in data. Ex. Population shifts, Changing
income
Seasonality- Short-term, fairly regular variations related to the calendar or time of day
Ex. Restaurants, service call centers, and theaters all experience seasonal demand
Cycles- Wavelike variations lasting more than one year. These are often related to a variety of
economic, political, or even agricultural conditions
Irregular variations- Due to unusual circumstances that do not reflect typical behavior
Ex. labor strike, weather event
Random variation- Residual variation that remains after all other behaviors have been
accounted for

Time-Series Forecasting

1. Naïve Forecast
Uses a single previous value of a time series as the basis for a forecast. The forecast for a time
period is equal to the previous time period’s value. Can be used when the time series is stable,
there is a trend and there is seasonality

2. Averaging Techniques
These techniques work best when a series tends to vary about an average. Averaging techniques
smooth variations in the data. They can handle step changes or gradual changes in the level of a
series. Techniques include the moving average, weighted moving average, exponential
smoothing

a. Moving Average- technique that averages a number of the most recent actual values in
generating a forecast.
 As new data become available, the forecast is updated by adding the newest value and dropping
the oldest and then recomputing the average. The number of data points included in the
average determines the model’s sensitivity
Fewer data points used-- more responsive
More data points used-- less responsive

Formula:
n

A t i
Ft  MA t  i 1
n
where
Ft  Forecast for time period t
MA t  n period moving average
At 1  Actual value in period t  1
n  Number of periods in the moving average

b. Weighted Moving Average- The most recent values in a time series are given more weight in
computing a forecast. The choice of weights, w, is somewhat arbitrary and involves some trial and error

Formula:

Ft  w n Atn  w n1 At(n1)  ... w1 At1

where
w t  weight for period t, w t1  weight for period t 1, etc.
At  the actual value for period t, At1  the actual value for period t 1, etc.
c. Exponential Smoothing- A weighted averaging method that is based on the previous forecast plus a
percentage of the forecast error

Formula:

Ft  Ft1   (At1  Ft1)

where
Ft  Forecast for period t
Ft1  Forecast for the previous period
 = Smoothing constant
At1  Actual demand or sales from the previous period


Other Forecasting Methods

a. Focus Forecasting

Some companies use forecasts based on a “best current performance” basis and apply several
forecasting methods to the last several periods of historical data. The method with the highest
accuracy is used to make the forecast for the following period. This process is repeated each
month.

b. Diffusion Model

Historical data on which to base a forecast are not available for new products. Predictions are
based on rates of product adoption and usage spread from other established products. It takes
into account facts such as Market potential, attention from mass media and word-of-mouth.

Using Forecast Information

a. Reactive approach- views forecasts as probable future demand, reacts to meet that demand

b. Proactive approach- seeks to actively influence demand. Ex. advertising, pricing, product
modifications. It generally requires either an explanatory model or a subjective assessment of
the influence on demand.