Forecasting

Definition
• The meaning of forecasting in Oxford dictionary
is given ‘to predict’ or ‘to estimate’.
• Forecasting is the art and science of predicting
future events.
What is forecasting all about?

Demand for a product We try to predict the future by

looking back at the past

Predicted
demand
looking back
Time six months
Jan Feb Mar Apr May Jun Jul Aug

Actual demand (past sales)

Predicted demand
 Why forecasting requires?

• Consider the example of Dell.

• Dell performs assembly of P.C. components in
response to the customer orders.
• To determine the amount of components to have
on hand and to determine the capacity needed in
its plants.
• Dell requires the forecast of future demand.
 Characteristics of forecasting
• A causal relationship is needed for forecasting.
• If what happens is purely random and does not depend on
anything, you cannot predict what will happen in future.
• If a student got A grades only during his/her first two
semesters, the probability that he/she fails an exam is
smaller.

Forecasting
Previous data Future data
 Forecasting Time Horizons
Short-range forecast
Forecasting will be done up to 3 months.
Purchasing, workforce levels, job assignments
Medium-range forecast
3 months to 3 years
Sales and production planning, budgeting
Long-range forecast
3+ years
New product planning, facility location, research and
development
 Types of Forecasts

– Economic forecasts
– Predict a variety of economic indicators like inflation
rates, interest rates, etc.

Technological forecasts

– Predict new technologies required for production

process.

Demand forecasts
– Predict the future demand for a company’s products.
Type of Forecasting Methods

Qualitative Quantitative
methods methods
 Qualitative methods

• These types of forecasting methods are based on

judgments, opinions, intuition, emotions, or
personal experiences of expert.
• It is subjective in nature.
• They do not rely on any mathematical
computations.
 Quantitative methods

• These types of forecasting methods are based on

mathematical (quantitative) models.
• It is objective in nature.
• They heavily rely on mathematical computations.
 Qualitative Forecasting Methods

Jury of Executive Delphi Sales Force Market

Opinion Method Composite Survey
 Jury of Executive Opinion
• Approach in which a group of managers meet
with their own idea about the forecast.
• They discuss, revise their opinions according to
other’s opinions.
• Finally, they develop a forecast.
• Hardware accessories manufacturer uses this
method to estimates order.
 Delphi Method
• Approach in which consensus agreement is
reached among a group of experts based on
questionnaires.
• Automobile manufacturer uses this method.
 Sales Force Composite
• Approach in which each salesperson estimates
sales in his or her region.
• Then estimated sales are combined at district
level followed by state level and then nation
level.
• Ex: Insurance Company about insurance
policies, Medicare supplement policies.
 Market Survey
• Approach that uses interviews, feedback form
and surveys to judge preferences of customer
to assess demand.
• It is purely based on customer opinions.
• Apple use market survey to find out what
exactly customer wants from their device.
• They then figure out how to make those
requirements in a reality.
 Quantitative Forecasting Methods

Time-Series Models Associative Models

 Time-Series Models
• Time series models look at past patterns of data
and attempt to predict the future based upon the
underlying patterns contained within those data.
• Ex: If we are predicting the demand of Umbrella
then we have to use the past sales of umbrella to
make the forecasts.
 Associative Models
• Associative models incorporate the variables
that might influence the quantity being
forecast.
• For example, an associative model for
Umbrella sales might use factors such as
– weather,
– advertising budget, and
– competitors’ prices.
 Types of Quantitative Forecasting Methods

Quantitative
Forecasting

Time Series Associative

Models Models

Naive Simple Moving Exponential Trend

Approach Average Average Smoothing Projection

Exponential Smoothing with Linear Multiple

Trend Adjustment Regression Regression
 Naive Approach
In this method demand in next period is the
same as demand in most recent period.
e.g., In other words, if sales of a product, say
MI cell phones were 68 units in September,
Then we can forecast that October sales will
also be 68 phones.
Where:
• Ft+1 = forecast for next period, t+1
• At = Actual value for current period, t
• t = current time period
 Example: 1

• A restaurant wants to forecast the sales of

mushroom curry for the month of April.
Total sales of mushroom curry for March
were 320. If management uses the naive
method to forecast, what is their forecast of
mushroom curry for the month of April?
 Simple Average Method

• It is one of the simplest forecasting models.

• Here the forecast is made by simply taking an
average of all past actual sales data.
• Forecast for next period (t+1) will be equal to the
average of all past actual sales data.
 + +
=

Where:
• Ft+1 = forecast demand for next period, t+1
• At = Actual demand for current period, t
• t = current time period
• n = No. of past data available
 Example: 2
• New Tools Corporation is forecasting sales for its
classic product, Handy-Wrench. Handy-Wrench
sales have been steady, and the company uses a
simple average to forecast. Weekly sales over the
past five weeks are available. Use the Simple
average method to make a forecast for week 6.
 Moving Average Method
• A moving-average forecast uses a specified
number of past sales data values to generate a
forecast.
• Forecast for next period (t+1) will be equal to
the average of specified number of most recent
data.
• We consider only latest data for forecasting.
• Moving average method is useful if market
demand will stay fairly steady over time.
Where ‘n’ is number of periods involved in moving
average.
 Example: 3.1
• Actual sales data of product for a 6 months are given in
following Table. Make a forecast for the month of July
using three period moving average and five period
moving average.
Months Actual Sales
January 260
February 245
March 210
April 200
May 250
June 275
July
Example: 3.2
 Weighted Moving Average
The forecast for next period (t+1) will be equal
to the weighted average of a specified number
of the most recent observations.
Weights are based on experience and decision
of expert.
 Example: 4
• A manager at Fit Well department store wants to forecast
sales of swimsuits for August using a three-period
weighted moving average. Sales for May, June, and July
are as follows:

• The manager has decided to assign more weight to recent

data. The weights for swimsuits are applied as 3,2,1.
 Example: 5
• Shipments (in tons) of welded tube by an aluminium
producer are shown below:

a) Plot the data on graph and comment on the relationship.

b) Using 3-year moving average forecast shipments for
year 4 to year 12.
c) Using a weight of 3 for the most recent data, 2 for the
next, and 1 for the oldest, forecast shipments for year 4
to 12.
 Exponential Smoothing
Exponential smoothing is a weighted average of
the most recent actual value and forecast value.
 Exponential Smoothing
The new forecast for next period (t+1) will be
calculated as follows:

next period forecast = current period’s forecast + (current

period’s actual demand – current period’s forecast)

Ft+1 = Ft + (At – Ft)

Where:
Ft+1 = forecast for next period
Ft = forecast for current period
= weighting factor also called as smoothing
coefficient for weighting factor (0 1).
At = actual demand in the current period.
The smoothing constant, , is generally in the
range from .05 to .50 for business applications.
When reaches the extreme of 1.0, then
exponential smoothing becomes as Naive
approach.
If actual demand is fluctuating, in this situation
give more weight to recent data (then value is
high).
If actual demand is fairly stable, in this situation
give more weight to past data) then value is
low).
 Example: 6
• A firm uses simple exponential smoothing (
= 0.1) to forecast demand. The forecast for the
week 1 was 500 units, whereas actual demand
turned out to be 450 units. Forecast the demand
for the week 2.
 Example: 7
• The Hot Tamale Mexican restaurant uses
exponential smoothing to forecast monthly usage
of tabasco sauce. Its forecast for September was
200 bottles, whereas actual usage in September
was 300 bottles. If the restaurant’s managers use
an of 0.70, what is their forecast for October?
Example: 8
a) Identify forecast demand for period 1 to 13
using = 0.3 and = 0.5.
b) Plot the data on graph.
Exponential Smoothing with trend Adjustment

The exponential smoothing fails to respond to

trends.
Hence there is requirement to modify the
exponential smoothing when a trend is present.
Trend adjusted exponential smoothing forecast
consists of exponential smoothing forecast with
trend adjustment factor added to it.
Trend adjustment exponential smoothing forecast
= Exponential smoothing forecast + Trend
adjustment factor.
AFt+1 = Ft+1 + Tt+1
Where Tt+1 = (Ft+1 - Ft) + (1- ) Tt
Where Tt = current period trend adjustment
= Smoothing coefficient for trend factor (0
1).
And Ft+1 = At + (1- ) Ft
 Example: 9
• Given the following data for 9 months, compute
trend adjusted smoothing forecast for each
month. Use = 0.3 (weighting factor), = 0.6
(smoothing coefficient for the trend factor). The
forecast demand for the month of Jan is 2,100
units.
 Example: 10
• A large Portland manufacturer wants to forecast
demand for a piece of pollution-control
equipment. A review of past sales, as shown
below, indicates that an increasing trend is
present. Smoothing constants are assigned the
values of = 0.2 and = 0.4. The firm assumes
the initial forecast for month 1 was 11 units and
the trend over that period was 2 units. Identify
forecasted demand for 10th month using
exponential smoothing with trend adjustment.
 Example: 11
• HiTek Computer Services wants to develop an
adjusted exponentially smoothed forecast using
the 12 months of demand shown in the table. It
will use the exponentially smoothed forecast
with = 0.5 with a smoothing constant for trend,
of 0.30. Help HiTek Computer Services to
develop an adjusted exponentially smoothed
forecast for months 1 to 13.
 Forecast Error
• A forecasts will always deviate from the actual
demand.
• A large degree of error may indicate that the
forecasting technique is wrong, one has to change
the technique.
• Forecast error is the difference between the actual
and the predicted value of a time series data.
• Forecast error can be given by:
[

Forecast error = Actual demand - Forecast value

Where:
• et = forecast error at period t
• At = Actual demand at period t
• Ft = Forecast value at period t
 Forecast error measures

• There are three measures used in practice to

calculate the overall forecast error.
o Mean Absolute Deviation (MAD)
o Mean Squared Error (MSE)
o Mean Absolute Percent Error (MAPE)
 Mean Absolute Deviation (MAD)

• MAD is the “average of absolute deviation

between actual and forecast values”.
• This value is computed by taking the sum of the
absolute deviation of actual and forecast values
dividing by the number of periods of data (n).
 Example: 12
• During the past 8 quarters, the Port of Baltimore has
unloaded large quantities of grain from ships. The port’s
operations manager wants to test the use of exponential
smoothing to see how well the technique works in
predicting tonnage unloaded. He guesses that the forecast
of grain unloaded in the first quarter was 175 tons. The
values of to be examined is 0.10. Compare the actual
data with the data we forecast and then find the mean
absolute deviation.
Quarter Actual Tonnage Unloaded Quarter Actual Tonnage Unloaded
1 180 5 190
2 168 6 205
3 159 7 180
4 175 8 182
 Example: 13
• A company is comparing the accuracy of two
different forecasting methods. Use MAD to
compare the accuracies of these methods for
the past five weeks of sales. Which method
provides greater forecast accuracy?
Week Actual Forecast with Forecast with
Sales Method A Method B
1 25 30 30
2 18 20 16
3 26 23 25
4 28 29 30
5 30 25 25
 Mean Squared Error (MSE)

• The mean squared error (MSE) is a second way

of measuring the overall forecast error.
• MSE is the “average of the squared differences
between the actual and forecast values”.
 Example: 14
• Sales of Volkswagen’s popular Beetle have
grown steadily at auto dealerships in Nevada
during the past 5 years (see table in next slide).
The sales manager had predicted before the new
model was introduced that first-year sales would
be 410 VWs. Using exponential smoothing
constant = 0.30, develop forecasts for years 2
through 5, and identify MSE
 Example: 15

• Anandi Beach Resort is a popular resort at Goa.

Table gives the details of actual demand (in
units), which represents the number of
registrations of customers the resort receives in
past 15 days. If the forecast of demand at day one
is 700 units apply exponential smoothing
forecasting method to arrive at forecast for 15
days taking = 0.5. Measure the overall forecast
error by applying Mean Square Error.
Day Actual Demand (in units)
1 721
2 801
3 854
4 826
5 802
6 897
7 969
8 1078
9 1192
10 1064
11 1005
12 1275
13 1392
14 1458
15 1503
 Mean Absolute Percent Error (MAPE)

• A problem with both the MAD and MSE is that

their values depend on the magnitude of the item
being forecast.
• If the actual and forecast demand is multiple of
thousands, the MAD and MSE values will be
very large.
• To avoid this problem, we can use the Mean
Absolute Percent Error (MAPE) .
 Example: 16

• Table gives the data for actual demand of a

product ‘A’ and forecast ‘F’ for a product for last
12 months. Using Mean Absolute Percentage
Error (MAPE) measure forecast error?
Month Actual Demand Forecasts Month Actual Demand Forecasts
1 1578 1584 7 2001 1982
2 1689 1699 8 2053 2073
3 1795 1724 9 1856 1866
4 1522 1512 10 1685 1673
5 1643 1687 11 1715 1720
6 1894 1901 12 1811 1801
 Example: 17

• Bhavishya Life Insurance Company has its head

quarters based at Chennai. Table gives the details
of the actual number of insurance policies
subscribed by it throughout the country (in units)
in past 2 weeks (14 days). Apply exponential
smoothing to arrive at the forecasts for given 14
days by taking = 0.5 and Make graph to
compare the actual demand pattern with the
forecast and also identify MAPE. (Consider
forecast demand for day one is 120 units)
Day Actual Demand Day Actual Demand
(Units) (Units)
1 125 8 172
2 138 9 160
3 149 10 179
4 130 11 184
5 145 12 197
6 158 13 203
7 166 14 213
Comparison of Measures of Forecast Errors
 Trend Projections
• In this method a straight line is drawn through
the historical data points in a fashion that all
points should be as close as possible to the
straight line .
• For example, consider actual demand for a
product in past 7 days is as follows:
Day Actual Demand Day Actual Demand
1 125 5 145
2 130 6 158
3 149 7 166
4 130
• Plot these data on x-y-plane. By plotting you will
get many points on x-y-plane.
• Draw the straight line using these points in such a
fashion that all points should be as close as
possible to the straight line.
• Now to obtain forecast demand at any point of
time, go on straight line at that point of time,
project point on straight line to y axis.
How to draw straight line
• The equation of line is:

• Where b = slope of line

a = point of intersection at y axis
Slope: Slope of line is the measure of the
steepness of line.
 a and b can be given by following equation

or
 Example: 18
• The demand for electric power at N.Y. Edison
over the past 7 years are shown in the following
Table (in megawatts). The firm wants to forecast
next year’s demand by fitting a straight-line trend
to these data. Identify forecasted demand for 8th
year?
 Example: 19
• Aroma Drip Coffee Incorporation produces
commercial coffee machines that are sold all
over the world. The company’s production
facility has operated at near capacity for over a
year. Plant Manager, thinks that sales growth will
continue and he wants to develop long range
forecasts to help to plan facility requirements for
next 3 years. Sales records for the past 10 years
have been complied. Forecast the demand for
next 3 years using Trend Projection method.
Year Annual Sales (Thousands of Units)
1 1000
2 1300
3 1800
4 2000
5 2000
6 2000
7 2200
8 2600
9 2900
10 3200
 Associative Models
• Associative forecasting models usually consider
several variables that may affect the quantity
being predicted.
• This approach is more powerful than the time-
series methods.
• It is due to reason that it usage only the historical
values for the forecast.
• For example, the sales of Umbrella might get
affected by the factor such as
Weather,
Advertising budget, And
Competitors’ prices.
• In associative model there are two type of
variables:
1. Independent variable
2. Dependent variable
• Independent variable: There are many factors,
which may affect the forecasting of any product’s
demand.
• Dependent variable: Future demand is dependent
variable.
• The dependent variable (future sales of product) is
dependent on the independent variables.
• For Example: Selling of two-wheeler
• Future demand would be called the dependent
variable.
• The other variables like
Price of petrol,
Price of bike,
Competitors’ prices
Promotional strategies and
Salary of people
would be called independent variables .
 Types of Associative Models
• Linear Regression
• Multiple Regression
 Linear Regression

• Linear regression is linear approach to modelling

the relationship between a dependent variable and
one independent variable.

• y = dependent variable
• b = slope of regression line
• a = y-axis intercept
• x = independent variable
 Difference between trend projection and linear
regression
• Trend projection always have positive slope but
linear regression can also have a negative slope.
• In trend projection the independent variable is
always time where as in linear regression the
independent variable need not be time, can be
any variable.
 Coefficient of correlation for regression line

• Coefficient of correlation (r) is a measure of the

strength of the relationship between independent
variable and dependent variable.
• Values of correlation lies between (+1) to (-1).
 Types of correlation between independent variable
and dependent variable

• Positive correlation: In positive correlation, when

one variable increases then other variable also
increases.
• Negative correlation: In negative correlation, if one
variable increases the other variable decreases.
• No correlation: There is no any pattern between
independent variable and dependent variable.
• Positive correlation
– Perfect Positive Correlation (r =1)
– Strong Positive Correlation (r = 0.7 to 0.9)
– Moderate Positive Correlation (r = 0.4 to 0.6)
– Weak Positive Correlation (r = 0.1 to 0.3)
• Negative correlation
– Perfect Negative Correlation (r = -1)
– Strong Negative Correlation (r = -0.7 to -0.9)
– Moderate Negative Correlation (r = -0.4 to -0.6)
– Weak Negative Correlation (r = -0.1 to -0.3)
• No correlation (r = 0)
 Example: 20
• A maker of personalized golf shirts has been tracking
the relationship between sales and advertising dollars
over the past four years. The results are as follows:

• Use linear regression to find out what sales would be if

the company invested $53,000 in advertising for next
year. Also identify strength of relationship between
independent variable and dependent variable.
 Example: 21
• The general manager of a building materials
production plant feels that the demand for
plasterboard shipments may be related to the
number of construction permits issued in the county
during the previous quarter. The manager has
collected the data shown in Table.
(a) Compute values for the slope b, intercept a
coefficient of correlation r.
(b) Determine a point estimate for plasterboard
shipments when the number of construction permits
is 30.
 Multiple Regression
• Multiple regression is approach to modelling the
relationship between a dependent variable and
more than one independent variable.

• y = dependent variable
• a = y-axis intercept
• x1 and x2= two independent variables
• b1 and b2= coefficients of the two independent
variables
• Where:
• y = dependent variable
• a = y-axis intercept
• x1, x2 ... xn= n independent variables
• b1, b2 ... bn= coefficients for the n independent
variables