School of Accountancy, Business and Hospitality

Business Administration Department

Curriculum 2018-2019

COURSE LEARNING MODULE

OMGT 1013 (Operations Management and Total Quality Management)
AY 2022-2023

Lesson 7: Forecasting

Topic: Elements of good forecasts

Steps in the forecasting process
Approaches to forecasting
Qualitative forecasts

Learning Outcomes: After reading this module, you are expected to:

1. Relate the importance/significance of forecasting in business;

2. Make a forecast using quantitative forecasting methods.

LEARNING CONTENT

Introduction:

STORY

Henredon produces low volumes of intricate, handcrafted, household furniture that is sold in 600 retail
outlets. Because the demand for high-quality furniture is low, holding it in inventory is very expensive for
retailers. Nonetheless, before the recession of the 19803, Henredon’s retailers carried large inventories to
attract customers who demanded both high quality and timely service. The recession, however, changed the
way retailers dealt with Henredon. They cut inventories to remain price competitive while pressuring Henredon
to maintain quality levels and reduce delivery lead times to less than two months.

The average time required to manufacture and ship an order was 11 weeks before the recession. To
meet the demand for faster delivery, Henredon needed to reduce the amount of time required to manufacture
and ship orders. Accurate forecasts of demand were essential for meeting this competitive priority. The
forecasting system in use before the recession based production and inventory schedules on the average of
the last four months’ demand for a product. This approach wasn’t effective because more than 10 percent of
Henredon’s products were new each year and had no prior order history.

The new forecasting system treats new products differently from mature products. Forecasts for new
products are based on a curve created from orders from semi-annual furniture shows and Henredon’s past
experiences with similar products. The curve is used for the first 12 months of a product’s life, after which
traditional statistical forecasting techniques are used. Middle managers, as well as top management, provide
inputs to the forecasts. More accurate forecasts provided by the system have helped cut the amount of time
needed to manufacture and ship ' orders to about five weeks. This improvement increased customer service
and reduced inventories. Henredon’s orders during the recession increased 3 percent over the pre-
recessionary period even though, industry wide, sales declined.
OMGT 1013-Operations Management and TQM | 1
Lesson Proper:

Henredon’s success demonstrates the value of forecasting. A forecast is a prediction of future events
used for planning purposes. At Henredon, management needed accurate forecasts of retailer demand to
reduce lead times and inventory levels. Changing business conditions resulting from global competition, rapid
technological change, and increasing environmental concerns exert pressure on a firm’s capability to generate
accurate forecasts. Forecasts are needed to aid in determining what resources are needed, scheduling
existing resources, and acquiring additional resources. Accurate forecasts allow schedulers to use machine
capacity efficiently, reduce production times, and cut inventories. The manager of a fast-food restaurant needs
to forecast the number of customers at various times of the day, along with the products they will want, in order
to schedule the correct number of cooks and counter clerks. Managers may need forecasts to anticipate
changes in prices or costs or to prepare for new laws or regulations, competitors, resource shortages, or
technologies.

Forecasting methods may be based on mathematical models using historical data available, qualitative
methods drawing on managerial experience, or a combination of both. In this module we explore several
forecasting methods commonly used today and their advantages and limitations. We also identify the decisions
that managers should make in designing a forecasting system.

DEMAND CHARACTERISTICS

At the root of most business decisions is the challenge of forecasting customer demand. It is a difficult
task because the demand for goods and services can vary greatly. For example, demand for lawn fertilizer
predictably increases in the spring and summer months; however, the particular weekends when demand is
heaviest may depend on uncontrollable factors such as the weather. Sometimes patterns are more predictable.
Thus, weekly demand for haircuts at a local barbershop may be quite stable from week to week, with daily
demand being heaviest on Saturday mornings and lightest on Mondays and Tuesdays. Forecasting demand in
such situations requires uncovering the underlying patterns from available information. In this section, we first
discuss the basic patterns of demand and then address the factors that affect demand in a particular situation.

Patterns of Demand

The repeated observations of demand for a product or service in their order of occurrence form a
pattern known as time series. The five basic patterns of most demand time series are

1. horizontal, or the fluctuation of data around a constant mean;

2. trend, or systematic increase or decrease in the mean of the series over time;

3. seasonal, or a repeatable pattern of increases or decreases in demand, depending on the time of day, week,
month, or season;

4. cyclical, or less predictable gradual increases or decreases in demand over longer periods of time (years or
decades); and

5. random, or unforecastable, variation in demand.

Cyclical patterns arise from two influences. The first is the business cycle, which includes factors that
cause the economy to go from recession to expansion over a number of years. The other influence is the
product or service life cycle, which reflects the stages of demand from development through decline. Business
cycle movement is difficult to predict because it is affected by national or international events, such as

OMGT 1013-Operations Management and TQM | 2

presidential elections or political turmoil in other countries. Predicting the rate of demand build-up or decline in
the life cycle also is difficult. Sometimes firms estimate demand for a new product by starting with the demand
history for the product it is replacing. For example, the demand rate for digital audiotapes might emulate the
demand build-up for stereo cassette tapes in the early stages of that product’s life cycle. The ability to make
intelligent long-range forecasts depends on accurate estimates of cyclical patterns.

Four of the patterns of demand-horizontal, trend, seasonal, and cyclical- combine in varying degrees to define
the underlying time pattern of demand for a product or service. The fifth pattern, random variation, results from
chance causes and thus cannot be predicted. Random variation is an aspect of demand that makes every
forecast wrong.

Factors Affecting Demand

What factors cause changes in the demand for a particular product or service over time? Generally,
such factors can be divided into two main categories: external and internal.

External Factors. External factors that affect demand for a firm’s products or services are beyond
management’s control. A booming economy may positively influence demand, although the effect may not be
the same for all products and services. Furthermore, certain economic activities, such as changes in
government regulations, affect some products and services but not others. For example, a state law limiting the
sulfur content of coal used in steam-powered electric generating plants reduces the demand for high-sulfur
coal but doesn’t affect the demand for electricity.

Certain government agencies and private firms compile statistics on general economic time series to help
organizations predict the direction of change in demand for their products or services. Of prime importance is
the turning point-that is, the period when the long-term rate of growth in demand for a firm’s products or
services will change. Although predicting the exact timing of turning points is impossible, some general
economic time series have turning points that can be useful in estimating the timing of the turning points in a
firm’s demands.

Leading indicators, such as the rate of business failures, are external factors with turning points that typically
precede the peaks and troughs of the general business cycle. For example, an upswing in residential building
contracts might precede an increase in the demand for plywood by several weeks, for homeowners’ insurance
by several months, and for furniture by one year. This indicator gives some advance warning to plywood
manufacturers, insurance companies, and furniture manufacturers about possible demand increases.
Coincident indicators, such as unemployment figures, are time series with turning points that generally match
those of the general business cycle. Lagging indicators, such as retail sales, follow those turning points,
typically by several weeks or months. Knowing that a series is a lagging indicator can be useful. For example,
a firm needing a business loan for expansion should realize that interest rates will drop to a low point several
weeks after the business cycle reaches its trough.

Let’s look briefly at other external factors that affect demand. Consumer tastes can change quickly, as they
often do in clothing fashions. The consumer’s image of a product can be another big factor in changing
demand. For example, in the last decade sales of tobacco products in the United States have dropped
significantly because many people believe that those products can be hazardous to their health. In addition,
competitors’ actions regarding, advertising promotions, and new products also affect sales. For example, a
United Parcel Service commercial showing the speedy delivery of a parcel reduces the demand for the
services of competitors, such as FedEx or DHL. Finally, the success of one product or service affects the
demand for complementary products or services. The Milwaukee plant of Harley Davidson stimulates the sales

OMGT 1013-Operations Management and TQM | 3

of many motorcycle parts and components locally. Future demand for parts and components there depends on
Harley-Davidson’s success in that area.

Internal Factors. Internal decisions about product or service design, price and advertising promotions,
packaging design, salesperson quotas or incentives, and expansion or contraction of geographic market target
areas all contribute to changes in demand volume. The term demand management describes the process of
influencing the timing and, volume of demand or adapting to the undesirable effects of unchangeable demand
patterns. For example, automobile manufacturers use rebates to boost car sales.

Management must carefully consider the timing of demand, an extremely important factor in efficiently utilizing
resources and production capacity. Trying to produce for peak customer demand during the peak demand
period can be very costly. To avoid this situation, firms often use price incentives or advertising promotions to
encourage customers to make purchases before or after traditional times of peak demand. For example,
telephone companies encourage customers to make long distance calls after normal business hours by
offering lower evening and weekend rates. This practice helps spread demand more evenly over the day.
Another tactic is to produce two products that have different heavy seasonal demand periods. A producer of
engines for tractor lawn mowers, for instance, might also make engines for snowmobiles to even out resource
and production requirements over the year. In this way costly changes in work-force level and inventory can be
minimized.

Finally, some companies schedule delivery dates for products or services according to the current workload
and capacity. Doctors, dentists, and other professionals use this approach by asking patients to make
appointments for their services. Manufacturers of custom-built products also work to backlogs of demand.

Designing the Forecasting System

3 Decisions involved:

1. What to forecast?
2. What type of forecast technique to use?
3. What type of computer hardware or software to use?

1. Deciding What to Forecast

 Level of Aggregation
Aggregation- clustering several similar products or services

 Units of Measurement
 Most useful forecasts for planning and analyzing operations problems are those based on
product or service units.
 If forecasting the number of units of demand for a product or service isn’t possible, forecast the
standard labor or machine hours required for each critical resources.

2. Choosing the Forecasting Technique

2 General Types:

1. Qualitative Methods- include judgment methods which translate the opinions of managers, expert
opinions, consumer surveys and sales force estimates into quantitative
estimates
2. Quantitative Methods- includes causal methods and time series analysis

OMGT 1013-Operations Management and TQM | 4

 a. Causal Methods- use historical data on independent variables such as promotional
campaigns, economic conditions, and competitors’ actions to predict demand
b. Time Series Analysis- a statistical approach that relies heavily on historical data
-used to project future size of demand and recognizes trends and
seasonal patterns
- this will be the focus of the topic for this week

Time Horizon- a key factor in choosing the proper forecasting approach

a. Short-term (0-3 months)- managers typically are interested in forecasts of demand for individual
products
- There is a little time to correct errors in demand forecast, so forecasts should
be as accurate as possible
- Time Series Analysis is the method used often

b. Medium-term (3 months- 2 years)- managers typically forecast total sales demand in dollars or in the
number of units of the group of similar products or services
- Causal methods are commonly used

c. Long-term (2 years and above)- for time horizons exceeding two years, forecasts usually are developed
for total sales demand in dollars or some other common unit of measurement
- Three types of decisions- facility location, capacity planning and process
choice- require market demand estimates for an extended period into the
future
-Causal and judgment methods are the primary techniques used

3.Forecasting with Computers

Categories of Software Forecasting Technique will Parameters will be specified

Packages be chosen by: by:
Manual User User
Semi-automatic User Software
Automatic Software Software

METHODS OF FORECASTING

A. JUDGMENT METHODS

Sales Force Estimates-forecasts compiled from estimates of future demands made periodically by members of
a company’s sales force

Advantage
The sales force is the group most likely to
know which products or services customers
will be buying in the near future, and in what
quantities.
Sales territories often are divided by district
or region. Information broken down in this
manner can be useful for inventory
management, distribution, and sales force
staffing purposes.
Disadvantage
Individual biases of the salesperson may taint
the forecast.
Salesperson may not always be able to
detect the difference between what a
customer “wants” and “needs”.
OMGT 1013-Operations Management and TQM | 5
 The forecast of individual sales force If the firm uses individual sales as a
members can be combined easily to get performance measure, salesperson may
regional or national sales. underestimate their forecasts.

Executive Opinion- a forecasting method in which the opinions, experience and technical knowledge of one or
more managers are summarized to arrive at a single forecasts.

Advantage
Can be used to modify existing sales forecast
to account for unusual circumstances.
Can be used for technological forecasting.
Disadvantage
It can be costly because it takes valuable
executive time.
Although that may be warranted under
circumstances, it sometimes gets out of
control.
If executives are allowed to modify a forecast
without collectively agreeing to the changes,
the resulting will not be useful.

Market Research- a systematic approach to determine consumer interest in a product or service by creating
and testing hypotheses through data-gathering surveys.

Advantage
May be used to forecasts demand for the
short, medium and long term.
Yields important information.
Disadvantage
Numerous classifications and hedges
typically included in the findings.
The survey results may not reflect the
opinions of the market.
The survey might produce imitative, rather
than innovative ideas because the customer’s
reference point is often limited.

Delphi Method- a process of gaining consensus from a group of experts while maintaining their anonymity.

Advantage
Useful when there are no historical data from
which to develop statistical models.
Can be used to develop long-range forecasts
of product demand and new product sales
projections.
Can also be used for technological
forecasting.
The results can provide direction for a firm’s
research and development staff.
Disadvantage
The process can take a long time.
Responses may be less meaningful than if
experts were accountable for their responses.
There is little evidence that Delphi forecasts
achieve high degrees of accuracy.
Poorly designed questionnaires will result in
ambiguous or false conclusions.

Guidelines for Using Judgment Forecasts

 Adjust quantitative forecasts when their track record is poor and the decision maker has important
contextual knowledge.

 Make adjustments to quantitative forecasts to compensate for specific events.

OMGT 1013-Operations Management and TQM | 6

B. TIME SERIES METHODS

1. Naive Forecast – This approach uses two(2) patterns which include the following:

First: the forecast for the next period equals the demand for the current period. So if the actual demand
for Wednesday is 35 customers, the forecasted demand for Thursday is 35 customers.

Second: the increase or decrease in demand observed between the last two periods is used to adjust
the current demand to arrive at a forecast. Suppose that last week the demand was 120 units and the
week before it was 108 units. Demand was increased to 12 units in one week, so the forecast for next
week would be 132 units.

2. Simple moving average- used to estimate the average of a demand time series and thereby remove
the effects of random fluctuation.

Specifically, the forecast for period t+1, can be calculated as:

Ft+1= sum of the last n demands/ n= Dt+Dt-1+Dt-2..../ n

Where Dt= actual demand in period t
n= total number of periods in the average
Ft+1= forecast for period t+1

Example:

a. Compute a three-week moving average forecast for the arrival of medical clinic patients in week 4.
The number of arrivals for the past three weeks was
Week patient arrivals
1 400
2 380
3 411

b. If the actual number of patient arrivals in week 4 is 415, what is the forecast for week 5?

Solution

a. The moving average forecast at the end of week three is

F4= (411+380+400)/3= 397.8

Thus the forecast for week 4 is 398 patients
Note: Always follow the rule in “rounding off”.

b. The forecast for week 5 requires actual arrivals from week 2-4, the three most recent weeks of data.

F5= (415+411+380)/3= 402

The forecast for week 5 is 402 patients.
OMGT 1013-Operations Management and TQM | 7
 3. Weighted moving average- each historical demand in the average can have its own weight. The sum
of the weights equals 1.
Example:
The analyst for medical clinic has assigned weights of 0.70 to most recent demand, 0.20 to the demand 1
week ago, and 0.10 to demand 2 weeks ago.

Solution:
The average demand for week 3 is

F4= 0.70(411)+ 0.20(380)+ 0.10(400)= 403.7 or 404 patients.

Suppose actual demand for week 4 is 415 patients. The forecast for week 5 would be

F5= 0.70(415)+0.20(411)+0.10(380)=410.7 or 411

4. Exponential smoothing- a sophisticated weighted moving average method that calculates the
average of time series by giving recent demands more weight than earlier demands.

Ft+1= a(demand this period)+(1-alpha)(initial forecast)

= aDt + (1-a) initial F

Example:

Again consider the patient arrival data in previous example. It is now end of week 3. Using alpha= 0.10,
calculate the exponential smoothing forecast for week 4.

Solution:

The exponential smoothing method requires an initial forecast. Suppose we take demand data for past
two weeks and average them, (400+380)/2=390 as an initial forecast. To obtain forecast for week 4, we
calculate the average at end of week three as

F4= 0.10(411)+0.90(390)=392.1 patients

Forecast for week 4 would be 392 patients. If the actual demand for week 4 proved to be 415, the
forecast for week 5 would be

F5= 0.10(415)+ 0.90(392)=394.4 or 394 patients

*** END of LESSON***

REFERENCES

OMGT 1013-Operations Management and TQM | 8

Textbooks

Chase, Richard,et.al. Production and Operations management: Manufacturing and Services 8th ed.
Irwin/McGrwa-Hill. Boston

Stevenson, William J. (2018). Operations management thirteenth edition. McGraw Hill Education, 2 Penn
Plaza, New York, NY 10121.

OMGT 1013-Operations Management and TQM | 9