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Forecasting
Learning objectives
Introduction
Every organization needs the market for selling their product or services. These sales depend on
demand. The demand for a product or service depends upon customer requirements and needs
and it can change. The organization has to plan its production according to these changes and
fluctuations of demand in the market. The estimate of demand for sales of a product or service
will be based on previous record and present trend.
1. Determine the purpose of the forecast that will provide an indication of:
a) The level of details required,
b) The amount of resources and
c) The desired level of accuracy.
2. Establish a time horizon that the forecast must cover, keeping in mind that accuracy
decreases as the length of the forecast period increases.
3. Select an appropriate forecasting technique particularly the quantitative models.
4. Gather and analyze the appropriate historical data and prepare the forecast. This requires
identifying all major assumptions that are made in conjunction with preparing and using
the forecast.
5. Monitor the forecast to check its validity. If it is unsatisfactory, reexamine the methods or
techniques, assumptions, validity of data, and make necessary adjustments to prepare a
revised forecast.
2.4 Types of Forecasting
There are two types of forecasting technique. These are:
Qualitative forecasting technique is a technique that is used when there is no historical data
available about past performance. These forecasting techniques are subjective and judgmental in
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nature and most of the time they are based on opinion and expertise judgment. Qualitative
forecasting techniques rely on analysis of subjective inputs obtained from customers, sales
Person, managers and experts.
One of the simplest and widely used method of forecasting which consists of collecting opinions
and judgments of individuals who are expected to have the best knowledge of current activities
or future plans. This technique has its own advantages and disadvantage.
Advantage
Decision is fast
Responsibility and accountability is clear
Brings together the considerable knowledge, experience, skill and talent of
various managers
Managers (experts) will acquire experience that is obtained in the discussion.
Disadvantage
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2. Sales force Opinions
In this method, the sales representatives are required to estimate the demand for each product and
the forecast of each sales representative is consolidated to prepare the overall forecast for the
company.
This forecasting technique has also its own advantages and disadvantages
Advantages
Disadvantage
3. Consumer Surveys
This forecasting technique is based on the data which is collected from the consumers. Because it
is the consumers who ultimately determine demand, it seems important to solicit information
from them.
Advantage
Disadvantage
4. Delphi Method
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Advantage
Disadvantage
Qualitative techniques consist of mainly analyzing objective or hard data. This usually avoids
personnel biases that sometimes contaminate qualitative methods. It is based on actual historical
statistical data using mathematical and statistical methods to forecast demand. Thus, it is
objective and is also called statistical forecasting.
2. Causal Methods
A time series is a set of some variable (demand) overtime (e.g. hourly, daily, weekly, quarterly
annually). Time series analyses are based on time and do not take specific account of outside or
related factors.
Time series analysis is a time-ordered series of values of some variables. The variables value in
any specific time period is a function of four factors:
a) Trend c) Cycles
b) Seasonality d) Randomness
A) Trend – It is the movement in a time series that generally continues in the same direction
(upward, downward, or remain the same overtime) over a long period of time. It refers to
only smooth, regular, long-term movement of the data and has nothing to do with sudden and
erratic movements either in upward and downward direction. It represents a long time secular
movement, characteristic of many economic series.
B) Seasonality- refers to any regular pattern recurring with in a time period of no more than
one year. These effects are often related to seasons of the year or tend to repeat themselves
each year. The cause being, climate (natural cause) and customs, habits and conventions
(man-made causes).
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Example:
Weather variations – sales of winter and summer
Vacations or holidays – airline travel, greeting card, visitors at tourists and
resort centers.
Theaters demand on weekends
Daily variations: banks may overcrowd during the afternoon.
C) Cycle – are long-term swings about the trend line and are usually associated with a business
cycle (phases of growth and decline in a business cycle). Example: In a recession,
employment, production
D) Randomness – are sporadic effects due to chance and unusual occurrences. Time series is
subjected to occasional influences, which may occur just once, or several times, but without
any pattern and regularity. These variations are called irregular or random or erratic
variations or fluctuations. Examples: High sales of televisions due to world cup soccer, wars,
earthquakes, floods, fires, strikes, lockouts, etc
The naive method is one of the simplest forecasting models. It assumes that the next period’s
forecast is equal to the current period’s actual. For example, if your sales were 500 units in
January, the naïve method would forecast 500 units for February. It is assumed that there is little
change from period to period. Mathematically, we could put this in the following form:
Ft+1 = At
Solution:
Our equation is
Ft+1 = At
Adding the appropriate time period:
FApril = AMarch
FApril = 320 dinners
Therefore, the forecast for March is 320
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The naive method can be modified to take trend into account. If we see that our trend is
increasing by 10 percent and the current period’s sales are 100 units, a naive method with trend
would give us current period’s sales plus 10 percent, which is a forecast of 110 units for the next
period. The naïve method can also be used for seasonal data. For example, suppose that we have
monthly seasonality and know that sales for last January were 230 units. Using the naive method,
we would forecast sales of 230 units for next January.
Advantage
Disadvantage
One of the simplest averaging models is the simple mean or average. Here the forecast is made
by simply taking an average of all data:
A t−1 + At−2 + A t−3 +.. .+ At−n
t = n
F
Where Ft+1 _ Forecast of Demand for Next Period, T _ 1
At = Actual Value for Current Period, T
N = Number of Periods or Data Points to Be Averaged
A. Simple Moving average
A simple moving average is obtained by summing and averaging values from a given number of
periods repetitively, each time deleting the oldest value and adding the new value.
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A t−1 + At−2 + A t−3 +.. .+ At−n
SMA = Ft = n
n
∑ A t −i
i=1
=
Where n
SMA – simple moving average
Ft - Forecast for period t
At-i - Actual demand in period t-i
n - Number of periods (data points) in the moving average
Simple moving average is preferable if the demand for a product is neither growing nor
declining rapidly and also does not have any seasonal characteristics.
Example 1:
A food processor uses a moving average to forecast next month’s demand. Past actual demand
(in units) is shown in the following table
Month 1 2 3 4 5 6 7 8
Actual demand 105 106 110 110 114 121 130 128
Required
b. Find a simple 5 month moving average to forecast the demand for month 10 if the actual
demand for month 9 is 123.
Solution
128+130+121+114 +110
a) SMA9 = F9 = 5
= 120.6
Therefore, the 5-month moving average forecasted demand for month 10 is 123.2.
Note: In moving average, as each new actual value becomes available, the forecast is updated by
adding the newest value and dropping the oldest value and computing the average. Consequently
the ‘forecast’ moves by reflecting only the most recent values.
In weighted moving average, the weight is given in such a way that more weight is given to the
most recent value in the time series. Weights can be percentages or any real numbers. In
weighted moving average, forecasts are calculated by:
A department store may find that in a four-month period the best forecast is derived by using
40% of the actual demand for the most recent month, 30% two months ago, 20% of three months
ago and 10% of four months ago. The actual demands were as follows.
Required:
WMA = 95x0.4+105x0.3+90x0.2+100x0.10
= 97.5 units
b. Suppose the demand for month 5 actually turned out to be 110. Compute forecast for month 6.
F6 =WMA = 0.4x110+0.30x95+0.2x105+0.1x90
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F6 = 102.5 units.
The other type of time series forecasting method is simple exponential smoothing which weights
past data in an exponential manner so that most recent data carry more weight in the moving
average.
With simple exponential smoothing, the forecast is made up of the last period forecast plus a
portion of the difference between the last period actual demand and the last period actual demand
and the last period forecast.
Mathematically
Ft = F t-1 + (A t-1 - F t-1)
Where
Ft = Forecast for period t
Ft-1 = Forecast for the previous period
= Smoothing constant (0< <1)
A t-1 = Actual demand for the previous period
The difference between the actual demand and the previous forecast (i.e. A t-1 – Ft-1) represents
the forecast error. As we observe from the equation, each forecast is simply the previous forecast
plus some correction for demand in the last period. Thus,
If actual demand was above the last period forecast, the correction will be positive, and
If the actual demand was below the last period forecast, the correction will be negative.
The smoothing constant, actually dictates how much corrections will be made. It is a number
between 0 and 1, and it is used to compute the forecast.
Exponential smoothing is the most widely used of all forecasting techniques, because;
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- The actual demand of the previous period
Example 1:
The production supervisor at a fiber board plant uses a simple exponential smoothing technique
( = 0.2) to forecast demand. In April, the forecast was for 20 shipments, and the actual demand
was for 20 shipments. The actual in May and June was 25 and 26 shipments. Forecast the value
for July.
Solution
Fmay = FApril + (A April –F April) FJune = FMay + (AMay –FMay) FJuly = FJune + (AJune –FJune)
= 20+0.2(20-20) = 20+0.2(25-20) = 21+0.2(26-21)
= 20 = 21 = 22
Therefore, `the forecast for July is 22 shipments.
D) Trend equation
This method is a version of the linear regression technique. It attempts to draw a straight line
through the historical data points in a fashion that comes as close to the points as possible.
(Technically, the approach attempts to reduce the vertical deviations of the points from the trend
line and does this by minimizing the squared values of the deviations of the points from the line).
Ft = at + b
Where: Ft = forecast for period t
a = scope of the line
b = value of Ft, at t = 0
t = specified number of time periods from t = 0
The coefficients of the line, a and b can be computed from historical data using these two
equations.
n . ∑ ty−Σt . Σy
2 2
a = n. Σt −( Σt )
Σy−aΣt
b= n
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Example:
Monthly demand for Wonji sugar factory over the past six months for sugar is given below.
Required:
a) Obtain the trend equation?
b) Forecast the demand for the next two months?
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Solution
First let’s find the values of the coefficients a and b.
n . Σ ty−Σt . Σy Σy−aΣt
2 2
a= n . Σt −( Σt ) , b= n
T t2 y ty
1 1 112 112
2 4 125 250
3 9 120 360
4 16 133 532
5 25 136 680
6 36 140 840
Σy−aΣt 766−5. 31 x 21
b= n = 6 = 109
Casual forecasting techniques rely on identification of related variables that can be used to
predict values of the variable of interest (demand). Casual methods are used when historical data
are available and there is relationship between the factors to be forecasted.
Example
Regression and correlation techniques are means of describing the association between two or
more variables. More specifically, regression and correlation methods are related to the
following issues
I. Bringing out the nature of relationship between any two variables, say X and Y
II. Measuring the rate of change in one (the dependent) variable associated with a
given change in the other (independent) variable.
III. Evaluating the strength of the relationship and quantifying the closeness of such
relationship.
- Measuring the rate of change in one (the dependent) variable associated with a given
change in the other (independent) variable.
Regression means ‘dependence’ and involves estimating the value of a dependent variable, Y,
from an independent variable X.
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Correlation: - is concerned about evaluating the strength of the relationship and quantifying the
closeness of such relationship.
In simple linear regression, only one independent variable is used and the model takes the form
Y = a + bx
Where
Y = predicted (dependent) variable, demand
a = value of Y at X = 0
b = slope of the line
Note:
1. It is convenient to represent the values of the predicted variable on the Y-axis and values
of the predictor variable on the X-axis.
2. The coefficients a and b of the line are obtained by using the formula
n . Σ xy−Σx . Σy
2 2
b = n . Σx −(Σx )
Σy−bΣx
, or y − b x
a= n
n = Number of Period Observations
3. The correlation coefficient r, can be obtained by using the following formula and
coefficient of determination is r 2 .
n. Σ xy− Σx . Σy
√[ n . Σx − ( Σx ) ] [ nΣy − ( Σy ) ]
2 2 2 2
Example:
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The general manager of a building materials production plant feels the demand for plaster board
shipments may be related to the number of constructions permits issued in the country during the
previous quarter. The manager has collected the data shown in the accompanying table.
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Solution
a) To derive the regression forecasting equation, first let’s find the values of the
Coefficients a and b
X Y XY X2 Y2
15 6 90 225 36
9 4 36 81 16
20 6 120 400 36
25 9 225 625 81
n = 8 pairs of observation
n . Σ xy−Σx . Σy
2 2
b = n . Σx −(Σx )
8 x 2146 − 184 x 80
= 8 x 5006−(184)2
2448
=0 . 39
= 6192
Σy− bΣx 80 − 0 . 39(184 )
a= n = 8 = 0.915
Thus, the regression equation is;
Y = a + bx
Y = 0.915 + 0.395x
B) plaster board demand,
i) if no of permit = 30
Y = 0.915 + 0.395 (30) = 12.76
= 13 shipments
ii) if not of permit = 35
Y = 0.915 + 0.395 (35)
= 14.74
= 15 shipments
iii) if not of permit = 40
Y = 0.915 + 0.395 (40)
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= 16.75
= 17 shipments
C) Coefficient of correlation and determination
n. Σ xy− Σx . Σy
2 2 2
Note: Correlation coefficient, r is a number between -1 & 1.Correlation coefficient can be
positive, zero or negative.
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