FORECAST

ING
Operations Management
FORECASTING
Forecasting is a technique that uses historical data as inputs to make
informed estimates that are predictive in determining the direction of future
trends.

Businesses utilize forecasting to determine how to allocate their budgets or

plan for anticipated expenses for an upcoming period of time. This is typically
based on the projected demand for the goods and services offered.
KEY TAKEAWAYS

Forecasting involves making predictions about the future.

In finance, forecasting is used by companies to estimate earnings or other

data for subsequent periods.

Traders and analysts use forecasts in valuation models, to time trades, and to
identify trends.

Forecasts are often predicated on historical data.

Because the future is uncertain, forecasts must often be revised, and actual
results can vary greatly.
HOW FORECASTING WORKS
Investors utilize forecasting to determine if events affecting a company, such as sales
expectations, will increase or decrease the price of shares in that company. Forecasting also
provides an important benchmark for firms, which need a long-term perspective of operations.

Equity analysts use forecasting to extrapolate how trends, such as gross domestic product
(GDP) or unemployment, will change in the coming quarter or year. Finally, statisticians can
utilize forecasting to analyze the potential impact of a change in business operations. For
instance, data may be collected regarding the impact of customer satisfaction by changing
business hours or the productivity of employees upon changing certain work conditions. These
analysts then come up with earnings estimates that are often aggregated into a consensus figure.
If actual earnings announcements miss the estimates, it can have a large impact on a company’s
stock price.
Forecasting addresses a problem or set of data. Economists make
assumptions regarding the situation being analyzed that must be established
before the variables of the forecasting are determined. Based on the items
determined, an appropriate data set is selected and used in the manipulation
of information. The data is analyzed, and the forecast is determined. Finally, a
verification period occurs when the forecast is compared to the actual results
to establish a more accurate model for forecasting in the future.
FORECASTING TECHNIQUES
In general, forecasting can be approached using qualitative techniques or
quantitative ones. Quantitative methods of forecasting exclude expert
opinions and utilize statistical data based on quantitative information.
Quantitative forecasting models include time series methods, discounting,
analysis of leading or lagging indicators, and econometric modeling that may
try to ascertain causal links.
QUALITATIVE TECHNIQUES
Qualitative forecasting models are useful in developing forecasts with a limited scope.
These models are highly reliant on expert opinions and are most beneficial in the short
term. Examples of qualitative forecasting models include interviews, on-site visits, market
research, polls, and surveys that may apply the Delphi method (which relies on
aggregated expert opinions).

Gathering data for qualitative analysis can sometimes be difficult or time-consuming. The
CEOs of large companies are often too busy to take a phone call from a retail investor or
show them around a facility. However, we can still sift through news reports and the text
included in companies’ filings to get a sense of managers’ records, strategies, and
philosophies.
TIME SERIES ANALYSIS
A time series analysis looks at historical data and how various variables have interacted with one
another in the past. These statistical relationships are then extrapolated into the future to generate
forecasts along with confidence intervals to understand the likelihood of the actual outcomes falling
within that scope. As with all forecasting methods, success is not guaranteed.

The Box-Jenkins Model is a technique designed to forecast data ranges based on inputs from a
specified time series. It forecasts data using three principles: autoregression, differencing, and moving
averages. Another method, known as rescaled range analysis, can be used to detect and evaluate the
amount of persistence, randomness, or mean reversion in time series data. The rescaled range can be
used to extrapolate a future value or average for the data to see if a trend is stable or likely to reverse.

Most often, time series forecasts involve trend analysis, cyclical fluctuation analysis, and issues of
seasonality.
Econometric Inference
Another quantitative approach is to look at cross-sectional data to identify links among
variables—although identifying causation is tricky and can often be spurious. This is
known as econometric analysis, which often employs regression models. Techniques
such as the use of instrumental variables, if available, can help one make stronger causal
claims.

For instance, an analyst might look at revenue and compare it to economic indicators
such as inflation and unemployment. Changes to financial or statistical data are
observed to determine the relationship between multiple variables. A sales forecast may
thus be based on several inputs such as aggregate demand, interest rates, market share,
and advertising budget (among others).
CHOOSING THE RIGHT FORECASTING METHOD
The right forecasting method will depend on the type and scope of the forecast. Qualitative methods
are more time-consuming and costly but can make very accurate forecasts given a limited scope. For
instance, they might be used to predict how well a company’s new product launch might be received
by the public.

For quicker analyses that can encompass a larger scope, quantitative methods are often more useful.
Looking at big data sets, statistical software packages today can crunch the numbers in a matter of
minutes or seconds. However, the larger the data set and the more complex the analysis, the pricier it
can be.

Thus, forecasters often make a sort of cost-benefit analysis to determine which method maximizes
the chances of an accurate forecast in the most efficient way. Furthermore, combining techniques
can be synergistic and improve the forecast’s reliability.
BUSINESS FORECASTING
Business forecasting tries to make informed guesses or predictions about the
future state of certain business metrics such as sales growth or economy-wide
predictions such as gross domestic product (GDP) growth in the next quarter.
Business forecasting relies on both quantitative and qualitative techniques to
improve accuracy. Managers use forecasting for internal purposes to make
capital allocation decisions and determine whether to make acquisitions,
expand, or divest. They also make forward-looking projections for public
dissemination such as earnings guidance.
WHAT ARE SOME LIMITATIONS OF FORECASTING
The biggest limitation of forecasting is that it involves the future, which is
fundamentally unknowable today. As a result, forecasts can only be best
guesses. While there are several methods of improving the reliability of
forecasts, the assumptions that go into the models, or the data that is
inputted into them, has to be correct. Otherwise, the result will be garbage in,
garbage out. Even if the data is good, forecasting often relies on historical
data, which is not guaranteed to be valid into the future, as things can and do
change over time. It is also impossible to correctly factor in unusual or one-off
events like a crisis or disaster.
WHAT ARE THE FORECASTING TECHNIQUES
There are several forecasting methods that can be broadly segmented as either qualitative
or quantitative. Within each category, there are several techniques at one’s disposal.

Under qualitative methods, techniques may involve interviews, on-site visits, the Delphi
method of pooling experts’ opinions, focus groups, and text analysis of financial
documents, news items, and so forth.

Under quantitative methods, techniques generally employ statistical models that look at
time series or cross-sectional data, such as econometric regression analysis or causal
inference (when available).
THE BOTTOMLINE
Forecasts help managers, analysts, and investors make informed decisions about the
future. Without good forecasts, many of us would be in the dark and resort to guesses or
speculation. By using qualitative and quantitative data analysis, forecasters can get a
better handle of what lies ahead.

Businesses use forecasts and projections to inform managerial decisions and capital
allocations. Analysts use forecasts to estimate corporate earnings for subsequent
periods. Economists may make more macro-level forecasts as well, such as predicting
GDP growth or changes to employment. However, since we cannot definitively know the
future, and since forecasts often rely on historical data, their accuracy will always come
with some room for error—and, in some cases, may end up being way off.
ELEMENTS OF A GOOD FORECAST
Not every forecasting system will work for every facility or every industry, but there’s a lot of things they all have in common. If you want to determine the
right forecasting system for your factory, here’s a few elements you’re going to want to keep in mind:

The forecast should be timely: A certain amount of time is going to be needed to respond to a new forecast. Capacity can’t be expanded overnight, and
in order to increase or reduce production to meet the forecast you’re going to need enough time to reconfigure your equipment and processes.
Accordingly, try to leave enough time in your forecasting to cover any potentially needed changes.

The forecast should be accurate: Sure, this sounds a little obvious, but any forecasting needs to be as accurate and researched as possible. This will
enable any user to plan for possible error, and will provide a good basis for comparing alternative forecasts.

The forecast should be reliable: In a similar vein to being accurate, a forecast system needs to produce the same results every time. Even an occasional
error could cause big problems for your overall forecast and projections, and could leave users with the uneasy feeling that their system isn’t as reliable
as it should be.

The forecast should be in the correct units: The forecast needs to be in a unit of measurement that is the most meaningful to whoever will be using it.
If the forecast is primarily financial, measuring it in the cost of the items as opposed to the quantity of items produced will prove more useful, while
production planners need to know how many of each unit will be produced, and so on and so forth.

The forecast should be simple to understand and use: Forecasts that are overly complicated tend not to instill a lot of confidence in users. Make sure
your forecasts are thorough enough to cover everything that needs to be forecasted, but simple enough that new users can get acclimated quickly.