Chapter Two

Forecasting
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Learning objectives

After completing this chapter, you will be able to:

Know the reason for Forecasting

Identify Features of Good Forecasting
Discuss Steps in Forecasting Process
Understand the types of forecasting techniques and its computation
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.

2.1. Why Forecasting?

Forecasts are vital to every business organization and for every significant management
decision.
Forecasting is the basis of corporate long-range planning.
In functional areas of finance and accounting, forecasts provide the basis for budgetary
planning and cost control.
Marketing relies on sales forecasting to plan new products, compensate sales personnel
and make other key decisions.
Production and operation personnel use forecasts to make periodic decisions involving
process selection capacity planning, and facility layout, as well as for continual decisions
about production planning, scheduling and inventory.

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 2.2. Features of Good Forecasting
Components, subassemblies or/enquired services that are part of the finished product may
not required formal forecast (i.e. not all materials required formal forecasts).
Forecast should be used for end items and services that have uncertain demand.
The purpose of forecasting activities is to make the best use of present information to
guide decisions towards the objectives of the organization in general.
Accurate projections of future activity levels can minimize short-term fluctuations in
production and help balance workloads.
This reduces hiring, firing and overtime activities and helps maintain good labor
relationship.
Good forecasts also help managers have appropriate level of materials available when
needed.
By anticipating employment and materials needs, the forecasts enable managers to make
better use of facilities and give improved service to customers.
Generally, good forecast

Improve employee relation

Improve materials management
Helps to have better use of capital and facilities and
Improves customer’s service.

2.3 Steps in the Process of Forecasting

There are five basic steps in the forecasting process.

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.

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 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:

2.4.1 Qualitative techniques

2.4.2 Quantitative techniques

2.4.1 Qualitative techniques

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
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.

Forecasts based on judgment, experience or opinions are appropriate when:

a) Forecasts must be prepared quickly in a short period of time,

b) Available data may be obsolete or up to date information might not be available
because of rapid and continuous changes in the external environment such as
economic and political conditions,
c) Historical data cannot be available like demand for a newly introduced product, and
d) The forecasting period is long range that past events will not repeat themselves in a
similar fashion.
There are four common types of qualitative forecasting techniques. They are:

1. Expert opinion method

2. Sales opinion

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 3. Consumer surveys
4. Delphi technique

1. Expert Opinion methods

One of the most simple 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

Probably poor forecast (due to lack of experience)

Domination by one or few manger
Diffusing responsibility for the forecast over the entire group may result in less
pressure to produce a good forecast.
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

It can reset in quality forecast

This pools together knowledge
Can see from different approaches

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Disadvantage

Time taking decision

Influenced by majority high stares persons
Avoidance of responsibility
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

tap information that may not be available else where

enhance the quality and accuracy of forecasts
Disadvantage

Experience and knowledge is constructing

Expensive and time consuming
4. Delphi Method

This is a qualitative method of forecasting which involves the development, distribution,

collection and analysis of series of questionnaires to get the views of expertise that are located at
different geographic areas to generate the forecast. A moderator compiles results and formulates
a new questionnaire that is again submitted to the same group of experts. The goal is to achieve a
consensus forecast.

Advantage

The tendency of process loss is avoided/minimized

No influence of the majority
Disadvantage

It takes time to reach a consensus

Coordination and interpretation difficulty

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 2.4.2 Quantitative Forecasting Techniques
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.

There are two types of quantitative forecasting techniques:

1. Time Series Analysis

2. Causal Methods
1. Time Series Analysis
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 – is a general pattern of change overtime. 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.
Example:
 Weather variations – sales of winter and summer
 Vacations or holidays – air line travel, greeting card, visitors at tourists and
resort centers.
 Theaters demand on weekends
 Daily variations: banks may over crowded 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).
D) Randomness – are sporadic effects due to chance and unusual occurrences

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Types of Time Series Analysis

A The Naive Method

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
Where Ft+1 = forecast for next period, t _ 1
At =actual value for current period, t
t =current time period

A restaurant is forecasting sales of chicken dinners for the month of April. Total sales of chicken
dinners for March were 320. If management uses the naïve method to forecast, what is their
forecast of chicken dinners for the month of April?
Solution:
Our equation is
Ft+1 = At
Adding the appropriate time period:
FApril = AMarch
FApril = 320 dinners
Therefore the forecast for March is 320
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
Simple and easy to use
Disadvantage
Only good if data change little from period to period

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B. Simple Mean or Average
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
Ft = n

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.

A t−1 + At−2 + A t−3 +.. .+ At−n

SMA = Ft = n
n
∑ A t −i
i=1
=
n
Where
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

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 Month 1 2 3 4 5 6 7 8
Actual demand 105 106 110 110 114 121 130 128

Required

a. Compute a simple 5 month moving average to forecast demand for month 9

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 forecasted demand for month 9 is 120.6.

123+128+130+ 121+ 114

b) SMA10 = F10 = 5

= 123.2
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.

B) Weighted Moving average

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:

Ft = WMA = W1At-1+W2.At-2+… +Wn.At-n

n
∑ A t−1 . W i
= i=1

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 Where
Ft =forecast in time t
WMA = weighted moving average
W = weight
A = Actual demand value

Example 1

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 our months ago. The actual demands were as follows.

Month Month 1 Month 2 Month 3 Month 4

Demand 100 90 105 95

Required:

a. Compute weighted 4-month MA for month 5

WMA = 95x0.4+105x0.3+90x0.2+100x0.10

= 97.5 units

b. Suppose the demand for month 5 actually turned out to be 100. Compute forecast for month 6.

F6 =WMA = 0.4x110+0.30x95+0.2x105+0.1x90

F6 = 102.5 units.

C) Simple Exponential Smoothing

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.

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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;

 Exponential forecasting models provide closer forecasts to actual demand.

 Formulating an exponential smoothing model is relatively easy.
 The user can easily understand the model
 It requires little computation
 It requires only three pieces of data
- The most recent forecast
- The actual demand of the previous period
- The smoothing constant, 
Example 1:

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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

First forecast the demand for may and June

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
A linear trend equation has the form

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
Example:

Monthly demand for Wonji sugar factory over the past six months for sugar is given below.

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 Month Sept. Oct. Nov. Dec. Jan. Feb.

Actual demand (in ‘000 tones) 112 125 120 133 136 140

Required:

a) Obtain the trend equation?

b) Forecast the demand for the next two months?

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

=21 91 766 2554

Now let’s compute a, and b

n . Σ ty−Σt . Σy 6 x 2774−21 x 766

2 2 2
a= n . Σt −( Σt ) = 6 x 91−(21) = 5.314

Σy−aΣt 766−5. 31 x 21
b= n = 6 = 109

a) The trend equation

Ft = Y = at + b
= 5.31t + 109
b) Forecast for the next two months (i.e. March and April)
Fmarch = F7 = 5.31(7) + 109 13
= 146,000 tones
FApril = F8 = 5.31 x 8 + 109
= 151,000 tones
2. Casual Forecasting Methods

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

 Sales volume are usually related to

promotion
Quality
price
 Real estate prices are usually related to
Property location
Square footage
 Crop yield are related to
Soil conditions
Amounts and timings of water
Fertilizer application

Types of Casual Methods of Forecasting

Regression and Correlation Methods

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.
Regression: - It is concerned about the first two issues, i.e.

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 - Bringing out the nature of relationship between any two variables.
- 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.

Correlation: - is concerned about evaluating the strength of the relationship and quantifying the
closeness of such relationship.

Simple Linear regression and correlation

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 .

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 n. Σ xy − Σx . Σy

Coefficient of correlation (r) = √[ n . Σx − ( Σx ) ] [ nΣy − ( Σy ) ]

2 2 2 2

Example:

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.

Construction permits Plaster board shipments

15 6

9 4

40 16

20 6

25 13

25 9

15 10

35 16

Required:

a) Derive a regression forecasting equation?

b) Determine plaster board demand when the number construction permit is
i. 30
ii. 35
iii. 40
c) Compute coefficient of determination (r 2) and coefficient of correlation (r), and interpret the
result.

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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

40 16 640 1600 256

20 6 120 400 36

25 13 325 625 139

25 9 225 625 81

15 10 150 225 100

35 16 560 1225 256

x=184 y=80 xy=2146 x2=5006  y2=950

n = 8 pairs of observation
n . Σ xy−Σx . Σy
2 2
b = n . Σx −(Σx )
8 x 2146 − 184 x 80
2
= 8 x 5006−(184)
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
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= 13 shipments
ii) if not of permit = 35
Y = 0.915 + 0.395 (35)
Note: Correlation coefficient, r is a number between -1 & 1.Correlation coefficient can be
positive, zero or negative.

r = 1  perfect positive relation.

r = 0 lack of any relationship between the two variables.

r =-1  perfect negative relationship.

Coefficient of correlation, r overstates the degree of relationship. Thus, we use coefficient of

determination, r2. Coefficient of determination, r2 ranges from 0 and 1, and it is a more objective
and definitive measure of the degree of relationship.

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