CHAPTER TWO

FORECASTING

2.1 Meaning of Forecasting

Forecasts are estimates of the occurrence, timing or magnitude of future event.
Forecasts are statements about future specifying the volume of sale to be
achieved or material demand required and equipments, and other inputs
needed to meet sale. They give operation managers a rational basis for
budgeting, capacity planning, sales, production and inventory, Personnel and
material management.

Forecasting is the basis of planning ahead even though the actual demand is
quite uncertain thus, it involves estimation of the future, and of particular
interest here is the expected demand of company’s product. Therefore, forecast
of future demand is the link between company’s internal expectations with
outside environment that permits planning function to commence activities. A
popular definition of forecasting is that it is estimating the future demand
product, service and the resources necessary to produce an output.
2.2 Characteristics of forecasts
The following are the characteristics of forecasts:-
1. Forecasting techniques generally assumes that the same underling
causal system that assisted in the past will continue to exist in the
future.
2. Forecasts are rarely perfect; actual results usually differ from predicted
values.
3. Forecasts for a group of items tends to be more accurate than forecasts
for individual item, because forecasting errors among items in a group
usually are smaller than that of individual items.
4. Forecast accuracy decreases as the time period covered by the forecast-
time horizon increases.

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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.
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 Uses of Forecast
Components, subassemblies or/enquired services that are part of the finished
product may not require formal forecast (i.e. not all materials requires 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

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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.
2.5 Types of Forecasting
There are two types of forecasting technique. These are:
1. Qualitative forecasting techniques
2. Quantitative forecasting techniques
1. Qualitative Approaches
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. These
are:

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 1. Expert opinion method
2. Sales person’s opinion
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 manager
- 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 form 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 constraining
- 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 (somebody in charge of the discussion) compiles (gather
things together) 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. Quantitative Forecasting Techniques
Quantitative techniques consist of mainly analyzing objective or hard dat. This
usually avoids personal 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 or 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 – airline travel, greeting card, visitors at
tourists and resort centers.
 Theaters demand on weekends

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  Daily variations: banks may over crowded during the
afternoon.
C) Cycle – are long-term swings (moves) 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 (occurring irregularly) effects due to chance
and unusual occurrences.

Types of Time Series Analysis

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:

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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 105 106 11 110 114 121 130 128
demand 0

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
= 616/5 = 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

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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

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 four months ago. The
actual demands were as follows.
Month Month 1 Month 2 Month 3 Month 4
Deman 100 90 105 95
d
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 = 0.4x100+0.30x95+0.2x105+0.1x90
F6 = 98.5 units.
C) Simple Exponential Smoothing

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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 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

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  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:
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

= 20+0.2(20-20)
= 20
FJune = FMay +  (AMay –FMay)
= 20+0.2(25-20)
= 21
FJuly = FJune +  ( AJune –FJune)
= 21+0.2(26-21)
= 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 = slope of the line
b = value of Ft , at t = 0
t = specified number of time periods from t = 0

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The coefficients of the line, a and b can be computed from historical data
using these two equations.
n . ∑ ty−Σt . Σy
a= n. Σt 2 −( Σt )2
Σy−aΣt
b= n
Example:
Monthly demand for Wonji sugar factory over the past six months for sugar is given below
Month (in ‘000 tones) Sept. Oct Nov. Dec. Jan. Feb.
Actual demand 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 2774

Now lets 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

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 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
= 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
 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 for the
following issues
I. Bringing out the nature of relationship between any two variables, say X and Y

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 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.
- 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

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 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

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 Plaster board

permits 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 (r2) and coefficient of correlation (r),
and interpret the numbers

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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

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 B) plaster board demand,
i) if no of permit = 30
Y = 0.915 + 0.395 (30) = 12.76
= 13 shipments
ii) if no of permit = 35
Y = 0.915 + 0.395 (35)
= 14.74
= 15 shipments
iii) if no of permit = 40
Y = 0.915 + 0.395 (40)
= 16.75
= 17 shipments
C) Coefficient of correlation and determination
n. Σ xy − Σx . Σy

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

2 2 2 2

8 x 2146− 184 x 80

r= √[ 8 x 5006 − ( 184) ] x [ 8 x 950 − ( 80 ) ]

2 2

2448
r = √ 2 ,430 , 400
r = 0.90  r2 = 0.81
Interpretation
* r = 0.81 means 81 percent of the total variation in plaster board shipments is explained by construction
permits. What remains is the coefficient of determination (i.e. 0.19). It indicates that 19% of the total
variation, which remains unexplained, is due to the factors other than the construction permits.

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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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