Chapter Two
Forecasting
May, 2022
By: Fetene G. (Msc)
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units to be covered:
Explain the meaning, characteristics and uses
of forecasting
Discuss different types of forecasting
techniques
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Introduction to Forecasting
Forecasting is a tool used for predicting future
demand based on past demand information.
Forecast affects decisions and activities
throughout the organization in:-
Accounting, finance
Human resources
Marketing
Operations
Product / service design
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Importance of Forecasting
Marketing managers: use sales forecasts to determine optimal sales
force allocations set sales goals, and plan promotions and advertising.
Planning for capital investments: predictions about future economic
activity are required so that returns or cash inflows accruing from the
investment may be estimated.
The personnel department requires a number of forecasts in planning
for human resources.
Managers of nonprofit institutions and public administrators also
must make forecasts for budgeting purposes.
Universities forecast student enrollments, cost of operations, and, in
many cases, the funds to be provided by tuition and by government
appropriations.
The bank has to forecast: Demands of various loans and deposits
Money and credit conditions so that it can determine the cost of
money it lends.
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Characteristics of forecasts
i. Forecasts are rarely perfect; actual results
usually differ from predicted values.
ii. 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.
iii. Forecast accuracy decreases as the time
period covered by the forecast-time horizon
increases.
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Forecasting Range (Horizon)
Short-range forecasts typically encompass the immediate future and are
concerned with the daily operations of a business firm, such as daily
demand or resource requirements. A short-range forecast rarely goes
beyond a couple months into the future.
A medium-range forecast typically encompasses anywhere from 1 or 2
months to 1 year. A forecast of this length is generally more closely
related to a yearly production plan and will reflect such items as peaks
and valleys in demand and the necessity to secure additional resources for
the upcoming year.
A long-range forecast typically encompasses a period longer than 1 or 2
years. Long-range forecasts are related to management's attempt to plan
new products for changing markets, build new facilities, or secure long-
term financing. In general, the further into the future one seeks to predict,
the more difficult forecasting becomes.
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Techniques of forecasting
There are two types of forecasting technique.
They are:
1. Qualitative forecasting techniques
2. Quantitative forecasting techniques
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Qualitative Forecasting Methods
The qualitative (or judgmental) approach can be useful in formulating
short-term forecasts and can also supplement the projections based on the
use of any of the quantitative methods.
Individual Expert: individual market experts can be hired to watch for
industry trends, perhaps even by geographic area, and might even work with
sales people to estimate future demand for products
Executive Opinions/Group Consensus: The subjective views of executives
or experts from sales, production, finance, purchasing, and administration are
averaged to generate a forecast about future sales. Usually this method is used
in conjunction with some quantitative method, such as trend extrapolation.
Delphi Method: this method requires one person to administer and
coordinate the process and poll the team members (respondents) through a
series of sequential questionnaires.
Consumer Surveys: Some companies conduct their own market surveys
regarding specific consumer purchases. Surveys may consist of telephone
contacts, personal interviews, or questionnaires as a means of obtaining data.
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Quantitative Forecasting Techniques
Quantitative analysis typically involves two approaches:
Time Series Forecasting Methods: Time series forecasting
methods are based on analysis of historical data (time series: a
set of observations measured at successive times or over
successive periods). They make the assumption that past
patterns in data can be used to forecast future data points.
• Naïve or Projection
• Simple Moving Average
• Weighted Moving Average
• Exponential Smoothening
Causal/Regression Methods: Causal models establish a
quantitative link between some observable or known variable
(like advertising expenditures) with the demand for some
product.
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Time Series Models
Forecaster looks for data patterns as
Data = historic pattern + random variation
Historic pattern to be forecasted:
Level (long-term average) – data fluctuates around a constant
mean
Trend – data exhibits an increasing or decreasing pattern
Seasonality – effects are similar variations occurring during
corresponding periods, e.g., December retail sales. Seasonal can
be quarterly, monthly, weekly, daily, or even hourly indexes.
Cycle – are the long-term swings about the trend line. They are
often associated with business cycles and may extend out to
several years in length.
Irregular variations - caused by unusual circumstances
Random variations - caused by chance, cannot be predicted
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Cont.
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Cont.
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Time Series Models
• Projection: The easiest time series method simply
projects future demand based on the last period’s
demand. The forecast for the period t, Ft, is simply a
projection of previous period t-1 demand, At-1
Ft=At-1
• E.g. If the actual demand of period t is 120, then the
forecast of the period t+1 is 120.
• This method, although easy to use, doesn’t make use of
data that is easily available to most managers; thus,
using more of the historical data should improve the
forecast. Averages of past demand might be more useful
and are discussed next.
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Time Series Models
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Time Series Models
• Simple Moving Average (A company sells storage shed, Determine
the forecast of January using 3 month simple moving average.)
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Weighted Moving Average
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Cont.
• E.g. Consider the weights 3/6, 2/6,1/6 for periods t-1, t-2 and t-3
respectively which are added to one. Determine the forecast of
January.
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Exponential Smoothing
• Include all past observations
• •Form of weighted moving average
• •Weight recent observations much more
heavily than very old observations:
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Cont.
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Cont.
Why use exponential smoothing?
• Uses less storage space for data
• More accurate
• Easy to understand
• Little calculation complexity
• There are simple accuracy tests
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Cont.
• By using this method calculate the 16th period forecasted
demand using α = 0.1 & α = 0.40 for the following table.
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Factors considered when selecting a model
. The amount & type of available data
Some methods require more data than others
2. Degree of accuracy required
Increasing accuracy means more data
3. Length of forecast horizon
Different models for 3 month vs. 10 years
4. Presence of data patterns
Lagging will occur when a forecasting model
meant for a level pattern is applied with a trend
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Measuring Forecast Error
Forecasts are never perfect
Need to know how much we should rely on our
chosen forecasting method.
Measuring forecast error:
Note that:
Over-forecasts = negative errors
Under-forecasts = positive errors.
Large values of negative or positive errors shows
there is bias in the forecast.
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Cont.
Mean Absolute Deviation (MAD)
measures the total error in a forecast without regard
to sign.
Cumulative Forecast Error (CFE)
Also called running sum of forecast error (RSFE)
Measures any bias in the forecast
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Cont.
Mean Square Error (MSE)
Penalizes larger errors
Ideal values =0 (i.e., no forecasting error)
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Measuring Accuracy: Tracking signal
• The tracking signal is a measure of how often our
estimations have been above or below the actual
value. It is used to decide when to re-evaluate using a
model.
TS =
Positive tracking signal: most of the time actual
values are above our forecasted values
Negative tracking signal: most of the time actual
values are below our forecasted values
Usually 3 ≤ TS 8, out of this range investigate!
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Measuring Forecast Accuracy and Error
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Summery
Three basic principles of forecasting are: forecasts are rarely
perfect, are more accurate for groups than individual items, and are
more accurate in the shorter term than longer time horizons.
The forecasting process involves five steps: decide what to forecast,
evaluate and analyze appropriate data, select and test model,
generate forecast, and monitor accuracy.
Forecasting methods can be classified into two groups:. Qualitative
and quantitative. Qualitative methods are based on the subjective
opinion of the forecaster and quantitative methods are based on
mathematical modelling.
Time series models are based on the assumption that all
information needed is contained in the time series of data.
Causal models assume that the variable being forecast is related to
other variables in the environment.
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Cont.
There are four basic patterns of data: level or horizontal,
trend, seasonality, and cycles. In addition, data usually
contain random variation. Some forecast models used to
forecast the level of a time series are: naïve, simple mean,
simple moving average, weighted moving average, and
exponential smoothing. Separate models are used to forecast
trends and seasonality.
Three useful measures of forecast error are mean absolute
deviation (MAD), mean square error (MSE) and tracking
signal.
There are four factors to consider when selecting a model:
amount and type of data available, degree of accuracy
required, length of forecast horizon, and patterns present in
the data.
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Thank you!
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