1/21/2010

Forecasting Fundamentals

Alessandro Anzalone, Ph.D

Hillsborough Community College, Brandon Campus

Agenda

1. Fundamental Principles of Forecasting

2. Major Categories of Forecasts
1. Qualitative Forecasting
2. Quantitative Forecasting — Causal
3. Quantitative Forecasting— Time Series
3. Forecast Errors
4. Computer Assistance
5. References

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Fundamental Principles of Forecasting

Forecasting is a technique for using past experiences to

project expectations for the future.

Fundamental Principles of Forecasting

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Fundamental Principles of Forecasting

Forecasts are almost always wrong. The issue is almost

never about whether a forecast is correct or not.not but
instead the focus should be on “how wrong do we
expect it to be and on the issue of “how do we plan to
accommodate the potential error in the forecast.” Much
of the discussion of buffer capacity and/or buffer stock
the firm mayy use is directlyy related to the size of the
forecast error.

Fundamental Principles of Forecasting

Forecasts are more accurate for groups or families of

items It is usually easier to develop a good forecast for
items.
a product line than it is for an individual product. as
individual product forecasting errors tend to cancel each
other out as they are aggregated. It is generally more
accurate. for example. to forecast the demand for all
familyy sedans than to forecast the demand for one
particular model of sedan.

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Fundamental Principles of Forecasting

Forecasts are more accurate for shorter time periods. In

general there are fewer potential disruptions in the near
general.
future to impact product demand. Demand for extended
time periods far into the future are generally less
reliable.

Fundamental Principles of Forecasting

Every forecast should include an estimate of error. The

first principle indicated the importance to answer the
question. “How wrong is the forecast?” Therefore, an
important number that should accompany the forecast is
an estimate of the forecast error. To be complete, a good
forecast has both the forecast estimate and the estimate
of the error.

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Fundamental Principles of Forecasting

Forecasts are no substitute for calculated demand. If

you have actual demand data for a given time period,
period
you should never make calculations based on the
forecast for that same time period. Always use the real
data, when available.

Qualitative Forecasting

Qualitative forecasting, as the name implies. are forecasts

that are generated from information that does not have a
well-defined analytic structure. They can he especially
useful when no past data is available, such as when a
product is new and has no sales history. To he more
specific. some of the key characteristics of qualitative
forecastingg data include:

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Qualitative Forecasting

The forecast is usually based on personal judgment or some external

qualitative data.
The forecast tends to be subjective and, since they tend to be
developed from the experience of the people involved, will often
be biased based on the potentially optimistic or pessimistic
position of those people.
An advantage is that this method often does allow for some fairly rapid
results.
In some cases, qualitative forecasts are especially important as they
may be the only method available.
These methods are usually used for individual products or product
families, seldom for entire markets.

Qualitative Forecasting

1. Market surveys

2. Delphi or panel consensus forecasting

3. Life cycle analogy forecasting

1. What is the time frame? How long will growth and maturity last?
2. How rapid will the growth be? How rapid will the decline be?
3. How large will the overall demand be, especially during the mature
phase?

4. Informed judgment

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Qualitative Forecasting

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Qualitative Forecasting

Generic Product Life cycle

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Quantitative Forecasting — Causal

1. This method is based on the concept of relationship between

variables, or the assumption that one measurable variable
“causes”
causes the other to change in a predictable fashion.
2. There is an important assumption of causality and that the causal
variable can be accurately measured. The measured variable that
causes the other to change is frequently called a “leading
indicator.” As an example, new housing starts is often used as a
leading indicator for developing forecasts for many sectors of the
economy.
3. If there are good leading indicators developed, these methods
often bring excellent forecasting results.

Quantitative Forecasting — Causal

4. As somewhat of a side benefit, the process of developing the

models will often allow the developers of the model to gain
additional significant market knowledge. For example, if you are
developing a causal model of vacation travel based on the
leading indicator of gasoline prices, there is a good chance you
will gain knowledge about both the mechanisms that control
gasoline prices as well as the patterns of typical vacation travel.
5. These methods are seldom used for product, but more commonly
used for entire markets or industries,
6. The methods are often time-consuming and very expensive to
develop, primarily because of developing the relationships and
obtaining the causal data.

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Quantitative Forecasting — Causal

Some of the more common methods of causal forecasting are given

as:

Input—output models. These can be very large and complex

models, as they examine the flow of goods and services
throughout the entire economy. As such, they require a
substantial quantity of data, making them expensive and time-
consuming to develop. They are generally used to project needs
for entire markets or segments of the economy, and not for
specific products.

Econometric models. These models involve a statistical analysis of

various sectors of the economy. Their use is similar to the input—
output models.

Quantitative Forecasting — Causal

Simulation models. Simulating sectors of the economy on computers

are growing in popularity and use with the development of ever
more powerful and less expensive computers and computer
simulation models. They can be used for individual products, but
once again gathering the data tends to be expensive and time-
consuming. The real value of these models is that they are fast
and economical to use once the data has “populated” the model.

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Quantitative Forecasting — Causal

Regression. A statistical method to develop a defined analytic

relationship between two or more variables. The assumption, as
with other causal models, is that one variable “causes”
causes the other
to move. Often the independent, or causal, variable is called a
leading indicator. A common example is when the news reports
on housing starts, since that is often a leading indicator of the
amount of economic activity in several related markets. Since
they are based on external data, causal forecasting methods are
sometimes called extrinsic forecasts.

Quantitative Forecasting— Time Series

Time-series forecasts are among the most commonly used for

forecasting packages linked to product demand forecasts. They
all essentially have one common assumption. That assumption is
that past demand follows some pattern, and that if that pattern
can be analyzed it can be used to develop projections for future
demand, assuming the pattern continues in roughly the same
manner. Ultimately that implies the assumption that the only real
independent variable in the time series forecast is time. Since
they are based on internal data (sales), they are sometimes
called intrinsic forecasts.

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Quantitative Forecasting— Time Series

Most time series forecasting models attempt to mathematically

capture the underlying patterns of past demand.

1. Random pattern
2. Trend pattern
3. Seasonal Pattern

Quantitative Forecasting— Time Series

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Quantitative Forecasting— Time Series

Quantitative Forecasting— Time Series

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Quantitative Forecasting— Time Series

Quantitative Forecasting— Time Series

Simple moving averages are as the name implies. nothing more

than the mathematical average of the last several periods of
actual demand. They take the form:

Where:
F is the forecast
t is the current time period meaning Fi is the forecast for the current
time period
Ai is the actual demand in period t, and
n is the number of periods being used.

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Quantitative Forecasting— Time Series

Quantitative Forecasting— Time Series

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Quantitative Forecasting— Time Series

Weighted moving averages are basically the same as simple moving

aver- ages, with one major exception. With weighted moving
averages the weight asas- signed to each past demand point used
in the calculation can vary. In this way more influence can be
given to some data points. typically the most recent demand
point. They take the basic form (the W stands for the weight):

Quantitative Forecasting— Time Series

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Quantitative Forecasting— Time Series

Simple exponential smoothing is another method used to smooth

the random fluctuations in the demand pattern. There are two
commonly used (mathematically equivalent) formulas:

Quantitative Forecasting— Time Series

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Quantitative Forecasting— Time Series

Quantitative Forecasting— Time Series

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Quantitative Forecasting— Time Series

Regression has sometimes been called the “line of best fit.” It is a

statistical technique to try to fit a line from a set of points by using
the smallest total squared error between the actual points and the
points on the line. A particular value for regression is to determine
trend line equations.

Quantitative Forecasting— Time Series

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Quantitative Forecasting— Time Series

Quantitative Forecasting— Time Series

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Forecast Errors

Forecast Errors

Mean Forecast Error (MFE). As the name implies, this term is

calculated as the mathematical average forecast error over a
specified time period. The formula is:

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Forecast Errors

Mean Absolute Deviation (MAD). The formula is again given as the

name of the term. It literally means the average of the
mathematical absolute deviations of the forecast errors
(deviations). The formula is, therefore:

Forecast Errors

Tracking Signal. Similar to the concept of control limits for statistical

process control charts, the tracking signal provides a somewhat
subjective limit for the forecasting method to go “off
off track
track” before
some action is taken. It is calculated from the MFE and the MAD:

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Computer Assistance

A demand pattern for 10 periods for a certain product was given as

127. 113. 121, 123. 117. 109. 131. 115. 127. and 118. Forecast
the demand for period 11 using each of the following methods: a
3-month moving average: a 3-month weighted moving average
using weights of 0.2, 0.3, and 0.5; exponential smoothing with a
smoothing constant of 0.3; and linear regression. Compute the
MAD for each method to determine which method would be
preferable under the circumstances. Also calculate the bias in the
data, if any, for all four methods, and explain the meaning.

Computer Assistance

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References

1. Stephen N. Chapman, The Fundamentals of Production Planning and Control,

Prentice Hall, 2006, ISBN-13: 978-0130176158.
2.
2 http://www statpac com/research-papers/forecasting
http://www.statpac.com/research papers/forecasting.htm
htm
3. http://www.demandmgmt.com/?q=home/white-papers/5-ways-improve-your-
forecast-accuracy
4. http://home.ubalt.edu/ntsbarsh/business-stat/otherapplets/MeasurAccur.htm
5. http://www.salesvantage.com/article/628/The-Key-to-Accurate-Sales-
Forecasting

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