Unit 2

Management of Conversion System

Chapter 3: Forecasting
Lesson 5: Forecasting Models

Learning Objectives
The role of Time in forecasting
Types of forecasting
Quantitative versus Qualitative Methods of forecasting

Hello students, today we will discuss a very interesting topic – forecasting.

What comes to your mind when you think of the term forecasting? ……
Everyday a shop owner thinks how many items he would be able to sell.
The florist at the roadside keeps flower thinking in mind how much he would be able to
sell by the end of the evening.
Here they are applying forecasting- albeit on a miniscule scale.
But let us probe further.

What is Forecasting?
Well, friends as we all know a very critical aspect of managing any organization is the
planning for the future. Hence, Forecasting is the art and science of predicting future
events. Forecasts are required throughout an organization and at all levels of decision
making in order to plan for the future and make effective decisions. The principal use of
forecasts in operations management is in predicting the demand for manufactured
products and services for time horizons ranging from several years down to 1 day.
Depending on the planning horizon, forecasting can be classified in three ways:

Short – range forecasting

(up to 1 year)
Medium – range forecasting
(up to 3 years)
 Long – range forecasting
(more than 3 years)

Ok. Then. So far, so good. Now let us explore further.

Now, who’s going to tell me about the various types of forecasts?
No, Come on.
How about a forecast of today’s weather?
You see light. Excellent.
We march ahead then.
Types of forecasts
In general, a contemporary business organization employs three distinct types of
forecasts.
These are given under:
1. Economic forecasts
2. Technological forecasts
3. Demand forecasts
Economic forecasts address the business cycle by predicting inflation rates, money
supplies, housing starts, and other planning indicators.

Technological forecasts are concerned with rates of technological progress, which can
result in the birth of exciting new products, requiring new plants and equipment.

Demand forecasts are projections of demand for a company’s products or services.

These forecasts, also called sales forecasts, drive a company’s production, capacity, and
scheduling systems and serve as inputs to financial, marketing, and personnel planning.

What is the strategic importance of forecasting?

Forecasting plays a very important role in the following areas:
Human resource management
(- hiring, training and laying-off workers all depend on anticipated demand.)
 Capacity planning
(– when capacity is inadequate, the resulting shortages can mean undependable
delivery, loss of customers, and loss of market share.)
Supply – chain management
(– good supplier relations and the ensuing price advantages for materials and parts
depend on accurate forecasts.)

Dear students, now that we have a clear idea of forecasting and its significance, let us try
to focus on the different facets of forecasting.

Demand
Forecast

Facility Transportation
and logistics
capacity
planning
Production
schedules

Material
Personnel planning
hiring

Personnel
schedules
Forecasting Approaches
It’s a bit like the story of three blind (sorry, visually impaired) men and an elephant.
Perception. It seems, plays a very important role in this respect.

There are numerous approaches to forecasting depending on the need of the decision
maker. Broadly speaking, these can be categorized in two ways:

Quantitative forecasting
Qualitative forecasting

Let’s go further and ask ourselves:-

When to use qualitative methods?

In general, we should consider using qualitative forecasting techniques when one or more
of the following conditions exist:
1. Little or no historical data on the phenomenon to be forecast exist.
2. The relevant environment is likely to be unstable during the forecast
horizon.
3. The forecast has a long time horizon, such as more than three to five years.

What are different Qualitative Methods of forecasting?

The various Qualitative Methods in vogue are as follows:
1. Jury of executive opinion –
 This method takes the opinions of a small group of high-level managers, often
in combination with statistical models, and results in a group estimate of
demand.
2. Sales force composite –
In this approach, each salespeople estimates what sales will be in his or her
region. These forecasts are then reviewed to ensure they are realistic, then
combined at the district and national levels to reach an overall forecast.
3.Delphi method –
This is an iterative group process. There are three different types of
participants in the Delphi process: decision makers, staff personnel, and
respondents. The decision makers usually consist of a group of five to ten
experts who will be making the actual forecast. The staff personnel assist the
decision makers by preparing, distributing, collecting, and summarizing a
series of questionnaires and survey results. The respondents are a group of
people whose judgments are valued and are being sought. This group provides
inputs to the decision makers before the forecast is made.
4. Consumer market survey –
This method take input from customers or potential customers regarding their
future purchasing plans. It can help not only in preparing a forecast but also in
improving product design and planning for new products.
5. Naïve approach –
It assumes that demand in the next period is the same as demand in the most
recent period. In other words, if sales of a product, say, Reliance WLL
phones, were 100 units in January, we can forecast that February’s sales will
also be 100 phones. Does this make any sense? It turns out that for some
product lines, selecting this naïve approach is a cost-effective and efficient
forecasting model.

To illustrate, let us see how theses techniques are put into practice. In the following
practical problem, we would examine the role of forecasting as applicable to POM in
practice
We shall see how Delphi method of forecasting is applied.

POM in practice- Forecasting with the Delphi method*

American Hoist and Derrick is a manufacturer of construction equipment, with annual
sales of several million dollars. Their sales forecast is an actual planning figure and is
used to develop the master production schedule, cash flow projections, and work-force
plans. On of the important components of their forecasting process is the use of the
Delphi method of judgmental forecasting.
In 1975, top management wanted an accurate 5-year forecast of their sales in
order to plan for expansion of production capacity. The Delphi method was used in
conjunction with regression models and exponential smoothing in order to generate a
forecast. A panel of 23 key personnel was established, consisting of those who had been
making subjective forecasts, those who had been using them or were affected by the
forecasts, and those who had a strong knowledge of the market and corporate sales. Three
rounds of the Delphi method were performed, each requesting estimates of:
Gross national product;
Construction equipment industry shipments;
American Hoist and Derrick construction equipment group shipments; and
American Hoist and Derrick corporate value of shipments.

As the Delphi technique progressed, responses for each round were collected, analyzed,
and summarized, and reported back to the panel. In the third-round questionnaire, not
only were the responses of the first two rounds included, but – in addition – related facts,
figures, and views of external experts wee sent.
As a result of the Delphi experiment, the 1995sales forecast error was less than
0.33 percent; in 1996 the error was under 4 percent. This was considerable improvement
over previous forecast errors of plus or minus 20 percent. In fact, the Delphi forecasts
were more accurate than regression models or exponential smoothing which had forecast
errors of 10 to 15 percent. An additional result of the exercise was educational in nature.
Managers developed a uniform outlook on business conditions and corporate sales
volume and thus had a common base for decision making.
 *Adapted from Applied Production and Operations Management (James R. Evans et
al), West publishing Company

Let us now discuss about quantitative approach of forecasting.

Quantitative Methods
The chief Quantitative methods are:
1. Moving averages
2. Exponential smoothing Time series models
3. Trend projection
4. Linear regression  Causal model

The time series models of forecasting predict on the basis of the assumption that the
future is a function of the past. In other words, they look at what has happened over a
period of time and use a series of past data to make a forecast. If we are predicting
weekly sales of washing machine, we use the past weekly sales for washing machine in
making the forecast.

A causal model incorporates into the model the variables or relationships that might
influence the quantity being forecast. A causal model for washing machine sales might
include relationships such as new housing, advertising budget, and competitors’ prices.
Moving over to a structured approach to forecasting, let me introduce the basic steps
involved in this process:-

Steps in Forecasting
There are eight steps to a forecasting system.
These are:
1. Determine the use of the forecast –
(What objectives are we trying to achieve?)
2. Select the items that are to be forecasted
3. Determine the time horizon of the forecast –
 (Is it short, medium, or long – range?
4. Select the forecasting model
5. Gather the data needed to make the forecast
6. Validate the forecasting model
7. Make the forecast
8. Implement the results

We now focus our attention to one of the most widely used and effective method of
forecasting.

Time Series Forecasting

A time series is based on a sequence of evenly spaced (weekly, monthly, quarterly, and
so on) data points. Forecasting time series data implies that future values are predicted
only from past values and that other variables, no matter how potentially valuable,
are ignored.

Decomposition of a Time Series

There are four main ways of decomposing the time series:
Trend
Seasonality
Cycles
Random variations
Two general forms of time series models are used in statistics. The most widely used is a
multiplicative model, which assumes that demand is the product of the four components:
Demand = T × S × C × R ,
where T denotes Trend
S denotes Season
C denotes Cycles
R denotes random variables
An additive model provides an estimate by adding the components together. It is
stated as:
 Demand = T + S + C + R

Moving Averages
Moving averages are useful if we can assume that market demands will stay fairly steady
over time. Moving average can be defined as the summation of demands of total periods
divided by the total number of periods.
Mathematically,
Moving average = ∑ Demand in previous n periods / n

where n is the number of periods in the moving average – for example, four, five, or six
months, respectively, for a four -, five -, or six – period moving average.

To make the calculation of moving average more clear, we take the sales of Washing
machine at Arvee Electronics.

Month Actual Washing Three-month moving

machine sales, units average
January 10
February 12
March 13
April 16 (10 + 12 + 13) / 3 = 11.67
May 19 (12 + 13 + 16) / 3 = 13.67
June 23 (13 + 16 + 19) / 3 = 16
July 26 (16 + 19 + 23) / 3 = 19.33
August 30 (19 + 23 + 26) / 3 = 22.67
September 28 (23 + 26 + 30) / 3 = 26.33
October 18 (26 + 30 + 28) / 3 = 28
November 16 (30 + 28 + 18) / 3 = 25.33
December 14 (28 + 18 +16) / 3 = 20.67
Points to ponder