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PRINCIPLES OF FORECASTING • 253

- -- -----_ .. _-----_ ... ----_.,._---_ .... _-_ ... _----


ave you ever gone to a reSlaurant and been told that they arc sold out
H of their "specials," or gone to the universily
that the texts for your course arc on backorder?
bookstore and found
Have you ever had a
pany at your home nnly to realize that you don't have enough food for
everyone invited? Just like getting caught unprepared in the rain, these
I
situalions show the consequences of poor forecasting. Planning for any
eyent requires a forecast of the futur~~VVhethc~ in business Of in our
own lives, we make forecasts of future events. Based on those forecasts
we make plans and take action .
.j:~reCistini is one of the most important business functions because
all olher business decisions are based on a forecast of the future. Deci,
sions such as which markets to pursue, which products to produce, how
much inventory to carry, and how many people to hire all require a fore'
cast. Poor forecasting results in incorrect business decisions and leaves
the company unprepared to mert future demands. The consequences
can be very costly in terms of lost sales and can even force a company
out.of business.
Fo-;;;~sts arc so important that companies are investing billions of
dollars in technologies that can help them better plan for the future. For ••• Forecasting
example, tlle'i"i:ecrcam giant Ben & Jerry's has invested in business intelligent software Predicting future evenlS.

that tracks the life of each pint of ice cream, from ingredients to sale. Each pint is
stamped with a tracking number that is stored in an Oracle database. Then the com-
pany uses the information to track trends, problems, and new business opportunities.
They can track such things as seeing if the ice cream flavor Chocolate Chip Cookie
Dough is gaining on Cherry Garcia for the top sales spot, producl sales by location,
and rales of change. This information is then used to more accurately forecast prod, Marketing
uct sales. Numerous other companies, such as Procter & Gamhle, General Electric,
Lands' End, Scars, and Red Rohin Gourmet Burgers, arc investing in the same type of
software in order to improve forecast accuracy.
In this chapter you will learn about forecasting, the different types of forecasting
.net hods available, and how to select and usc the proper techniques. You will also
:earn about the lalest available software that can help managers analyze and process
data to generate forecasts.

PRINCIPLES OF FORE(ASTING~
There are many types of forecasting models. They differ in their degree of complexity,
the amount of data they use, and t~e way they generate the forecast. However, some
features arc common to all forecasting models. They include the following:
I. Foremsrs are rarely perfect. Forecasting the future involves uncenainty. Therefore,
it is almost impossible to make a perfect prediction. Forecasters know that they
4 • CHAPTER 8 fORECASTING

have to live with a certain amount of error, which is the difference between what
is forecast and what actually happens. The goal of forecasting is to generate good
forecasts 011 the average over time and to keep forecast errors as low as possible.
2. Forecasts are more ace,urate for groups or families of items mther chem for individ-
ual items. When items are grouped together, their individual high and low val-
ues can cancel each other out. The data for a group of items can be stable even
when individual items in the group are very unstable. Consequently, one can
obtain a higher degree of accuracy when forecasting for a group of items rather
than for individual items. For example, you cannot expect the same degree of
accuracy if you arc forecasting sales of long-sleeved hunter green polo shirts
that you can expect when forecasting sales of all polo shirts_
3. Forecasts are more accurate for shorter chari lorrgeT time horizolls. The shorter the
time horizon of the forecast, the lower the degree of uncertainty. Data do not
change very much in the short run. As the time horizon increases, however,
there is a much greater likelihood that changes in established patterns and rela-
tionships will occur. Because of that, forecasters cannot expect the same degree
of forecast accuracy for a long-range forecast as for a short-range forecast. For
example, it is much harder to predict sales of a product two years from now
than to predict sales two weeks from now.

> STEPS IN THE FORECASTING PROCESS


Regardless of what forecasting method is used, there are some basic steps that should
be followed when making a forecast:
I. Decide what to forecast. Remember that forecasts are made in order to plan for the
future_ To do so, we have to decide what forecasts are actually needed. This is not
as simple as it sounds. For example, do we need to forecast sales or demand'
These are two different things, and sales do not necessarily equal the total amount
of demand for the product. Both pieces of information are usually valuable.
An important part of this decision is the level of detail required for the fore-
cast (e.g., by product or product group), the units of the forecast (e.g., product
units, boxes, or dollars), and the time horizon (e.g .. monthly or quarterly).
2. Evaluate ami allalyze appropriate data. This step involves identifying whal data
are needed and what data arc available. This will have a big impact on the selec-
tion of a forecasting model. For example, if you are predicling sales for a new
product you may not have historical sales information, which would limit your
use of forecasting models that require quantitative data.
We will also see in this chapter that different types of patterns can be ob-
served in the data. It is important to identify these patterns in order to select the
correct forecasting model. For example, if a company was experiencing a high
increase in product sales for the past year, it would be important to identify this
growth in order to forecast correctly.
3. Select and test tile forewstiug model. Once the data have been evaluated, the next
step is to select an appropriate forecasting model. As we will see, there arc many
models to choose from. Usually we consider factors like cost and ease of lise in
se1~clinga model. Anolher very important factor is accuraCy. A common proce-
dure is to narrow the choices to two or three different models and then test
them on historical data to see which one is most accurate.
TYPES Of fORECASTING METHOOS • 255

4. Gellerate tile forecast. Once we have selected a model we use it to generate the
forecast. But we are not finished, as you will see in the next step.
5. Monitor forecast occllracy. Forecasting is an ongoing process. After we have made
a forecast, we should record what actually happened. We can then use that in-
formation to monitor our forecast accuracy. This process should be carried out
cont.inuously. because environments and conditions often change. ""hat was 3
good forecasting model in the past might not provide good results for the fu-
ture. \Ve have to constantly be prepared to revise our forecasting model as our
data changes.

The rapid growth of information tech-. ~JOPRA~


nology (IT) has created a forecasting
challenge for manufacturers of industry
.~r------- Intel Corporation
\IIww.intcl.com
components
semiconductors.
such 3$ microchips
Companies
and
like Intel
~L ~~
have had difficulty in forecasting demand
for information technology used in inter-
nal applications. Forecasts arc critical in
order to plan production and have
t
1
enough product to meet demand. How-
ever, ovcrforccasting means having too
much of an expensive product that will
quickly become obsolete. The exponential growth in requirements and a short product
D
life cycle have added much uncertainty to the forecasting process. Intel has had to con-
sider many factors when generating its forecasts, such as key technology trends that are
driving the information revolution and future directions in the usc of IT.

TYPES OF FORECASTING METHOPS L..


Forecasting methods can be classified into two groups: qllolitnlive and qllontitn(ve.
TililC8-lSliowslliesnWo tlllegones and111elf c aractenstlcs .
.~litatiVt.forecasting methods,-often.ca lied .judgmental-methmls,a re mclhllds-i n ••• Qualitativ~ forecasting
lIobich the forecast is made subjectively.by the forecaster. Tney are educated-guesses by 1 methods
__ =- ----------.L... \ Forecast is made subjectivdy
by tht forecaster.

Qualitative Methods Quantitative Methods [ TABLE 8-1 !


Types of Forecasting Methods
1. Characteristics Based on human judgment. Based on mathematics;
opinions; subjective and quantitative in nature.
non mathematical.
. 2. Strengths Can incorporate latest Consistent and objective;
changes in the environment able to consider much
and "inside information." information and data at one
time.
3. Weaknesses Can bias the forecast and Often quantifiable data are
reduce forecast accuracy. not available. Only as good
as the data on which they
are based.
256 • CHAPTER 8 FORECASTING

forecasters or experts b\ti.~on..intutlion. kJ)o\OJlcdg~. and experience. When you de.


Cide;-ba~dl-onyour intuition, that a particular team is going towi". a baseball game,
you arc making a qualitative forecast. B~causeq"a!jt'tiw' mCjhQds.are..rmdc.by..pcoplc.
they are often biased. These biases can be related to personal motivation ("They ar<
going to set my budgetbased on my forecast, so I'd betler predict high."), mood (:'1 feel
lucky today'''), or conviction ("That pitch<r can strike anybody out').
••..Quanlitali'lc (orcc:l5ling Quantitative fore<:a.<ling methods, on the other hand, ~ed...on..malhematical
methods moddin~~arc-mathemati<al..thesc-mcthedYa,.,.consistent. n,e sam< model
FOrl'C3st is based on ~Ilgeru;;ale the exact same forecast from the same sct of data tvery time. These meth.
mathematical modding. ods are also obj<etive. They do not suffer from the biases found in qualitative forecasting.
Finally, thl'Se methods can consider a lot of information at one t,me. Because people have
I;mited lIl(ormation-proc<ssing-abihtieS-an-d can easily experienc;rnformation overload,
they cannot compete with math<maticaUy gen<rated forecasts in this area.
Both qualitative and quantitative forecasting methods have strengths and weak-
n<sses. Although quantitative methods are objective and consistent, th<y require data in
quantifiable form in order to generate a forecast. Often we do not have such data, for ex-
ample. if wt: arc making a strategic forccJst or if \lJe ar~ forecasting sales of a ntw prod-
uct. Also, quantitative methods are only as good as the data on which they are based.
Qualitative methods, on the oth<r hand, have the advantage of being able to incorporat<
last~minu[e "inside information" in the forecast, such .35.3n advertising campaign by a
competitor, a snowstorm delaying a shipment I or a heat wave incrc:asing sales of ice
crealll. Each method has its place, and a good forecaster learns to rely on both.

Inaccurate forecasts ca.n cost compa-


mesb,lliOriSOfdOilars in missed sales
Improving Sales or ~xcess invt.'ntory. One factor tlwt
Forecasting can significantly impact sales is the
,"eather. In the past there was little
companies could do to plan for
weather problems. However. new
busioesses have sprung up to help
I ;_.. 2 s,a ~ companies use weather data to pre-
I. ... , .. '. ~~ dict consumer behavior andmanag<
'-_ .._ . ' .. weather mk. It could be as Simple as
predicting a hot summer, a cold ,"inter, or an early spring. This type of information
Cln help companies move the right inventories to areas where consumers will be
more likely to buy them.
Planalytics Inc. IS a company that helps busine«es use weather data to make their
business plans. Its clients include Gillette's Duracell'" Batteries, Home Depot, and
Wal-Mart. In one «ample, Planalytics helped Duracell move a large number of bat-
teries to areas expecting to be hit by hurricanes during the hurricane season.
Although using weather data does not replace traditional forecasting methods, it is
one additional tool that can help compaoies improve their forecasting and planning.

Qualitative Methods
.:..------.----
There ar< many types of qualitative forecasting methods, some informal and some
structured. R<gardless of how structur<d the process is, however, remember that these
m2dcl,Dlle-based on subjective opinion and 3re not mathematical in nature. Some com-
mon qualitative methods are shown io Table 8-2 and are described in this section.
TYPES OF FORECASTING METHOOS • 257

Type Characteristics Strengths Weaknesses I TABLE 8.2.J


Qualitative FOrCc.1sling
Executive A group of managers Good for strategic One person's opinion
Methods
opinion meet and come up or new-product can dominate the
with a forecast. forecasting. forecas!.

Market Uses surveys and Good determinant of It can be difficult to


research interviews to identify customer preferences. develop a good
customer preferences. questionnaire.
Delphi Seeks to develop a Excellent for Time consuming


method consensus among a forecasting long-term to develop.
group of experts. product demand,
technological changes,
and scientific advances. Marketing

~xecutive Opinion ~ecut!ye opinion is a forecasting method in wh.i.ch..a.group of ~ Executive opinion


managg,S.J]1eet.and .collectivcly"dC:vClop..aJorccast. .I hIs method is often ~giLf.or FO,""S1ing m<lhod in which
stratcsi5-forccasting
_ - •
or forecasting
..
the
r
success of a ne.....
p roduct or service. Sonlctimes
'
a group 0Jf managers forecast.
'---collcctivcydcvdopa
It ~e..used-to-<:h8nge.an.cxlst.ng4orccastJ.o.account.fot-Unusual.evcntsl such as an
un usuaLhusiness.q<;le-Gf-Unapcaed.wrnpet ition.
Although managers can bring good insights to the forecast, this method has a num-
ber of disadvantages. Often the opinion of one "erson can dominate the forecast if that
p.!]:S0n.lla..mor";>ower4han-lhe-atheI-lnembcrs.of4he-group or IS very domineering.
Think about times when you were pari of a group for a course or for your job. Chances
arc that you experienced situations in which one person's views dominated.

Market Resea.Kb-Ma~eI-t'eSeaJ'ch is an approach that uses surveys and interviews ••. Market research
Approach 10 forecasting that
10 determine customer likes, dislikes. anaprCfcrences analOiaCiitiTy new product
relit'S on survcrs and
iilCas. Usually the compan)' hires an outside marketIng "rm to conduct a market re- intcryiews to determine
~:irch stud)'. There is a good chance that you were a participant in such a study if customer preferences.
someone called you and asked about your product preferences.
Market research can be a good determinant of customer references. Howcver,jL.-
h,as a number of shortc.9llliQgs,.One_o. CJll.O$t.C9,mlllon has to do wit ili"OWthe sur-
vey questions are designed. For example. a market research firm may_cal~nd aSk you
tOidentify which of theJoliowing.is.your-favorite.hobby: gardening, working on cars,
cooking •.OI.pla)'IDg.sports. But maybe none of these is your favorite because you pre-
fer playing the piano or fishing, and these options are not included. This question is
poorl)' designed because it forces you to pick a categor)' that you really don't fit in,
which can lead to misinterpretation of the survey results.

The Delpbi Method The Delphi method is a forecasting method in which the ob-

Marketing

••. Delphi mel hod


Appro:tch to forecasting in
JCctive is to reach a consensus among a group of experts while mamtalnlng their
which a forecast is the
ll1'1onymlty.Th~rchJ:qJUtnotl!ther a panclOT experts lilThCChosen Iield.l'hese product of a consensus
hperts do not have to be in the same facility or even in the same countr)'. They do ~mong a group of cXp<'rts.
not know who the other panelists arc. The process involves sending..9uestionnaires 1.0
th,.e.panelists, then summarizing the findings and sending them an u!,dated_q.uestion-
nairc incorporating the findings. This process continues until a conscns~c_a~bed~
-'fhCiaea behind the DcI hi method is that a panel of experts in a particular field
mi t no a ree on certain things. urwhanh"eyao agree on'willprob-abiy happen.
) -
258 • CHAPTER 8 . FORECASTING

.~ -
'~":t'.:
.~.'I-

Computers have made the use of quantitative


Market research being conducted in 3
modds much easier.
shopping mall.

Thsmcarchc£!s-job-is-to-identi fy-whal'lhe-exp"l~d-use..thtr~t he fore-


~his-melb.od-hastheadvanfageofnotaltowing-an)'G"lH<HIeminatnhe consen-
( _sus~and-il-has-b""n-sho\\in-to-work-very-welL Although it takes a large amounl of
f . een shown to' excellen ethod for recast iii lon~product
~ demand, technological cbange. and scirnLific a vances in medicine. For.example, if
you wished to predict the timing for an AIDS vaccine or a cure for cancer, you.would
probably usc this technique. .

Quantitative Methods
Quantitative methods are different from qualitative ones because they are based on
mathematics. Quantitative methodLQO also be divided into t\'lO categorics~ time se-
ries models and causal models. Although bolh are mathematical, the two categories
differ in their assumptions ana in the manner in which a forecast is generated. In this
section we \'IiH study some common quantitative models, which are summarized in
•••Timeseriesmodel~
aBased on the
forecasl be gcnerah!dthat ~
can assumption
from the information
.
Time ---=
Table 8-3. _---- ---.
.
senes models assume that all the mformattOn . ----
needed to generate a forecast
IS contained in the time series of data. A time series is a series of observations taken at
cont:lincd if) a timc series of regular intervals over a specified period of time, F,or example. if you wcre forccasting
data. quarterly corporate sales and had collected fIve years of quarterly sales data, you
•••Time seric5 would hav a timc seriesJIimc-ser~rysls assumes tfiat we can generatc. a torecast-
A serks of observationstakcn based on patterns intne data. As a forecasler, you would look for patterns such as
ov~rtime. trend. seasonality. and cycle. and use that information to generate a forecast.
~ Cousal models. rf"'\ Causal models, sometimes called associative models, use a ver~differen~ logic to
Based on the assumptton th:lt
th<variablc being forecast is
-vg~nerate
\ , __
7""'
a forecast. They assume t~at Ihe vanable we wIsh, to.!orecast ~s somehow
rdated.to oth~r variables in 9
rc tated to other variables 10 the envIronment. TllCforecaster S Job lS to dIscover how

-
the environment. thesc-Vifi'ables arc relatctfinm.a:th-eITi3tical term~ use that i'nfmmation to forecast
TYPES OF FORECASTING METHODS. 259

:he. future. ~OL£Xample,_wf-l11ight.de<;ide-lhaLSales arc related to advertising dollars


and GNP. From histori",l.dala.we.would-build .••-model-lhaLcrplains.rhe relationship
of i1lese varia.b.lcs.and.uscJt.lo.fo<ccasl.ror.por<lte .sales .
..'Iimc..secics..modcls..arc..generally ~~.r to use than ",usal models. Causal models
Gin be very complex, especially if they consider relationship's am.9_n.g.manY"y'~rj~J>les._
However, uffiC""SCfies models can oftcri'15e Just as accurate and have the advantage of
simplicity. They are easy to use and ",n generate a fore",st more quickly than ",usal
:nodels, which require model building. Each of these models is used for forcasting in
operations management and will be described in the next section.
rL ....TABLE
_ ..
8.3 !
Quantitative For~sting
Models

Type Description Strengths Weaknesses

Time Series. Models


Na'ive Uses last period's actual value Simple and easy to use. Only good if data change
as a forecast. little from period to period.
Simple Mean Uses an average of past data as Good for level pattern. Requires catJYing a lot of
a forecast. data.
Simple Moving A forecasting method in which Only good for level Important to select the
Average only n of the most recent pattern. proper moving average.
observations are averaged.
Weighted A forecasting method where n of Good for level pattern; Selection of weights
Moving the most recent observations are allows placing different requires good
Average averaged and past observations weights on past demands. judgment.
may have different weights.
Exponential A weighted average procedure with Provides excellent forecast Choice of alpha is critical.
Smoothing weights declining exponentially results for short to
as data become older. medium length forecasts.
Trend Adjusted An exponential smoothing model Provides good results for Should only be used for data
Exponential with separate equations for trend data. with trend.
Smoothing forecasting the level and trend.
Linear Trend Technique uses the least squares Easy to use and Oata should display a clear
Line method to fit a straight line to understand. trend over time.
past data over time.
Seasonal Computes the percentage amount Simple and logical Make sure seasonality is
Indexes by which data for each season procedure for computing actually present.
are above or below the mean. seasonality.

Causal (Associative) Models


Linear Uses the least squares method Easy to understand; Make sure a linear
Regression to model a linear relationship provides good forecast relationship is present.
between two variables. accuracy.
Multiple Similar to linear regression, but A powerful tool in Significantly increases data
Regression models the re"'tionship of forecasting when multiple and computational
multiple variables with the variables are being requirements.
variable being forecast. considered.