Forecasting and estimation techniques

Abstract

It is very common in any project or program that deviations occur on different scales between what is expected and reality. On many occasions, these deviations could have been reduced by statistical analysis of past examples and their respective forecasts. Throughout this article, we will focus on studying the main statistical methods used when making forecasts and how, by using them, organizations could optimize their supply chain or the management of their projects by forecasting the quantity of units or resources that the market or project in question will demand, based on historical data from previous seasons. As an output, the advanced management of the project will be optimized, resources will be assigned to the tasks or processes that really require them, unnecessary costs will be eliminated, and the time used to complete the project will be reduced.

From the beginning of the 20th century to the present day, the importance of forecasts has grown exponentially, since it gives the company a competitive advantage, as it will be able to plan its actions and take measures based on expectations. The term "forecast" can be associated with different fields, such as business, engineering, politics, project management... In this article we will approach the term forecast from an operations management perspective, defining the term as an accurate prediction of the future, based on past events and whose objective is to give the company valuable time to face future events, to be able to respond to the market demand and allowing the company to adapt capacity of production to fluctuations in demand: raw material consumption planning, supply chain management, quantities to order from suppliers, work shifts...

Forecasting approaches

Depending on the discipline (business, economics, politics, industry, society, commerce...), the term "forecast" will have one meaning or another. At the level of operations management, forecasting is defined as an approximation to future circumstances through a subjective and objective assessment being different from past data, but taking them as a starting point. Under no circumstances can forecasts be taken as if they were a "crystal ball" capable of seeing the future, since they will always have a percentage of error, depending on how the forecast has been made, as we will see below..

Therefore, the main characteristics of a forecast are the following:

1. A forecast is objective and subjective, this being the science of predicting future events, either through mathematical models, intuition or both together.

2. Foresight contributes to the improvement and development of a culture of continuous improvement and process optimization because through it, the organization will be able to coordinate itself to implement the necessary systems to face future events.

3. Forecasts can be both long term and short term, being therefore important in strategic decisions as well as in resource planning or other plans. They are also key in the short term in day-to-day operations.

Demand classification

Demand is a pattern that attempts to express the consumption or market need for a product. Depending on the sales patterns of the product, demand can be classified as follows:

In the first place, stable demand is characterized by following a common sales or production needs pattern during the time analyzed. That is, even with maximums and minimums, it can be assumed that during the set period the level of sales (and therefore production) will not fluctuate from the expected standards, that is, it will have a constant average.

Secondly, a trending demand pattern is defined as a constant or systematic increase or decrease in demand as time progresses. An example of trending demand could be the sale of electric scooters, whose demand has increased day by day in recent years.

Thirdly, seasonal demand is one that during specific periods of time the market is stronger and experiences an exceptional peak demand. An example of seasonal demand could be the sale of ice cream during summer periods or the increase in demand for bouquets of flowers on Valentine's Day.

Forecasting classification (short, middle and long term)

The forecast o estimation process can be structured in different levels, which are defined according to the objectives and the time horizon of visualization (short, medium and long term). These must be carried out under a continuous improvement model, executed periodically and their performance should de measured, in order to keep improving the quality of forecasts.

Forecasts can be classified according to the time horizon covered:

Short-term forecasts. Generally made with a vision of three months and with a maximum of one year, whose main applicability at the operational level is the planning of tasks, assignment of workers or immediate material needs.

Medium-term forecasts. Intended to anticipate events six months ahead, and up to a maximum of three years. Their main operational functionality is to make a sales forecast, from which a bill of materials (BOM) and a production planning will be made.

Long-term forecasts. Are made with a time horizon longer than three years and their main purpose is the development of new products or the planning of the use of facilities.

Forecasting methods

It can be projected into the future in two ways: through qualitative methods, in which we rely on past actions or on the implicit knowledge of the subject to intuit future actions. Or through quantitative methods, in which through the use of statistics or mathematical models, historical data are projected into the future.

Qualitative methods

Qualitative methods allow describing or forecasting events when there is no historical data or when such data is not really relevant for forecasting. They are based on intuition and past experience, such as the amount of resources used to manufacture a product or the number of items sold during a given period, for example.

There is a wide variety of intuitive methods, as will be seen below, all of which are highly complex and their results will not always coincide, as it depends on the group of participants who have been involved, whether they are employees who know the industry at first hand or people who are able to give sound advice on future demand.

1. Market research. These are consumer surveys to determine the interest of customers or users of a product or service.

2. Group consensus. The opinion of market experts, company insiders or industry executives is sought. Thanks to the experience of these people, who have a relatively accurate perception of market trends and the impact of possible changes, the company in question will be able to obtain fairly accurate data for its planning.

3. Delphi method. This method consists of obtaining the opinion of a group of anonymous experts through a list of questions about the industry and its market.

The method is as follows:

1. A series of questions about the desired industry and market is sent out.

2. Once the experts have responded, a report is compiled compiling the answers and their respective arguments.

3. The same report is sent to the respondents so that they can jointly adjust or modify their opinion based on the views of the others.

4. The process is repeated until the group of experts reaches a common agreement.

4. Salespersons' composite. Each salesperson makes an approximation of expected sales over a specific period of time in the region in which he/she is engaged, which will then be reviewed for validation.

The main advantage of qualitative methods is that they take into account intangible factors that are not considered in quantitative methods. In addition, it is very useful when historical data is not available, such as when a company enters a new industry or launches a new product in the market.

Quantitative methods

Quantitative methods assume that the past defines the future, neglecting changes in the environment that could affect future demand. However, once systems are in place that allow for the collection and analysis of demand data (data that most for-profit companies already possess), these methods are less expensive, quicker to use, and appear to be more "objective" than qualitative methods.

These methods are based on forecasting models built from time series. Therefore, statistical and mathematical methods, algorithms and optimization models, such as neural networks, are used to obtain future forecasts.

As mentioned above, their use depends directly on the availability of historical data.

Other factors that can affect forecasts

Demand tends to vary for different reasons that must be taken into account when forecasting. These factors are implicitly taken into account when qualitative methods are used in order to have accurate and realistic forecasts. While when quantitative methods are used, a readjustment of the results obtained must be made or, if a software is used to obtain them, they must be taken into account as external variables.

1. Seasonality pattern. Many goods and services are affected by seasonal variations in demand, suffering during a specific and predictable time, demand increases, and then falling back to standard levels.

2. Market conditions. All PESTEL elements (political, economic, social, technological, ecological and legal) are capable of influencing the market upwards or downwards, changing unexpectedly the market behavior. An example of this could be the increase in demand for electric cars as batteries improve their autonomy and charging points increase.

3. Commercial actions of the company. There are certain actions, such as marketing campaigns, sales periods or new store openings, where demand is expected to increase considerably.

Global forecasting process

1. Define the objective. Once the objective of a forecast has been defined, a planning horizon and degree of accuracy must be set (long, medium or short term). For example, to plan the operations of a company dedicated to the manufacture of scooters, it will be necessary to forecast the company's global sales for the coming year, in order to be able to make a detailed plan for the supply of raw materials, production processes, necessary resources or management of logistics for delivery to the customer.

2. Collect data. The main source of data collection is sales history (last weeks, last months, last years). The longer the sales history, the more accurate the forecasts (estimation techniques) will be, as history plays a key role in detecting patterns, trends or seasonal periods. To these historical data will be added data provided by sales records/customer surveys, such as demographic references, most influential products or reports of incoming and outgoing stock.

3. Validation and exploration analysis of the data collected. It is essential to graphically represent the historical demand obtained, in order to identify points of maximum or minimum demand, seasonal patterns or repetitive cycles of market demand. On the other hand, if data validation is to be performed by different areas of the company, the production department should confirm that enough units were manufactured to support the collected sales, or the marketing department should analyze whether the peak sales points coincide with the times when intensive marketing campaigns were carried out.

4. Choose the appropriate forecasting method and launch forecasts. Depending on the degree of accuracy desired, the resources and data available, qualitative or quantitative forecasts will be launched, with a given forecast horizon. Once these preliminary steps have been carried out, the desired forecasts will be launched.

5. Validate the forecasts obtained. Once the results have been obtained, all departments involved should verify that the data obtained are valid. Once this process has been completed, planning will be carried out based on the new forecasts. In other words, plan how to achieve the desired results. This planning, as mentioned above, will vary depending on the market in which the company is located and the type of industry in which it operates.

Moon et al (1998), based on their long involvement and experience in the forecasting field, suggest seven fundamental principles for forecast management, which if correctly applied could increase the efficiency, coordination and performance of the company. .

These seven key principles are the following:

1. Understand what forecasting is and is not.

2. Forecast demand, plan supply.

3. Communicate, Cooperate, and Collaborate (CCC).

4. Eliminate islands of analysis.

5. Use tools wisely.

6. Make it important.

7. Measure, Measure, and Measure.

Forecasting problems

There are some circumstances, which in principle would not necessarily affect the forecasts if they are handled properly, but which can sometimes be problematic if the necessary knowledge is not available.

1. One-off period of extraordinary sales. Time windows where the demand for a certain product shoots upwards in a totally unexpected way. This phenomenon of extraordinary demand should not be taken into account when making future forecasts, since it will deviate the forecasts that are real. For example, the peak demand for toilet paper during the first coronavirus crisis. This product suffered a very high demand, but this should not be confused with a seasonal demand or a trend, but rather that due to a specific circumstance the market demanded a lot of paper, a phenomenon which, in principle, will not occur again, or at least cannot be foreseen.

2. Product in phase of disappearance. On many occasions a product finds a substitute or the market launches an improved version of it, so, if it is detected that the product has settled among consumers, even with positive forecasts of the sale of the old product, its disappearance should be planned and the forecasts should be close to zero in the near future.

3. New articles. Contrary to the previous point, new products that are launched on the market do not have historical sales records or data to be used to make forecasts of how they will behave or how the market will adopt the inclusion of this new product. Therefore, there are two solutions to be taken by the person in charge. First, use historical records of a similar item or one that is expected to perform similarly. This data could be used as a reference to make initial forecasts. Secondly, there is the option of using standard release curves, i.e. if you assume that the product will have an exponential growth of a specific percentage or a trend increase of x%, this statistic can be used to make the first forecasts. It is important to emphasize that these first forecasts will probably differ more than usual with the real market behavior, but they can help the company to make a first planning.

Benefits and conclusion

The objective of forecasting systems is to provide information about future changes and their impact on market demand. It is a task that today can take up an entire department or even the possibility of having only one person responsible within the organization.

There are multiple approaches to forecasting, from advanced mathematical/statistical methods to simple hunches or intuitions of how the market will behave. The two methods that dominate forecasting in the area of operations management are qualitative and quantitative methods.

Qualitative methods include methods such as the delphi method, consulting market insiders or relying on the experience and opinions of potential customers.Quantitative methods, on the other hand, mathematically analyze what has happened in the past during a specific period of time and, based on the characteristics of the subject, establish forecasts for the future, which means that they are methods that assume that the future is a function of a direct relationship with the past.

Nowadays, the most common global process is to make initial forecasts using advanced quantitative methods by means of specialized software, of which there are dozens on the market. The forecasts obtained are reviewed by related members of the entire organization (sales, project managers, senior management or engineers) who must validate or correct them. In other words, there is no one best method for forecasting, but the use of both together is the best way to obtain results that really give a real vision of the future events to the company.

Forecasts have a great value in terms of advanced project management, since, as mentioned above, they allow the company to obtain a vision of the future in advance, helping the organization to position itself for the future and to be able to make the relevant decisions.

To be more specific, let's take the example of a company that builds cars and decides to make a sales forecast with a time horizon for the next three years. Let's see how this affects the company's organization:

Firstly, the human resources level, as the company has to coordinate to manufacture a specific number of cars per day, it will be able to manage the number of employees it needs at any given time and their work shifts to service the expected demand, avoiding overstaffing or understaffing costs.

Secondly, at supply chain level, the company could reach agreements with its suppliers to reduce costs thanks to the loyalty or recurrence of their orders, as well as plan the expected use of raw materials and thus optimize their use, saving large amounts of money.

At the logistics level, the company will be able to optimize its inventories and warehouses, since by knowing the quantities to be manufactured at any given time, it will be able to have only the necessary parts in stock. In this way, the company would save costs of parts permanence, since keeping meaningless units in the warehouse is a fixed cost that must be taken into account, and on the other hand, in the case of perishable products, the company would avoid the cost of discarding them, since it would only have the necessary products at the necessary time.

Finally, at the economic level, in addition to avoiding costs at the human resources, supply chain and operational levels, the company, by being able to foresee how much it will have to invest, will be able to manage its economic resources efficiently. That is to say, it will know when to keep its capital in cash or when it can afford a large outlay (to increase capacity, expand its facilities, invest in research and development...).