What is Forecasting?

Literally.
Fore.an ancient term of warning bearing the threat of harm at worst, and uncertainty at best, to those within potential range... + Cast serving up a projectile to the unseen and usually unknown beneath the deceptive surface = Forecast.... a warning to those who use it... a confession of uncertainty (or deception) by those who create it... a threat of harm to those in its path
From Tom Brown in Getting the Most of Forecasting

Forecast
Forecast: A statement about the future value of a

variable of interest, such as demand. Forecasts affect decisions and activities throughout an organization
Accounting, finance Human resources Marketing MIS Operations Product / service design

Examples of Uses of Forecasts

Accounting Finance Human Resources

Cost/profit estimates Cash flow and funding Hiring/recruiting/training

Marketing
MIS Operations Product/service design

Pricing, promotion, strategy

IT/IS systems, services Schedules, MRP, workloads New products and services

Elements of a Good Forecast

Timely

Reliable

Accurate

Written

Forecasting Approaches Qualitative Methods

Used when situation is vague & little data exist
New products New technology

Quantitative Methods
Used when situation is stable & historical data exist
Existing products Current technology

Involves intuition, experience

e.g., forecasting sales on Internet

Involves mathematical techniques

e.g., forecasting sales of color televisions

Judgmental forecasts

Time series forecasts & Associative models

Types of Forecasts Judgmental - uses subjective inputs

Time series - uses historical data assuming the future will be like the past
Associative models - uses explanatory variables to predict the future

Quantitative Forecasting Methods

Quantitative Forecasting

Time Series Forecasting

Associative Models
Linear regression Curvilinear regression Multiple regression

Nave

Averaging

Trend

Seasonality

Moving Average Weighted Moving Average Exponential smoothing

Linear trend linear trend equation trend-adjusted exponential smoothing Nonlinear trend

Additive Multiplicative

Techniques for Averaging Moving average Weighted moving average Exponential smoothing

Moving Average Moving average A technique that averages a number of recent actual values, updated as new values become available. n

Ft = MAn =
Where

1 At-i i=
n

i = an index that corresponds to periods. n = Number of periods (data points) in the moving average period. Ai = Actual value in period i. MAn = Forecast based on most-recent n periods. Ft = Forecast for time period t.

Example 2: Moving Average Find moving average with n = 5.

Period i Actual Demand
1 2 3 4 5 6 7 8 9 10 11 12 42 40 43 40 41 39 46 44 45 38 40 -

Forecast

Solution to Example 2 Start from F6 (forecast for period 6).

Period i
1 2 3 4 5 6 7 8 9 10 11 12

Actual Demand
42 40 43 40 41 39 46 44 45 38 40 -

Forecast
41.2 40.6 41.8 42.0 43.0 42.4 42.6

43+40+41+39+46 = 5

46+44+45+38+40 5

Smooth and Lag

Lag Increases with Periods

Weighted Moving Average

Assigns more weight to recent observed values More responsive to changes Selection of weights is arbitrary, but weights must add to one. The values for the weights are always given.

Example 3: Weighted Moving Average Find weighted moving average using Fi =0.4Ai-1 + 0.3Ai-2 + 0.2Ai-3 + 0.1Ai-4.
Period i 1 2 3 4 5 6 7 8 9 10 11 12 Actual Demand 42 40 43 40 41 39 46 44 45 38 40 Forecast

Solution to Example 3 Start from F5 (forecast for period 5).

Period Actual Forecas i Demand t
1 2 3 4 5 6 7 8 9 10 11 12 42 40 43 40 41 39 46 44 45 38 40 41.1 41.0 40.2 42.3 43.3 44.3 42.1 40.8

= 0.1(42)+.2(40)+.3(43)+.4(40)

= 0.1(39)+.2(46)+.3(44)+.4(45)

Shown solutions of Example 1, 2, and 3

48 46 44 42 40 38 36 Observed 34 32 30 1 2 3 4 5 6 7 8 9 10 11 12

MA
WMA

Exponential Smoothing Current forecast = Previous forecast + (Actual Previous forecast)

Ft = Ft-1 + (At-1 - Ft-1)

where
Ft = Forecast for period t Ft-1 = Forecast for period t-1 = Smoothing constant At-1 =Actual demand or sales for period t-1

Exponential Smoothing (Cont.) Premise: The most recent observations might have the highest predictive value.

Therefore, we should give more weight to the more recent time periods when forecasting.

Weighted averaging method based on previous forecast plus a percentage of the forecast error A-F is the error term, is the % feedback

Example 4: Exponential Smoothing

Period (t) Actual (At) Ft ( = 0.1) Error (A-F) Ft ( = 0.4) Error (A-F) 1 42 2 40 3 43 4 40 5 41 6 39 7 46 8 44 9 45 10 38 11 40 12

Solution to Example 4

Ft = Ft-1 + (At-1 - Ft-1) = (1 ) Ft-1 + At-1

For example: = 0.1 A1 = 42 F2 = 42 (Nave)

A2 = 40 F3 = F2 + (A2 - F2)
= 42 + 0 .1 (40 - 42) = 41.8

A3 = 43 F4 = F3 + (A3 - F3) = 41.8 + 0 .1 (43 - 41.8) = 41.92

Solution to Example 4 (Cont.)

Ft = Ft-1 + (At-1 - Ft-1)
Period (t) Actual (At) Ft ( = 0.1) Error (A-F) Ft ( = 0.4) Error (A-F) 1 42 2 40 42 -2.00 42 -2 3 43 41.8 1.20 41.2 1.8 4 40 41.92 -1.92 41.92 -1.92 5 41 41.73 -0.73 41.15 -0.15 6 39 41.66 -2.66 41.09 -2.09 7 46 41.39 4.61 40.25 5.75 8 44 41.85 2.15 42.55 1.45 9 45 42.07 2.93 43.13 1.87 10 38 42.36 -4.36 43.88 -5.88 11 40 41.92 -1.92 41.53 -1.53 12 41.73 40.92

Picking a Smoothing Constant

50
Actual .4

45
Demand 40 35 1 2 3 4 5 6 7 8

.1

9 10 11 12

Period

Linear Trend Equation

Ft

Ft = a + b t
0 1 2 3 4 5 t

Ft = Forecast for period t t = Specified number of time periods from t = 0 a = Value of Ft at t = 0 b = Slope of the line

Calculating a and b

b =

n (ty) - t y

n t - ( t)

y - b t a = n
n = Number of periods y = Value of the time series t = Specified number of time periods from t = 0

Example 5:
Calculator sales for a California-based firm over the last 10 weeks are shown in the following table.
Week (t)
1 2 3 4 5 6 7 8 9 10

y
700 724 720 728 740 742 758 750 770 775

yt
700 1448 2160 2912 3700 4452 5306 6000 6930 7750

t2
1 4 9 16 25 36 49 64 81 100

55

7407

41358

385

Solution to Example 5 Plot the data, and visually check to see if a linear trend line would be appropriate.
n = 10, t = 55, y =7407, yt = 41358, t2 = 385
b= 10(41358) - 55(7407) 10(385) - 55(55) = 413580 - 407385

1.
2.

3850 - 3025

7.51

a =

7407 - 7.51(55) 10

699.40

y = 699.40 + 7.51t

Solution to Example 5 (Cont.) Then determine the equation of the trend line, and predict sales for weeks 11 and 12.
y11 =699.40 + 7.51(11) = 782.01 y12 =699.40 + 7.51(12) = 789.51

3.

Solution to Example 5 (Cont.)

800 780

760 740 720 700

680 660 Observed Trend line

10

Associative Forecasting

Linear Regression
The object of linear regression is to obtain an equation of a straight line (Least squares line) that minimizes the sum of squared vertical deviations of the data points from the line.

yc = a + b x
Where
yc = Predicated (dependent) variable. x = Predictor (independent) variable. a = Value of yc when x = 0. b = Slope of the line.

Calculating Coefficients a and b

b =

n (xy) - x y

n x - ( x)

y - b x =ybx a = n
where n = Number of paired observations

Example 8 Linear Model Seems Reasonable

x 7 2 6 4 14 15 16 12 14 20 15 7 132 y 15 10 13 15 25 27 24 20 27 44 34 17 271 xy 105 20 78 60 350 405 384 240 378 880 510 119 3529 x2 49 4 36 16 196 225 256 144 196 400 225 49 1796 y2 225 100 169 225 625 729 576 400 729 1936 1156 289 7159

Computed relationship
50 40 30 20 10 0 0 5 10 15 20 25

A straight line is fitted to a set 12 3529 132 271 b 1.593 2 12 1796 132 of sample points. 271 1.593132 a 5.06 12

Correlation A measure of the strength and direction of the relationship between two variables. Correlation can range from -1.00 to +1.00.

r =

n (xy) - x y n x2 - ( x)2 n y2 - ( y)2

The square of the correlation coefficient, r2, provides a measure of how well a regression line fits the data.

Curvilinear and Multiple Regression Analysis

When nonlinear relationship are present, we must employ curvilinear regression. Models that involve more than one predictor

require the use of multiple regression analysis.

Forecast Accuracy

Accuracy and Control of Forecasts Error: Difference between the actual value and

the value that was predicted for a given period

et = At Ft Forecast errors influence decisions in two somewhat different ways
1. A choice between various forecasting alternatives

2. Evaluate the success or failure of a technique in use

Measures of Forecast Accuracy Mean Absolute Deviation (MAD)

Actualt Forecastt MAD = n

Mean Squared Error (MSE)

MSE = ( Actualt n -1

2 Forecastt)

Mean Absolute Percent Error (MAPE) MAPE = Actualt Forecastt Actualt 100

Example 9
Period 1 2 3 4 5 6 7 8 Actual 217 213 216 210 213 219 216 212 Forecast 215 216 215 214 211 214 217 216 (A-F) 2 -3 1 -4 2 5 -1 -4 -2 |A-F| 2 3 1 4 2 5 1 4 22 (A-F) 2 4 9 1 16 4 25 1 16 76
(|A-F|/Actual)100

0.92 1.41 0.46 1.90 0.94 2.28 0.46 1.89 10.26

MAD= e /n = 22 / 8 = 2.75 MSE = e2/ (n-1) = 76 / 7 = 10.86 MAPE = 10.26/8 = 1.28

Forecast Accuracy
Two aspects of forecast accuracy can have

potential significance when deciding among

forecasting alternatives :
1. Historical error performance of a forecast
choose the one yields the lowest MAD, MSE, or MAPE

2. The ability of a forecast to respond to changes

the cost of not responding quickly to a change relative to the
cost of responding to changes that are not really there