26

CHAPTER 3

FORECASTING

3.1 Introduction

The success of a business organization largely depends upon how its manager foresees the future and
consequently develop appropriate strategies. A sales manager has to forecast the expected demand in the
next period (day, week, month, quarter or year); accordingly, those units will be procured. Similarly, a
production manager has to forecast how many units of a product are to be produced in the next period.
Forecasting is not only relevant to traditional business organizations, but also to other organizations. The
finance minister of the federal government has to forecast the government’s revenue in the next financial
year before presenting his/her budget. Meteorologists also forecast regarding the weather in the next few
days. Some more forecasting problems: how much will the nation’s gross domestic product (GDP) grow
next year? What will be the inflation rate? The unemployment rate? Which political party will win in the
next general election?
Overall, poor forecasts may incur increased costs for the firm. There is a tendency among managers to
forecast by using their year long experience, intuition etc. This type of forecasts based upon human
judgments are acceptable sometimes, but not necessarily viable all the time. We should strive to forecast
which is as accurate as possible. To do this, we need to use scientific forecasting methods. These methods
can provide forecasts which will help us to make good decisions.
Depending upon the availability and type of data, a number of forecasting methods have been
developed. Usually, we use available historical data to make forecast. The methods, which utilize this
historical data, are known as quantitative methods or statistical forecasting methods. However, in many
situations, we may not have historical data or it may be very difficult to obtain them. In these cases, we can
use qualitative or judgmental forecasting methods. The methods belonging to various categories are
shown in Figure 3.1.

Forecasting Methods

Quantitative Qualitative

Time Series Causal Delphi

Jury of
Smothing Trend Projection Trend Projection with Regresion Executive Opinion
Seasonal Adjusment
Consumer
Marketing
Moving Exponentail Smoothing
Average Sales force
Composite
Simple Weighted

Figure 3.1: Classification of forecasting methods.

Following are the general steps to make forecasts:

1. Select the items or quantities that are to be forecasted.

2. Determine the time horizon of the forecast – is it 1 to 30 days (short term), one month to one year
(medium term), or more than one year (long term)?
3. Select the appropriate forecasting method.
4. Collect the necessary data.
5. Make the forecast.

We will start our decision with time series forecasting methods. A time series is a set of observations of a
variable measured at successive points of time or over successive periods of time (hourly, daily, weekly,
monthly, quarterly or yearly). For example, the demands of bicycles at every month starting from January
 27

till December at a particular cycle shop is a time series. The methods which utilize this time series, i.e.,
historical data to make forecasts are called time series methods. Note that time series methods use only the
data collected at previous time points, they do not consider any other factor. In other words, time series
techniques assume that whatever has happened in the past, the same trend will continue in the future, i.e.,
future is a function of the past.
A time series may consists of a number of components. In the following, we discuss these.

3.2 Various Components of a Time Series

Trend component: In a time series, the data may gradually increase or decrease. The gradual upward or
downward movement of the data over time is called trend. For example: the time series 24, 28, 35, 34, 39,
45 has a positive trend. Note that in this case all the individual data points need not be in an strictly
increasing order. Overall gradual upward (or downward) shifting will suffice to call that the series has
positive (or negative) trend. We can plot a scatter diagram for the time series data with respect to time. If
this series has linear positive trend, then we will get the diagram shown in Figure 3.2.

°
°
Variable °
°
°
°

° °

Time

Figure 3.2: Linear positive trend.

Remember that trend can also be non-linear. For simplicity, in our discussion, we will consider only linear
trend.

Cyclic component: If the time series data are repeated after a certain number of periods, then we call
that the time series has cyclic component. For example, the demand for winter sports equipment increases
every four years, before and after the Winter Olympics. The diagram of cyclic component is shown in
Figure 3.3.

Seasonal component: There are many items whose sale depends heavily upon a particular season. For
example, demand of warm cloths is more in winter season, likewise demand of umbrellas is more in the
rainy season. Greetings cards are more sold before national festivals. Seasonality is also observed in other
situations. For example, density of traffic on the high ways is not same throughout a day; it is the highest
during office hours, normal at other time, very low after mid night. In a typical restaurant, we see many
customers at lunch time, in other time not that much. The component of the time series that represents the
variability in the data due to seasonal influences is called the seasonal component. It is shown in Figure
3.4.
 28

Variable

Time

Figure 3.3: Cyclic component.

Variable

Time

Figure 3.4: Seasonal component.

Irregular or random component: Apart from the previous three components, a time series may also
consist of another component whose occurrence is totally unpredictable. This is called irregular component.
It does not follow any discernable pattern. Virtually, every time series has got this component.

3.3 Time Series Smoothing Methods

Smoothing methods are applicable only when the time series does not have any clear trend or seasonal
influence, i.e., the data are relatively stable over time. There are two kinds of smoothing methods: moving
average and exponential smoothing. Moving average again is of two types: simple moving average and
weighted moving average.

Simple Moving Average (s.m.a.)

The formula for simple moving average is

 29

∑d
i =1
i
t n +1 =
n

where d1, d2, … ,dn are the most recent data and n is the number of periods. To apply s.m.a. technique, we
need to choose an appropriate value of n. Note that the formula of s.m.a. technique is exactly same as the
formula of arithmetic mean. We will illustrate the formula by means of the following example:

Example 3.1: The demands of computers at Amir Computers Sdn. Bhd. from January until October are
shown in the following:

Table 3.1: Computer demand at Amir’s shop.

Month Demand
January 61
February 66
March 60
April 75
May 71
June 70
July 77
August 80
September 66
October 70

Forecast the demand for the month of November.

Let us choose n = 3. Therefore, the forecast for the month of November

80 + 66 + 70
=
3
= 72.

Now suppose that actual demand in November has been 75. Then the forecast error = 75 – 72 = +3. Note
that

Forecast Error = Actual data - Forecast data.

Again, suppose that for Amir’s shop, we need to forecast the demand for December. Note that the actual
demand for November is now available. So, in order to keep n = 3, we should drop data for the month of
August, which was used to calculate the forecasted value for November. In fact, in moving average
techniques, whenever a new data or recent data will be available, we need to drop the oldest data. Now , the
forecast for month of December

66 + 70 + 75
=
3
= 70.33 ≈ 70

Suppose that the actual demand in December is 67. Then forecast error = 67 – 70 = -3.
Note that forecast error can be negative. In the above, we have made forecasts for future months, namely
November and December. In fact, when we choose n = 3, we can forecast for the months starting from
 30

April onwards, though actually this is not required. These are calculated just to measure the accuracy of the
forecasting method used. Refer to the following table:

Table 3.2: Calculation of s.m.a. forecasts.

Month Actual S.M.A. Forecast* Forecast Squared
Demand Error Forecast
Error
January 61  
February 66  
March 60  
April 75 (61+66+60)/3 13 169
=62
May 71 (66+60+75)/3 4 16
=67
June 70 (60+75+71)/3 1 1
=69
July 77 (75+71+70)/3 5 25
=72
August 80 (71+70+77)/3 7 49
=73
September 66 (70+77+80)/3 -10 100
=76
October 70 (77+80+66)/3 -4 16
=75
November 75 (80+66+70)/3 3 9
=72
December 67 (66+70+75)/3 -3 9
=70
* Rounded to the nearest integer.

Forecast accuracy: Generally, it is very difficult to forecast with hundred percent accuracy. So there
will be forecast error. But, of course, the lesser the forecast error is, the better. We can measure the
accuracy of any forecasting method by computing mean squared error (or MSE). In order to compute
this, refer to the last column of above Table 3.2.

169 + 16 + … + 9
MSE for s.m.a =
9
394
=
9
= 43.78
Note that in the calculation, we have taken 9 (not 12) in the denominator, because forecast errors were
known for 9 months only.
We can repeat all the above computations by taking n = 2 or 4. If we do so, then we will get MSE for n
= 2 and 4. Now we can find out which value of n gives the least MSE, the corresponding value is preferred
for future forecasting.

Note 3.1: In our computations, we have chosen n = 3. However, there are situations where n = 4 or 5 or
even 6 is used. In general, forecasts computed using larger value of n are slower to react to recent changes
in data (i.e., the method is less responsive to recent changes in data) than those made using smaller value of
n.
 31

Weighted Moving Average (w.m.a.)

It is to be noted that we have assigned equal weights (or importance) to all the data in the simple moving
average formula. However, there are situations where older values may be less representative of current
condition than the last value observed. In this case, we should assign more weight to the most recent data
and then lesser and lesser to the older pieces of data.

∑w d
i =1
i i
Mathematically , w.m.a = n

∑w
i =1
i

where wi is the weight associated with data di,i=1,2,…,n.

Once again, let us choose n = 3. Choice of the set of weights is itself a problem. One reasonable choice
may be 3 for the most recent data, 2 for the middle one and 1 for the oldest data. Now we are in position to
make forecasts by this weighted moving average method. This has been shown in Table 3.3.

Table 3.3: W.M.A. forecasts.

Month Actual Demand W.M.A Forecast* Forecast error Squared
Forecast
Error
January 61  
February 66  
March 60  
April 75 [(3 × 60) + (2 × 66) + (1× 61)] 13 169
= 62
3 + 2 +1
May 71 [(3 × 75)+(2 × 60)+(1 × 66)]/6 3 9
=68
June 70 [(3 × 71)+(2 × 75)+(1 × 60)]/6 0 0
=70
July 77 [(3 × 70)+(2 × 71)+(1 × 75)]/6 6 36
=71
August 80 [(3 × 77)+(2 × 74)+(1 × 71)]/6 6 36
=74
September 66 [(3 × 80)+(2 × 77)+(1 × 70)]/6 -11 121
=77
October 70 [(3 × 66)+(2 × 80)+(1 × 77)]/6 -2 4
=72
November 75 [(3 × 70)+(2 × 66)+(1 × 80)]/6 5 25
=70
December 67 [(3 × 75)+(2 × 70)+(1 × 66)]/6 -5 25
=72
* Rounded to the nearest integer.

169 + 9 + … + 25
MSE for w.m.a. =
9
425
=
9
= 47.22
 32

We can proceed with a different set of weights and we can find which set of weights is better. Furthermore,
we can compare the accuracy of simple moving average and weighted moving average on the basis of the
present problem. We see that

MSE for s.m.a. = 44.78 < MSE for w.m.a. = 47.22.

Hence, for the present problem, simple moving average gives better forecasts compared to weighted
moving average (where weights are 3, 2, and 1). This is because in several cases, demand trend of the
proceeding month has not been followed in the next month. In general, there is no unique answer that s.m.a.
is better or w.m.a. is better, it depends upon the nature of the time series and what set of weights we have
assigned with the periods in the w.m.a. technique. If the most recent period’s data is weighted too heavily,
then the forecast might over react to a random fluctuation in the orders – the phenomenon observed in our
present problem; on the other hand, if it is weighted too lightly, then the forecast might under react to an
actual change in the pattern of order.
In the following exercise problem, you will find w.m.a. is better than s.m.a.

Self Test 3.1: The enrollments for the past 12 seminars in the time management course are shown below:

Seminar Enrollment
1 34
2 40
3 35
4 39
5 41
6 36
7 33
8 38
9 43
10 40
11 42
12 40

Forecast for the 4th seminar onward until 12th seminar using s.m.a. and w.m.a. with weights (3,2,1) and n =
3. Which of the two is better?

[Hint: MSE for s.m.a =13.20 and MSE for w.m.a = 12.71; hence w.m.a. is better than s.m.a]

Exponential Smoothing

We have experienced a number of difficulties in moving average methods, namely, the choice of n and
extensive amount of record keeping (note that if n = 3, then, to start the method at least 3 previous actual
pieces data should be available). These difficulties can be overcome by using exponential smoothing
forecasting method. The mathematical formula of exponential smoothing is the following:

Ft+1 = αYt+ (1-α) Ft

where Ft+1 = new forecast for period t+1

Ft = old forecast for period t
Yt = actual data for period t
α = smoothing constant, 0 ≤ α ≤1.

Note that by means of exponential smoothing, to forecast for the period t+1, three pieces of information are
required, viz., smoothing constant α, Ft and Yt. Since, in this case, to forecast for a certain period, we need
to know the record of only the immediately proceeding period’s data, we can forecast from second month
 33

(i.e., February) onwards. To start forecasting from the second month, we need to know the forecasted value
for the month of January, which we do not have. So, we assume that the forecast for January = actual
demand in January, i.e., F1 = Y1. Let us also assume that α = 0.6. All the computations are shown in Table
3.4.

Table 3.4: Exponential smoothing forecasting calculations.

Month Actual Exponential Smoothing Forecast Squared
Forecast Forecasts (α = 0.4)* Error Forecast
Error
January 61 61 (assumed)  
February 66 (0.4 × 61) + (0.6 × 61) = 61 5 25
March 60 (0.4 × 66) + (0.6 × 61) = 63 -3 9
April 75 (0.4 × 60) + (0.6 × 64) = 62 13 169
May 71 (0.4 × 75) + (0.6 × 62) = 67 4 16
June 70 (0.4 × 71) + (0.6 × 70) = 69 1 1
July 77 (0.4 × 70) + (0.6 × 70) = 69 8 64
August 80 (0.4 × 77) + (0.6 × 70) = 72 8 64
September 66 (0.4 × 80) + (0.6 × 74) = 75 -9 81
October 70 (0.4 × 66) + (0.6 × 78) = 72 -2 4
November 75 (0.4 × 70) + (0.6 × 71) = 71 4 16
December 67 (0.4 × 75) + (0.6 × 70) = 73 -6 36
* Rounded to the nearest integer.

MSE for exponential smoothing is

25 + 9 + … + 36
=
11
485
=
11
= 44.10

Note that, unlike previous cases, here we have taken 11 in the denominator because we have calculated
forecast errors from second period onwards.

Selection of the Smoothing Constant

Clearly, the forecasted values by exponential smoothing formula depends upon the value of α, the
smoothing constant. So, the choice of α should be made with care. Once again, note the exponential
smoothing formula:

Ft+1 = αYt + (1-α)Ft.

This formula shows that if the time series is relatively stable, i.e., amount of variability is less, then we
should prefer higher values of α, otherwise lower value.
We can also choose a ‘good’ value of α by performing a trial and error method. In the Table 3.5, we
have performed our experiment by taking α = 0.1, 0.2, 0.3, 0.4, 0.5, 0.6, 0.7, 0.8, 0.9, and 1.0. We observe
that α = 0.5 is the best for the present problem. Hence we should forecast for the future month, i.e., January
of next year by using α = 0.5 only, as below:

F13 = ( 0.5 × 67) + (0.5 × 73)

= 70.
 34

Table 3.5: MSEs corresponding to

various values of α
α MSE
0.1 70.23
0.2 52.56
0.3 46.14
0.4 43.97
0.5 43.96
0.6 45.64
0.7 47.87
0.8 51.25
0.9 55.39
1.0 60.18

Finally, we compare the accuracy of three smoothing methods discussed above. Refer to the following
table:

Table 3.6: MSEs for the three smoothing methods.

Smoothing Methods MSE
Simple Moving Average 44.78
Weighted Moving Average 47.22
Exponential Smoothing 43.96
(α = 0.5)

From the above table, we can conclude that exponential smoothing (α = 0.5) is the best.

Note 3.2: The exponential smoothing forecasting method is actually a special case of weighted moving
average technique where recent past data are strongly more weighted compared to the older data. Let us
observe the following:

F2 = α Y1 + (1 − α ) F1
= α Y1 + (1 − α )Y1
= Y1

F3 = α Y2 + (1 − α ) F2
= α Y2 + (1 − α )Y1

F4 = α Y3 + (1 − α ) F3
= α Y3 + (1 − α ) [α Y2 + (1 − α )Y1 ]
= α Y3 + (1 − α )Y2 + (1 − α ) 2 Y1

F5 = α Y4 + (1 − α ) F4
= α Y4 + (1 − α ) [α Y 3 + α (1 − α )Y2 + (1 − α ) 2 Y1 ]
= α Y4 + α (1 − α )Y3 + α (1 − α ) 2 Y2 + (1 − α ) 3 Y1

If we assume that α = 0.6, then

 35

F5 = 0.6Y4 + 0.24Y3 + 0.096Y2 + 0.064Y1

This shows that F5 is a weighted average of the first four time series value. Note that the weights are
decreasing exponentially, i.e., a very rapid rate. For this reason, it is called exponential smoothing. By the
way, why are these methods called smoothing methods? The answer is given in the following note.

Note 3.3: The first category of time series methods discussed above are called smoothing methods,
because they “smooth out” (by taking average) the random fluctuations caused by the irregular component
of the time series.

Note 3.4: In order to measure the accuracy of any forecasting method, we have used mean squared error
(MSE). Apart from MSE, there is another commonly used index which is mean absolute deviation (or
MAD). To calculate MAD, firstly we take absolute values of all the forecast errors and sum them. Then we
divide the sum by the total number of periods considered to calculate the sum.

Note 3.5: The reason for the word ‘moving’ in the name moving average is that, at every period the
average value changes or moves. For example, refer to the Table 3.2 (where s.m.a. forecasts are calculated).
The forecast for April is 62. Next forecast for May, the average value ‘moves’ to 67. For this reason the
method is called as simple ‘moving’ average. Same observation is true for weighted moving average.

3.4 Time Series Trend Projection

As stated in the previous section, if a time series consists of trend, positive or negative, then smoothing
methods (especially simple moving average and weighted moving average) should not be applied, because
these methods cannot capture the trend. For example, say the time series is: 46, 52, 58 …. It has a clear
positive trend. If the trend continues in the future, then demand is expected to be more than 58 in the fourth
period. But if we apply simple moving average or weighted moving average (considering any set of
weights), then forecasted value will always be less than 58, because these are simply averaging procedures
and an average cannot exceed the largest value in the series. We should use trend projection to forecast for
a time series which has a trend. Remember that, to have a trend, the data need not be in strictly increasing
or decreasing order, i.e., overall increase or decrease will suffice to call that the series has a positive or
negative trend.
In trend projection method, firstly, we find out the trend and then we project the trend in the future. For
this reason the methodology is called trend projection.
Trend projection is applicable to medium to large range forecasting problems, though for short-range
forecasting it is also used. Furthermore, trend can be linear (straight line) or non-linear (exponential,
logarithmic, etc). For simplicity, we shall consider only linear trend. Treatment of non-linear trend can be
obtained from any advanced book on Forecasting.
How to find out trend? The statistical method by which we can find out trend is called least squares
method. The method works in this way: firstly, we draw the scatter diagram of the given data. Then we
draw a straight line in such a manner that the line minimizes the sum of the squares of the vertical
differences from the line to each of the actual observations. Let us consider an example.

Example 3.3: At Ahmad’s shop, the sale of TV sets in the past 7 months are shown in the following
table:
Table 3.7: TV sales data.
Month Sales(100s)
January 52
February 57
March 56
April 60
May 65
June 69
July 75
 36

Forecast the demand for the month of August.

For our convenience, we replace the months by 1, 2, 3, 4, 5, 6, and 7. This is required for numerical
computations. Next, we draw a scatter diagram for the given time series data. Though this drawing is not
essential, but it gives a graphical view of the trend. This is shown in Figure 3.5.

80
•
70 •
•
60 •
Sales • •
•
50

1 2 3 4 5 6 7
Time

Figure 3.5: Scatter diagram for the sales data

Clearly, there is an upward trend in the data. We try to draw one straight line passing through all the points.
But this is not possible because the increment in the series is not proportional. So we need to draw the
straight line which is as close as possible to all the points. This is the concept in the least squares method.
Let us suppose the equation of the straight line is

Tt = b0+b1t

where ‘t’ is the independent variable (here time) and ‘T’ is the dependent variable (here demand of TV).
Following least squares method, we derive the following formulas of b0 and b1(details can be obtained from
any elementary book on Statistics):

b1 =
∑ tY − (∑ t ∑Y ) n
t t

∑ t − (∑ t ) n
2 2

bo = Y − b1 t

where Y =
∑Y t

t=
∑t
n
n = number of observations
 37

Table 3.8: Trend projection calculations (Example 3.3).

t Yt tYt t2
1 52 52 1
2 57 114 4
3 56 168 9
4 60 240 16
5 65 325 25
6 69 414 36
7 75 525 49
2
Σt = 28 ΣYt = 434 ΣtYt = 1,838 Σt = 140

b1 =
∑ tY − (∑ t ∑Y ) n
t t

∑ t − (∑ t ) n
2 2

1838 − (28 × 434) 7

=
140 − (28 × 28) 7
1838 −1736
=
140 −112
102
=
28
= 3.64
b0 = Y − b1t

=
∑Y t
− b1
∑t
n n
434 28
= − 3.64 ×
7 7
= 62 − 14.56
= 47.44

Hence the equation of the straight line is: Tt = 47.44 + 3.64t. The fact b1 = 3.64 indicates that the average
increase over the past seven months is 3.64 TVs (i.e., 364, because the data are given in terms of 100).
Now to forecast for August, simply we need to put t = 8 in the above equation. Therefore, the forecasted
demand for August

= [47.44 + (3.64 × 8)] × 100

= 76.56 × 100
= 7656 TV sets.

Note that by means of previously discussed time series smoothing techniques, we cannot forecast for the
month of September for the present problem, because to apply all these methods the actual demand in
August is required which we do not have yet. But by means of trend projection method, we can easily
forecast the demand for September. Simply we need to substitute t by 9, as we have done in the following.

Forecast for September (T9)

= [47.44 + (3.64 × 9)] × 100
= 80.2 × 100
= 8020.
 38

Note 3.6: The trend line which we have drawn in the scatter diagram is also called linear regression line
where b0 is the y-intercept and b1 is the slope (gradient) of the line.

3.5 Trend Projection with Seasonal Adjustment

As stated previously, there are many items whose sale depends upon some particular season. To forecast
for this type of time series, we must take seasonal factor into account. In this case, we need to follow the
steps stated below:

Step 1: Compute the seasonal indexes of the periods.

Step 2: Deseasonalize the series upon dividing the period’s data by its corresponding seasonal index.
Step 3: Find out the trend for the deseasonalized data by using trend projection method and then forecast.
Step 4: Adjust the forecasted values on multiplying by the seasonal index.

Example 3.4: The demand of tennis rackets at a particular shop in all the four quarters of the past three
years are shown in Table 3.9. Forecast for the four quarters in the year 4.

Table 3.9: Demand of tennis rackets in the past three years.

Year Quarter Sales (in 1000s)

1 3
1 2 9
3 6
4 2
1 4
2 2 11
3 8
4 3
1 5
3 2 15
3 11
4 3

Let us closely observe the given set of data.

Table 3.10: Demand of tennis rackets quarter wise.

Demand (in thousands)
Quarter ↓ Year
1 2 3
1 3 4 5
2 9 11 15
3 6 8 11
4 2 3 3

We observe that over the years the demand has increased in every quarter, i.e., demand has a positive trend.
Furthermore, within a year, there is a clear seasonal impact. The sales are much more in quarters 2 and 3
compared to quarters 1 and 4. So, to forecast for this type of time series, we will follow the foregoing four
steps.
 39

Step 1: In this step, we compute the seasonal indexes (i.e., indexes for the four quarters). To do this firstly
we construct Table 3.11.

Table 3.11: Computations of seasonal irregular components.

Year Quarter Sales 4-Qtr. Moving Centered Seasonal
(1000s) Average Moving Avg. Irregular
Component
1 3
2 9
(3+9+6+2)/4 = 5.00
1 3 6 (5.00+5.25)/2 = 5.13 6/5.13 = 1.17
(9+6+2+4)/4 = 5.25
4 2 (5.25+5.75)/2 = 5.50 2/5.50 = 0.36
(6+2+4+11)/4 = 5.75
1 4 (5.75+6.25)/2 = 6.00 4/6 = 0.67
((2+4+11+8)/4 = 6.25
2 11 (6.25+6.50)/2 = 6.38 11/6.38 = 1.72
2 (4+11+8+3)/4 = 6.50
3 8 (6.50+6.75) = 6.63 8/6.63 = 1.21
(11+8+3+5)/4 = 6.75
4 3 (6.75+7.75)/2 = 7.25 3/7.25 = 0.41
(8+3+5+15)/4 = 7.75
1 5 (7.75+8.50)/2 = 8.13 5/8.13 = 0.62
(3+5+15+11)/4 = 8.50
2 15 (8.50+8.50)/2 = 8.50 15/8.50 = 1.76
3 (5+15+11+3)/4 = 8.50
3 11
4 3

A number of explanations are required for Table 3.11. First three columns are self-explanatory. In the
fourth column, we have computed 4-quarter moving average. Some are again shown below:

3+9+6+ 2
= 5.00
4
9+6+2+4
= 5.25
4
6 + 2 + 4 + 11
= 5.75
4
… … … …

The 4-quarter moving averages are placed in the middle row of the four quarters. We would like to interpret
the moving average 5.00. This is the average demand of the four quarters in year 1. We can also interpret
this value as the demand in the middle quarter of year 1. But which one is the middle of quarters 1, 2, 3,
and 4? We divide every quarter into two equal halves. Then middle quarter can be found out.

       

1 1 2 2 3 3 4 4

Clearly, the middle quarter is

second half of quarter 2 and first half of quarter 3.

 40

Similarly, we can interpret the value 5.25 (second entry in the fourth column) as the demand in the middle
quarter of quarters 2, 3, 4 (all year 1) and quarter 1 (year 2).

       

2 2 3 3 4 4 1 1

The middle quarter is

second half of quarter 3 and first half of quarter 4.

From above, we find that demand in the first half of quarter 3 is 5.00 and that in the second half is 5.25.
Hence the average demand in quarter 3 is, once again,

5.00 + 5.25
= 5.13
2

This value is called centered moving average. In the same fashion, all other centered moving averages are
calculated. Now if we look across the row of quarter 3, we find that the actual demand at quarter 3 is 6 (in
fact, 6000) units but the calculated average demand is 5.13 units. The value obtained upon dividing 6 by
5.13, i.e., 6/5.13 = 1.17 is called seasonal-irregular component. Basically this is combined seasonal-
irregular component of the time series for quarter 3. In the same manner, we calculate seasonal irregular
components of the other quarters.
We obtain two values for seasonal irregular component for quarter 3, viz., 1.17 and 1.21. This variation
is due to irregular component. So, we take average to eliminate the influence of irregularity. This is done in
Table 3.12.
Table 3.12: Removal of irregular component.
Quarter Seasonal-irregular Seasonal Index
component
1 0.67, 0.62 (0.67+0.62)/2 = 0.65
2 1.72, 1.76 (1.72+1.76)/2 = 1.74
3 1.17, 1.21 (1.17+1.21)/2 = 1.19
4 0.36, 0.41 (0.36+0.41)/2 = 0.39

If we assume that the index of the quarter when sales is average as 1.00, then sum of all the indexes are
supposed to be exactly 4.00. However, the sum of all the four indexes in the last column of Table 3.12 is
3.97. Therefore, some adjustment is required so that sum of the indexes is exactly equal to 4.00. The
formula is:

4
Adjusted seasonal index = .
sum of the nonadjusted seasonl indexes

Applying the above formula, we obtain the final seasonal indexes of all the 4 quarters. These are shown in
Table 3.13.

Table 3.13: Computation of adjusted seasonal indexes

Quarter Index
1 0.65 × (4/3.97) = 0.655
2 1.74 × (4/3.97) = 1.753
3 1.19 × (4/3.97) = 1.199
4 0.39 × (4/3.97) = 0.393
 41

1.753 for quarter 2 shows that in this quarter, the sales are 75.3% higher than the average sales. On the
other hand, 0.665 for quarter 1 indicates that in this quarter sales are 33.5% ((1-0.665) × 100) lower than
the average sales.

Step 2: In this step, we deseasonalize the data by removing the seasonal effect. This is done upon dividing
the time series observations by the corresponding period’s seasonal index. Refer to Table 3.14.

Table 3.14: Deseasonalization of the time series data.

Year Quarter Yt St Yt/St

1 3 0.655 4.58
1 2 9 1.753 5.13
3 6 1.199 5.00
4 2 0.393 5.09
1 4 0.655 6.11
2 2 11 1.753 6.27
3 8 1.199 6.67
4 3 0.393 7.63
1 5 0.655 7.63
3 2 15 1.753 8.56
3 11 1.199 9.17
4 3 0.393 7.63

The last column of Table 3.14 gives the original time series minus the seasonal effect. A clear trend is
present in the series, as we observed in the very beginning. So, we need to find out this trend.

Step 3: The procedure is exactly the same as we discussed in the last section. Let us assume the trend
equation as:

Tt = b0 + b1t

where b1 =
∑ tY − (∑ t ∑Y ) n
t t

∑ t − (∑ t ) n
2 2

b0 = Y − b1t
It is to be noted that here Yt values are the deseasonalized values, not the actual given values. According to
the requirement, we construct Table 3.15.

Table 3.15: Trend projection calculation (Example 3.4).

t Yt t Yt t2
1 4.58 4.58 1
2 5.13 10.26 4
3 5.00 15.00 9
4 5.09 20.36 16
5 6.11 30.55 25
6 6.27 37.62 36
7 6.67 46.69 49
8 7.63 61.04 64
9 7.63 68.67 81
10 8.56 85.60 100
11 9.17 100.87 121
12 7.63 91.56 144
Total 78 79.47 572.60 650
 42

78 79.47
We have t= = 6.5, Y = = 6.6225
12 12
572.8 − (78 × 79.47) / 12
b1 = = 0.3933.
650 − (78 × 78) / 12
b0 = 6.6225 − 0.3933 × 6.5 = 4.066
Tt = 4.066 + 0.3933t.

Our overall problem is to forecast for the four quarters in year 4. Since we have already removed seasonal
effect from the time series and also we have taken t = 1, 2, …,12 to obtain the above trend line based upon
the 12 quarters of the past three years, we need to put t = 13, 14, 15, and 16 if we want to forecast for the 4
quarters in year 4. So,

T13 = 4.066 + 0.3933 × 13 = 9.179

T14 = 4.066 + 0.3933 × 14 = 9.572
T15 = 4.066 + 0.3933 × 15 = 9.966
T16 = 4.066 + 0.3933 × 16 =10.359

Step 4: Note that above are forecasts from deseasonalized data. Finally, we need to bring back the
seasonal effect. This is done upon multiplying the above forecast by the corresponding seasonal index. This
is done in Table 3.16

Table 3.16: Computation of the final forecasted values.

t Trend Forecast Seasonal Quarterly forecast
Index
13 9.179 × 1000 = 9179 0.655 6012
14 9.572 × 1000 = 9572 1.753 16780
15 9.966 × 1000 = 9966 1.199 11949
16 10.359 × 1000 = 10359 0.393 4071

We see from the Table 3.16 that the required forecasts for the four quarters in the year 4 are 6,012, 16,780,
11,949, and 4,071 respectively.

3.6 Linear Regression Analysis

As it was stated previously that, regression analysis is not a time series method, it is a causal method. In a
time series method, we assume that dependent variable say, demand depends only upon a single
independent variable, i.e., time. That is why time series methods use only the past historical data, which are
collected at a number of previous time points. However, in many situations the dependent variable not only
depends upon time but also on many other factors. For example, demand may be influenced by advertising
expenditure, price cut (i.e., SALE), competitors’ price and other various promotion strategies. If these
factors are present, then along with time we must also take into account all these. Here demand can be
regarded as ‘effect’ and those factors are ‘causes’. The method that establishes relationship (linear or non-
linear) between the effect (the dependent variable) and the causes (independent variables) is known as
causal method. Regression analysis falls under causal forecasting methods. The method which derives
linear relationship between dependent variable and only one independent variable (which is not time) is
known as linear regression analysis. The method which establishes relationship between the sole
dependent variable and a number of independent variables is called multiple regression analysis. For
discussion on multiple regression analysis, the reader is referred to any advanced book on Forecasting.
The distinction between trend projection and simple regression analysis should be clear. In trend
projection, we deal with only one independent variable, which is time. In simple regression analysis also
we deal with only one independent variable but that is not time. Since both the methods deal with only one
 43

independent variable, as far as the procedure is concerned, there is no difference between the two;
difference lies only in concepts. Despite the similarity from computational point of view, we will use
different notations for regression analysis.
Let us suppose the regression equation is:

y = b0+b1x
where y = dependent variable
x = independent variable
b0 = y-intercept
b1 = slop of the straight line.

Following least squares method, we obtain:

b1 =
∑ xy − (∑ x∑ y ) n
∑ x − (∑ x ) n
2 2

b0 = y − b x, y =
1
∑y , x=
∑x .
n n
Let us consider the following example:

Example 3.5: Hayat Restaurant has been spending money to attract new customers at its newly opened
outlet at the outskirt of Kuala Lumpur. The following table gives the advertisement expenditure along with
the corresponding total sales volume in monetary value.

Table 3.18: Hayat Restaurant advertisement and sales data.

Advertisement (1000s) Sales (1000s)
4 23
7 49
9 48
13 58
16 61

If Hayat spends $20,000, then how much sales he can expect?

The data shows clear positive trend. Which one should be regarded independent and which one
dependent variable? Note that in the last part of the question, the given data is advertisement expenditure,
so advertisement expenditure is independent variable, denoted by ‘x’. The other factor sales, denoted by ‘y’
will be regarded as dependent variable. Note that in Table 3.18, independent variable (x) is provided in the
firstly column and the dependent variable is in the second column. Usually this is the case. However,
sometimes independent variable may be provided in the second column. So, one should not always think
that the variable which is provided in the first column is x. You should note that in question which data is
provided, the corresponding variable is independent; it does not matter in which column it has been
provided.
Now our major task is to find out the regression equation y = b0+b1x, i.e., to find out the values of b0 and
b1. The formulas are provided before. According to the requirement of the formulas, we construct Table
3.19
Table 3.19: Linear regression computations
x y xy x2
4 23 92 16
7 49 343 49
9 48 432 81
13 58 754 169
16 61 976 256
Σx=49 Σy=239 Σxy=2597 Σx2=571
 44

b1 =
∑ xy − (∑ x∑ y ) n
∑ x − (∑ x ) n
2 2

2597 − (49 × 239 ) 5

= (Note that number of data points = 5.)
571 − (49 × 49 ) 5

2597 − 2342.2
=
571 − 480.2

254.8
=
90.8

= 2.8062.

b0 = y − b1 x
239 49
= − 2.8062 ×
5 5
= 47.8 − 27.5008
= 20.2992.

Hence the regression equation is

y = 20.2992 + 2.8062 x

If Hayat spends $20,000, then he can expect the following amount of sales:

y = [20.2992+(2.8062×20)]×1000
= $76423.

Note 3.7: In trend projection (a time series method) the independent variable time is provided
sequentially, i.e., January, February, March, …or numerically 1, 2, 3 …But in regression analysis,
independent variable is not provided sequentially (refer to the Table 3.18)

3.7 Correlation Coefficient

In the previous example, we found that the sales at the restaurant were ‘positively correlated’ with the
advertisement budget. In other words, sales depend upon advertisement. Now the question is to what extent
sales depends upon advertisement? We can find out the answer by computing correlation coefficient.
Correlation coefficient measures the strength of relationship between dependent variable and independent
variable(s). Correlation coefficient is denoted by ‘r’ and it lies in between 0 and 1, i.e., 0 ≤ r ≤ 1. Figure 3.6
shows various values of ‘r’ for different kinds of data.
 45

° °
° °
° r =1
° r = -1
°

(a) (b)

°
°
° ° ° ° ° °
° ° ° ° ° ° °
0<r<1
r=0

(c) (d)

Figure: 3.6: Correlation coefficient for various types of data.

The formula for correlation coefficient is albeit complicated but easy to remember. This is provided in
the following:

r=
∑ xy − ∑ x∑ y
n

n x − (∑ x )  n∑ y − (∑ y ) 
 ∑
2 2 2 2
  

For Hayat Restaurant we will compute correlation coefficient between advertisement and sales. To do so
we need to know Σx, Σy, Σxy, Σx2, and Σy2. From Table 3.19, we already know Σx, Σy, Σxy, and Σx2.
Additionally we need to compute Σy2. This has been computed in the following:

Table 3.20: Computations of correlation coefficient.

x y xy x2 y2
4 23 92 16 529
7 49 343 49 2401
9 48 432 81 2304
13 58 754 169 3364
16 61 976 256 3721
Σx=49 Σy=239 Σxy=2597 Σx2=571 Σy2=12319
 46

(5 × 2597) − (49 × 239)

r=
[(5 × 571) − (49) 2 ][(5 × 12319) − (239) 2 ]
12985 − 11711
=
(2855 − 2401)(61595 − 57121)
1274
=
454 × 4474
1274
=
1425.2
= 0.8939

The value 0.8939 is close 1.0. Hence we can conclude that the sales at the restaurant heavily depends upon
the amount of money spent for advertisement.

3.8 Qualitative Methods

The methods we have discussed in the previous sections require past numerical data. But there are
forecasting problems where previous numerical data may not be available or very difficult to obtain. For
example, suppose a company wants to introduce a new product. What will be its demand in the future?
Since the product is new, previous demand data are not available. For this type of problems, qualitative
forecasting methods can be used. These are mainly based upon experts’ judgments. Furthermore, these
methods are applicable when subjective factors are perceived to be very important. In the following, we
discuss a number of qualitative forecasting methods.

Jury of executive opinion: This is a widely used qualitative forecasting method to derive a long-term
strategic plan for an organization. This involves a small group of high profile managers who pool their best
judgments to collectively make the forecast. This method can be used for critical forecasts for which
several executives share responsibility and can provide different types of expertise.

Sales force composite: This bottom-up approach is used to make sales forecast. This method can be
used when a company employs a sales force to generate demand. Each sales person estimates future
demand. These estimates are passed through organization’s ladder and ultimately synthesized to make the
final forecast.

Consumer market survey: This method involves surveying potential customers regarding their future
purchasing plans and how they would respond various new features of a product. This method is
particularly helpful when designing a new product and ascertaining its future demand.

Delphi technique: It was developed at the Rand corporation shortly after World War II to forecast the
impact of a hypothetical nuclear attack on the United States. Although Delphi method has been used for
variety of applications, forecasting has been one of its primary use. It is an iterative procedure, which aims
at forecasting through consensus. It needs two categories of people: decision makers and respondents. All
are expected to be knowledgeable on the issue concerned. Respondents are physically separated; they are
located at different places or possibly different countries. Decision makers prepare a set of questionnaires
pertaining to the issue and these are communicated to the respondents (five or six in number) who are
experts on the issue. The respondent will fill up the questionnaires and send back to the decision makers.
Now based upon the responses of the experts, the decision makers will prepare a second set of
questionnaire. Basically, the second questionnaire will highlight the differences in opinions in the first
round. This second questionnaire again will be sent to the respondents and each of them will be asked to
reconsider and possibly revise his or her previous responses in the light of the group information provided.
The process continues in this manner. After several rounds, the decision makers may feel that some degree
 47

of consensus has been reached. This consensus is the required forecast. Delphi is normally used at the
highest level of a corporation or government to develop long-range forecasts.

3.9 Forecasting in Practice

1. American Airlines used time series methodology to forecast the demand of 5,000 different kinds of
spare parts ranging from landing gear to wing flaps to coffee makers. However, the methodology
was slow to respond to the external factors such as changes in aircraft utilization, fleet expansions
and meeting demand for each spare part at each station.
To correct the deficiencies, American Airlines developed the Rotables Allocation and Planning
System (RAPS), which used regression analysis to generate demand forecasts for spare parts, assist
in allocating spare parts to airports, to compute the availability of each spare part, and to establish a
relationship between monthly part removals and various functions of monthly flying hours in less
than an hour. All the parts covered by the RAPS are essential to the operation of an aircraft to the
extent that a part shortage can even result in the cancellation of a flight and if that is the case then
costs could be substantial. Using RAPS, the materials management group at the Airlines estimated
that it had one-time savings of $7 million and recurring annual savings of nearly $1 million.

(Source: Tedone, J. (1989) “Repairable part management”, Interfaces, 19/4, 61-68.)

2. Taco Bell, whose annual sales revenue exceeds $5 billion, is an international fast food company with
6,500 locations world wide and like most quick service restaurants, it understands the quantitative
trade-off between labor and speed of service. Unlike a manufacturing company, it is not possible for
Taco Bell to produce its fast food in advance and store them in inventory. The company has
observed that more than 50% of daily sales come from the 3-hour lunch period, i.e., from 11:00 AM
to 2:00 AM so it is very critical for Taco Bell to ensure that proper staffing is in place at all times as
customers do not want to wait for more than 3 minutes for services.
To achieve the goal of minimizing customers’ waiting time and also maximizing company’s
revenue, the company chose 6-week moving average method to forecast demand in specific 15
minute intervals during each day of the week. The forecasts are compared to statistical forecasting
control limits that are continuously updated and the length of the moving average is adjusted when
the forecasts move out of control. The forecasting model has been so successful that in its first four
years of use, Taco Bell achieved savings of over $40 million in addition to increasing customer
service.

(Source: Henter, J. and Swart, W. (1998) “An integrated labor management system for Taco Bell”,
Interfaces, 28/1, 75-91.)

3. The Unemployment Insurance Economic Forecasting Model (UIEFM) which is in use by the state
employment agencies was developed by U.S Department of Labor in collaboration with a consulting
firm. This model not only forecasts how much the state will need to pay in unemployment insurance
based on factors such as unemployment rate, wage levels, and the size of the labor force but has also
been proven to be an invaluable insurance systems and in guiding related legislative policies.

4. LL. Bean, a major retailer, sells quality outdoor goods and apparel. This company has a call center
where two 800 numbers are provided, one for making enquiries or reporting problems and the other
for placing orders. The company generates 70% of its total sales volume through orders taken at its
cell center. The employees at this center are trained to answer just one of the 800 numbers, therefore,
to forecast staffing requirements for the two 800 numbers on a weekly basis, separate statistical
forecasting methods were developed. These models not only helped L.L. Bean to enhance its
scheduling efficiency but also saved them $ 300,000 annually.
 48

3.10 Summary
Forecasting is a fundamental task for any business organization. In particular, any company which is
engaged in producing goods needs to forecast the demand of its goods. Depending on the nature of the
forecasting problem, a variety of methods have been developed. These methods are broadly classified into
two categories: quantitative and qualitative. When historical or past data are available, then quantitative
techniques can be applied. However, in many situations, it is difficult to obtain past numerical data, or else
a number of subjective factors are associated with the problem, in those cases we can apply qualitative
forecasting methods. Major quantitative methods discussed in this chapter include moving average,
exponential smoothing, trend projection, trend projection with seasonal adjustment, and regression analysis.
On the other hand, qualitative methods discussed are: jury of executive opinion, Delphi etc. Generally
speaking, qualitative forecasting methods are somewhat more widely used compared to quantitative
techniques. Among quantitative techniques moving average and regression analysis are widely used. Many
organizations prefer to use qualitative method(s) combined with appropriate quantitative method(s).

_______