FORECASTING METHODS

Dr. T. T. Kachwala

Mumbai | India
IMPORTANCE OF FORECASTING

In management situations, forecasting is important because the lead time for decision
making ranges from several years (for case of capital investment) to few days (for
transportation schedules) to few hours (for production schedules).

The important component of forecasting is the distinction between uncontrollable external

events (originating with National economy, governments, customers and competitors) and
controllable internal events (such as marketing or manufacturing decision within the
firms). The success of a company depends on both the type of events, but forecasting
applies directly to the former (uncontrollable external events), while decision making
applies directly to the latter (controllable internal events). Planning is the link that
integrates them
IMPORTANCE / DEFINITION OF
FORECASTING

Suppose we forecast the sales volume for a particular product for the next
quarter of the year. Production schedules, raw material purchasing plan,
inventory policies & sales quota will be affected by the quarterly forecast we
provide. Consequently, poor forecast will result in increased cost for the firm.

• Definition: The word forecast means projection of past into the future for
e.g. Demand forecasting: based on past demand, we forecast future demand
values.
TYPES OF FORECASTING TECHNIQUES

Two general types of forecasting techniques are used for demand forecasting.
1. Quantitative Method
2. Qualitative Method

• Quantitative forecasting methods can be used when:

1. past information about variable being forecast is available
2. information can be quantified
3. assuming that pattern of past will continue into the future
TIME SERIES METHODS

1. If historical data are restricted to past values of the variable that we are
trying to forecast, the forecasting procedure is called time series method.

2. The objective of time series method is to discover a pattern in the

historical data and then extrapolate this pattern into the future

3. The forecast is based solely on past values of the variable that we are
trying to forecast and past forecast errors.
RANDOM FLUCTUATION IN TIME SERIES

In time series analysis, measurements may be taken at regular intervals.

They generally exhibit random fluctuation as indicated below (Average
Sales is Constant)
RANDOM FLUCTUATIONS / TREND IN THE
TIME SERIES

Random fluctuations of the time series is the residual factor that includes
deviation of actual time series values from those expected due to random
variability in the time series. The irregular component is caused by the short
term, unanticipated, uncontrollable and non recurring factors that affect the time
series. Because this component accounts for random variability in the time series
it is unpredictable.

Sometimes the time series may show gradual shifts or movements to relatively
higher or lower values over a long period of time. The gradual shifting of time
series is referred as the trend in the time series.
TREND IN THE TIME SERIES

This shifting or trend is usually the result of long term factors such as
changes in population, changes in technology & customer preferences
FORECASTING METHODS OF TIME SERIES

• 1. Smoothing Methods
a) Moving Average
b) Weighted Moving Average
c) Exponential Smoothing

• 2. Causal Forecast
a) Two Variable Regression Model
b) Three Variable Regression Model
3. Trend Projection
SMOOTHING METHODS

The objective of smoothing method is to “smooth” out “the random

fluctuations” caused by the irregular component of the time series. The
popular smoothing methods are: moving average, weighted moving average
& exponential smoothing. These smoothing methods are appropriate for a
stable time series i.e. one that exhibits no significant trend or seasonal effects.
Many manufacturing environments require forecast for thousands of items
weekly or monthly. Thus in choosing a forecasting technique simplicity &
ease of use are important criteria. Smoothing methods are easy to use &
generally provide high accuracy for short range forecast such as forecast for
the next time period
SIMPLE AVERAGE METHOD

1
f t 1   d t  d t -1  d t -2  d t -3  .... n terms ... 
n
f t+1 = forecast for period ‘t + 1’

d t = actual demand for period ‘t’

d t-1 = actual demand for period ‘t - 1’

Simple Average Method is not very popular because it uses distant past
data. The more popular method is the Moving Average Method
MOVING AVERAGE METHOD

This method uses the average of the most recent data values in the time series as a
forecast for the next period.

The term moving indicates that, as the new observations become available for the
time series, it replaces the oldest observation and the new average is computed. As
a result the average will move as the new observations will become available.

The first decision we have to take while using moving average is to decide the
number of periods
3 PERIOD MOVING AVERAGE

Assuming three periods

1
f t 1  d t  d t -1  d t -2 
3
1
Sub t  3, f 4   d 3  d 2  d1 
3
1
Sub t  4, f 5  d 4  d3  d 2 
3
4 PERIOD MOVING AVERAGE

Assuming four periods

1
f t 1  d t  d t -1  d t -2  d t -3 
4
1
Sub t  4, f 5   d 4  d 3  d 2  d1 
4
1
Sub t  5, f 6   d5  d4  d3  d2 
4
SELECTING THE NUMBER OF PERIODS IN MOVING AVERAGE METHOD

An important consideration in selecting a forecasting method is the accuracy of forecast. We define

forecast error as ≡ et = │dt - ft│

We want the forecast errors to be small. The MSE (Mean Squared Error) is an often used measure of
the accuracy of a forecasting method.
1  e2
MSE  n t

For a particular time series, different lengths of moving averages, will affect the accuracy of the
forecast. One possible approach in moving average to choosing the number of periods to be included,
is to use trial & error to identify the number of periods that minimizes MSE.

We must forecast the next value in the time series using the number of data values that minimizes the
MSE for the historical times series
WEIGHTED MOVING AVERAGE METHOD

In moving average method, each observation in the calculation receives the same weight.
One variation known as Weighted Moving Average, involves selecting different weights for
different data values and then computing a weighted average of the most recent data.

To use the weighted moving average method, we must select the number of periods and then
choose weights for each of the periods.

In general, if we believe that the recent past is a better predictor of the future than the distant
past, larger weights should be given to the more recent periods.
WEIGHTED MOVING AVERAGE METHOD

f t 1  α 0 d t  α 1 d t -1  α 2 d t -2  .............
f t+1 = forecast for period ‘t + 1’
α 0 , α1 , α 2 are the weights associated with d t , d t  1 and d t  2
respectively such that:
 αi  1
If we believe what is more recent is more relevant then:

α 0  α1  α 2  ......
The only mandatory requirement in selecting the weights is that their sum must be equal
to 1. The two decisions we have to take while using weighted moving average is to
decide the number of periods & the value of weights
3 PERIOD WEIGHTED MOVING AVERAGE

f t  1  α 0 d t  α1 d t - 1  α 2 d t - 2 (Assuming 3 periods)

Sub t  3, f 4  α 0 d 3  α 1 d 2  α 2 d1

Sub t  4, f 5  α 0 d 4  α1 d 3  α 2 d 2
One set of suggested values of  are:
3 2 1
α0  ; α1  ; α2 
6 6 6
For a particular time series, different values of weight, will affect the accuracy of the
forecast. One possible approach is to use trial & error to identify the values of weight that
minimizes MSE.
EXPONENTIAL SMOOTHING METHOD

Exponential smoothing is a special case of the weighted moving averages method in

which we select only one weight – the weight for the most recent observation. The
weights of the other data values are automatically computed using geometric
progression and get smaller & smaller as observations move further into the past. The
advantage of exponential smoothing over weighted moving average is that we have to
select only one value of  in exponential smoothing whereas in weighted average we
select more than one value for example 0, 1 and so on
f t  1  α d t  (1 - α) f t
f t + 1 = forecast for period ‘t + 1’
 = smoothing constant such that (0    1)
dt = actual demand for period ‘t’
ft = forecast for period ‘t’
EXPONENTIAL SMOOTHING METHOD

Initialization of calculation - Assume that f1 = d1 or f2 = d1

f3 onwards can be calculated using the formula as indicated below:

f t 1  α d t  (1 - α ) f t

Substitute t = 2, f3 =  d2 + (1 - ) f2
Substitute t = 3, f4 =  d3 + (1 - ) f3
Although any value of  between 0 & 1 are acceptable, some values
will yield a better forecast than the others.
SELECTING THE VALUE OF  IN EXPONENTIAL
SMOOTHING

The criterion we use to determine the desirable value for the smoothing constant
 is the same as the criterion for determining the number of periods of data to
include in the moving average calculation. i.e. we choose the value of  that
minimizes MSE through trial & error.

Spreadsheet packages like Excel spreadsheets are an effective aid in choosing a

good value for  for exponential smoothing & selecting weights for weighted
moving average method & selecting number of periods for moving average
method.

With the time series data & forecasting formulas in the spreadsheets, one can
experiment with different values of , or moving average weights or number of
periods & choose the values providing the smallest MSE.
CAUSAL METHODS OF FORECASTING

1. Forecast can also be developed using causal methods, which is based on the
assumption that the variable we are trying to forecast exhibits a cause-effect
relation with one or more other variable.

2. Regression analysis is used as a causal forecasting method. For example, Sales

volume for any product is influenced by advertising expenditures, so regression
analysis may be used to develop an equation showing how these two variables
are related. Then, once the advertisement budget has been set for next period, we
could substitute this value into the equation to develop a prediction or forecast of
the sales volume for that period.

3. Note that if a time series method had been used to develop the forecast then
advertisement expenditure would not even have been considered. i.e. time series
method would base the forecast solely on past sales.
WHAT IS CORRELATION ANALYSIS?

Correlation Analysis measures the degree of linear association between two or more
variables.
If a change in one variable results in a corresponding change in the other variable either
in the same direction or in the opposite direction, we say the variables are correlated.
The popular methods to assess Correlation are Scatter Diagram & Karl Pearson’s
Correlation Coefficient
KARL PEARSON’S CORRELATION COEFFICIENT

xy
r
 x 2  y 2

xX-X

yY-Y
X Y
X Y
n n

The value of ‘r’ lies between -1 & +1

USING REGRESSION ANALYSIS IN FORECASTING

Regression Analysis is a statistical technique that can be used to develop a mathematical

equation between two or more variables. In regression, the variable that is being predicted
is called dependent variables and the variables used to predict the value of the dependent
variable are called independent or explanatory variables.

Regression analysis involving one independent variable and one dependent variable with
a straight line relationship is called simple linear regression. Regression analysis
involving two or more explanatory variables is called multiple regression analysis.
WHAT IS REGRESSION ANALYSIS?

Regression Analysis is the study of the dependence of one variable

(dependent variable) on one or more other variable (explanatory variable) in
order to determine the average value of the dependent variable given the
values of the explanatory variable.

Based on the past data, we calculate the regression model (coefficients) &
then using the regression model we estimate the average value of the
dependent variable for given or known value of the independent variable
REGRESSION ANALYSIS

The regression equation of Y on X is expressed as follows:

Ŷi  β̂1  β̂ 2 X i
Where

Ŷi is the estimate of the dependant variable Y

β̂1 is the regression coefficient (Intercept term)

β̂ 2 is the regression coefficient (Slope of the line)

Xi is the explanatory variable

REGRESSION ANALYSIS
REGRESSION ANALYSIS

The following are the formulas for the estimators;

x i yi
β̂ 2 
x i2

β̂1  Y - β̂ 2 X

Where xi  Xi - X

y i  Yi - Y

X and Y are the respective arithemati c mean

The Coefficient of Determination = r2

USING TREND PROJECTION IN FORECASTING

When we use regression analysis to relate the variable that we want to forecast to
other variables that are supposed to influence that variable, it becomes a causal
forecasting method. Using regression analysis for trend projection is not a causal
forecasting method because only past values of sales, the variable being forecast,
are used.
If we use simple linear regression to fit to a linear trend to sales time series then,
the sales isn’t actually causally related to time, instead time is a surrogate for
variables to which sales is actually related, but which are unknown or too difficult
or costly to measure.
USING TREND PROJECTION IN FORECASTING

The type of time series pattern for which the trend projection method is
applicable shows a consistent increase or decrease over time. It is not stable.
So the smoothing methods are not applicable.

The trend component does not follow each and every up and down movement.
Rather the trend component reflects the gradual shifting, for example, growth
of time series values.
TREND ANALYSIS IN TIME SERIES
USING REGRESSION FOR TREND ANALYSIS

Ŷt  β̂1  β̂ 2 X t

Ŷt is the estimated Sales value

β̂1 is the intercept term

β̂ 2 is the slope of the regression line

Xt is the time variable (surrogate variable)

β̂1  Y - β̂ 2 X

β̂ 2 
xy ; where x  X - X and y  Y - Y
x 2
Problem FM5B**
Fit an appropriate (3 Variable) regression model to the following data {Y Agricultural Production;
X2 Expenditure on Fertilizer; X3 Expenditure on Irrigation Projects}
----------------------------------------------------------------------------
Y 6 10 11 19 20 25 30
----------------------------------------------------------------------------
X2 1 2 3 7 10 11 13
----------------------------------------------------------------------------
X3 20 40 40 51 52 60 60
----------------------------------------------------------------------------

The following Summary Output is available (from Standard Software)

ˆ  1.34  1.39X  0.14X

i 2i 3i

p value (t test) 0.015 0.295

R = 0.986

R2 = 0.974

β̂ 2 95% C
L
 0.43 to 2.37

(F test – Anova) p value = 0.0007