Chapter Three

Forecasting
 Topics to be covered

 Introduction

 Importance of Forecasting

 Forecasting Range

 Techniques of Forecasting

 Qualitative
 Quantitative
1
Introduction to Forecasting
 A statement about the future value of a variable of interest such

as demand and a tool used for predicting future value (demand)

based on past information.

 Process of predicting a future event underlying basis of

all business decisions:
 Production

 Inventory

 Personnel and Facilities, etc

2
Importance of Forecasting
 Marketing managers:
 Use sales forecasts to determine optimal sales force allocations.
 Set sales goals.
 Plan promotions and advertising.
 Planning for capital investments:
 Predictions about future economic activity.
 Estimating cash inflows accruing from the investment.
 The personnel department:
 Planning for human resources.

3
Importance of Forecasting
 Managers of nonprofit institutions:
 Forecasts for budgeting purposes.
 Universities:
 Forecast student enrollments.
 Cost of operations.
 The bank has to forecast:
 Demands of various loans and deposits
 Money and credit conditions so that it can determine the cost of
money it lends.

4
Importance of Forecasting
 Manufacturers:
 Worker absenteeism
 Machine availability
 Material costs
 Transportation and production lead times, etc.
 Service providers:
 Forecasts of population
 Demographic variables
 Weather, etc.

5
Principles of Forecasting
 Many types of forecasting models that differ in complexity and amount
of data & way they generate forecasts:

 Forecasts rarely perfect because of randomness.

 Forecasts more accurate for groups vs. individuals.

 Forecast accuracy decreases as time horizon increases.

6
Steps of Forecasting
1. Decide what needs to be forecasted.
 Level of detail, units of analysis & time horizon required.

2. Evaluate and analyze appropriate data.

 Identify needed data & whether it’s available.

3. Select and test the forecasting model.

 Cost, ease of use & accuracy.

4. Generate the forecast.

5. Monitor forecast accuracy over time.

7
Forecasting Techniques
 Qualitative Methods

 Used when situation is vague and little data exist.

 New products

 New technology

 Innovative products

 Involves intuition, experience.

 Forecasts generated subjectively by the forecaster.

 Educated guesses.
Forecasting Techniques
 Quantitative Methods

 Used when situation is ‘stable’ and historical data exist.

 Existing products

 Current technology

 Involves mathematical techniques or mathematical modeling.

 e.g., forecasting sales of color televisions.

 Commodity products that are sold every day.

Forecasting Techniques

10
Quantitative Forecasting Techniques
 Quantitative analysis typically involves two approaches:

 Causal models

 Time-series methods

 Causal/Regression Methods:

 Causal models establish a quantitative link between observable or

known variable (like advertising expenditures) with the demand for

some product.

11
Causal Models
 Causal models establish a cause-and-effect relationship between
independent and dependent variables.
 A common tool of causal modeling is linear regression:

 Additional related variables may require multiple regression modeling.

Y  a  bX
 Y- Dependent Variable

 X- Independent Variable

12
Linear Regression
 Identify dependent (Y) and
independent (X) variables
 Solve for the slope of the line:
b
 XY  X  Y 
 X 2  X  X 
b
 XY  n XY

 X  nX2 2

 Solve for the y intercept:

a  Y  bX
 Develop your equation for the
trend line:
 Y=a + bX

13
 Linear Regression- Example
 A company has been tracking the relationship between sales and
advertising dollars. Use linear regression to find out what sales might be
if the company invested $53,000 in advertising next year using the
following previous data.

Sales $
(Y)
Adv.$
(X)
XY X^2 Y^2
b
 XY  n XY
 X  nX
2 2
1 130 32 4160 2304 16,900

2 151 52 7852 2704 22,801

3 150 50 7500 2500 22,500

4 158 55 8690 3025 24964

5 153.85 53
Tot 589 189 28202 9253 87165

Avg 147.25 47.25

14
 Correlation Coefficient
 Correlation coefficient (r) measures the direction and strength of the
linear relationship between two variables. The closer the r value is to 1.0
the better the regression line fits the data points.
Quantitative Forecasting Techniques
 Time Series Forecasting Methods
 Time series forecasting methods are:

 Based on analysis of historical data.

 Set of evenly spaced numerical data:

 Obtained by observing response variable at regular time periods.

 Forecast based only on past values:

 Assumes that factors influencing past and present will continue

influence in future.

16
Time Series Patterns
 Historic data may exhibit one of the following pattern:

 Level (long-term average) – data fluctuates around a constant

mean.
 Trend – data exhibits an increasing or decreasing pattern.

 Seasonality – effects are similar variations occurring during

corresponding periods, can be quarterly, monthly, weekly, daily, or
even hourly indexes.
 Cycle – are the long-term swings about the trend line.

17
Time Series Patterns

18
Time Series Models
 Time Series : a set of observations measured at successive times
or over successive periods.
 Naïve or Projection

 Simple Moving Average

 Weighted Moving Average

 Exponential Smoothing

19
Time Series Models
 Naïve or Projection

 The forecast for the period t, Ft, is simply a projection of previous period

t-1 demand, At-1.

 Ft = At-1

 E.g. If the actual demand of period t is 120, then the forecast of the

period t+1 is 120.

 This method, although easy to use, doesn’t make use of data that is
easily available to most managers; thus, using more of the historical
data should improve the forecast. 20
Time Series Model
 Simple Moving Average (MA)

 An n-period moving average uses the last n periods of demand as a

forecast for next periods demand:

 Where n = total number of periods in the average,

 Ft= Forecast for period t,

 At-1, At-2,….At-n = Actual value for periods 1, 2,…, n.

21
Time Series Model
 Simple Moving Average (MA)

 To determine the length of n:

 Higher value of n - greater smoothing, lower responsiveness.

 Lower value of n - less smoothing, more responsiveness.

 A large value of n is appropriate if the underlying pattern of

demand is stable.

 A smaller value of n is appropriate if the underlying pattern is

changing or if it is important to identify short-term fluctuations.

22
Time Series Model
 Example: A company sells storage shed, Determine the forecast of January
using 3 month simple moving average.

23
Time Series Model
 Weighted Moving Average:

 A weighted moving average is a moving average where each historical

data may be weighted differently.

 This runs counter to ones intuition that the most recent data is the
most relevant.

 Thus, the weighted moving average allows for more emphasis to be

placed on the most recent data. This forecast is:

24
Time Series Model
 Weighted Moving Average:

 Where wt-1 is the weight applied to the actual demand incurred during

period t-1, and so on.

 Intuitively, the expectation would be that the more recent demand data

should be weighted more heavily than older data; so, generally, one would
expect the weights to follow the relationship wt ≥ wt-1 ≥ wt-2 ≥ ….

 The sum of the weights is one.

25
Time Series Model
 Weighted Moving Average: Consider the weights 3/6, 2/6, 1/6 for periods t-1, t-2
and t-3 respectively which are added to one. Determine the forecast of January.

26
Time Series Model
 Exponential smoothing:

 Nice properties of a weighted moving average would be one where the

weights not only decrease as older and older data are used, but one
where the differences between the weights are “smooth”.

 Obviously the desire would be for the weight on the most recent data to
be the largest.

27
Time Series Model
 Exponential smoothing:

 The weights should then get progressively smaller the more periods one
considers into the past.

 The exponentially decreasing weights of exponential smoothing

forecast fit this bill nicely.

28
Time Series Model
 Why use exponential smoothing?

 Uses less storage space for data

 More accurate

 Easy to understand

 Little calculation complexity

 The smoothing constant 𝜶 expresses how much our forecast will react
to observed differences.
 If 𝜶 is low: there is little reaction to differences.

 If 𝜶 is high: there is a lot of reaction to differences.

29
Time Series Model
 Selecting Smoothening Constant (α):

 The appropriate value of the smoothing constant, 𝜶, however, can

make the difference between an accurate forecast and an inaccurate
forecast.

 In picking a value for the smoothing constant, the objective is to

obtain the most accurate forecast.

 Several values of the smoothing constant may be tried, and the one
with the lowest MAD could be selected.

30
Time Series Model
 Exponential smoothing: Example

31
Time Series Model
 Exponential smoothing: Selecting smoothing constant.

 The smoothing constant with less MAD should be selected, thus α = 0.1

32
Selecting the Right Forecasting Model
 Selecting the right forecasting methods depends on:

1. The amount & type of available data

 Some methods require more data than others
2. Degree of accuracy required
 Increasing accuracy means more data
3. Length of forecast horizon
 Different models for 3 month vs. 10 years
4. Presence of data patterns

33
Selecting the Right Forecasting Model
 Forecasting during product life cycle

34
 Measuring Forecast Error
 Forecasts are never perfect

 Need to know how much we should rely on our chosen forecasting

method.
 Measuring forecast error: E t  A t  Ft

 Note that:

 Over-forecasts = negative errors

 Under-forecasts = positive errors.

 Large values of negative or positive errors shows there is bias in the

forecast.
35
Measures of Forecast Error
 Mean Absolute Deviation (MAD)

 Measures the total error in a forecast without regard to sign

 Cumulative Forecast Error (CFE)

 Also called running sum of forecast error (RSFE)

 Measures any bias in the forecast

 Mean Square Error (MSE)

 Penalizes larger errors

n


n
A t - Ft

 t t
A - F 2

t =1 MSE = t =1 RMSE = MSE

MAD =
n n
n
RSFE  (At  Ft )
CFE   actual  forecast  i 1

 Ideal values = 0 (i.e., no forecasting error) 36

Measuring Accuracy: Tracking signal

 The tracking signal is a measure of how often our estimations have

been above or below the actual value. It is used to decide when to re-
evaluate using a model.

RSFE
TS 
MAD
 Positive tracking signal: most of the time actual values are
above our forecasted values
 Negative tracking signal: most of the time actual values are
below our forecasted values

Usually 3 ≤ TS ≤ 8, out of this range investigate!

37
Measuring Forecast Accuracy and Error

Weighted (n=3,
S.N Actual Naïve Simple t-1=0.45, Exponential Exponential Exponential
(n=3) t-2=0.35, (α=0.1) (α=0.5) (α=0.8)
t-3=0.2)
1 110 105 105 105
2 100 110.0 105.5 107.5 109.0
3 120 100.0 105.0 103.8 101.8
4 140 120.0 110.0 108.5 106.5 111.9 116.4
5 170 140.0 120.0 115.0 109.8 125.9 135.3
6 150 170.0 143.3 137.0 115.8 148.0 163.1
7 160 150.0 153.3 152.5 119.2 149.0 152.6
8 190 160.0 160.0 161.0 123.3 154.5 158.5
9 200 190.0 166.7 161.5 130.0 172.2 183.7
10 190 200.0 183.3 178.5 137.0 186.1 196.7
11 190.0 193.3 193.5 142.3 188.1 191.3
MAD 17.8 23.3 26.6 38.4 18.1 16.6
CFE 80.0 163.3 186.0 372.9 166.1 107.9
RMSE 58.3 74.5 81.8 141.5 72.5 61.1
TS 4.50 7.00 7.00 9.71 9.17 6.52

38