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FORECASTING

I. Introduction
-- What is forecasting?
 Scientific (educated) guess
 Based on past data or experience
 Rarely perfect
 Group forecast more accurate
 Shorter time horizon, more accurate

-- Why forecasting?

-- Forecasting time horizon


 Short range – usually less than 3 months
 Medium range – 3 months to 3 years
 Long range – over 3 years

-- Which forecasting method to use?


 Time horizon
 Costs vs. accuracy
 Easy to understand?

-- Pattern of Data
 Trend – gradual upward or downward movement
 Seasonality – repeated pattern
 Cycle – background pattern over long period of time
 Randomness – unexplainable, unpredictable, unknown fluctuations

II. Qualitative Forecasting Methods


- no past data is available, for managerial decision, long term forecast
 Jury of executive opinion
 The Delphi technique – systematic survey of experts
 Sales force composite
 Consumer market survey

III. Quantitative Forecasting Methods


1) Smoothing Techniques:
- for data with no clear pattern, short term forecast

 Naive: Ft+1 = Yt

 n Period Moving Average (MA-n): equal weight for n data


Forecast = (most recent n data)/n
 n Period Weighted Moving Average (WMA-n): flexible weight assignment
Forecast = (weight * most recent n data)/(weight)

 Exponential Smoothing with smoothing constant : very little data record required, more
weight on recent data, weight decreases exponentially
Ft+1 = Ft +α (Yt - Ft) = αYt + (1-α)F t 0   < 1,

-- Example: Forecast the score for test 5 by the above smoothing techniques with  and
F1 = 77.

Test 1 2 3 4 5
Avg.Score 72 82 85 90 ?

-- Relationship between smoothing techniques


 average of past data, but differ in weight distribution
 all methods lag behind actual data change
 more weight on most recent data, more responsive, less smooth

-- Thinking challenge:
1. Which method requires the least amount of data?
2. What happens if the  in the exponential smoothing method increases?

2) Trend Projection by Linear Regression


- for data with linear trend pattern, medium term

Step 1. Find a trend line y = a + bx to fit the past data the best (minimizing mean squared
errors)

b
 xy  n x y
 best slope:
 x2  nx
2

 best intercept: a  y  b x
where x and y are averages of x’s and y’s
-- Example continues:
X y xy x2 y2

* Excel commands:
 calculating b:“=slope(range of y’s, range of x’s)”
 calculating a:“=intercept(range of y’s, range of x’s)”
Step 2. Trend projection
 Trend projection forecast: Fnext = a + b*xnext
-- Example continues:

Step 3. Find forecast interval, if necessary


 Forecast interval = Fnext +- Z(1+ /2 *Sy,x

 standard error: Sy,x = y 2


 a  y  b xy
n2
-- Example continues:

* Excel commands:
 calculating Sy,x:”=steyx(range of y’s, range of x’s)”

3) Causal Model by Linear Regression


- same set up as trend projection, except that x is an independent variable (other than
time), y is a dependent variable, medium term

-- Example: The sales manager of a large apartment rental complex feels the demand for
apartments may be related to the number of newspaper ads placed during the previous month.
She has collected the data shown below.
Ads 15 9 40 20 25 25 15 35
Rental 6 4 16 6 13 9 10 16
If the number of ads placed in this month is 30, what would be her estimate of rentals in the
coming month?

-- Correlation coefficient r: measures the strength of linear relationship between x and y


 -1  r  +1
n xy   x  y
r=

 n x 2
 
 ( x ) 2 * n y 2  (  y ) 2 
* Excel command:
 calculating r:”=correl(range of y’s, range of x’s)”

-- Interpretation:
 r > 0:
 r = 0:
 r < 0:
 r2 = coefficient of determination: % of variation in the dependent variable (y) is explained
by regression equation (linear relationship).

-- Example continued: How strong is the relationship between the ads placed and the rentals?
4) Decomposition of Time Series
- for data with both trend and seasonality patterns, short to medium term

-- Idea:
1. Decompose the past data (filter out the seasonal influence from original data)
2. Forecast trend pattern and seasonality pattern separately
3. Combine the forecasts using the multiplicative model: Y t = Tt * St

-- Example: Data of a popular brand of sweater sale (by quarters) over the past three years:
2000 Sale 2001 Sale 2002 Sale
(t) (Yt) (t) (Yt) (t) (Yt)
1 12 5 16 9 18
2 25 6 32 10 45
3 76 7 80 11 84
4 52 8 62 12 60
Forecast the sale of each season in 2003.

Step 1. Draw the historical data diagram to check if there is an obvious seasonal pattern

Step 2. Calculate the "seasonal indexes" (S) for each season.


 Seasonal Index = Avg. Seasonal Sale / Avg Sale
Y (spring) = ===> S(spring) =
Y (summer) = ===> S(summer) =
Y (fall) = ===> S(fall) =
Y (winter) = ===> S(winter) =

Y =

Step 3. Deseasonalize the original data: Tt = Yt / S

2000 Sale 2001 Sale 2002 sale


(t) (Tt) (t) (Tt) (t) (Tt)
1 5 9
2 6 10
3 7 11
4 8 12

Step 4. Calculate the trend based on the deseasonalized demand by linear regression T t = a
+ bt
a= b=

Step 5. Use trend projection to forecast the demand with trend only.
T13 = T14 =

T15 = T16 =
Step 6. Use seasonal indexes to modify the forecasts to reflect the seasonality patterns: F = T
*S
F13 = F14 =

F15 = F16 =

IV. Choosing a Forecasting Method


- all criteria are a function of the forecast error

 forecast error = actual realization (Y)– forecast (F)

1. Bias – measures the direction of forecast


Bias = (forecast error)/n

2. Mean Absolute Deviation (MAD)


- same penalty for small and large errors
MAD = (|forecast error|)/n

3. Mean Squared Error (MSE)


– more penalty on large errors
MSE = (forecast error 2)/n

4. Mean Absolute Percent Error (MAPE)


- relative error, scale independent
MAPE = (|forecast error|/Actual Data)/n

-- Comparing different forecasting methods


 Based on past performance
 Measure dependent
 Choose  (for exp. Smoothing) and n (for MA) to minimize MAD, MSE, or MAPE
-- Example: Same data as earlier
Exp Smoothing with alpha = 0.1
Test Avg Score Forecast Err |Err| Err Square |Err|/Actual
1 72 77 -5 5 25 0.069444
2 82 76.5 5.5 5.5 30.25 0.067073
3 85 77.05 7.95 7.95 63.2025 0.093529
4 90 77.845 12.155 12.155 147.744 0.135056
Bias MAD MSE MAPE
5.15125 7.65125 66.54913 0.091276

Exp Smoothing with alpha = 0.2


Test Avg Score Forecast Err |Err| Err Square |Err|/Actual
1 72 77 -5 5 25 0.069444
2 82 76 6 6 36 0.073171
3 85 77.2 7.8 7.8 60.84 0.091765
4 90 78.76 11.24 11.24 126.3376 0.124889
Bias MAD MSE MAPE
5.01 7.51 62.0444 0.089817

Trend Projection with a = 68 b= 5.7


Test Avg Score Forecast Err |Err| Err Square |Err|/Actual
1 72 73.7 -1.7 1.7 2.89 0.023611
2 82 79.4 2.6 2.6 6.76 0.031707
3 85 85.1 -0.1 0.1 0.01 0.001176
4 90 90.8 -0.8 0.8 0.64 0.008889
Bias MAD MSE MAPE
0 1.3 2.575 0.016346

V. Control of the Forecasting Process


- to check if the performance of a forecasting method changes
-- Tracking Signal control chart:
 plotting statistic TS(t) = RSFE(t)/MAD(t)
 RSFE(t) = running sum of the forecast error through time t
 MAD(t) = MAD through time t
 3 sigma control chart limits: UCL = 3, LCL = -3, CL = 0
-- Interpretation?

-- Example: A forecasting method provides the following


forecasts in the past 6 periods. Does its performance change
over time?
T Y F Error RFSE(t) MAD(t) TS(t)
1 8 6
2 7 9
3 10 6
4 2 6
5 12 8
6 11 7

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