Forecasting

Dr. Yousaf Ali Khan

Department of Management Sciences and Humanities
GIK Institute of Engineering Sciences and Technology
 What is Forecasting?

 Process of predicting a future event

 A statement about the future. I see that you will
get an A this semester.
 Forecasts more accurate for
groups vs. individuals
 Forecast accuracy decreases
as time horizon increases
 Uses of Forecasts
Accounting Cost/profit estimates

Finance Cash flow and funding

Human Resources Hiring/recruiting/training

Marketing Pricing, promotion, strategy

MIS IT/IS systems, services

Operations Schedules, workloads

Product/service design New products and services

Forecasting Time Horizons
 Short-range forecast
 Up to 1 year, generally less than 3 months
 Purchasing, job scheduling, workforce
levels, job assignments, production levels
 Medium-range forecast
 3 months to 3 years
 Sales and production planning, budgeting
 Long-range forecast
 3+ years
 New product planning, facility location,
research and development
Elements of a Good Forecast

Timely

Reliable Accurate

Written
Steps in the Forecasting
Process

“The forecast”

Step 6 Monitor the forecast

Step 5 Prepare the forecast
Step 4 Gather and analyze data
Step 3 Select a forecasting technique
Step 2 Establish a time horizon
Step 1 Determine purpose of forecast
Steps in the Forecasting Process
 Types of Forecasts
 Economic forecasts
 Address business cycle – inflation
rate, money supply, etc.
 Technological forecasts
 Predict rate of technological progress
 Impacts development of new
products
 Demand forecasts
 Predict sales of existing product
 Determine the type of model to be
used
1. Who will be using the forecast and what
information do they require?
2. How relevant is historical data, and what is
its availability?
3. How accurate does the forecast have to be?
4. What is the time period of the forecast?
5. How much time do we have to develop the
forecast?
6. What is the cost or benefit (value) of this
forecast to our company?
 Determine the forecast horizon
• Inverse relationship between forecast
accuracy and time horizon.
– The longer the time horizon the more
inaccurate the forecast will be.
• Time horizon should be at least as long as
time period of strategic plan.
• Product life cycles influence length of
forecasts.
– Technological product sales would have a
short forecast.
– Milk sales would have a long forecast.
 Types of Forecasting Models
• Judgmental models, which use qualitative
methods, uses subjective inputs
• Time series models, which use quantitative
methods, uses historical data assuming
the future will be like the past
• Causal models or Associative Model,
uses explanatory variables to predict the future
which use cause-and effect methods.
 Forecasting Approaches
Qualitative Methods
 Used when situation is vague and
little data exist
 New products
 New technology
 Involves intuition, experience
 Forecasting Approaches
Quantitative Methods
 Used when situation is ‘stable’ and
historical data exist
 Existing products
 Current technology
 Involves mathematical techniques
 e.g., forecasting sales of color televisions
 Judgmental Models
• Judgmental models are qualitative and essentially use
estimates based on expert opinion.
– Survey of Sales Forces: most appropriate for manufacturing and
wholesale firms.
– Surveys of Customers: applicable to all firms. Customers express
preference for new or modified products.
– Historical Analogy: most appropriate for firms that have several
outlets. Introduction of new product which has characteristics similar to
previous products.
– Market Research: can include surveys, tests, and observations.
Results are statistically extrapolated to develop forecasts of demand
for products.
– Delphi Method uses a panel of experts to obtain a consensus of
opinion. Used primarily for unique new products or processes for
which no previous data exists.
 Time Series Models
• Time series forecasting
models normally use historical
records that are readily available
within the firm or industry to predict
future sales.
– For this reason they are often referred to as
internal or intrinsic models.
– Assumption in time series forecasting is that past
sales are a fairly accurate predictor of future sales.
 Overview of Quantitative
Approaches
.
1. Naive approach
2. Moving averages
Time-Series
3. Exponential Models
smoothing
4. Trend projection
5. Linear regression Associative
Model
Time Series Components

Trend Cyclical

Seasonal Random
 Time Series Forecasts
• Trend - long-term movement in data
• Seasonality - short-term regular variations
in data
• Cycle – wavelike variations of more than
one year’s duration
• Irregular variations - caused by unusual
circumstances
• Random variations - caused by chance
Forecast Variations
Irregular
variation

Trend

Cycles

90
89
88
Seasonal variations
 Trend Component
 Persistent, overall upward or
downward pattern
 Changes due to population,
technology, age, culture, etc.
 Typically several years
duration
 Seasonal Component
 Regular pattern of up and
down fluctuations
 Due to weather, customs, etc.
 Occurs within a single year
Number of
Period Length Seasons
Week Day 7
Month Week 4-4.5
Month Day 28-31
Year Quarter 4
Year Month 12
Year Week 52
 Cyclical Component
 Repeating up and down movements
 Affected by business cycle, political,
and economic factors
 Multiple years duration
 Often causal or
associative
relationships

0 5 10 15 20
 Random Component
 Erratic, unsystematic, ‘residual’
fluctuations
 Due to random variation or
unforeseen events
 Short duration and
nonrepeating

M T W T F
 Naive Approach
 Assumes demand in next
period is the same as
demand in most recent period
e.g., If January sales were 68, then
February sales will be 68
 Sometimes cost effective and efficient
 Can be good starting point
 The forecast for any period equals the
previous period’s actual value.
 Simple Mean or Average
• One of the simplest averaging models is the simple mean or
average. Here the forecast is made by simply taking an average
of all data:
 Moving Average Method
 MA is a series of arithmetic means
 Used if little or no trend
 Used often for smoothing
 Provides overall impression of data over
time

∑ demand in previous n periods

Moving average = n
 Moving Average Example
Actual 3-Month
Month Shed Sales Moving Average

January 10
February 12
March 13
April 16 (10 + 12 + 13)/3 = 11.66
May 19 (12 + 13 + 16)/3 = 13.66
June 23 (13 + 16 + 19)/3 = 16
July 26 (16 + 19 + 23)/3 = 19.33
Weighted Moving Average

 Used when trend is present

 Older data usually less important
 Weights based on experience and
intuition
∑ (weight for period n)
x (demand in period n)
Weighted =
moving average
∑ weights
 Weights Applied Period
Weighted Moving Average3
2
Last month
Two months ago
1 Three months ago
6 Sum of weights

Actual 3-Month Weighted

Month Shed Sales Moving Average

January 10
February 12
March 13
April 16 [(3 x 13) + (2 x 12) + (10)]/6 = 121/6
May 19 [(3 x 16) + (2 x 13) + (12)]/6 = 141/3
June 23 [(3 x 19) + (2 x 16) + (13)]/6 = 17
July 26 [(3 x 23) + (2 x 19) + (16)]/6 = 201/2
 Moving Average And
Weighted Moving Average
Weighted
30 – moving
average
25 –
Sales demand

20 – Actual
sales
15 –
Moving
10 – average

5 –
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Exponential Smoothing Model
• Exponential smoothing model uses a smoothing
constant, alpha (α), as an adjustment in determining
the forecast.
• A smoothing constant is a value assigned by the
forecaster to adjust the forecast based on the
forecaster assumption of the relationship between
sales in one time period and sales in the next time
period.
• Alpha can have any value between 0 and 1; however,
alpha is normally 0.1, 0.2 or 0.3.
 Exponential Smoothing

New forecast = last period’s forecast

+ a (last period’s actual demand
– last period’s forecast)

Ft = Ft – 1 + a(At – 1 - Ft – 1)
where Ft = new forecast
Ft – 1 = previous forecast
a = smoothing (or weighting)
constant (0  a  1)
 Choosing 
The objective is to obtain the most
accurate forecast no matter the
technique.

We generally do this by selecting the model

that gives us the lowest forecast error
Forecast error = Actual demand - Forecast value
= At - Ft
Common Measures of Error
Cumulative Sum of Forecast Errors
CFE = ∑e =∑ (actual – forecast)
Mean Absolute Deviation (MAD)

MAD = ∑ |actual - forecast|

n Good tracking signal
Tracking Signal
has low values
∑ (actual – forecast)
TS=
MAD
Mean Squared Error
∑ (forecast errors)2
MSE =
n
Mean Absolute Percent Error (MAPE)
n

MAPE =
100 ∑ |actual - forecast |/actual
i i i
i=1
n
Surprise Quiz
 Causal Models
• Causal models are also known as external
or exogenous models.
– Causal models take into account variables in the general
economy that affect the revenue obtained by a company.
– Causal models can be simple or very complex.
– Most of them require multiple regression analysis, which is
normally beyond the scope of a small business manager.
• One of the best known causal method is
regression model.
 When Is Causal Forecasting Used?
• Know or believe something caused demand to act a certain
way
• Demand or sales patterns that vary drastically with
planned or unplanned events
• Examples of a variable that causes demand to act a certain
way:
Sales of ice cream increase when temperature is high
New home starts increase when interest rates are low
Number of employees increase when demand increases
• An planned event could be a sale or and advertising
promotion.
• An unplanned event could be a snow storm or severe
weather, strike, or materials shortages.
 Linear Regression Model
• Linear regression uses a statistical method known as
least squared method, this method minimizes the sum of
the squared errors (Deviations)
– Four areas of variation:
• Seasonal variation is caused by the predictable
shopping habits of our customers.
• Trend variation is variation caused by growth or decline
in demand for our product or service over time.
• Cyclical variation is caused by general economic factors
that affect our industry.
• Noise is random variation in our data that is not
explained by the preceding factors.
 Linear Regression Model (Cont)
• Linear regression is used to determine two factors:
• – the slope of the regression line
• – the intercept of the regression line
• Basic formula for the regression line
• y = a + bx
• y is the dependent variable. A dependent variable is one
that relies on other variables for its value.
• x is the independent variable. An independent variable is one
that does not depend on other variables for its value. In
forecasting models, x is often a time period.
• a is the y intercept. The y intercept is the value of y when x
equals 0.
• b is the slope of the regression line. Slope is defined as rise
over run.
 Least Squares Method
Equations to calculate the regression variables
^
y = a + bx
Sxy - nxy
b=
Sx2 - nx2
a = y - bx
 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
1999 1 74 1 74
2000 2 79 4 158
2001 3 80 9 240
2002 4 90 16 360
2003 5 105 25 525
2004 6 142 36 852
2005 7 122 49 854
∑x = 28 ∑y = 692 ∑x2 = 140 ∑xy = 3,063
x=4 y = 98.86

∑xy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
∑x2 - nx2 140 - (7)(42)

a = y - bx = 98.86 - 10.54(4) = 56.70

 Least Squares Example
Time Electrical Power
Year Period (x) Demand x2 xy
1999 1 74 1 74
2000 2 79 4 158
2001The trend3 line is 80 9 240
2002 4 90 16 360
^
2003 y =5 56.70 + 10.54x
105 25 525
2004 6 142 36 852
2005 7 122 49 854
Sx = 28 Sy = 692 Sx2 = 140 Sxy = 3,063
x=4 y = 98.86

Sxy - nxy 3,063 - (7)(4)(98.86)

b= = = 10.54
Sx2 - nx2 140 - (7)(42)

a = y - bx = 98.86 - 10.54(4) = 56.70

 Least Squares Example
Trend line,
160 – ^y = 56.70 + 10.54x
150 –
140 –
Power demand

130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
50 –
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1999 2000 2001 2002 2003 2004 2005 2006 2007
Year
 Least Squares Method

Actual observation Deviation7

(y value)
Values of Dependent Variable

Deviation5 Deviation6

Deviation3

Deviation4

Deviation1
Deviation2
Trend line, y =^ a + bx

Time period
 Correlation
• Measures the strength of the relationship
between the dependent and independent
variable
• Once a model has been developed and tested,
the effectiveness of the model needs to be
determined. Correlation is used to determine
how strong the relationship between the
dependent and independent variables are.
Correlation Coefficient Formula
nSxy - SxSy
r=
[nSx2 - (Sx)2][nSy2 - (Sy)2]

r = correlation coefficient
n = number of periods
x = the independent variable
y = the dependent variable
y
Correlation
y

(a) Perfect positive x (b) Positive x

correlation: correlation:
r = +1 0<r<1

y y

(c) No correlation: x (d) Perfect negative x

r=0 correlation:
r = -1
 Coefficient of Determination
 Coefficient of Determination, r2, measures the
percent of change in y predicted by the change in x
 Values range from 0 to 1
• A high value of r2, say .80 or more, would indicate
that the independent variable is a good predictor of
values of the dependent variable.
• A low value say .25 or less, would indicate a poor
predictor
• A value Between .25 and .80 would indicate a
moderate predictor.
 Seasonal Variations In Data
The multiplicative seasonal model can modify
trend data to accommodate seasonal
variations in demand
1. Find average historical demand for each season
2. Compute the average demand over all seasons
3. Compute a seasonal index for each season
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the number of
seasons, then multiply it by the seasonal index for that
season
 Seasonal Index Example
Demand Average Average Seasonal
Month 2003 2004 2005 2003-2005 Monthly Index
Jan 80 85 105 90 94
Feb 70 85 85 80 94
Mar 80 93 82 85 94
Apr 90 95 115 100 94
May 113 125 131 123 94
Jun 110 115 120 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
 Seasonal Index Example
Demand Average Average Seasonal
Month 2003 2004 2005 2003-2005 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94
Mar 80 93 average
82 2003-2005
85monthly demand
94
Seasonal index
Apr 90 = 95 115average monthly
100 demand 94
May 113 125 131 123 94
= 90/94 = .957
Jun 110 115 120 115 94
Jul 100 102 113 105 94
Aug 88 102 110 100 94
Sept 85 90 95 90 94
Oct 77 78 85 80 94
Nov 75 72 83 80 94
Dec 82 78 80 80 94
 Seasonal Index Example
Demand Average Average Seasonal
Month 2003 2004 2005 2003-2005 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 85 80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90 95 115 100 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 115 94 1.223
Jul 100 102 113 105 94 1.117
Aug 88 102 110 100 94 1.064
Sept 85 90 95 90 94 0.957
Oct 77 78 85 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
 Seasonal Index Example
Demand Average Average Seasonal
Month 2003 2004 2005 2003-2005 Monthly Index
Jan 80 85 105 90 94 0.957
Feb 70 85 Forecast
85 for 2006 80 94 0.851
Mar 80 93 82 85 94 0.904
Apr 90Expected
95 annual
115 demand = 1,200
100 94 1.064
May 113 125 131 123 94 1.309
Jun 110 115 120 1,200 115 94 1.223
Jan x .957 = 96
Jul 100 102 113 12 105 94 1.117
Aug 88 102 110 1,200 100 94 1.064
Sept 85 90
Feb 95 12 90 = 85
x .851 94 0.957
Oct 77 78 85 80 94 0.851
Nov 75 72 83 80 94 0.851
Dec 82 78 80 80 94 0.851
 Seasonal Index Example
2006 Forecast
140 – 2005 Demand
130 – 2004 Demand
2003 Demand
120 –
Demand

110 –
100 –
90 –
80 –
70 –
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Time