Business Forecasting

Library of Congress Cataloging-in-Publication Data Hanke,John E.,1940– Business forecasting / John

E.Hanke,Dean W. Wichern.– 9th ed. p. cm. ISBN-13:978-0-13-230120-6 (hardcover) ISBN-10:0-13-
230120-2 (hardcover) 1. Business forecasting. I. Wichern,Dean W. II. Title. HD30.27.H37 2009
658.4’0355—dc22

History:
Over the next 300 years, significant advances in data-based forecasting methods
occurred, with much of the development coming in the twentieth century.
Regression analysis, decomposition, smoothing, and autoregressive moving
average methods are examples of data-based forecasting procedures discussed in
this book.These procedures have proved to be highly effective and routinely appear
in the menus of readily available forecasting software. Along with the development
of data-based methods, the role of judgment and judgmental approaches to
forecasting has grown significantly over the last 25 years. Without any data
history, human judgment may be the only way to make predictions about the
future.In cases where data are available,judgment should be used to review and
perhaps modify the forecasts produced by quantitative procedures.

TYPES OF FORECASTS:
When managers are faced with the need to make decisions in an atmosphere of
uncertainty, what types of forecasts are available to them? Forecasting procedures
might first be classified as long term or short term. Long-term forecasts are
necessary to sethe general course of an organization for the long run;thus,they
become the particular focus of top management.Short-term forecasts are needed to
design immediate strategies and are used by middle and first-line management to
meet the needs of the immediate future. Forecasts might also be classified in terms
of their position on a micro–macro continuum, that is, in terms of the extent to
which they involve small details versus large summary values.For example,a plant
manager might be interested in forecasting the number of workers needed for the
next several months (a micro forecast),whereas the federal government is
forecasting the total number of people employed in the entire country (a macro
forecast). Finally, forecasts might be classified according to the nature of the
output. One must decide if the forecast will be a single number best guess (a point
forecast),a range of numbers within which the future value is expected to fall (an
interval forecast),or an entire probability distribution for the future value (a density
forecast).

FORECASTING STEPS:
All formal forecasting procedures involve extending the experiences of the past
into the future.Thus, they involve the assumption that the conditions that generated
past relationships and data are indistinguishable from the conditions of the future.
A human resource department is hiring employees, in part, on the basis of a
company entrance examination score because,in the past,that score seemed to be an
important predictor of job performance rating.To the extent that this relation
continues thold,forecasts of future job performance—hence hiring decisions—can
be improved by using examination scores. If, for some reason, the association
between examination score and job performance changes, then forecasting job
performance ratings from examination scores using the historical model will yield
inaccurate forecasts and potentially poor hiring decisions.This is what makes
forecasting difficult.The future is not always like the past.To the extent it
is,quantitative forecasting methods work well.To the extent it isn’t,inaccurate
forecasts can result.However,it is generally better to have some reasonably
constructed forecast than no forecast. The recognition that forecasting techniques
operate on the data generated by historical events leads to the identification of the
following five steps in the forecasting process:

1. Problem formulation and data collection

2. Data manipulation and cleaning

3. Model building and evaluation

4. Model implementation (the actual forecast)

5. Forecast evaluation

In step 1, problem formulation and data collection are treated as a single step
because they are intimately related. The problem determines the appropriate data.
If a quantitative forecasting methodology is being considered, the relevant data
must be available and correct. Often accessing and assembling appropriate data is a
challenging and time-consuming task. If appropriate data are not available, the
problem may have to be redefined or a no quantitative forecasting methodology
employed. Collection and quality control problems frequently arise whenever it
becomes necessary to obtain pertinent data for a business forecasting effort.

Step 2, data manipulation and cleaning, is often necessary. It is possible to have too
much data as well as too little in the forecasting process. Some data may not be
relevant to the problem. Some data may have missing values that must be
estimated. Some data may have to be repressed in units other than the original
units. Some data may have to be preprocessed (for example, accumulated from
several sources and summed). Other data may be appropriate but only in certain
historical periods (for example, in forecasting the sales of small cars, one may wish
to use only car sales data since the oil embargo of the 1970s rather than sales data
over the past 60 years). Ordinarily, some effort is required to get data into the form
that is required for using certain forecasting procedures.

Step 3, model building and evaluation, involves fitting the collected data into a
forecasting model that is appropriate in terms of minimizing forecasting error. The
simpler the model is, the better it is in terms of gaining acceptance of the
forecasting process by managers who must make the firm’s decisions. Often a
balance must be struck between a sophisticated forecasting approach that offers
slightly more accuracy and a simple approach that is easily understood and gains
the support of—and is actively used by—the company’s decision makers.
Obviously, judgment is involved in this selection process. Since this book
discusses numerous forecasting models and their applicability, the reader’s ability
to exercise good judgment in the choice and use of appropriate forecasting models
will increase after studying this material.

Step 4,model implementation, is the generation of the actual model forecasts once
the appropriate data have been collected and cleaned and an appropriate
forecasting model has been chosen. Data for recent historical periods are often held
back and later used to check the accuracy of the process.

Step 5,forecast evaluation, involves comparing forecast values with actual

historical values. After implementation of the forecasting model is complete.

FORECASTING SOFTWARE:
Today, there are a large number of computer software packages specifically
designed to provide the user with various forecasting methods.Two types of
computer packages are of primary interest to forecasters: (1) general statistical
packages that include regression analysis, time series analysis, and other
techniques used frequently bforecasters and (2) forecasting packages that are
specifically designed for forecasting applications. In addition, some forecasting
tools are available in Enterprise Resource Planning (ERP) systems. Graphical
capabilities,interfaces to spreadsheets and external data sources,numerically and
statistically reliable methods,and simple automatic algorithms for the selection and
specification of forecasting models are now common features of business
forecasting software. However, although development and awareness of
forecasting software have increased dramatically in recent years, the majority of
companies still use spreadsheets (perhaps with add-ins) to generate forecasts and
develop business plans. Examples of stand-alone software packages with
forecasting tools include Minitab, SAS, and SPSS.There are many add-ins or
supplemental programs that provide forecasting tools in a spreadsheet
environment. For example, the Analysis ToolPak add-in for Microsoft Excel
provides some regression analysis and smoothing capabilities.There are currently
several more comprehensive add-ins that provide a (almost) full range of
forecasting capabilities.

It is sometimes the case, particularly in a spreadsheet setting, that “automatic”

forecasting is available.That is, the software selects the best model or procedure for
forecasting and immediately generates forecasts.We caution, however, that this
convenience comes at a price.Automatic procedures produce numbers but rarely
provide the forecaster with real insight into the nature and quality of the
forecasts.The generation of meaningful forecasts requires human intervention, a
give and take between problem knowledge and forecasting procedures (software).

Summary:
The purpose of a forecast is to reduce the range of uncertainty within which
management judgments must be made.This purpose suggests two primary rules to
which the forecasting process must adhere:
1. The forecast must be technically correct and produce forecasts accurate enough
to meet the firm’s needs.

2. The forecasting procedure and its results must be effectively presented to

management so that the forecasts are used in the decision-making process to the
firm’s advantage;results must also be justified on a cost-benefit basis.

Forecasters often pay particular attention to the first rule and expend less effort on
the second.Yet if well-prepared and cost-effective forecasts are to benefit the firm,
those who have the decision-making authority must use them.This raises the
question of what might be called the “politics” of forecasting. Substantial and
sometimes major expenditures and resource allocations within a firm often rest on
management’s view of the course of future events. Because the movement of
resources and power within an organization is often based on the perceived
direction of the future (forecasts),it is not surprising to find a certain amount of
political intrigue surrounding the forecasting process.The need to be able to
effectively sell forecasts to management is at least as important as the need to be
able to develop the forecasts.

References:
Bernstein,P.L.Against the Gods: The Remarkable Story of Risk. New
York:Wiley,1996.

Carlberg,C.“Use Excel’s Forecasting to Get Terrific Projections. “Denver Business

Journal 47 (18) (1996):2B.

Chase,C.W.,Jr.“Selecting the Appropriate Forecasting Method.”Journal of

Business Forecasting 15 (Fall 1997):2.

Diebold,F.X.Elements of Forecasting,3rd ed. Cincinnati,Ohio:South-

Western,2004.

Georgoff,D.M.,and R.G.Mardick.“Manager’s Guide to Forecasting.”Harvard

Business Review 1 (1986):110–120.

Hogarth,R.M.,and S.Makridakis.“Forecasting and Planning:An

Evaluation.”Management Science 27 (2) (1981):115–138.
Short-Term Electricity Demand Forecasting Using Double Seasonal
Exponential Smoothing.
Introduction
Online electricity demand prediction is required for the control and scheduling of
power systems. The forecasts are required for lead times from a minute-ahead to a
day-ahead. At National Grid, which is responsible for the transmission of
electricity in England and Wales, online prediction is based on half-hourly data. A
profiling heuristic is used to produce forecasts for each minute by interpolating
between each half-hourly prediction. The National Grid one hour-ahead forecasts
are a key input to the balancing market, which operates on a rolling one hour-ahead
basis to balance supply and demand after the closure of bi-lateral trading between
generators and suppliers.

Weather is a key influence on the variation in electricity demand (see Taylor and
Buizza1,2). However, in a real-time online forecasting environment, multivariate
modelling is usually considered impractical. A multivariate online system would
be very demanding in terms of weather forecast input and would require default
procedures in order to ensure robustness3. Univariate methods are considered to be
sufficient for the short lead times involved because the weather variables tend to
change in a smooth fashion, which will be captured in the demand series itself. In
this paper, we consider online, univariate forecasting of half-hourly data. A time
series of electricity demand recorded at half-hourly intervals contains more than
one seasonal pattern. Figure 1 shows half-hourly demand in England and Wales for
a fortnight in June 2000. A within-day seasonal cycle, of duration 48 half-hour
periods, is apparent from the similarity of the demand profile from one day to the
next, particularly on weekdays. A within-week seasonal cycle, of duration 336
half-hour periods, is evident when one compares the demand on the corresponding
day of adjacent weeks. There is strong appeal in using a forecasting method that is
able to capture information in both seasonalities. Holt-Winters exponential
smoothing is a popular approach to forecasting seasonal

time series. The robustness and accuracy of exponential smoothing methods has
led to their widespread use in applications where a large number of
seriesnecessitates an automated procedure, such as inventory control. This suggests
that Holt-Winters might be a reasonable candidate for the automated application of
online electricity demand forecasting. However, the method is only able to
accommodate one seasonal pattern. The multiplicative seasonal ARIMA model has
been extended in order to model the within-day and within-week seasonality’s in
electricity demand. In this paper, we adapt the Holt-Winters method so that it can
accommodate two seasonalities. This involves the introduction of an additional
seasonal index and an extra smoothing equation for the new seasonal index.

In the next section, we describe how ARIMA models have been adapted for online
electricity demand forecasting, in order to capture multiple seasonalities in the
demand series. We then show how the Holt-Winters method can be adapted for
series with more than one seasonality. The section that follows presents an
empirical forecast comparison of the new formulation with the standard Holt-
Winters method and with a multiplicative double seasonal ARIMA model. In the
final section, we provide a summary and conclusion.

Multiplicative Double Seasonal ARIMA Models:

The multiplicative seasonal ARIMA model, for a series, Xt, with just one seasonal
pattern can be written as:

where L is the lag operator, s is the number of periods in a seasonal cycle, ∇ is the
difference operator, (1-L), ∇s is the seasonal difference operator, (1-Ls), d and D
are the orders of differencing, ε t is a white noise error term, and φ p, ΦP, θ q and
ΘQ are polynomial functions of orders p, P, q and Q, respectively. The model is
often expressed as ARIMA(p,d,q)×(P,D,Q)s.It is multiplicative in the sense that the
polynomial functions of L and Ls are multiplied on each side of the equation to
give a rich function of the lag operator.

The multiplicative double seasonal ARIMA model can be written as:

Double Seasonal Holt-Winters Exponential Smoothing:

where α , γ and δ are smoothing parameters, and is the k-step-ahead forecast. The
seasonality is multiplicative in the sense that the underlying level of the series is
multiplied by the seasonal index. Holt-Winters for additive seasonality is an
alternative formulation, which involves the addition of seasonal factors to the
underlying trend. The multiplicative version is appropriate if the magnitude of the
seasonal variation increases with an increase in )(ˆ kX the mean level of the series,
while the additive version should be used if the seasonal effect does not depend on
the current mean level.

Double Seasonal Holt-Winters:

where α , γ , δ and ω are smoothing parameters. Applying the method to a series of

half-hourly demand, one would set s1=48 and s2=336, as in the multiplicative
double seasonal ARIMA model of Laing and Smith7. Dt and Wt would then
represent the within-day and within-week seasonalities, respectively. A double
additive seasonality method can be developed in a similar way from the standard
Holt-Winters method for additive seasonality.

Double Seasonal ARIMA model:

Acknowledgements
We are grateful to Shanti Majithia, Chris Rogers and Sal Sabbagh of National Grid
for supplying data and information regarding the company’s online demand
forecasting. We are also grateful for the useful comments of the anonymous
referees.

References
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electricity demand forecasting. International Journal of Forecasting 19: 57-70.

2 Taylor JW and Buizza R (2002). Neural Network Load Forecasting with

Weather Ensemble Predictions. IEEE Transactions on Power Systems 17: 626-632.

3 Bunn DW (1982). Short-term forecasting: A review of procedures in the

electricity supply industry. Journal of the Operational Research Society 33: 533-
545.

4 Infield DG and Hill DC (1998). Optimal smoothing for trend removal in short-
term electricity demand forecasting. IEEE Transactions Power Systems 13: 1115-
1120.

5 Christiaanse WR (1971). Short-term load forecasting using general exponential

smoothing. IEEE Trans. on Power Apparatus and Systems Pas-90: 900-902

6 Lamedica R, Prudenzi A, Sforna M, Caciotta M and Cencelli VO (1996). A

neural network based technique for short-term forecasting of anomalous load
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methods for predicting the CEGB demand. Proceedings of the Ninth Power
Systems Computation Conference.

8 Darbellay GA and Slama M (2000). Forecasting the short-term demand for

electricity - Do neural networks stand a better chance? International Journal of
Forecasting 16: 71-83.