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Forecasting

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ED CRUZ

SCHOOL OF APPLIED ECONOMICS

UNIVERSITY OF SOUTHEASTERN PHILIPPINES

FORECASTING

Definitions:

b. The process of making statements

about events whose actual outcomes

(typically) have not yet been observed.

DATA

QUANTITATIVE

SOFTWARE

METHODS

FORECASTING SYSTEM

USES OF FORECASTING

1. “Closing the gap”

2. Policy & advocacy

3. Marketing and Budgeting

4. Procurement and Pipeline

Planning

5. Quality Assurance

6. Preventing supply imbalance

TYPES OF FORECASTING METHODS

A. Qualitative methods

• Subjective

• Don’t rely on mathematical computations.

QUALITATIVE FORECASTING METHODS

TYPES OF FORECASTING METHODS

B. Quantitative methods

• Based on quantitative models

• Objective in nature

• Rely on mathematical

computations.

QUANTITATIVE FORECASTING METHODS

CHARACTERISTICS OF FORECASTING

depend on anything, you cannot predict what will

happen.

CHARACTERISTICS OF FORECASTING

some idea about its probability distribution is

necessary.

things can happen.

CHARACTERISTICS OF FORECASTING

You gain confidence in your forecast if you can

find it by different ways.

CHARACTERISTICS OF FORECASTING

You cannot estimate the future demand

accurately if you do not take into account facts

which influence the demand.

Examples:

- an advertising or promotion campaign has been

launched;

- a new product which replaces the old one is

now available.

FORECASTING

METHODOLOGIES

PATTERNS THAT MAY BE PRESENT IN A TIME

SERIES

time, with no growth or decline.

Trend: Data exhibit a steady growth or decline over

time.

Seasonality: Data exhibit upward and downward swings

in a short to intermediate time frame

Cycles: Data exhibit upward and downward swings in

over a very long time frame.

Random: Erratic and unpredictable variation

TIME SERIES ANALYSIS

the future.

Types :

(a)Stationary They differ by

the shape of the

(b)Trend-based line which best

fits the observed

(c)Seasonal data.

TIME SERIES ANALYSIS

importance they

(b) Moving Average give to the data

and by their

(c) Exponential Smoothing complexity.

4 STAGES OF ECONOMIC AND BUSINESS RESEARCH

form of the model? Is it reasonable to assume a

constant, an increasing, a decreasing or a seasonal

demand?

2. Parameterize the model – Model

Estimation

Question:

How to find values for the parameters: a, b,

... ?

Answer:

Use a method which tunes the parameters

in order to fit the curve with the

observations

3. EVALUATION OF ESTIMATES

a. Theory

Do they make sense in terms of economic

criteria?

b. Statistics

Are they reliable?

Criteria- t test, F test, R2, variances

4. Prediction and evaluation of the forecast

and evaluation of prediction errors

Forecast = model extrapolated in the future

Question:

How confident are we in this forecast ?

Answer:

If the errors made with this model in the

past are small, the error we will make will

be small too.

FORECASTING STATIONARY TIME SERIES

TIME SERIES MODELS

Model Description

Simple Moving Average recent observations, with each observation

receiving the same emphasis (weight)

Uses an average of a specified number of the most

Weighted Moving Average recent observations, with each observation

receiving a different emphasis (weight)

Exponential Smoothing

declining exponentially as data become older

Trend Adjusted Exponential Smoothing mechanism for making adjustments when strong

trend patterns are inherent in the data

A mechanism for adjusting the forecast to

Seasonal Indexes accommodate any seasonal patterns inherent in

the data

Linear Trend Line

fit a straight line to the data

Yea Total Annual

Quarter 1 Quarter 2 Quarter 3 Quarter 4

r Demand

1 20 28 34 18 100

2 58 86 104 52 300

3 40 54 72 34 200

Naïve method

The forecast for next period (period t+1) will be equal to this period's actual

demand (At). We assume that each year (beginning with year 2) we made a

forecast, then waited to see what demand unfolded during the year. A forecast

is then made for the subsequent year, and so on right through to the forecast for

year 7.

Actual

Demand (At) Forecast

Year (Ft) Notes

There was no prior demand data on

1 100 --

which to base a forecast for period 1

From this point forward, these forecasts

2 300 100

were made on a year-by-year basis.

3 200 300

4 500 200

5 600 500

6 700 600

EXERCISE

Quarter Sales

1 50147

2 49325

3 57048

4 76781

5 48617

6 50898

7 58517

8 77691

9 50862

10 53028

11 58849

12 79660

13 51640

14 54119

15 65681

16 85175

17 56405

18 60031

19 71486

20 92183

21 60800

22 64900

23 76997

24 103337

MOVING AVERAGE

time at the last N values. All these values have the

same importance. For example, D(t-N) and D(t-1) have

equal importance in the computation of the moving

average

a. mean method

b. simple weighted average.

Mean (simple average) method: The forecast for next period

(period t+1) will be equal to the average of all past historical

demands.

Actual

Demand (At) Forecast

Year (Ft) Notes

There was no prior demand data on

1 100 --

which to base a forecast for period 1

From this point forward, these forecasts

2 300 100

were made on a year-by-year basis.

3 200 200

4 500 200

5 600 275

6 700 340

7 400

Simple moving average method: The forecast for next period

(period t+1) will be equal to the average of a specified number of

the most recent observations, with each observation receiving

the same emphasis (weight).

Actual

Demand (At) Forecast

Year (Ft) Notes

This forecast was a guess at the

1 100 200

beginning.

This forecast was made using a naïve

2 300 100

approach.

From this point forward, these forecasts

3 200 200

were made on a year-by-year basis.

4 500 250

5 600 350

6 700 550

7 650

4

WEIGHTED MOVING AVERAGE

weighted average) inappropriate and want to give

higher weights to more recent data – weighted

average.

METHODS FOR STATIONARY TIME SERIES

(WEIGHTED MOVING AVERAGE)

EXAMPLE (A):

Weighted moving average method: The forecast for next period (period t+1) will be

equal to a weighted average of a specified number of the most recent observations.

After the third year, the weights that were used are as follows: Most recent year, .5;

year prior to that, .3; year prior to that, .2

Actual

Demand Weight Forecast

Year (At) (Ft) Notes

This forecast was a guess at the

1 100 0.2 200

beginning.

This forecast was made using a

2 300 0.3 100

naïve approach.

This forecast was made using a

3 200 0.5 300

naïve approach.

From this point forward, these

4 500 210 forecasts were made on a year-by-

year basis.

5 600 370

EXPONENTIAL SMOOTHING

data is given a decreasing weights.

This set of forecasts was made using an α value of .1

Actual

Demand (At) Forecast

Year (Ft) Notes

This was a guess, since there was no

1 100 200

prior demand data.

From this point forward, these forecasts

2 300 190

were made on a year-by-year basis.

3 200 201

4 500 200.9

5 600 230.81

6 700 267.729

7 310.9561

When we made the forecast for last period (Ft), it

was made in the following fashion:

following:

METHODS FOR STATIONARY TIME SERIES

(EXPONENTIAL SMOOTHING)

COMPARISON BETWEEN MOVING AVERAGE AND

EXPONENTIAL SMOOTHING

Similarities

1. assume stationary process;

2. single method parameter (N for the MA and α for

the exponential smoothing); and

3. lag behind trend

If there is a general trend, both approach will follow

but with some delay

COMPARISON BETWEEN MOVING AVERAGE AND

EXPONENTIAL SMOOTHING

Differences

By their definition, the two approaches do not

incorporate the same amount of data.

1. number of data taken into account

(Although ES takes all the data into account, its

recursive formulation allows the new forecast

to be determined on the basis of the last forecast

and last observation only).

2. computation and memory

COMPARISON BETWEEN MOVING AVERAGE AND

EXPONENTIAL SMOOTHING

Variables

for the MA: choose N

A large value for N will characterize a stable forecast.

This is a quality if the process is stable,

it isn't if the process undergoes some changes.

for the ES: choose a

A small value for a will characterize a stable forecast (we

give very little importance to the new

observation D(t)). Again, this is appropriate if the process

is stable and it isn't if the process

undergoes some changes.

EXERCISES

173 104 220

TREND-BASED TIME SERIES

trend.

know whether the demand roughly follows a line or

not. The problem here is to determine the constants

a and b.

TREND-BASED TIME SERIES

Linear

Regression :

Y(t) = a + bt

The regression

analysis aims

at fitting a

straight line in

the set of points

METHODS FOR TREND-BASED TIME

SERIES

squares method to fit a straight line to the data

exponential smoothing model with a mechanism for

making adjustments when strong trend patterns are

inherent in the data

METHODS FOR TREND-BASED TIME

SERIES (LINEAR REGRESSION)

Numerically, we obtain the following equations:

a= -10.500 b + 1.501;

b= 0.133 - 0.0732 a;

linear regression analysis implicitly gives the same

weights to all the data.

METHODS FOR TREND-BASED TIME

SERIES (LINEAR REGRESSION)

Y= 0.43 + 0.10t

METHODS FOR TREND-BASED TIME SERIES (DOUBLE

EXP. SMOOTHING (HOLT))

An exponential smoothing algorithm that allows for local

linear trend in a time series

Current level of TS + Current slope or in level of TS

- To anticipate the upward or downward movement.

Lt= (Lt – Lt-1) + (1 - ) Tt-1 0< < 1

Where:

Lt - Estimate of level

Tt – Estimates of slope at time t

and - smoothing constant 0< <1

Xt(h) = Lt + hT h= 1, 2, 3

METHODS FOR TREND-BASED TIME SERIES (DOUBLE

EXP. SMOOTHING (HOLT))

model parameters a and b where a is the

intercept at time 0 and b the slope. Here

however, we will use the parameters a(t-1)

and b(t-1) where a(t-1) is the intercept at

time (t-1) and b(t-1) is the estimated slope

for the interval [t-1,t]. Note (but

incidentally) that both model parameters

are computed at time (t-1)

METHODS FOR TREND-BASED TIME SERIES (DOUBLE

EXP. SMOOTHING (HOLT))

slope has to be multiplied by 1 in order to

obtain the forecast for time t.

METHODS FOR TREND-BASED TIME SERIES (DOUBLE

EXP. SMOOTHING (HOLT))

Here we show how a new forecast is derived on the basis of the previous forecast and of

the observed data. On the basis of a(t-1) and of b(t-1), the forecast F(t) has been computed

at time (t-1). Now we are at time t. We observed D(t) and we must compute a(t) and b(t) so

that

a new forecast F(t+1) can be determined.

METHODS FOR TREND-BASED TIME SERIES (DOUBLE

EXP. SMOOTHING (HOLT))

We choose to set a(t) between the previous forecast F(t) and the observed data D(t). That

is, a(t) is a compromise between D(t) and F(t)=a(t-1)+b(t-1).

For the slope, we choose a value between the previous slope, b(t-1), and the slope of the

line passing by a(t-1) and a(t). That is, b(t) is a compromise between b(t-1) and (a(t)-a(t-1)).

Both compromises are ruled by smoothing factors: and .

METHODS FOR TREND-BASED TIME SERIES (DOUBLE

EXP. SMOOTHING (HOLT))

With these values, we obtained b(0)=0; b(10)=0.050; b(20)=0.091 while the model used to

generate the data had a slope equal to 0.1. Here below you see the values of the model

parameters a and b as the forecasts evolved.

METHODS FOR TREND-BASED TIME SERIES (DOUBLE

EXP. SMOOTHING (HOLT))

\

METHODS FOR TREND-BASED TIME SERIES (DOUBLE

EXP. SMOOTHING (HOLT))

The following values were observed: b(0)=0.2; b(10)=0.141 and b(20)=0.102 for a model using a

slope equal to 0.1. To avoid this initialization problem, a solution consists in using a linear

regression on the first data to initialize the model parameters a and b.

METHODS FOR TREND-BASED TIME SERIES (DOUBLE

EXP. SMOOTHING (HOLT))

Making forecasts :

Assume the forecasts are along the line

For example, with the LR, the forecast

F(t,t+x) is given by the curve Y(t+x). With

the double exponential smoothing, the

forecast is F(t,t+x)= a(t) + b(t)x.

METHODS FOR TREND-BASED TIME SERIES (LINEAR

REGRESSION VS. HOLTS METHOD)

Similarity :

adequate for series with trends

Differences :

LR: - lots of work

- equal weight for all the data

- (a weighted version is possible)

Double ES (Holt):

- easy to compute

- decreasing (possibly dynamic) weights

- difficult to initialize

SEASONAL TIME SERIES

Additive vs Multiplicative Models

the difference between the January and July

values is approximately the same each year. In

other words, the amplitude of the seasonal effect

is the same each year. The residuals are roughly

the same size throughout the series

Multiplicative Models

In many time series involving quantities (e.g. money, wheat

production, ...), the absolute differences in the values are of less

interest and importance than the percentage changes.

that the July value is the same proportion higher than the January

value in each year, rather than assuming that their difference is

constant. Assuming that the seasonal and other effects act

proportionally on the series is equivalent to a multiplicative

model,

Fortunately, multiplicative models are equally easy to fit

to data as additive models! The trick to fitting a

multiplicative model is to take logarithms of both sides

of the model,

base 10), the four components of the time series again

act additively.

METHODS FOR SEASONAL TIME

SERIES

(CMA Method)

(b) Triple exponential smoothing

(Winters’ Method)-

CMA METHOD

reality this method provides the

seasonal coefficients only.

6 steps of CMA Method

1. examine data and determine cycle length (T)

2. determine the seasonal coefficients

3. extract seasonal coefficients from data

(deseasonalize)

4. determine the trends (by another method)

5. make (deseasonalized) forecasts

6. introduce seasonal coefficients

DESEASONALIZATION

SLIDES

METHODS FOR SEASONAL TIME

SERIES (WINTERS’ METHOD)

The method here consists in a triple exponential

smoothing by which all the model parameters

(a, b and the c's) are updated when a new observation is

obtained. We also assume that the cycle length has

been previously determined. The model parameters "a"

and "b" are updated as with the double exponential

smoothing, except that the observation is first

deseasonalized. The third equation updates the

corresponding seasonal coefficient. There again, a

compromise is made between the previous value of the

seasonal coefficient and the observed coefficient.

METHODS FOR SEASONAL TIME

SERIES (WINTERS’ METHOD)

METHODS FOR SEASONAL TIME

SERIES (WINTERS’ METHOD)

First, the trends is used to determine the deseasonalized forecast (a + b t).

Then, the adequate seasonal coefficient is introduced.

Here below is a plot of the forecast made daily using the Winter's method. We

can observe that the trend is adequate but that the seasonal coefficients

are not yet adequate.

5. EVALUATION OF FORECAST

Here we try to determine whether the forecast is good,

that is accurate and not biased. There are two usual

ways of measuring the accuracy of the forecasts.

EVALUATION OF FORECAST

The following result is extremely useful since it allows to

determine the variation of the error process from the

measure of the MAD.

could derive that the error process has a standard

deviation s equal to 10 units. The probability that the

demand exceeds the forecast by 20 units is then 0.023.

EXAMPLE: Ft = 120 Units

MAD = 8 Units

= 10 Units

EVALUATION OF FORECAST

We can thus argue that the forecast is correct (equal to

120) up to an error term which is distributed as a normal

with mean 0 and standard deviation s. We can then

derive the probability that the demand falls within some

confidence interval.

Prob[Ft - 2 s < Dt < Ft - 2 ] = 0.95

95 percent confidence interval = [100 - 140]

Valid method if the errors and the

previsions are made in the same way

This means that if the errors are measured by comparing the

real demand and the forecasts made two days before, then

we can build a confidence interval for a forecast made today

for the demand in two days.

EVALUATION OF FORECAST

Note that the MAD is sometimes computed by

using an exponential smoothing process.

Tracking Signal

overestimate and underestimate the demand

rather regularly. If your method is biased, then

you will repetitively under (or over-) estimate the

demand. The tracking signal aims at checking

whether there is some bias or not.

EVALUATION OF FORECAST

Theoretically, if there is no bias, this sum should remain

close to zero. The division by the MAD aims at measuring

the distance from the mean (here, 0) in terms of MAD.

We can plot the tracking signal over time for checking

purpose. We could also decide the limits it should not

exceed. Typical values are a few standard deviations.

WHICH METHOD TO USE?

Depends on: Observation

If you have few observations, it will be difficult to

define a detailed model. A linear regression for

computing the trends requires at least 10

observations to be valid. If you have some seasonal

variation, 3 or 4 cycles of observations are necessary

for your model to start being effective.

Finally, the amount of energy to spend for the

forecasting process plays also a role too.

WHICH METHOD TO USE?

Depends on: Time Horizon

The time horizon is also important. Do you want to

make a forecast for tomorrow, next month, next year or

the next 5 years ? How does the demand process vary

with respect to your time horizon ? Linear regressions

(and causal relationship methods) seem for example

more robust for long term forecast. In any case, the

observations on which you base your forecast is a

direct indicator of the horizon range for which your

forecast is valid.

EXERCISES

WHICH METHOD TO USE?

Depends on: The MAD Observed

fourths of your observations to set the parameters of

your model and then, use the last fourth of

observations to compare the forecasts of your model

with what really happened. Comparing the errors (the

MAD) made by different methods (and/or by different

models) provides an immediate selection criterion.

THANK YOU!

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