Forecasting

 Introduction
 Subjects of Forecasts
 Prerequisites for a Good Forecast
 Forecasting Techniques
 Expert Opinion
 Surveys and market research
 Surveys of spending plans
 Economic indicators
 Projections
 Econometric models
Introduction

All organizations conduct their activities in an

uncertain environment. The major role of
forecasting is to reduce this uncertainty.

In order that corporate management can set

reasonable targets for its objectives, it must
have available the relevant forecasts, both for
the short and long terms.

Corporate planners in all areas will utilize an

array of forecasts in constructing the various
portions of the business plan.
 Subjects of Forecasts
 Macro forecasts
 Gross domestic product
 Consumption expenditure
 Producer durable equipment expenditure
 Residential construction
 Industry forecasts
 Sales of an industry as a whole
 Sales of a particular product within an industry
 Subjects of Forecasts
 Firm-level forecasts
 Sales
 Costs and expenses
 Employment requirements
 Square feet of facilities utilized
Prerequisites of a Good
Forecast
A good forecast should
 be consistent with other parts of the
business.
 be based on adequate knowledge of the
relevant past.
 take into consideration the economic and
political environment.
 be timely.
Forecasting Techniques
1. Expert opinion
2. Opinion polls and market research
3. Surveys of spending plans
4. Economic indicators
5. Projections
6. Econometric models
Forecasting Techniques
Qualitative forecasting is based on
judgments of individuals or groups.

Quantitative forecasting utilizes

significant amounts of prior data as a
basis for prediction.
Forecasting Techniques
Naïve methods project past data
without explaining future trends.

Causal (or explanatory) forecasting

attempts to explain the functional
relationships between the dependent
variable and the independent variables.
Forecasting Techniques
Choosing the right technique depends
on various factors.
1. the item to be forecast
2. the relation between value and
cost
3. the quantity of historical data
available
4. the time allowed to prepare the
forecast
Expert opinion
Jury of executive opinion: A
forecast generated by experts (e.g,
corporate executives) in meetings.

The major drawback is that persons

with strong personalities may exercise
disproportionate influence.
Expert opinion
Opinions of Sales Representatives

A drawback is that salespeople may be

overly optimistic or pessimistic.

Further, they may be unaware of the

broad economic patterns that may
affect demand.
 Expert opinion
Delphi Method: A form of expert opinion
forecasting that uses a series of written questions
and answers to obtain a consensus forecast.

 Experts do not meet to discuss and agree on a

forecast, eliminating the potential pitfall
resulting from using a jury of executive
opinion.

 There is no need for unanimity of opinion; the

forecast can include a range of opinions.
 Opinion polls and market
research

Opinion polls: A forecasting method

in which sample populations are
surveyed to determine consumption
trends.

•may identify changes in trends

•choice of sample is important
•questions must be simple and clear
 Opinion polls and market
research
Market research is closely related to
opinion polling.

Market research will indicate “not only

why the consumer is or is not buying, but
also who the consumer is, how he or she
is using the product, and what
characteristics the consumer thinks are
most important in the purchasing
decision.”
 Surveys of Spending Plans
Surveys of spending plans seek information
about “macro-type” data relating to the
economy.

 Consumer intentions
 Survey of Consumers, Survey Research Center,
University of Michigan
 Consumer Confidence Survey, The Conference
Board
 Surveys of Spending Plans
Surveys of spending plans seek
information about “macro-type” data
relating to the economy.

 Inventories and sales expectations

 Capital expenditure surveys

Economic Indicators
Economic Indicators: A barometric
method of forecasting in which
economic data are formed into indexes
to reflect the state of the economy.

Indexes of leading, coincident, and

lagging indicators are used to forecast
changes in economic activity.
Economic Indicators
Leading indicators predict changes in
future economic activity.

Coincident indicators identify peaks and

troughs in economic activity.

Lagging indicators confirm upturns and

downturns in economic activity.
Economic Indicators
 Economic Indicators
General rule of thumb
If, after a period of increases, the leading
indicator index sustains three consecutive
declines, a recession (or a slowing) will
follow.
 Economic Indicators
Drawbacks
 Leading indicators occasionally forecast
recessions that do not occur.
 A change in the index does not indicate
the precise size of the decline or
increase.
 The data are subject to revision in the
ensuing months.
Projections
Trend projections: A form of naïve
forecasting that projects trends from
past data.

1. Compound growth rate

2. Visual time series projections
3. Least squares time series projection
Projections
Compound growth rate: Forecasting
by projecting the average growth rate
of the past into the future.

 First, calculate the constant growth rate

using available data.
 Then project this constant growth rate
into the future.
Compound Growth Rate

 Provides a relatively simple and timely

forecast

 Appropriate when the variable to be

predicted increases at a constant
percentage
Compound Growth Rate
General formula:

E = B(1+i)n

E = final value n = years in the

series
B = beginning value i = constant growth
rate
Compound Growth Rate
Solve the general formula for the
constant growth rate, i.

i = (E/B)1/n –1
Compound Growth Rate
Then project this constant growth rate
forward.

E = B(1+i)n
E = projection n = years (series +
projection)
B = beginning value
Projections
Time series forecasting: A naïve
method of forecasting from past data
by using least squares statistical
methods.
A time series analysis usually examines
•Trends
•Cyclical fluctuations
•Seasonal fluctuations
•Irregular movements.
 Time Series Projections
Advantages
1. easy to calculate
2. does not require much judgment or
analytical skill
3. describes the best possible fit for past
data
4. usually reasonably reliable in the short
run
Time Series Projections
Yt = f(Tt, Ct, St, Rt)

Yt = Actual value of the data at time t

Tt = Trend component at t
Ct = Cyclical component at t
St = Seasonal component at t
Rt = Random component at t
Time Series Projections
The task of the analyst is to decompose
the time series of Y into its four
components.

The method of moving averages is

used to isolate seasonal fluctuations.
Time Series Projections
Computation of the trend utilizes the
least squares method.

The dependent variable is the

deseasonalized series.

The independent variable is time,

starting with period 1.
Time Series Projections
Possible forms of the estimated
equation include:

 Straight line: Y = a + b(t)

 Exponential: Y = abt
 Quadratic: Y = a + b(t) + c(t)2
Time Series Projections
To the isolate cyclical component
another smoothing operation can be
preformed with a moving average.

The length of the moving-average

period is determined individually for
each case.
Time Series Projections
The remaining fluctuation is considered
the random component of the series.

The random factors cannot be predicted

and therefore should be ignored for
projection purposes.
Common Characteristics of
Forecasting
 Forecasts are rarely perfect

 Forecasts are more accurate for

aggregated data than for individual
items

 Forecast are more accurate for shorter

than longer time periods
Forecasting Steps
 What needs to be forecast?
 Level of detail, units of analysis & time horizon
required
 What data is available to evaluate?
 Identify needed data & whether it’s available
 Select and test the forecasting model
 Cost, ease of use & accuracy
 Generate the forecast
 Monitor forecast accuracy over time
Types of Forecasting Models
 Qualitative (technological) methods:
 Forecasts generated subjectively by the
forecaster

 Quantitative (statistical) methods:

 Forecasts generated through mathematical
modeling
 Qualitative Methods
Type Characteristics Strengths Weaknesses
Executive A group of managers Good for strategic or One person's opinion
opinion meet & come up with new-product can dominate the
a forecast forecasting forecast

Market Uses surveys & Good determinant of It can be difficult to

research interviews to identify customer preferences develop a good
customer preferences questionnaire

Delphi Seeks to develop a Excellent for Time consuming to

method consensus among a forecasting long-term develop
group of experts product demand,
technological
changes, and
Statistical Forecasting
 Time Series Models:
 Assumes the future will follow same patterns as
the past

 Causal Models:
 Explores cause-and-effect relationships
 Uses leading indicators to predict the future
 E.g. housing starts and appliance sales
 Composition
of Time Series Data
 Data = historic pattern + random
variation
 Historic pattern may include:
 Level (long-term average)
 Trend
 Seasonality
 Cycle
Time Series Patterns
Methods of Forecasting the Level
 Naïve Forecasting
 Simple Mean
 Moving Average
 Weighted Moving Average
 Exponential Smoothing
Time Series Problem
Determine forecast for Period Orders
periods 11 1 122
 Naïve forecast 2 91
3 100
 Simple average
4 77
 3- and 5-period moving 5 115
average 6 58
 3-period weighted moving 7 75
average with weights 0.5, 8 128
0.3, and 0.2 9 111
10 88
 Exponential smoothing
11
with alpha=0.2 and 0.5
Time Chart of Orders Data

140

120

100

80

60

40

20

0
1 2 3 4 5 6 7 8 9 10
Naïve Forecasting
Next period forecast = Last Period’s
actual:

Ft 1  At
Simple Average (Mean)
Next period’s forecast = average of all
historical data

At  At 1  At  2  .............
Ft 1 
n
Moving Average
Next period’s forecast = simple average
of the last N periods

At  At 1  .........  At  N 1
Ft 1 
N
The Effect of the Parameter N
 A smaller N makes the forecast more
responsive
 A larger N makes the forecast more
stable
Weighted Moving Average

Ft 1  C1 At  C2 At 1  .........  C N At  N 1
where
C1  C2  .........C N  1
Exponential Smoothing

Ft 1  At  1   Ft
where
0  1
The Effect of the Parameter 
 A smaller  makes the forecast more
stable
 A larger  makes the forecast more
responsive
 Time Series Problem Solution

Simple Simple Weighted Exponential Exponential

Naïve Simple Moving Moving Moving Smoothing Smoothing
Period Orders (A) Forecast Average Average (N=3) Average(N=5) Average (N=3) ( = 0.2) ( = 0.5)
1 122 122 122
2 91 122 122 122 122
3 100 91 107 116 107
4 77 100 104 104 102 113 104
5 115 77 98 89 87 106 91
6 58 115 101 97 101 101 108 103
7 75 58 94 83 88 79 98 81
8 128 75 91 83 85 78 93 78
9 111 128 96 87 91 98 100 103
10 88 111 97 105 97 109 102 107

11 88 97 109 92 103 99 98
Forecast Accuracy
 Forecasts are rarely perfect
 Need to know how much we should rely on
our chosen forecasting method
 Measuring forecast error:
Et  At  Ft
 Note that over-forecasts = negative errors
and under-forecasts = positive errors
 Tracking Forecast Error
Over Time
 Mean Absolute Deviation (MAD):
 A good measure of the actual error
MAD 
 actual  forecast
in a forecast n

Mean Square Error (MSE):

 actual - forecast
 2

 Penalizes extreme errors MSE 

n

 Tracking Signal
Exposes bias (positive or negative)  actual - forecast 
 TS 
MAD
 Accuracy & Tracking Signal Problem: A company is comparing the
accuracy of two forecasting methods. Forecasts using both methods are
shown below along with the actual values for January through May. The
company also uses a tracking signal with ±4 limits to decide when a
forecast should be reviewed. Which forecasting method is best?

Method A Method B
Month Actual F’cast Error Cum. Tracking F’cast Error Cum. Tracking
sales Signal Error Signal
Error
Jan. 30 28 2 2 2 28 2 2 1

Feb. 26 25 1 3 3 25 1 3 1.5
March 32 32 0 3 3 29 3 6 3
April 29 30 -1 2 2 27 2 8 4
May 31 30 1 3 3 29 2 10 5

MAD 1 2
MSE 1.4 4.4
Forecasting Trends
 Trend-adjusted exponential smoothing
 Three step process:
 Smooth the level of the series:
St  At  (1   )( St 1  Tt 1 )
 Smooth the trend:
Tt   (St  St 1 )  (1   )Tt 1
 Calculate the forecast including trend:
FITt 1  St  Tt
 Forecasting trend problem: a company uses exponential smoothing with trend to
forecast usage of its lawn care products. At the end of July the company wishes to
forecast sales for August. July demand was 62. The trend through June has been 15
additional gallons of product sold per month. Average sales have been 57 gallons
per month. The company uses alpha+0.2 and beta +0.10. Forecast for August.

 Smooth the level of the series:

S July  αA t  (1  α)(S t 1  Tt 1 )  0.262  0.857  15  70

 Smooth the trend:

TJuly  β(S t  S t 1 )  (1  β)Tt 1  0.170  57   0.915  14.8

 Forecast including trend:

FITAugust  S t  Tt  70  14.8  84.8 gallons
Adjusting for Seasonality
 Calculate the average demand per season
 E.g.: average quarterly demand
 Calculate a seasonal index for each season of
each year:
 Divide the actual demand of each season by the
average demand per season for that year
 Average the indexes by season
 E.g.: take the average of all Spring indexes, then
of all Summer indexes, ...
Adjusting for Seasonality
 Forecast demand for the next year & divide
by the number of seasons
 Use regular forecasting method & divide by four
for average quarterly demand
 Multiply next year’s average seasonal demand
by each average seasonal index
 Result is a forecast of demand for each season of
next year
 Seasonality problem: a university wants to develop forecasts for
the next year’s quarterly enrollments. It has collected quarterly
enrollments for the past two years. It has also forecast total
enrollment for next year to be 90,000 students. What is the
forecast for each quarter of next year?

Quarter Year 1 Seasonal Year 2 Seasonal Avg. Year3

Index Index Index
Fall 24000 26000
Winter 23000 22000
Spring 19000 19000
Summer 14000 17000
Total 90000
Average
 Seasonality Problem: Solution

Quarter Year 1 Seasonal Year 2 Seasonal Avg. Year3

Index Index Index
Fall 24000 1.20 26000 1.24 1.22 27450
Winter 23000 1.15 22000 1.05 1.10 24750
Spring 19000 0.95 19000 0.90 0.93 20925
Summer 14000 0.70 17000 0.81 0.76 17100
Total 80000 4.00 84000 4.00 4.01 90000
Average 20000 21000 22500
Casual Models
 Often, leading indicators hint can help
predict changes in demand
 Causal models build on these cause-
and-effect relationships
 A common tool of causal modeling is
linear regression:
Y  a  bx
Linear Regression
 Identify dependent (y) and
independent (x) variables
b
 XY  X  Y  Solve for the slope of the
 X 2  X  X 


line
b
 XY  n X Y

 X  nX
2 2

 Solve for the y intercept

a  Y  bX
 Develop your equation for
the trend line
Y=a + bX
 Linear Regression Problem: A maker of golf shirts 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.

b
 XY  n X Y
Sales $ Adv.$ XY X^2 Y^2
 X  nX 2 2
(Y) (X)
1 130 48 4240 2304 16,900 30282  451.25147.25
b  3.58
2 151 52 7852 2704 22,801 10533  451.25
2

3 150 50 7500 2500 22,500 a  Y  bX  147.25  3.5851.25

4 158 55 8690 3025 24964 a  -36.20
5 153.85 53 Y  a  bX  -36.20  3.58x
Y5  -36.20  3.5853  153.54
Tot 589 205 30282 10533 87165
Avg 147.25 51.25
OVERVIEW

 Demand Curve Estimation

 Identification Problem
 Interview and Experimental Methods
 Regression Analysis
 Measuring Regression Model Significance
 Measures of Individual Variable
Significance
Demand Curve Estimation
 Simple Linear Demand Curves
 The best estimation method balances
marginal costs and marginal benefits.
 Simple linear relations are useful for
demand estimation.
 Using Simple Linear Demand Curves
 Straight-line relations give useful
approximations.
Identification Problem
 Changing Nature of Demand Relations
 Demand relations are dynamic.
 Interplay of Supply and Demand
 Economic conditions affect demand and
supply.
 Shifts in Demand and Supply
 Curve shifts can be estimated.
 Simultaneous Relations
Interview and Experimental
Methods
 Consumer Interviews
 Interviews can solicit useful information
when market data is scarce.
 Interview opinions often differ from actual
market transaction data.
 Market Experiments
 Controlled experiments can generate useful
insight.
 Experiments can become expensive.
Regression Analysis
 What Is a Statistical Relation?
 A statistical relation exists when averages
are related.
 A deterministic relation is true by
definition.
 Specifying the Regression Model
 Dependent variable Y is caused by X.
 X variables are independently determined
from Y.
 Measuring Regression Model
Significance
 Standard Error of the Estimate SEE) increases
with scatter about the regression line.
 Goodness of Fit, r and R2
 r = 1 means perfect correlation; r = 0
means no correlation.
 R2 = 1 means perfect fit; R2 = 0 means
no relation.
 Corrected Coefficient of Determination,
R2
 Adjusts R2 downward for small samples.
 F statistic
 Tells if R2 is statistically significant.
Measures of Individual Variable
Significance
t statistics
 t statistics compare a sample characteristic to the
standard deviation of that characteristic.
 A calculated t statistic more than two suggests a
strong effect of X on Y (95 % confidence).
 A calculated t statistic more than three suggests a
very strong effect of X on Y (99 % confidence).
 Two-tail t Tests
 Tests of effect.
 One-Tail t Tests
 Tests of magnitude or direction.
 How Good is the Fit?
 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.

n  XY    X  Y 
r
 X    X   Y    Y 
2 2
2 2
n * n
(4)30,282  (205)589
r  .888
4(10,533) - (205) * 487,165  589
2 2

r 2  .982  .788
2

2
 Coefficient of determination ( r ) measures the amount of variation in the
dependent variable about its mean that is explained by the regression line.
2
Values of ( r ) close to 1.0 are desirable.
Factors for Selecting a
Forecasting Model
 The amount & type of available data
 Degree of accuracy required
 Length of forecast horizon
 Presence of data patterns
Forecasting Software
 Spreadsheets
 Microsoft Excel, Quattro Pro, Lotus 1-2-3
 Limited statistical analysis of forecast data
 Statistical packages
 SPSS, SAS, NCSS, Minitab
 Forecasting plus statistical and graphics
 Specialty forecasting packages
 Forecast Master, Forecast Pro, Autobox, SCA