FORECASTING

- To tell/find out something that may most likely

happen in future
- perfect forecasting is impossible
- but we can have best use of forecasting methodology
in management

Practical problems in forecasting

- how to select the best forecasting method for a given
situation
- how to evaluate forecast accuracy

Methods of forecasting can be put into 3 classes:

- Extrapolation – also called “time series method”
- Causal
- Judgemental

Extrapolation:
- moving averages
- exponential smoothing (- both use special kinds of
averages of the most recent data to forecast)
- trend line analysis : (the comparision of regression
models of the rate of growth of data overtime) eg.
dependent variable – sales and independent variable-
f(t)
- the straight line projection (a linear trend is used)
- classical decomposition- assumes that data are made
up of at least 3 components (seasonality, trend and
randomness)
- method attempts to separate
- Box jetkins : a sophisticated statistical technique
which attempts to pick an optimal from a large no. of
posssibilities( detailed not required)

Causal
- Causal regression ( beyond the scope of the course)
(sales vs. funtion of advertisement and price)
- Simulation: develops a model of process and then
conducts a series of trial and error experiments to
predict the behaviour of process over time.
Judgemental forecasting:

- done when there is few data to build a quantitative

model (sales forecast of new product)
- used when historical data are no longer
representative (eg. OPEC decisions, gulf war )
- Quantitative forecast can be still used as benchmark
to evaluate judgement accuracy
- Quantitative methods used to adjust the data for
seasonality and give better picture of trends
- Judgement may be biased so it is compared with
quantitative forecast
- Gambler’s fallacy
- Conservatism in forcasting
- Bias can be reduced by averaging forecasts from
different sources.
- Forecasting is input to planning

Time Series Pattern (Extrapolation)

- assumes that the time series follows some pattern

which can be extrapolated into future
Four types of trends:
- Constant Level trend
(forecast for any period in the future is a horizontal
line)
- Linear trend
(straight line trend with constant growth)
- Exponential trend
(amount of growth increase continuously)
- Damped trend
(used for longer-range forecasting, trend become a
horizontal line in later stage)

3 types of seasonality
- Non seasonality
- Additive Seasonality
(seasonal fluctuation are of constant size)- less
common
- Multiplicative Seasonality
(seasonal fluctuations are proportional to the data)
The Naive Forecasting Model ( benchmark model)

Ft+1= Xt
Forecasting for next period = Observed value this period

Evaluating Forecast Accuracy:

- Mean Absolute deviation (MAD)
- Mean absolute percentage error(MAPE)
- Mean Square error(MSE)

Forecasting models ranked differently according to accuracy

measure.
- MAD gives equal weight to each error where as MSE
gives more weight to larger errors)
- MSE is most often used in practice
- Forecast accuracy are compared with given model
with that of a benchmark model (Discard if error is
higher)

Forecast error equation:

et = x t – F t
error = Data – Forecast

Example of A naive Forecasting Model

-The mean error measures are computed only for the last half
of the data.
- The first part of data is used to fit the forecasting model
- Fitting data – Warm up sample
- second part – forecasting sample

Rule of thumb:
- to put at least six non-seasonal data points
- two complete seasons of seasonal data in warm up
sample
- If fewer data, no need to bother with two samples
In a long time series, common practice simply divide
half
MOVING AVERAGE FORECASTING
- UNWEIGHTED
(EQUAL WEIGHTS TO OLD AND NEW DATA)
- WEIGHTED
( MORE WEIGHTS TO MOST RECENT DATA)

Ft+1 = (Xt+Xt-1+Xt-2)/3 - Here N=3, mean of N data points

Forecast = Mean of the last N data points

The value of N could be other than 3 , the best one is

determined by experiments.

Better than the Naive Model as MSE(Mean square errror)

of the moving average is improved(less)
t Data Forecast Error Forecast for t+1
(Xt) (Ft) et= Xt-Ft Ft+1= (Xt+Xt-1+Xt-2)/3
1 28
2 27
3 33
4 25 29.3 -4.3
5 34 28.3 5.7
6 33 30.7 2.3
7 35 30.7 4.3
8 30 34.0 -4.0
9 33 32.7 0.3
10 35 32.7 2.3
11 27 32.7 -5.7
12 29 31.7 -2.7
13 30.3

MSE (PERIOD 7 –12) = (4.32+(-4.0)2+0.32+2.32+(-

5.7)2+2.72)/6
= 13.3

MSE (FOR NAIVE MODEL) = 18.3

SIMPLE EXPONENTIAL SMOOTHING

If et is +ve, forecast are increased

If et is –ve, forecast are decreased
(This process of adjustment continues unless the errors
reach zero. This does not happen but is always the
goal)

THE SIMPLE SMOOTHING EQUATION

Ft+1 = Ft + α et
Forecast fo t+1 = Forecast for t + α x Error in t
Here, α = Smoothing parameter ( 0 < α < 1)

t Data Forecast Error Forecast for t+1

(Xt) (Ft) et= Xt-Ft Ft+1= Ft+α et
1 28 30 -2.0 F2= 30.0+0.1(-2.0)= 29.8
2 27 29.8 -2.8 F3=29.8+0.1(-2.8)=29.5
3 33 29.5 3.5 F4=29.9
4 25 29.9 -4.9 F5=29.4
5 34 29.4 4.6 F6=29.9
6 33 29.9 3.1 F7=30.2
7 35 30.2 4.8 F8=30.7
8 30 30.7 -0.7 F9=30.6
9 33 30.6 2.4 F10=30.8
10 35 30.8 4.2 F11=31.2
11 27 31.2 -4.2 F12=30.8
12 29 30.8 -1.8 F13=30.6
13 30.6

MSE((PERIOD 7-12) = (4.82+0.72+2.42+4.22+4.22+1.82)/6

= 11.3
MSE (MOVING AVERAGE) = 13.3
(FOR NAIVE MODEL) = 18.3

TO Choose α , a range of trial must be tested , “ the best

fitting α with minimum MSE is chosen as best.
(Nine trials – from 0.1 to 0.9)
Basic Idea: on Simple Exponential Smoothing

- a new average can be computed from an old average

and the most recent observed demand.

At = α Xt + (1 – α) At-1
F t+1 = At Ft = At-1
Ft+1 = α Xt+ (1-α) Ft
After rearranging
Ft+1 = Ft + α et
New forecast = old forecast + a proportion of the error
between the observed demand and the old forecast

α controls the proportion of error

How exponential smoothing

Ft+1 = a Xt + (1-a) Ft
Generalizing:

Ft+1 = α Xt+ α(1-α) Xt-1 + α (1-α)2 Xt-2 + ....+ α (1-α)t-1X1+(1-α)t F1

This expression indicates that the weights on each
preceeding demand decrease exponentially, by a factor of (1-
α), until the demand from the first period and the initial
forecast F1 is reached.

If α = 0.3, t=3
F4 = 0.3 X3 + 0.21X2+ 0.147X1 + 0.343 F1

Notice that the weights on the demand decreases

exponentially over time and all the weights add upto 1

Therefore exponentially smoothing is just a special form of

the weighted average, with weights decreasing exponentially
over time.
TIME SERIES REGRESSION (Containing trend):
Two ways
- Fit a trend line to past data and then to
project the line into the furure.
- Smooth the trend with an expanded version
of the simple smothing model

Regression: process of estimating relationship

between two variables (eg. sales and time)

- the best fitting line is found out which give the

minimum sum of the squares of errors.

- The Least Squares Method is used to fit the

Regression model.

Ft = a + bt

Linear Regression Calculation

b = slope of the best fitting trend line

a = intercept of the best-fitting trend line

An Example: The computerland forecasting problem

(sales vs time(12 months)
t x tX t2
1 60
2 55
3 64
4 51
5 69
6 66
Summation (t X) – n mean t mean x
b = --------------------------------------------------
Summation t2 – n (mean t)2
a = Mean x – b mean t

Disadvantages;
- All regression forecasts are based on a
single equation
- Re computing the changing trend is tideous
- Equal weight is assigned to all observations
- Even if model fits for warmup sample, it may
not be for later forecasting

Smooth the linear trend: with an expanded version of

the simple smothing model

simple expo. smoothing- continually adjusts the

forecasts according to the errors.

Smoothing a linear trend also works similarly,except

- errors are used to continually adjust two things
- the intercept of the trend line
- the slope of the trend line
The adjustments are made with a sequence of
equations repeated each period.

Smoothed level at the end of t (St)

= forecast for t + α 1 x error in t
Smoothed trend at the end of t (Tt)
= Smoothed trend at the end of t-1 + α 2 x error in t

S t = F t + α 1 et Tt= Tt-1+α 2 et

α 1 = smoothing parameter for level which control the rate at

which the level is adjusted

α 2= smoothing parameter for trend which control the rate at

which trend is adjusted.
(we need two parameters because the trend in any period is
usually very small compared with the level)
- best through experimentation

Ft+1= St + Tt just like Ft = a + bt

Steps:(Exponential Smoothing with Linear Trend)

- time series regression on warm up sample
- the intercept(a) and slope (b) of the regression are always used as
the initial values of S and T (as S0 and T0)
- Choose α1 and α2 (here α1=0.1 and α2=0.01)
- Evaluate F1= S0 + T0
- Evaluate et=Xt-Ft i.e. (e1)
- Evluate St = Ft + α 1 et
- Evaluate Tt= Tt-1+α 2 et
- Evaluate Ft+1= St + Tt

Smoothing picks up changing trend in half of the data

The general forecasting equation for exponential smoothing of a linear
trend.

Ft+m= St + mTt

where m = the no. of periods into the future we want to forecast.

F13= S12 + (1) T12

F14= S12 + (2) T12
Exponential Smoothing with Non linear trend
St = Ft + α1 et
Tt = φ Tt-1 + α2 et
Ft+1 = St + φ Tt
where φ is the non linear trend modification parameter, value other than 1
 Exponential Smoothing with a linear trend, α 1= 0.10, α 2 = 0.01

T Data Forecast Error Level at the end of t Trend at the end of t Forecast for t+1
(Xt) (Ft) et = X t - F t St= Ft + a1et Tt=Tt-1+a2et Ft+1 = St + Tt
0 S0= 54.9 T0= 1.7 F1=54.9+1.7= 56.6
1 60.0 56.6 3.4 S1= T1=1.7+.01(3.4)=1.7 F2=56.9+1.7=58.6
56.6+.1(3.4)=56.9
2 55.0 58.6 -3.6 S2= 58.6+.1(-3.6) T2=1.7+.01(-3.6) =1.7 F3=58.2+1.7=59.9
=58.2
3 64.0 59.9 4.1 S3=60.3 T3=1.7 F4=62.0
4 51.0 62.0 -11.0 S4=60.9 T4=1.6 F5=62.5
5 69.0 62.5 6.5 S5=63.2 T5=1.7 F6=64.9
6 66.0 64.9 1.1 S6=65.0 T6=1.7 F7=66.7
7 83.0 66.7 16.3 S7=68.3 T7=1.9 F8=70.2
8 90.0 70.2 19.8 S8=72.2 T8=2.1 F9=74.3
9 76.0 74.3 1.7 S9=74.5 T9=2.1 F10=76.6
10 95.0 76.6 18.4 S10=78.4 T10=2.3 F11=80.7
11 72.0 80.7 -8.7 S11=79.8 T11=2.2 F12=82.0
12 88.0 82.0 6.0 S12=82.6 T12=2.3 F13=84.9
13 84.9

MSE(Periods 7 – 12) = 185.1

DECOMPOSITION OF SEASONAL DATA

SEASONAL – TIME SERIES PATTERN WHICH REPEATS

ITSELF, AT LEAST APPROXIMATELY EACH YESR
FOR SEASONAL DATA-
-THE PEAKS AND TROUGHS SHOULD BE CONSISTENT
-THERE SHOULD BE AN EXPLANATION( WEATHER,
HOIDAYS)
DECOMPOSITON:
- SEPARATION OF TIME SERIES INTO ITS COMPONENT
PARTS (SEASONALITY, TREND, CYCLE, AND RANDOMNESS)
DESEASONALIZED OR SEASONALLY ADJUSTED DATA:
- DATA AFTER REMOVING THE SEASONAL PATTERN

FORECASTING IS DONE FOR DESEASONALIZED DATA AND

SEASONAL PATTERN WIL BE PUT BACK TO GET
SEASONALIZED FORECAST

ACTUAL DATA
DESEASONALIZED DATA = ------------------------------------------
SEASONAL INDEX

ACTUAL DATA
SEASONAL INDEX = ---------------------------------------------
AVERAGE FOR THE YEAR
IF DATA ARE MONTHLY, 12 SEASONAL INDICES
IF DATA ARE QUARTERLY, 4 SEASONAL INDICES

THE WOLFPACK FORECASTING PROBLEM

CHOOSING A WARM UP(12) AND A FORECASTING SAMPLE(4)
9 STEPS IN FORECASTING SEASONAL DATA(MA APPROACH)
1. COMPUTE A MOVING AVERAGE BASED ON THE
LENGTH OF SEASONALITY
-THE AVERAGE SHOULD BE PLACED NEXT TO THE
CENTER
PERIOD. OR IMMEDIATELY NEXT TO CENTRE POINT.
-IF THERE ARE N PERIODS OF QUARTERLY DATA N-3 MA
-IF THERE ARE N PERIODS OF MONTHLY DATA N-11 MA
2. DIVIDE THE ACTUAL DATA BY THE
CORRESPONDING MOVING AVERAGE (TO GET
APPROXIMATE INDICES)
3. AVERAGE THE RATIOS TO ELIMINATE AS MUCH
RANDOMNESS AS POSSIBLE
4. COMPUTE A NORMALIZATION FACTOR TO
ADJUST THE MEAN RATIOS SO THEY SUM TO
4(QUARTERLY DATA) OR 12(MONTHLY DATA)
5. MULTIPLY THE MEAN RATIOS BY THE
NORMALIZATION FACTOR TO GET THE FINAL
SEASONAL INDICES
6. DESEASONALIZE THE DATA BY DIVIDING BY THE
SEASONAL INDEX
7. FORECAST THE DESEASONALIZED DATA (SIMPLE
EXPONENTIAL SMOOTHING HERE) α=0.1
minimizing the MSE for deseasonalized data in the
warm up sample
8. SEASONALIZE THE FORECASTS FROM STEP 7 TO
GET THE FINAL FORECASTS
9. COMPUTE THE MSE (USING SEASONAL ERROR)
FOR THE FORECASTING ERROR