FORECASTING

I. Introduction
-- What is forecasting?
Scientific (educated) guess
Based on past data or experience
Rarely perfect
Group forecast more accurate
Shorter time horizon, more accurate
-- Why forecasting?
-- Forecasting time horizon
Short range usually less than 3 months
Medium range 3 months to 3 years
Long range over 3 years
-- Which forecasting method to use?
Time horizon
Costs vs. accuracy
Easy to understand?
-- Pattern of Data
Trend gradual upward or downward movement
Seasonality repeated pattern
Cycle background pattern over long period of time
Randomness unexplainable, unpredictable, unknown fluctuations
II. Qualitative Forecasting Methods
- no past data is available, for managerial decision, long term
forecast
Jury of executive opinion
The Delphi technique systematic survey of experts
Sales force composite
Consumer market survey
III. Quantitative Forecasting Methods
1) Smoothing Techniques:
- for data with no clear pattern, short term forecast

Naive: Ft+1 = Yt

n Period Moving Average (MA-n): equal weight for n data

Forecast = (most recent n data)/n

 n Period Weighted Moving Average (WMA-n): flexible weight

assignment
Forecast = (weight * most recent n data)/(weight)

Exponential Smoothing with smoothing constant : very little data

record required, more weight on recent data, weight decreases
exponentially
Ft+1 = Ft + (Yt - Ft) = Yt + (1-)Ft
0 < 1,

-- Example: Forecast the score for test 5 by the above smoothing

techniques with and F1 = 77.
Test
Avg.Score

1
72

2
82

3
85

4
90

5
?

-- Relationship between smoothing techniques

average of past data, but differ in weight distribution
all methods lag behind actual data change
more weight on most recent data, more responsive, less smooth
-- Thinking challenge:
1. Which method requires the least amount of data?
2. What happens if the in the exponential smoothing method
increases?
2) Trend Projection by Linear Regression
- for data with linear trend pattern, medium term
Step 1. Find a trend line y = a + bx to fit the past data the best
(minimizing mean squared errors)
xy n x y
b
best slope:
2
x2 nx

best intercept: a y b x
where x and y are averages of xs and ys
-- Example continues:
X
y
xy
x2

* Excel commands:
calculating b:=slope(range of ys, range of xs)
calculating a:=intercept(range of ys, range of xs)

y2

Step 2. Trend projection

Trend projection forecast: Fnext = a + b*xnext

-- Example continues:
Step 3. Find forecast interval, if necessary
Forecast interval = Fnext +- Z(1+ /2 *Sy,x

standard error: Sy,x =

a y b xy
n2

-- Example continues:
* Excel commands:
calculating Sy,x:=steyx(range of ys, range of xs)
3) Causal Model by Linear Regression
- same set up as trend projection, except that x is an independent
variable (other than time), y is a dependent variable, medium term
-- Example: The sales manager of a large apartment rental complex feels
the demand for apartments may be related to the number of newspaper ads
placed during the previous month. She has collected the data shown
below.
Ads
15
9
40
20
25
25
15
35
Rental
6
4
16
6
13
9
10
16
If the number of ads placed in this month is 30, what would be her
estimate of rentals in the coming month?
-- Correlation coefficient r: measures the strength of linear
relationship between x and y
-1 r +1

r =

n x

n xy x y

( x ) 2 * n y 2 ( y ) 2

* Excel command:
calculating r:=correl(range of ys, range of xs)
-- Interpretation:
r > 0:
r = 0:
r < 0:
r2 = coefficient of determination: % of variation in the dependent
variable (y) is explained by regression equation (linear
relationship).
-- Example continued: How strong is the relationship between the ads
placed and the rentals?

4) Decomposition of Time Series

- for data with both trend and seasonality patterns, short to
medium term
-- Idea:
1.

2.
3.

Decompose the past data (filter out the seasonal influence from
original data)
Forecast trend pattern and seasonality pattern separately
Combine the forecasts using the multiplicative model: Yt = Tt *
St

-- Example: Data of a popular brand of sweater sale (by quarters) over

the past three years:
2000
Sale
2001
Sale
2002
Sale
(t)
(Yt)
(t)
(Yt)
(t)
(Yt)
1
12
5
16
9
18
2
25
6
32
10
45
3
76
7
80
11
84
4
52
8
62
12
60
Forecast the sale of each season in 2003.
Step 1. Draw the historical data diagram to check if there is an
obvious seasonal pattern
Step 2. Calculate the "seasonal indexes" (S) for each
Seasonal Index = Avg. Seasonal Sale / Avg Sale
===> S(spring)
Y (spring) =
(summer)
=
===> S(summer)
Y
===> S(fall) =
Y (fall) =
(winter)
=
===> S(winter)
Y
Y

season.
=
=
=

Step 3. Deseasonalize the original data: Tt = Yt / S

2000
(t)
1
2
3
4

Sale
(Tt)

2001
(t)
5
6
7
8

Sale
(Tt)

2002
(t)
9
10
11
12

sale
(Tt)

Step 4. Calculate the trend based on the deseasonalized demand by

linear regression Tt = a + bt
a =
b =
Step 5. Use trend projection to forecast the demand with trend only.
T13 =
T14 =
T15 =

T16 =

Step 6. Use seasonal indexes to modify the forecasts to reflect the

seasonality patterns: F = T * S
F13 =
F14 =

F15 =

F16 =

IV. Choosing a Forecasting Method

- all criteria are a function of the forecast error

forecast error = actual realization (Y) forecast (F)

1. Bias measures the direction of forecast

Bias = (forecast error)/n
2. Mean Absolute Deviation (MAD)
- same penalty for small and large errors
MAD = (|forecast error|)/n
3. Mean Squared Error (MSE)
more penalty on large errors
MSE = (forecast error2)/n
4. Mean Absolute Percent Error (MAPE)
- relative error, scale independent
MAPE = (|forecast error|/Actual Data)/n
-- Comparing different forecasting methods
Based on past performance
Measure dependent
Choose (for exp. Smoothing) and n (for MA) to minimize MAD, MSE,
or MAPE

-- Example: Same data as earlier

Exp Smoothing with alpha =
0.1
Test Avg Score
Forecast
Err
|Err|
Err Square |Err|/Actual
1
72
77
-5
5
25
0.069444
2
82
76.5
5.5
5.5
30.25
0.067073
3
85
77.05
7.95
7.95
63.2025
0.093529
4
90
77.845
12.155
12.155
147.744
0.135056
Bias
MAD
MSE
MAPE
5.15125 7.65125
66.54913
0.091276
Exp Smoothing with alpha =
0.2
Test Avg Score
Forecast
Err
|Err|
Err Square |Err|/Actual
1
72
77
-5
5
25
0.069444
2
82
76
6
6
36
0.073171
3
85
77.2
7.8
7.8
60.84
0.091765
4
90
78.76
11.24
11.24
126.3376
0.124889
Bias
MAD
MSE
MAPE
5.01
7.51
62.0444
0.089817
Trend Projection with a =
Test Avg Score
Forecast
Err
1
72
73.7
2
82
79.4
3
85
85.1
4
90
90.8
Bias

68
|Err|
-1.7
2.6
-0.1
-0.8
MAD
0

b=
5.7
Err Square |Err|/Actual
1.7
2.89
0.023611
2.6
6.76
0.031707
0.1
0.01
0.001176
0.8
0.64
0.008889
MSE
MAPE
1.3
2.575
0.016346

V. Control of the Forecasting Process

- to check if the performance of a forecasting method changes
-- Tracking Signal control chart:
plotting statistic TS(t) = RSFE(t)/MAD(t)
RSFE(t) = running sum of the forecast error through time t
MAD(t) = MAD through time t
3 sigma control chart limits: UCL = 3, LCL = -3, CL = 0
-- Interpretation?
-- Example: A forecasting method provides the following forecasts in the
past 6 periods. Does its performance change over time?
T
Y
F
Error
RFSE(t)
MAD(t)
TS(t)
1
8
6
2
7
9
3
10
6
4
2
6
5
12
8
6
11
7