CISM02-Unit 9 PDF

Forecasting
Dr Valentina Plekhanova
CISM02: Decision Support for Management
Unit 9
Unit 9: Learning Outcomes

1. To understand the different forecasting methodologies that are applied in
practice
2. To understand the criteria for selection of forecasting methodologies
3. To understand the different approaches to forecasting that can be applied in
practice
4. To calculate and explain a trend using moving averages
5. To carry out exponential smoothing calculations
6. To suggest a suitable value of the smoothing constant for a given set of data
7. To understand the principles of simple linear regression
8. To calculate and interpret the key statistics from a regression equation
9. To use different approaches to forecasting
10. To be able to apply forecasting methods to the practical problems
11. To be able to explain the limitations of forecasting methods
12. To be able to explain the key stages of the forecasting process
CISM02 Decision Support for Management
Unit 9
Famous Forecasting Quotes

"It is far better to foresee even without certainty than not to foresee at all. "
Henri Poincare in The Foundations of Science, page 129
"I have seen the future and it is very much like the present, only longer."
Kehlog Albran, The Profit
This nugget of pseudo-philosophy is actually a concise description of statistical forecasting.
We search for statistical properties of a time series that are constant in time--levels, trends,
seasonal patterns, correlations and autocorrelations, etc. We then predict that those
properties will describe the future as well as the present.
"Prediction is very difficult, especially if it's about the future."

Nils Bohr, Nobel laureate in Physics
This quote serves as a warning of the importance of validating a forecasting model out-ofsample. It's often easy to find a model that fits the past data well--perhaps too well! - but
quite another matter to find a model that correctly identifies those patterns in the past data
that will continue to hold in the future.
Unit 9
Forecasting in Management
Forecasting is used in various domains of management, such as:
Personnel management
Resource management
Finance management
Organisational management
Unit 9
Forecasting (0)
All forecasting methodologies can be divided into three broad headings, i.e.
forecasts based on:
The data from past activities
are cheapest to collect but
may be outdated and past
behaviour is not necessarily
indicative of future behaviour.
What people have done:

examples Regression
Analysis, Time Series Analysis
What people say:
examples Surveys,
Questionnaires
What people do:
examples Testing
Marketing, Reaction Test
Lucey, 2002
The data derived from recording

what people actually do are the most
reliable but also the most expensive
and occasionally it is not feasible for
the data to be obtained.
Data derived from surveys are more
expensive to obtain and needs critical
appraisal intensions as expressed in
surveys and questionnaires are not always
translated into action.
Unit 9
Forecasting (1)
An important use of quantitative models is in the prediction of the future. In
order to plan and control effectively, management needs estimates of future
levels of sales, costs, manpower requirements, and a variety of other factors.
Before taking almost any decision, a manager must make a number of
forecasts about future conditions and the effects of various courses of action.
These forecasts may be made only mentally, even subconsciously, but they are
a necessary part of decision making.
When forecasts have to be made on the basis of past data, managers has two
main approaches available to them
using intuition
using a model.
The use of intuition involves experience, knowledge of the market, flair etc. and
its importance should not be underestimated.
From Hull, et. al. Model Building Techniques
for Management, Saxon House, 1977
Unit 9
Forecasting (2)
However, when used alone, it does have a number of drawbacks:
Hull, et. al. 1977
Intuitive forecasts tend to be biased. This is partly due to the personality of the
forecaster and whether he/she is an optimist or a pessimist, but also to confusion
between targets and forecasts. If the forecasts is to be used as a target,
individuals will set forecasts on the low side. On the other hand, if the forecast is
to be used as a basis for budget allocations, individuals will set forecasts on the
high side to increase their share of the total budget.
It is difficult to forecast the limits of accuracy for an intuitive forecast.
The time of people with the skill and knowledge to make such forecasts is
expensive.
In many forecasting situations, for example, stock control, a very large number
of separate forecasts have to be made and the use of intuitive forecasting can be
very time-consuming.
Model building is a way of overcoming these drawbacks. If the model is chosen
correctly there will be no bias.
Unit 9
Forecasting (3)
Furthermore, the error is a forecast can be estimated and, generally, if a large
number of forecasts are required, they can be produced in a routine way by
either a junior clerk or a computer at relatively low cost.
However, a forecast which is produced by model building is sometimes no more
than an extrapolation of past data. It may ignore the effects of changes some
external important factors such as government policy, increases in the number of
competitors and any other events which are not reflected in the past data.
Hull, et. al., 1977

Unit 9
Available Forecasting Methodologies
(1)
There are several dimensions that can be used in grouping existing forecasting
methodologies. Many of these are technical in their orientation.
For example, the distinction between statistical methods and non-statistical
methods might be considered, or that between time series methods and causal
methods.
Still another technical distinction can be made between those methods that are
quantitative in their orientation and those that are qualitative.
The most general distinction is between informal forecasting approaches and
formal forecasting methods.
The informal forecasting methodologies are based largely on intuitive feel and
lack systematic procedures that would make them easily transferable for
application by others.
The formal forecasting methodologies seek to overcome this weakness by
systematically outlining the steps to be followed so that they can be repeatedly
applied to obtain suitable forecasts in a range of situations.
Unit 9
Available Forecasting Methodologies
(2)
Formal forecasting methodologies can be divided into those that are qualitative
and those that are quantitative.
Qualitative forecast methods
subjective
Quantitative forecast methods
based on mathematical formulas
The quantitative methods, in turn, can be subdivided into the categories of
time series techniques and causal or regression techniques.
The qualitative segment also includes two categories:
???
Techniques based on subjective assessment (the judgement of managers)

Techniques based on the forecasting of technological developments.
Unit 9
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Criteria for Selection of

Forecasting Methodologies
A number of different criteria have been suggested as a basis for
making a selection decision for an appropriate forecasting
methodology. These include:
Accuracy
The time horizon of forecasting
The value of forecasting
The availability of data
The type of data pattern
The experience of the practitioner at forecasting
Unit 9
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Forecasting: Framework
Data (time series, or historical data)

Forecasting method (e.g. Moving average, Trend analysis)
Forecast
Forecast Evaluation (i.e. Forecast accuracy measurement)
Unit 9
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Forecasting Situation & Methodology

In the very short-term, randomness (i.e. where it is not seasonality,
trends, or cyclicality) is usually the most important.
As the time horizon is lengthened, seasonality takes on increasing
importance, followed by cyclicality. For the every long-term time
horizon, seasonality becomes less important, and trend plays a primary
role.
Time horizon reflect such correlated characteristics as the value of
accuracy in forecasting, the cost of various methodologies, the
timeliness of their results, and the types of data patterns involved in the
forecasting situation.
Unit 9
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Forecasting Methods
Qualitative: Delphi method, Surveys, Forecast by analogy, Scenario
building
use management judgment, expertise, and opinion to predict future
demand
Time series
statistical techniques that use historical demand data to predict future
demand
Causal/ Econometric methods: Regression methods
attempt to develop a mathematical relationship between demand and
factors that cause its behavior
Other Methods: Simulation
Unit 9
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Categories of Forecasting Methods

Time series methods:
Time Series methods use historical data as the basis of estimating future
outcomes.
Moving Average
Exponential Smoothing
Extrapolation
Linear prediction
Trend Estimation
Growth Curve
Unit 9
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Causal / econometric methods
Some forecasting methods use the assumption that it is possible to identify the
underlying factors that might influence the variable that is being forecast. For
example, sales of umbrellas might be associated with weather conditions. If the
causes are understood, projections of the influencing variables can be made
and used in the forecast.
Regression Analysis using linear regression or non-linear regression
Autoregressive Moving Average (ARMA)
Autoregressive Integrated Moving Average (ARIMA)
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Judgmental methods
Judgmental forecasting methods incorporate intuitive judgments, opinions and
probability estimates.
Composite Forecasts
Surveys
Delphi Method
Scenario Building
Technology Forecasting
Forecast by Analogy
Other methods
Simulation
Prediction Market
Probabilistic Forecasting and Ensemble Forecasting
Reference Class Forecasting
Unit 9
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Qualitative Methods
Management, marketing, purchasing, and engineering are sources for

internal qualitative forecasts
Surveys, Forecast by analogy, Scenario building
Delphi method: involves soliciting forecasts about technological advances
from experts
Unit 9
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Quantitative Methods
Time Series Models:
Assumes the future will follow same patterns as the past
Relate the forecast to only one factor - time
Include
moving average
exponential smoothing
linear trend line
Causal / Econometric Models:
Explores cause-and-effect relationships
Uses leading indicators to predict the future,
e.g. housing starts and appliance sales
Unit 9
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Quantitative Forecasting:
Time-Series Models
Two factors are important in a time-series model: the series we want to
forecast (such as weekly supermarket sales) and the period of time to
which we are referring.
Advantage of time-series models is that the basic rules of accounting
are oriented toward sequential time period. This means that in most
firms data is readily available on the basis of these time periods and
can be used in the application of a time-series forecasting technique.
Unit 9
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10
Quantitative Forecasting:
Time-Series Models Time Horizon
Medium/long range forecasts deal with more comprehensive issues

and support management decisions regarding planning and products,
plants and processes.
Short-term forecasting usually employs different methodologies than
longer-term forecasting.
Short-term forecasts tend to be more accurate than longer-term

forecasts.
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Time Series Data Composition

Data = historic pattern + random variation
Historic pattern to be forecasted:
Level (long-term average)
Trend
Seasonality
Cycle
Random Variation cannot be predicted

Unit 9
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11
Time Series Components

Trend: Long-term upward or downward change in a time series
Seasonal: Periodic increases or decreases that occur within one
year
Cyclical: Periodic increases or decreases that occur over more than
a single year
Irregular: Changes not attributable to the other three components;
non-systematic and unpredictable
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Moving Average
Naive forecast
demand the current period is used as next periods forecast
Simple moving average
stable demand with no pronounced behavioral patterns
Weighted moving average
weights are assigned to most recent data
Unit 9
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12
Forecasting: Nave Methods

One of the simplest time series methods is Nave I. This method uses the most
recently observed value as a forecast. Thus, if product demand for the coming
week were to be predicted, the observed value of demand for the most recent
week would be used as that forecast. This is equivalent to giving a weigh of 1.0
to the most recent observed value and a weight of 0.0 to all other observations.
An important application of Nave methods is to use their forecasting accuracy as
a basis for comparing alternative approaches. It is not uncommon to find that one
of the Nave methods may provide adequate accuracy for certain situations. It
may also be the case that more sophisticated methods (which are usually much
more costly) do not give sufficient improvement in accuracy over these methods
to justify their use.
We sold 532 pairs of shoes last
week, I predict well
sell 532 pairs this week.
Unit 9
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Forecasting: Moving Averages (1)

Let us consider example that introduces the way in which model building can be
used in short term forecasting (i.e. in situations where a forecast is being
produced two to three months in advance).
The simplest approach to forecasting using past data is to assume that in the
short run the underlying mean is constant with the actual data being subject to
random fluctuations about the mean.
We might choose to average the previous six values in an attempt to estimate
this underlying mean and use it as our forecast. This procedure is called the
moving average method.
The length of time over which a moving average is taken will vary according to
choice and circumstances, and three month and twelve month average are all
relatively common. The method by which a moving average can be calculated is
shown in Table below.
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13
Forecasting: Moving Averages (1.2)

Notes:
It is called moving because as new demand data becomes available,
the oldest data is not used.
Updated (recomputed) for every new time period
May be difficult to choose optimal number of periods
May not adjust for trend, cyclical, or seasonal effects
Unit 9
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Simple Moving Average

n
Di
i=1
MAn =
where
n = number of periods in the moving average

Di = demand in period i
Unit 9
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14
Simple Moving Average: Example

MONTH
ORDERS
PER MONTH
Jan
Feb
Mar
Apr
May
June
July
Aug
Sept
Oct
Nov
99.0
85.0
82.0
88.0
95.0
91.0
120
90
100
75
110
50
75
130
110
90
-
Calculations:
MOVING
AVERAGE
Di
i=1
MA5 =
90 + 110 + 130+75+50
5
= 91 orders for November
Unit 9
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Suppose that it is now the end of month 6. The total of the previous six
months demands is: 31+29+30+33+34+29=186.
Month
Demand
Total demand
in last 6
months
6 month
moving
average
Forecast
(1)
(2)
(3)
(4)
(5)
31
29
30
33
34
29
186
31
31
The 6 month average is: 186/6=31.

Unit 9

30
15

Note that we use the moving average as the forecast of the next demand in
month 7, as shown in column 5 of the table. When we know the demand in
month 7, the moving average is updated to forecast month 8.
Suppose the actual demand in month 7 is thirty-seven units. We could update
the 6 month moving average by re-calculating for what, after month 7, would be
the previous six month, i.e. 2,3,4,5,6 and 7, and proceed as before. This would
be correct, but there is an easier way.
The previous total was 186. If we subtract from this the earliest demand which
occurred in that total and add the latest demand we have:
New total = 186-31+37=186+6 = 192. This gives the same result as adding the
demand figures for months 2,3,4,5,6 and 7.
The new moving average is 192/6=32.
Month
Demand
Total demand in
last 6 month
6 month moving
average
37
192
32
Forecast
32
Unit 9
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Suppose the demand in month 8 in fact proves to be 33 units. Proceeding in
the same way, the new total demand for six months 3,4,5,6,7 and 8 is then:
192 29 + 33 = 196.
Month
Demand
Total demand
in last 6
months
6 month
moving
average
Forecast
(1)
(2)
(3)
(4)
(5)
37
192
32
33
196
32.67
32
32.67
Note that it is not essential to have both columns 4 and 5;

both have been shown here only for
the purpose of explanation.
Unit 9
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16
Sales
400
o
300
o
o
200
forecast
100
o
Time (month)
6 period moving average

Unit 9
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When the time horizon for forecasting is fairly short, it is usually the
randomness element that is major concern.
One way to minimize the impact of randomness on individual forecasts
is to average several of the past values rather than using only a single
value.
The Moving Average approach is one of the simplest ways to reduce

the impact of randomness. This method consists of weighting N of the
recently observed values by 1/N. (Note that the N most recent terms
are thereby included in the average.)
Unit 9
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17
Forecasting: Moving Averages

Formal Representation (7)
In simple terms the technique of forecasting with moving average can
be represented as follows:
St+1 = (xt + xt-1 + + xt-N+1)/ N
where St = the forecast for time t
xt = the actual value at time t
N = the number of values included in the average.
St = (xt-1 + xt-2 + + xt-N)/ N

(should be updated for each period)
St+1 = xt/ N - xt-N/N + St

It is obvious that each new forecast based on a moving average is an
adjustment of the preceding moving average forecast.
It is easy to see why the smoothing effect increases as N becomes larger
because a much smaller adjustment is being made between each forecast.
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Weighted Moving Average

Adjusts moving average method to more closely reflect data fluctuations
WMAn =
i=1
Wi Di
where
Wi = the weight for period i, between 0 and 100

percent
Wi = 1.00
Unit 9
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18
Weighted Moving Average:

Example
Month
August
September
October
Weight
Data
17%
33%
50%
130
110
90
3
November Forecast:
WMA3 =
i=1
Wi Di
= (0.50)(90) + (0.33)(110) + (0.17)(130)

= 103.4 orders
Unit 9
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Forecasting with
Smoothing Techniques (1)
One type of problem that managers frequently face is that of preparing shortterm forecast for a number of different items. As a result of the nature of these
situations, the variable to be forecast can generally be assumed to change only
slightly during each subsequent time period.
Obviously there can be occasions on which it might change a considerable
amount in a single period, but generally speaking many of these items exhibit a
fairly stable series of values over a short time horizon.
In the government sector forecasting situations would include predicting
unemployment figures for each of several industries on a short-term basis and
perhaps changes in the price index for each of several commodities.
The techniques that are used most often in the above situations are referred to
as smoothing methods.
Unit 9
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19
Forecasting with
The historical data is used to obtain a smoothing value for the series
which becomes the forecast for some future period.
In applying a smoothing techniques there are two steps:
1. In the first some kind of smoothing values is computed based on
historical data.
2. In the second that value is used as a forecast for some future time.
(Forecasts are obtained by smoothing/averaging past values in, e.g. a

liner or exponential manner.)
Unit 9
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Forecasting with
The basic notion inherent in some smoothing techniques such as
moving average, exponential smoothing and other forms is that there is
some underlying pattern in the values of the variables to be forecast and
that the historical observations of each variable represent the
underplaying pattern as well as random fluctuations.
The goal of these forecasting methods is to distinguish between the

random fluctuation and the basic underlying pattern by smoothing the
historical values. This amounts to eliminating the extreme values found
in the historical sequence and basing a forecast on some smoothing
intermediate values.
Unit 9
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20

- Characteristics (6)
Can provide reasonably good forecasts over the short-term period.
The variable to be forecast can generally be assumed to change only
slightly during each subsequent time period
The different moving averages produce different forecasts.
The greater the number of periods in the moving average, the greater
the smoothing effect.
In the underlying trend of the past data is thought to be fairly constant
with substantial randomness, then a greater number of periods should
be chosen.
Unit 9
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- Characteristics (7)
Limitations of moving averages:
When there are changes in the basic pattern of the variable being forecast
moving averages may not adapt rapidly to the changes. Two common types of
change can help to illustrate this limitation. The first, referred to as a step change.
The second is the ramp change or trend.
Equal weighting (or importance) is given to each of the values used in the
moving average calculation, whereas it is reasonable to suppose that the most
recent data is more relevant to current conditions. (Note: no weight is given to
values observed before that period.)
The moving average calculation takes no account of data outside the period of
average, so full use is not made of all the data available.
An n period moving average requires the storage of n-1 values to which is
added the latest observation. This may not seem much of a limitations when only
a few items are considered, but it becomes a significant factor when, for example,
a company carries a number of thousands stock items each of which requires a
moving average calculation involving say 6 months of usage data to be recorded.
Unit 9
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21
Averaging method
Weights most recent data more strongly
Reacts more to recent changes
Widely used, accurate method
Exponential smoothing:
popular technique for short-run forecasting by business forecasters. It
uses a weighted average of past data as the basis for a forecast. The
procedure gives heaviest weight to more recent information and smaller
weights to observations in the more distant past. The reason for this is
that the future is more dependent upon the recent past than on the
distant past.
Unit 9
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Forecasting: Exponential Smoothing

This approach to time series forecasting is very similar to the Moving
Average approach but does not use a constant set of weights for the N
most recent observations. Rather, an exponentially decreasing set of
weights is used so that the more recent values receive more weight than
older values.
This notion of giving greater weight to more recent information is one
that has strong intuitive appeal for managers and makes sense based
on studies of the accuracy of exponential smoothing methods.
Additionally, the computational characteristics of this method make it
unnecessary to store all of the past values of the data series being
forecast. The only data required are the weight that will be applied to the
most recent value, the most recent forecast and the most recent actual
value.
Unit 9
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22
Forecasting Method
Ft +1 = Dt + (1 - )Ft
where:
Ft +1 =forecast for next time period
Dt =actual value/demand for present period
Ft =previously determined forecast for present period (i.e. the forecast for
the present time period t )
=weighting factor, exponential smoothing constant; a value between 0
and 1
Unit 9
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Why is it Exponential?
By direct substitution of the defining equation for simple exponential smoothing
back into itself we find that
Ft +1 = Dt + (1 - )Ft = Dt + (1 - ) [ Dt-1 + (1 - )Ft-1 ]= Dt + (1 - ) Dt-1 +
(1 - )Ft-1 = [Dt + (1 - ) Dt-1 + (1 - )Dt-2 + (1 - )Dt-3 + ] + (1)t D0
In other words, as time passes the smoothed statistic Ft +1 becomes the weighted
average of a greater and greater number of the past observations Dtn, and the
weights assigned to previous observations are in general proportional to the
terms of the geometric progression {1, (1), (1)2, (1)3, }.
A geometric progression is the discrete version of an exponential function, so this
is where the name for this smoothing method originated from.
Unit 9
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23
Geometric Progression
In mathematics, a geometric progression, also known as a geometric sequence,
is a sequence of numbers where each term after the first is found by multiplying
the previous one by a fixed non-zero number called the common ratio.
For example, the sequence 2, 6, 18, 54, ... is a geometric progression with
common ratio 3 and 10, 5, 2.5, 1.25, ... is a geometric sequence with common
ratio 1/2. The sum of the terms of a geometric progression is known as a
geometric series.
Thus, the general form of a geometric sequence is a , ar , ar2 , ar3 , ar4 ,
and that of a geometric series is
a + ar + ar2 + ar3 + ar4 +
where r 0 is the common ratio and a is a scale factor, equal to the sequence's
start value.
Unit 9
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Effect of Smoothing Constant

0.0 1.0
If = 0.20, then Ft +1 = 0.20 Dt + 0.80 Ft
If = 0, then Ft +1 = 0 Dt + 1 Ft 0 = Ft
Forecast does not reflect recent data
If = 1, then Ft +1 = 1 Dt + 0 Ft = Dt
Forecast based only on most recent data
Unit 9
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24
Exponential Smoothing (=0.30)

Period
1
2
3
4
5
6
7
8
9
Month
Demand
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
37
40
41
37
45
50
43
47
56
10 Oct
11 Nov
12 Dec
F2 = D1 + (1 - )F1
= (0.30)(37) + (0.70)(37)
= 37
F3 = D2 + (1 - )F2
= (0.30)(40) + (0.70)(37)
= 37.9 .
F13 = D12 + (1 - )F12
52
55
54
= (0.30)(54) + (0.70)(50.84)
= 51.79
Unit 9
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Period
Month Demand( = 0.3)
1
2
3
4
5
6
7
8
9
10
11
12
13
Jan 37
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan
40
41
37
45
50
43
47
56
52
55
54
Unit 9
FORECAST, Ft + 1
( = 0.5)
37.00
37.90
38.83
38.28
40.29
43.20
43.14
44.30
47.81
49.06
50.84
51.79
37.00
38.50
39.75
38.37
41.68
45.84
44.42
45.71
50.85
51.42
53.21
53.61
50
25
70
60
= 0.50
Actual
Orders
50
40
= 0.30
30
20
10
0
Month
|
1
|
2
|
3
|
4
|
5
|
6
|
7
|
8
|
9
|
10
|
11
|
12
Unit 9
|
13
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Forecasting Method
Most frequently used time series method because of
ease of use and minimal amount of data needed
Need just three pieces of data to start:
Last periods forecast (Ft)
Last periods actual value (Dt)
Select value of smoothing coefficient, between 0 and 1.0
If no last period forecast is available, average the last few

periods or use naive method
Higher values (e.g. 0.7 or 0.8) may place too much
weight on last periods random variation
Unit 9
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26
Forecasting: Trend Estimation

- Linear Trend Line (0)
Number of Orders
280
Trend Line
260
o
240
o
220
Error
Forecast based on 5 period moving average
200
Time (weeks)
Moving average: forecasting error due to presence of trend

Unit 9
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Forecasting: Trend Estimation (1)

To obtain a forecast we can fit a regression line to the past data and
project this forward. The equation of the regression line is:
y y = b (x x)
where
y = the value of the item to be forecast, in this case sales, during a
particular time period;
x = the corresponding time period;
b = the trend, in this case average increase in sales per month;
y = the mean of the y values for which data are available;
x = the mean of the x values for which data are available.
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27

x"
y"
and
y
n
where n = number of pairs of values available.

The best estimate of the trend is given by
x y
xy n
b
( x)
x
2
As the trend is likely to change over time, only the more recent data can be
used to estimate the trend. Table below shows a calculation of the regression
line for example which considers sales figures for the last five months.
Unit 9
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x=15/5=3.0; y= 245/5=49.0;
b= {751-(15 x 245)/5} / {55 (15 x 15)/5}= {751-735} / {55-45}=1.6
The equation of the regression line is: y 49.0 = 1.6 (x 3.0) , i.e.
y = 44.2 + 1.6 x
To obtain a forecast of sales for nest month we just substitute x = 6 in the
above equation, i.e. forecast = 44.2 + 1.6 x 6 = 53.8
Month
Sales
xy
x2
46
46
47
94
52
156
45
180
16
x =15
55
275
y =245
Unit 9
xy =751
25
x 2 =55
Regression
analysis
using
previous five
months
sales
56
28
Measure Forecast Accuracy

The goal of any measurement instrument is to have high accuracy (matching
reality as close as possible) and to also have a high precision (being able to
consistently replicate results and to measure with as many significant digits as
appropriately possible).
Accuracy is defined as, "The ability of a measurement to match the actual value of
the quantity being measured". If in reality it is 34.0 F outside and a temperature
sensor reads 34.0 F, then than sensor is accurate.
In order to benefit from the value of forecasting it is necessary to keep
performance metrics that measure its effectiveness.
While all forecasts will be incorrect, the degree of error should be minimized. For
example, a forecast with +/- 10% variability is much better than a forecast with +/50% variability.
By measuring and monitoring the forecast errors, new learning may be applied to
future forecasts, further reducing forecast errors.
Unit 9
57
Measurement: Remarks
Measurement is the determination of the size or magnitude of something.
Measurement is not limited to physical quantities, but can extend to quantifying
almost anything imaginable.
In physics and engineering, measurement is the process of comparing physical
quantities of real-world objects and events. Established standard objects and
events are used as units, and the measurement results in at least two numbers
for the relationship between the item under study and the referenced unit of
measurement, where at least one number estimates the statistical uncertainty in
the measurement, also referred to as measurement error (in a philosophical
distinction). Measuring instruments are the means by which this translation is
made.
In scientific research, measurement is essential. It includes the process of
collecting data which can be used to make claims about learning. Measurement
is also used to evaluate the effectiveness of a program or product (known as an
evaluand).
A measurement is a comparison to a standard. -- William Shockley
Unit 9
58
29
Forecast Accuracy
Questions!
What is the accuracy of a particular forecast?
How to measure the suitability of a particular forecasting method for a
given data set?
Forecast error
difference between forecast and actual demand

MAD:
mean absolute deviation
MAPD:
mean absolute percent deviation
Cumulative error
Average error or bias
Unit 9
59
Definition of the Forecast Error

Error (e) of a forecast is measured as a difference between the actual (A)
and forecasted values (F), that is,
Error =Actual value Forecasted value = A F
or, in a relative form:

e=100% (A-F)/A.
Remarks The error can be determined only when actual (future) data
are available.
Unit 9
60
30
Absolute Error
Absolute error - absolute uncertainty. Compare with relative error.
The uncertainty in a measurement, expressed with appropriate units.
For example, if three replicate weights for an object are 1.00 g, 1.05 g,
and 0.95 g, the absolute error can be expressed as 0.05 g.
Absolute error is also used to express inaccuracies; for example, if the

"true value" is 1.11 g and the measured value is 1.00 g, the absolute
error could be written as 1.00 g - 1.11 g = -0.11 g.
Note that when absolute errors are associated with indeterminate errors,
they are preceded with ""; when they are associated with determinate
errors, they are preceded by their sign.
Unit 9
61
Relative Error
Relative error - relative uncertainty.
Compare with absolute error.
The uncertainty in a measurement compared to the size of the
measurement.
For example,
if three replicate weights for an object are 2.00 g, 2.05 g, and 1.95 g,
the absolute error can be expressed as 0.05 g and the relative error is
0.05 g / 2.00 g = 0.025 = 2.5%.
Unit 9
62
31
Types of Errors & Mistake

Systematic errors have an identifiable cause and affect the accuracy of results.
Random errors are errors that affect the precision of a set of measurements.
Random error scatters measurements above and below the mean, with small
random errors being more likely than large ones.
A mistake is a measurement which is known to be incorrect due to carelessness,
accidents, or the ineptitude of the experimenter. It's important to distinguish
mistakes from errors: mistakes can be avoided. Errors can be minimized but not
entirely avoided, because they are part of the process of measurement. Data that
is mistaken should be discarded. Data that contains errors can be useful, if the
sizes of the errors can be estimated.
Unit 9
63
Gross Error
Compare with systematic error, random error and mistake.

Gross errors are undetected mistakes that cause a measurement to be very
much farther from the mean measurement than other measurements.
Errors that occur when a measurement process is subject occasionally to large
inaccuracies.
Unit 9
64
32
How to measure Forecasting Error?:

Mean Absolute Deviation (MAD)
Mean Absolute Deviation (MAD)
First absolute deviation is calculated for each of the data point.
Absolute Deviation is mod difference between forecast and actual value for the
data point. It is averaged over selected time zone to get MAD. This means, there
is no differentiation between positive and negative error. Also there is no
reference to base on which the error is measured.
For example, if the error is 3 over the forecast of 100 and error of 3 over forecast
of 30 is treated the same way. This is the most elementary form of Forecast Error
calculation. This is used in scenarios where cost of forecast error is very less and
demand is relatively stable.
Unit 9
65
How to measure Forecasting Error?:

Cumulative Spot Error
Cumulative Spot Error
Spot Error is difference between Forecast and Actual value. It can be
positive or negative. It is added over the selected time zone to get
cumulative spot error.
This method distinguishes between positive and negative error.

This type of error measurement is suitable in case of stocked goods
where demand for one period can be compensated the next period.
Surplus Inventory of one period can be used in next period.
Unit 9
66
33
Standard Statistical Measures

to Estimate Errors
The evaluation of Naive Forecasting Techniques relies primarily on the
comparison of the forecasts with the corresponding actual values .
To preliminary evaluate a forecast and suitability of a method, various
statistical measures may be used.
In evaluating forecasts obtained by means of the moving average
method, the following measures may be used:
Mean Error (ME)
Mean Absolute Error (MAE)
Mean Squared Error (MSE)
Mean Percentage Error (MPE)
Mean Absolute Percentage Error (MAPE)
Unit 9
67
Mean Error (ME)

n
ME At Ft / n
i 1
The ME can be very misleading.

A ME value of zero can mean that the method forecasted the actual values
perfectly (unlikely) or that the positive and negative errors cancelled each
other out.
It tends to Understate the error in all cases.
Unit 9
68
34
Mean Absolute Error (MAE)

n
MAE ( At Ft ) / n
i 1
MAE is a way of dealing with the Understatement of ME.

By using the Absolute values of the error, the mean gives a better
indication of the models fit.
Unit 9
69
Mean Squared Error (MSE)

n
2
MSE At Ft / n
i 1
The MSE eliminates the positive/negative problem by squaring the

errors.
The result tends to place more emphasis on the larger errors and,
therefore, gives a more conservative measure than the MAE.
Unit 9
70
35
Measures: Remarks
The previous three measures are series specific; i.e., they only allow
evaluation of the series that generated the errors.
The next two measures, by using the percentage of the error relative to
the actual, are designed to allow comparison of the results with different
models.
Unit 9
71
Mean Percentage Error (MPE)

n At Ft
MPE
t 1 At
100
/ n
The MPE is a relative measure of the forecasting error.

It is subject to the averaging of the positive and negative errors.
Unit 9
72
36
Mean Absolute Percentage

Error (MAPE)
n At Ft
MAPE
t 1
At
100
/n
MAPE is a comparative measure that does not have the problem of

averaging the positive and negative errors.
It is relatively easy to use to communicate a models effectiveness.
Unit 9
73
Mean Absolute Deviation
MAD =
Dt - Ft
n
where
t = period number
t
Ft = forecast for period t
n = total number of periods
Dt = demand in period
= absolute value
Unit 9
74
37
MAD: Example
DEMAND, Dt
1
2
3
4
5
6
7
8
9
10
11
12
Ft ( =0.3)
(Dt - Ft)
37
37.00
40
37.00
41
37.90
Dt -38.83
Ft
37
MAD
45 =
38.28
n
50
40.29
53.39
43
43.20
=
47
1143.14
56
44.30
52 = 4.8547.81
55
49.06
54
50.84
3.00
3.10
-1.83
6.72
9.69
-0.20
3.86
11.70
4.19
5.94
3.15
3.00
3.10
1.83
6.72
9.69
0.20
3.86
11.70
4.19
5.94
3.15
49.31
53.39
557
Unit 9
|Dt - Ft|
Roberta Russell & Bernard W. Taylor, III
PERIOD
75
Other Accuracy Measures

Mean absolute percent deviation (MAPD)
MAPD =
|Dt - Ft|
Dt
Cumulative error
E = et
Average error
et
E= n
Unit 9
76
38
Comparison of Forecasts
FORECAST
MAD
MAPD
Exponential smoothing ( = 0.30) 4.85

9.6% 49.31
Exponential smoothing ( = 0.50) 4.04
8.5% 33.21
Adjusted exponential smoothing
3.81
7.5% 21.14
( = 0.50, = 0.30)
Linear trend line
2.29
4.9%
Unit 9
(E)
4.48
3.02
1.92
77
Statistical Measures
of Goodness of Fit
In trend analysis the following measures will be used:
The Correlation Coefficient
The Determination Coefficient
Unit 9
78
39
The Correlation Coefficient
The correlation coefficient, R, measure the strength and direction of

linear relationships between two variables. It has a value between 1
and +1
A correlation near zero indicates little linear relationship, and a
correlation near one indicates a strong linear relationship between the
two variables
Unit 9
79
The Coefficient of Determination
The coefficient of determination, R2, measures the percentage of

variation in the dependent variable that is explained by the regression or
trend line.
It has a value between zero and one, with a high value indicating a good
fit.
Unit 9
80
40

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Forecasting

Unit 9: Learning Outcomes

CISM02 Decision Support for Management

Famous Forecasting Quotes

"Prediction is very difficult, especially if it's about the future."

CISM02 Decision Support for Management

What people have done:

The data derived from recording

Hull, et. al. 1977

Hull, et. al., 1977

Available Forecasting Methodologies

Available Forecasting Methodologies

Techniques based on subjective assessment (the judgement of managers)

CISM02 Decision Support for Management

Criteria for Selection of

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Data (time series, or historical data)

CISM02 Decision Support for Management

Forecasting Situation & Methodology

CISM02 Decision Support for Management

CISM02 Decision Support for Management

Categories of Forecasting Methods

CISM02 Decision Support for Management

Categories of Forecasting Methods

CISM02 Decision Support for Management

Categories of Forecasting Methods

Management, marketing, purchasing, and engineering are sources for

CISM02 Decision Support for Management

CISM02 Decision Support for Management

CISM02 Decision Support for Management

Medium/long range forecasts deal with more comprehensive issues

Short-term forecasts tend to be more accurate than longer-term

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Time Series Data Composition

Random Variation cannot be predicted

Time Series Components

CISM02 Decision Support for Management

CISM02 Decision Support for Management

Forecasting: Nave Methods

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Forecasting: Moving Averages (1)

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Forecasting: Moving Averages (1.2)

CISM02 Decision Support for Management

Simple Moving Average

n = number of periods in the moving average

CISM02 Decision Support for Management

Simple Moving Average: Example

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= 91 orders for November

Forecasting: Moving Averages (2)

The 6 month average is: 186/6=31.

From Hull, et. al. Model Building Techniques

Forecasting: Moving Averages (3)

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Forecasting: Moving Averages (4)

Note that it is not essential to have both columns 4 and 5;

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Forecasting: Moving Averages (5)

6 period moving average

Forecasting: Moving Averages (6)

The Moving Average approach is one of the simplest ways to reduce