‘analysis of time-series data, Chapter $ Demand Forecasting | 189 CASE APPLICATION 5-1 | Forecasting the Number of McDonald's Restaurants Worldwide Increased competition and lower profit mar- States and abroad. ‘Thus, McDonald's is well gins at home are driving McDonald’s and other along to reaching the estimated minimum mar- large U.S. fast-food chains to expand abroad, ket potential abroad (in Canada and Australia, where competition is weaker and profit mar- it has already surpassed it) Bins are higher (refer to Case Application 3-1), Some countries in which McDonald's is In fact, by 2002 there were more McDonald’s hardly present are estimated to be able to sus- restaurants abroad (15,900) than in the United tain a Jarge number of its restaurants. For ex- States (12,800). McDonald’s operated in 121 ample, Fortune estimated that India could sus- countries, and four out of five of its new tain at least 489, as compared with the current restaurants were abroad. 34. To be remembered, however, is that For- Using data on each country’s population tunes estimates were based on the assumption and per capita income, Fortune magazine esti-- that tastes in the rest of the world were the mated in 1993 the potential number of restau- same as in the United States, Although con- fants that McDonald's could build in each verging, tastes are unlikely to ever become the country if tastes were similar to U.S. tastes, same, and so these can be regarded only as ‘The results for some countries are indicated in rough “guesstimates.” In 2002, McDonald's Table 5-1. Fortune came ‘up with a total world: predicted that it would reach 50,000 restau- wide number of 42,000 restaurants. Atthe time rants worldwide during this decade, But with of Fortune’s estimate in 1993, there were 3,597. changing tastes in the United States and abroad McDonald’s restaurants abroad. By 2002, toward lighter and healthier foods, McDon- there were a total of 30,093 in the United ald’s expansion is slowing down considerably. McDonald’s Actual and Potential Restaurants around the World Number of Number of | Minimum Cauncy __Resaurantin 1999___Restaurant'n 2002 Marker Pore Japan 1,070 6,100 i Canada 394 10 : Briain 550 i ‘ Germany 535 3,235 a Australia 4il ‘526 r Hae na 2207 fo China 3B 8a Ae Source: “McDonald's Conquers the World,” Fortune (October 17, 1994), p. 104, and McDonald's 2002 Web ite (hetp:d/www.mcdonalds.com). Time-Series Analysis SHEE Wz One of the most frequently used forecasting methods is time-series analysis or the “2 Time-series data, discussed in Chapter 4, refers to the values of a variable arranged chronologically by days, weeks, months, quarters, or fears. The first step in time-series analysis is usually to plot past values of the van.Part 2 Demand Analysis able that we seek to forecast (say, the sales of a firm) on the vertical axis and time on the horizontal axis in order to visually inspect the movement of the time series over time. Time-series analysis attempts to forecast future values of the time series by ex- amining past observations of the data only. The assumption is that the time series will continue to move as in the past (i.e., the past pattern will continue unchanged or will be similar in the future). For this reason, time-series analysis is often referred to as naive forecasting. In this section, we first examine why most time-series data fluctuate and then.ex- amine how to use this information to forecast values of the time series. Reasons for Fluctuations in Time-Series Data If we plot most economic time-series data, we discover that they fluctuate or vary over time. This variation is usually caused by secular trends, cyclical fluctuations, seasonal variations, and irregular or random. influences. These sources of variation are shown in Figure 5-1 and are briefly examined below: 1, Secular trend refers to a long-run increase or decrease in the data series (the straight solid line in the top panel of Figure 5-1). For example, many time series of sales exhibit rising trends over the years because of population growth and in- creasing per capita expenditures. Some, such as typewriters, follow a declining trend as more and more consumers switch to personal computers. 2., Cyclical fluctuations are the major expansions and contractions im most eco- nomic time series that seem to recur every several years (the heavy dashed curved line in the top panel of Figure 5-1). For example, the housing construc- tion industry follows long cyclical swings lasting 15 to 20 years, while the auto- mobile industry seems to follow much shorter cycles. 3; Seasonal variation refers to the regularly recurring fluctuation in economic ac- tivity during each year (the heavy dashed curved line in the bottom panel of Fig- ue 5-1) because of weather and social customs. Thus, housing starts used t0 be much more numerous in spring and summer than in autumn and winter (because of weather conditions), while retail sales are greatest during the last quarter of each year (because of the holidays). 4. Irregular or random influences are the variations in the data series resulting from wars, natural disasters, strikes, or other unique events. These are shown by the solid line segments in the bottom panel of Figure 5-1. ‘The total variation in the time series of sales (not shown in Figure 5-1) is the re- sult of all four factors operating together. Thus, the original sales data would shaw the seasonal and imegular variations superimposed on the cyclical fisgttuations around the rising trend (the reader should try to sketch such original sales data). Since cyclical swings or business cycles can be of different duration and can arise from a variety of causes that even today are not yet fully understood, they are usually ex- amined separatelv with qualitative techniques (see Section 5-4). Similarly, irregularChapter 5192, Part2 Demand Analysis ot random influences in time series, by their very nature, cannot be examined sys- tematically or forecasted. Thus, in this section we concentrate on forecasting the val- ues of time-series data by using only the long-term trend and the seasonal variation in the data. Trend Projection ‘The simplest form of time-series analysis is projecting the past trend by fiting a straight line to the data either visually or, more precisely, by regression analysis. The linear regression model will take the form of S, = So + bt (5-1) where S; is the value of the time series to be forecasted for period f, Sp is the estimated value of the time series (the constant of the regression) in the base period (i.¢., at time period = 0), b is the absolute amount of growth per period, and ris the time period in which the time series is to be forecasted. For example, fitting a regression line to the electricity sales (consumption) data running from the first quarter of 2000 (t= 1) to the last quarter of 2003 (t= 16) given in Table 5-2, we get estimated regression Equation 5-2. $,= 11.90 + 0.394 —-R?= 0.50 (4.00) (5-2) Regression Equation 5-2 indicates that electricity sales in the city in the last quarter of 1999 (that is, Sq) are estimated to be 11.90 million kilowatt-hours and increase at the average rate of 0.394 million kilowatt-hours per quarter. The trend variable is sta- tistically significant at better than the 1 percent level (inferred from the value of 4 for the ¢ statistic given in parentheses below-the estimated slope coefficient) and “ex- plains” 50 percent in the quarterly variation of electricity consumption in the city (from R? = 0.50). Thus, based on the past trend, we can forecast electricity con- sumption (in million kilowatt-hours) in the city to be S17 = 11.90 + 0.394(17) = 18.60 in the first quarter of 2004 Sig = 11.90 + 0.394(18) = 18.99 in the second quarter of 2004 yy = 11.90 +0,394(19) = 19.39 in the third quarter of 2004 Sap = 11.90 + 0.394(20) = 19.78 in the fourth quarter of 2004 These forecasts are shown by the dots on the dashed portion of the trend line ex- tended into 2004 in Figure 5-2 (disrev ard for the moment the encircled points above and below the line). Note that the forecasted values of electricity sales read off the extended trend line take into consideration only the long-run trend factor in the data. By completely disregarding the significant seasonal variation in the data (see the fig- ure), the forecasted values are likely to be far off their actual future values. In the next subsection, we will see how to incorporate this seasozial variation to significantly im-