Lecture 10 Forecasting: Its importance and limitations Forecasting Prediction of future events and conditions are called forecasts,

and the act of making such predictions is called forecasting. Any organization must be able to make forecasts in order to make intelligent decisions. For instance, water quality, unemployment rate, inflation rate, welfare payments, student enrolment, etc. Business firms require forecasts of many events and conditions in all phases of their operations. Examples: a) In marketing departments: Total demand for product must be forecasted in order to plan total promotional effort. b) In finance: Interest rates must be predicted to plan new capital acquisitions. c) In personnel management: Forecast the number of workers in order to plan job requiting and training programs. d) Process control: Forecast the behavior of the industrial process in order to control the number of defective items. e) Strategic management: Forecast of general economic conditions, price and cost changes, technological change, and market growth in order to plan long-term future of the company. Information concerning events occurred in the past is very important to learn in order to forecast about the future. Types of the forecast There are two types of forecasting: (1) point forecast, and (2) prediction interval forecast. Point Forecast: A point forecast is a single number that represents our best prediction of the actual value of the variable being forecasted. Prediction Interval Forecast: A prediction interval forecast is an interval or range of numbers that is calculated so that we are very confident that the actual value will be contained in the interval. Forecasting Methods There are many forecasting methods that can be used to predict future events. These methods can be divided into two basic types: Qualitative methods and Quantitative methods. Qualitative Forecasting Methods Qualitative forecasting techniques are used when historical data are limited or not available at all. These methods are usually based on the opinions of experts to predict future events subjectively. These methods are required when new product is being introduced. To forecast sales for the new product, a company must rely on expert opinion, which can be supplied by members of its sales force and market research team. There are some commonly used qualitative forecasting techniques. They are also called Judgmental forecasting methods: 1) Subjective curve fitting: In predicting sales of the new product, it is convenient to consider product life cycle. This life cycle consist of three stages: a) growth (requires S-curve), b) maturity, and c) decline. The subjective construction of such curve is difficult and requires a great deal of expertise and judgment.
Instructor: Azmat Nafees Time Series and Forecasting 22-Jan-12 1

2) Delphi method: The Delphi method assumes that the panel members are recognized experts in the field of interest, and assumes combined knowledge of panel members may produce predictions. Each participant is asked to respond a questionnaire and return it to panel coordinator. 3) Time-independent Technological comparison: In this method, which is often used in predicting technological change, changes in one area are predicted by monitoring changes that take place in another area. The forecaster tries to determine a pattern of change in one area, often called primary trend, which he believes will result in new developments in some other area. Quantitative Forecasting Method Quantitative forecasting methods are used when historical data are available. Quantitative methods can be grouped in two kinds: Univariate models and Casual models. Univariate models: These models predict future values of the variable of interest solely on the basis of the historical pattern (time series) of that variable, assuming that the historical pattern will continue. Univariate models are most useful when conditions are expected to remain the same; they are not useful in not very useful in forecasting the impact of changes in management policies, e.g. increase in price or advertising expenditures. Univariate models include Time series regression, classical decomposition, exponential smoothing, and the Box-Jenkins methodology. Casual models: These models predict future values of the variable of interest based on relationship between that variable to be forecasted and the other variables. That is, the relationship between dependent variable to be forecasted and the other independent variables. The use of casual models involves the identification of other variables that are related to the variable to be predicted. In business world, casual models are advantageous because they allow management to evaluate the impact of various alternative policies. For example, management might wish to predict how various price structures and levels of advertising expenditures will affect sales. On the other hand, casual models are difficult to develop. Moreover, the ability to predict the dependent variable depends on the ability of the forecaster to accurately predict future values independent variables. Choosing a Forecasting Technique Forecasts are generated for points in time that may be a number of days, weeks, months, quarters, or years in the future. The forecaster must consider the following factors when choosing the forecasting technique: 1. The time frame, i.e. immediate, short term, medium, or long term 2. The pattern of data, i.e. the four components of time series (T, C, S, I) 3. The cost of forecasting, i.e. cost of developing the model must be considered 4. The accuracy desired, i.e. some situation forecast limit as much as 20% error as acceptable and in some situations forecast error cannot be more than 1%. 5. The availability of data, i.e. the quantity of available data 6. The ease of operation and understanding, i.e. if the manager does not have confidence in the technique used in predictions, then the predicted values will not be used in the decision making process.

Instructor: Azmat Nafees

Time Series and Forecasting

22-Jan-12

Errors in forecasting: All forecasting situations involve some degree of uncertainty. The presence of irregular component means that some error in forecasting is expected. However, if the effect of irregular component is small, then determination of appropriate trend, seasonal, or cyclical patterns should allow us to forecast with accuracy. The large forecasting errors may indicate that the irregular component is so large that no forecasting technique will produce accurate forecasts, or may indicate that the forecasting technique is not capable of accurately predicting the trend, seasonal, or cyclical components. There are two ways we can estimate the forecast errors: Bias: The errors that are considered as systematic errors Random Errors: Forecast errors expressed in term of variability Forecast Error Measures Bias Average Error The average of the deviation of all the forecasts is known as average error (AE). This can be given by: = Variability Mean Absolute Deviation (MAD) The average of the absolute deviation of all the forecasts is known as mean absolute deviation (MAD). That is given by: = = Mean Squared Error (MSE) The average of the squared errors for all forecasts is called as Mean Squared Error (MSE). Given by: = = Standard deviation: =

Mean absolute percentage error (MAPE) The average of the absolute percentage errors for all forecasts is known as Mean absolute percentage error. This can be given by: = 100

Measuring forecast errors: The forecast error for a particular forecast is = where = actual value for time period t and is a predicted value for time period t. If the forecasting technique is accurately forecasting the trend, seasonal and cyclical components then the forecast errors should be purely random and reflect only irregular components. Absolute Deviation (AD) In order to prevent positive and negative forecast errors from cancelling each other out is to take absolute values of the forecasting errors. The absolute values of forecasting errors are called absolute deviations. That is given by: = = Mean Absolute Deviation (MAD) The average of the absolute deviation of all the forecasts is known as mean absolute deviation (MAD). That is given by:
Instructor: Azmat Nafees

=
Time Series and Forecasting 22-Jan-12 3

Example 1: Computation of Mean absolute error Actual Predicted Absolute Error Value Value Deviation = 25 28 29 Totals 22 30 30 3 -2 -1 = 3 2 1 6 = = = 6 =2 3

Squared Error (SE) The other way to prevent positive and negative forecast errors from cancelling each other out is to take square of the forecasting errors. The squares of forecasting errors are called squared errors. That is given by: = = Mean Squared Error (MSE) The average of the squared errors for all forecasts is called as Mean Squared Error (MSE). Given the squared errors, we can define the mean squared errors, such as: The forecaster would prefer smaller forecast errors to larger errors. Example 2: Computation of Mean squared error Actual Predicted Error Squared Error Value Value = 25 28 29 Totals 22 30 30 3 -2 -1
=

9 4 1 14 = = = 14 = 4.67 3

Difference between MAD and MSE The basic difference between MAD and MSE is that the MSE, unlike MAD, penalizes a forecasting technique much more for larger errors than for small errors. The MSE and MAD can be used to: 1) Aid in the process of selecting a forecasting model. 2) Monitor a forecasting system in order to detect when something has gone wrong with the system.

Instructor: Azmat Nafees

Time Series and Forecasting

22-Jan-12

Example 3: Comparison of the errors produced by two different methods Actual Predicted Absolute Error Squared Error Value Value Deviation = 60 64 67 Totals 57 61 70 +3 +3 -3 = 3 3 3 9 = = Actual Value 60 64 67 Totals Predicted Value 59 65 73 = = = 9 =3 3
=

9 9 9 27

27 =9 3

Error = +1 -1 -6

Absolute Deviation = 1 1 6 8 = = = = = =

Squared Error
=

1 1 36 38 8 = 2.67 3

Interpretation: Forecasting method A has produced predictions yielding moderate forecasting errors, while forecasting method B has produced predictions yielding two small errors along with one large error. Forecasting method A has larger MAD, while forecasting method B has the larger MSE. This is so because in the calculation of the MSE, forecasting method B is heavily penalized for its large error in forecasting the actual value 67. Absolute percentage error (APE) A way of measuring the forecasting error that allows comparison across different time series with values of different magnitude is called absolute percentage error. This type of error can be calculated as: = 100 = 100

38 = 12.67 3

Mean absolute percentage error (MAPE) The average of the absolute percentage errors for all forecasts is known as Mean absolute percentage error. This can be given by: =

Instructor: Azmat Nafees

Time Series and Forecasting

22-Jan-12

Example 4: Actual Value

Predicted Value

Error = 3 2 1

Absolute Percentage Error

25 28 29 Totals

22 30 30

12.0 7.1 3.5 22.6 = = 22.6 = 7.5 3

Analysis using Accuracy Measures (Forecasting Errors) for choosing the best model: Example: Cedar Fair operates seven amusement parks and five separately gated water parks. Its combined attendance (in thousands) for the last 5 years is given in the following table. A partner asks you to study the trend in attendance. Fit an exponentially smoothed curve with smoothing constant = 0.2 and forecast the values of each year.
Forecast Squared Forecast value Attendance Smoothed value error Error (SE) (000) 1998 8 11.2 12 -4.0000 16 1999 12 11.36 11.2 0.8000 0.64 2000 14 11.89 11.36 2.6400 6.9696 2001 16 12.71 11.89 4.1120 16.90854 2002 10 12.17 12.71 -2.7104 7.346268 Method I: The initial value is set as E1 = Y1 = 11,703. When we take = 0.2, then = 0.2 + 0.8 = 0.2 11,890 + 0.8 11,703 = 11,740.4 And = 0.2 + 0.8 = 0.2 11,703 + 0.8 11,703 = 11,703 Thus MSE = 9.57

Year

Method II: Fitting exponential smoothing technique with level constant 0.2 and trend constant 0.3, we get the following forecast and forecast errors: Year Attendance (000)
Smoothed value for level Smoothed value for trend Forecast value Forecast error Squared Error (SE)

1998 1999 2000 2001 2002

8 12 14 16 10

9.92 10.86 12.08 13.57 13.71

0.66 0.74 0.88 1.07 0.79

10.40 10.58 11.60 12.97 14.64

-2.40 1.42 2.40 3.03 -4.64

5.7600 2.0278 5.7493 9.1985 21.5385

22-Jan-12 6

Instructor: Azmat Nafees

Time Series and Forecasting

Here MSE = 8.85 Method III: Now using exponential growth equation, we can estimate the forecast values for each year as: Year Attendance (000) 8 12 14 16 10
Exponential trend estimate Forecast error Squared Error (SE)

1998 1999 2000 2001 2002

7.5429 12.6286 14.8571 14.2286 10.7429

0.45714 -0.62857 -0.85714 1.77143 -0.74286

0.20898 0.39510 0.73469 3.13796 0.55184

Here MSE = 1.01 The best method among previous three to estimate the forecast is Exponential Trend Fitting.

Instructor: Azmat Nafees

Time Series and Forecasting

22-Jan-12