Business and Economic Forecasting

Chapter 5 Demand Forecasting is a critical managerial activity which comes in two forms:

Quantitative Forecasting +2.1047%

Gives the precise amount or percentage

Qualitative Forecasting
Gives the expected direction Up, down, or about the same
2005 South-Western Publishing Slide 1

What Went Wrong With

SUVs at Ford Motor Co?
Chrysler introduced the Minivan
in the 1980s

Ford expanded its capacity to produce the Explorer, its popular SUV Explorers price was raised substantially in 1995 at same time competitors expanded their offerings of SUVs. Must consider response of rivals in pricing decisions
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Significance of Forecasting
Both public and private enterprises operate under conditions of uncertainty. Management wishes to limit this uncertainty by predicting changes in cost, price, sales, and interest rates. Accurate forecasting can help develop strategies to promote profitable trends and to avoid unprofitable ones. A forecast is a prediction concerning the future. Good forecasting will reduce, but not eliminate, the uncertainty that all managers feel.
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Hierarchy of Forecasts
The selection of forecasting techniques depends in part on the level of economic aggregation involved. The hierarchy of forecasting is:

National Economy (GDP, interest rates,

inflation, etc.)

sectors of the economy (durable goods)

industry forecasts (all automobile manufacturers) > firm forecasts (Ford Motor Company)
Product forecasts (The Ford Focus)
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Forecasting Criteria
The choice of a particular forecasting method depends on several criteria:

1.costs of the forecasting method compared with

its gains

2.complexity of the relationships among

variables

3.time period involved 4.accuracy needed in forecast 5.lead time between receiving information and
the decision to be made
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Accuracy of Forecasting
The accuracy of a forecasting model is measured by how close the actual variable, Y, ends up to the ^ forecasting variable, Y. ^ Forecast error is the difference. (Y - Y) Models differ in accuracy, which is often based on the square root of the average squared forecast error over a series of N forecasts and actual figures Called a root mean square error, RMSE.

RMSE =

{ (Y -

^ 2 Y) /

N }
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Quantitative Forecasting
Deterministic Time Series
Looks For Patterns Ordered by Time No Underlying Structure

Like technical security analysis

Econometric Models
Explains relationships Supply & Demand Regression Models

Like fundamental security analysis

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Time Series
Examine Patterns in the Past
Dependent Variable Cyclical Variation Secular Trend

X
X

Forecasted Amounts To TIME

The data may offer secular trends, cyclical variations, seasonal variations, and random fluctuations. Slide 8

Elementary Time Series Models for Economic Forecasting

1. Naive Forecast

NO Trend

Yt+1 = Yt
Method best when there is no trend, only random error Graphs of sales over time with and without trends When trending down, the Nave predicts too high

time
Trend

time
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2. Nave forecast with adjustments for secular trends

Yt+1 = Yt + (Yt - Yt-1 ) This equation begins with last periods forecast, Yt. Plus an adjustment for the change in the amount between periods Yt and Yt-1. When the forecast is trending up, this adjustment works better than the pure nave forecast method #1.
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3. Linear &

4. Constant rate of growth

Uses a Semi-log Regression

Linear Trend Growth

Used when trend has a constant AMOUNT of change Yt = a + bT, where Yt are the actual observations and T is a numerical time variable

Used when trend is a constant PERCENTAGE rate Log Yt = a + bT, where b is the continuously compounded growth rate
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More on Constant Rate of Growth Model a proof

Suppose: Yt = Y0( 1 + G) t where g is the annual growth rate Take the natural log of both sides:
Ln Yt = Ln Y0 + t Ln (1 + G) but Ln ( 1 + G ) g, the equivalent continuously compounded growth rate SO: Ln Yt = Ln Y0 + t g
^ ^

Ln Yt = a + b t
where b is the growth rate
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Numerical Examples: 6 observations

MTB > Print c1-c3. Sales Time Ln-sales 100.0 109.8 121.6 133.7 146.2 164.3 1 2 3 4 5 6 4.60517 4.69866 4.80074 4.89560 4.98498 5.10169
Using this sales data, estimate sales in period 7 using a linear and a semi-log functional form

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The regression equation is Sales = 85.0 + 12.7 Time Predictor Coef Constant 84.987 Time 12.6514 s = 2.596 Stdev 2.417 0.6207 t-ratio p 35.16 0.000 20.38 0.000 R-sq(adj) = 98.8%

R-sq = 99.0%

The regression equation is Ln-sales = 4.50 + 0.0982 Time

Predictor Coef Stdev Constant 4.50416 0.00642 Time 0.098183 0.001649 s = 0.006899 R-sq = 99.9%

t-ratio p 701.35 0.000 59.54 0.000 R-sq(adj) = 99.9%

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Forecasted Sales @ Time = 7

Linear Model
Sales = 85.0 + 12.7 Time
Sales = 85.0 + 12.7 ( 7) Sales = 173.9

Semi-Log Model
Ln-sales = 4.50 + 0.0982 Time

Ln-sales = 4.50 + 0.0982 ( 7 )

Ln-sales = 5.1874 To anti-log:

linear

e5.1874 = 179.0

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Sales Time Ln-sales

100.0 109.8 121.6 133.7 146.2 164.3 179.0 173.9 1 2 3 4 5 6 4.60517 4.69866 4.80074 4.89560 4.98498 5.10169 7 semi-log 7 linear

Semi-log is exponential

Which prediction do you prefer?

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5. Declining Rate of Growth Trend

A number of marketing penetration models use a slight modification of the constant rate of growth model In this form, the inverse of time is used

Ln Yt = b1 b2 ( 1/t )
This form is good for patterns like the one to the right It grows, but at continuously a declining rate

time
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6. Seasonal Adjustments: The Ratio to Trend Method

Take ratios of the actual to 12 quarters of data the forecasted values for past years. Find the average ratio. This is the seasonal adjustment Adjust by this percentage by multiply your forecast by the seasonal adjustment
I II III IV I II III IV I II III IV

If average ratio is 1.02, adjust forecast upward 2%

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Quarters designated with roman numerals.

7. Seasonal Adjustments: Dummy Variables

Let D = 1, if 4th quarter and 0 otherwise Run a new regression:

Yt = a + bT + cD
the c coefficient gives the amount of the adjustment for the fourth quarter. It is an Intercept Shifter. With 4 quarters, there can be as many as three dummy variables; with 12 months, there can be as many as 11 dummy variables

EXAMPLE: Sales = 300 + 10T + 18D

12 Observations from the first quarter of 2002 to 2004-IV. Forecast all of 2005.

Sales(2005-I) = 430; Sales(2005-II) = 440; Sales(2005-III) = 450; Sales(2005-IV) = 478

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Soothing Techniques 8. Moving Averages

Dependent Variable A smoothing forecast method for data that * * jumps around * Best when there is no * trend 3-Period Moving Ave. Yt+1 = [Yt + Yt-1 + Yt-2]/3

*
Forecast Line

TIME
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Smoothing Techniques

9. First-Order Exponential Smoothing

A hybrid of the Naive Each forecast is a function of all past observations and Moving Average methods Can show that forecast is ^ ^ based on geometrically Yt+1 = wYt +(1-w)Yt declining weights. A weighted average of past actual and past forecast.
^ Yt+1 = w .Yt +(1-w)wYt-1 + ^ t-1 + (1-w)2wY

Find lowest RMSE to pick the best alpha.

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First-Order Exponential Smoothing Example for w = .50

1 2 3 4

Actual Sales 100 120 115 130

Forecast 100 initial seed required .5(100) + .5(100) = 100

?
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First-Order Exponential Smoothing Example for w = .50

1 2 3 4

Actual Sales 100 120 115 130

Forecast 100 initial seed required .5(100) + .5(100) = 100 .5(120) + .5(100) = 110

?
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First-Order Exponential Smoothing Example for w = .50

1 2 3 4

Actual Sales 100 120 115 130

Forecast 100 initial seed required .5(100) + .5(100) = 100 .5(120) + .5(100) = 110 .5(115) + .5(110) = 112.50
.5(130) + .5(112.50) = 121.25
Period 5 Forecast
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MSE = {(120-100)2 + (110-115)2 + (130-112.5)2}/3 = 243.75 RMSE = 243.75 = 15.61

Qualitative Forecasting

10. Barometric Techniques

Direction of sales can be indicated by other variables.
PEAK peak
Index of Capital Goods

Motor Control Sales

TIME
4 Months

Example: Index of Capital Goods is a leading indicator There are also lagging indicators and coincident indicators
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Time given in months from change LEADING INDICATORS* COINCIDENT M2 money supply (-12.4) INDICATORS S&P 500 stock prices (-11.1) Nonagricultural payrolls Building permits (-14.4) (+.8) Initial unemployment claims Index of industrial (-12.9) production (-1.1) Contracts and orders for Personal income less plant and equipment (-7.4) transfer payment (-.4) LAGGING INDICATORS
Prime rate (+2.0) Change in labor cost per unit of output (+6.4)
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*Survey of Current Business, 1994 See pages 206-207 in textbook

Handling Multiple Indicators

Diffusion Index: Wall Street With Louis Ruykeyser has eleven analysts. If 4 are negative about stocks and 7 are positive, the Diffusion Index is 7/11, or 63.3%. above 50% is a positive diffusion index Composite Index: One indicator rises
4% and another rises 6%. Therefore, the Composite Index is a 5% increase. used for quantitative forecasting
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Qualitative Forecasting
Common Survey Problems New Products have no historical data -- Surveys can assess interest in new ideas.

11. Surveys and Opinion Polling Techniques

Sample bias- telephone, magazine

Biased questions- advocacy surveys

Survey Research Center of U. of Mich. does repeat surveys of households on Big Ticket items (Autos)

Ambiguous questions Respondents may lie on questionnaires

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Qualitative Forecasting 12. Expert Opinion

The average forecast from several experts is a Consensus Forecast.
Mean Median Mode Truncated Mean Proportion positive or negative

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EXAMPLES:
IBES, First Call, and Zacks Investment -earnings forecasts of stock analysts of companies Conference Board macroeconomic predictions Livingston Surveys--macroeconomic forecasts of 50-60 economists

Individual economists tend to be less accurate over time than the consensus forecast.
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13. Econometric Models

Specify the variables in the model Estimate the parameters
single equation or perhaps several stage methods

Qd = a + bP + cI + dPs + ePc
But forecasts require estimates for future prices, future income, etc.
Often combine econometric models with time series estimates of the independent variable.

Garbage in

Garbage out
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example
Qd = 400 - .5P + 2Y + .2Ps anticipate pricing the good at P = $20 Income (Y) is growing over time, the estimate is: Ln Yt = 2.4 + .03T, and next period is T = 17.
Y = e2.910 = 18.357

The prices of substitutes are likely to be P = $18. Find Qd by substituting in predictions for P, Y, and Ps Hence Qd = 430.31

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14. Stochastic Time Series

A little more advanced methods incorporate into time series the fact that economic data tends to drift

yt = a + byt-1 + et
In this series, if a is zero and b is 1, this is essentially the nave model. When a is zero, the pattern is called a random walk. When a is positive, the data drift. The Durbin-Watson statistic will generally show the presence of autocorrelation, or AR(1), integrated of order one. One solution to variables that drift, is to use first differences.
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Cointegrated Time Series

Some econometric work includes several stochastic variable, each which exhibits random walk with drift Suppose price data (P) has positive drift Suppose GDP data (Y) has positive drift Suppose the sales is a function of P & Y Salest = a + bPt + cYt It is likely that P and Y are cointegrated in that they exhibit comovement with one another. They are not independent. The simplest solution is to change the form into first differences as in: DSalest = a + bDPt + cDYt
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