BIS Application Chapter two Forecasting

Forecasting
Forecasting is the process of extrapolating the past into the future

Forecasting is something that organization have to do if they are to plan for future. Many forecasts attempt to use past date in order to identify short, medium or long term trends, and to use these patterns to project the current position into the future.
Backcasting: method of evaluating forecasting techniques by applying them to historical data and comparing the forecast to the actual data
Forecasting Models 2

Forecasting
Why Forecasting?

Characteristics of Forecasts
Forecasts are usually wrong or seldom correct Aggregate forecasts are usually more accurate Less accurate further into the future

Assumptions of Forecasting Models

Information (data) about the past is available The pattern of the past will continue into the future.
Forecasting Models 3

The forecasting approach to forecasting

Starts with gathering and recording information about the situation Entering the data into the worksheet, Creating graphs The data and graphs are examined visually to get some understanding of the situation (judgmental phase) Developing hypotheses and models Trying alternative forecasting approaches and doing what if analysis to check if the resulting forecast fits the data
Forecasting Models 4

Demand Forecast A Deviation A Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan
7 6 5

11.8 6.3 9.5 5.3 10.1 7 11.3 7.3 9.5 5 10.7 6

7.1
11.8 6.3 9.5 5.3 10.1 7 11.3 7.3 9.5 5 10.7 6

4.7 5.5 3.2 4.2 4.8 3.1 4.3 4 2.2 4.5 5.7 4.7 6

Deviations

4 3 2 1 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan

Forecasting Models

Forecasting Approaches 1- Qualitative Forecasting

Forecasting based on experience, judgment, and knowledge

2- Quantitative Forecasting
Forecasting based on data and models

Forecasting Models

Forecasting Approaches
Judgmental/Qualitative
Market survey Expert opinion Decision conferencing Data cleaning Data adjustment Seasonal indexes Environmental factors Moving average Exponential smoothing Trend projection Regression Curve fitting Econometric

Quantitative models Time Series Causal

Forecasting Models

Quantitative Forecasting
Time Series Models:
Sales1999 Sales1998 Sales1997

Time Series Model

Year 2000 Sales

Casual Models:
Price Population Advertising

Causal Model

Year 2000 Sales

Forecasting Models

Time series model

Is based on the hypothesis that the future can be predicted by analyzing historical data samples. The time series model have the following type , which can be classifies as shown below:

Forecasting directly from the data value (non seasonal)

-Moving average -Exponential smoothing Forecasting by identifying patterns in the past data (seasonal) (Chapter 3) -Trend projections -Seasonal influences -Cyclical influences
Forecasting Models 9

Time series model

The Time series model can be also classified as Non-seasonal Model

Trend
Moving average Exponential smoothing

Seasonal Model

Seasonal Decomposition Cyclical influence

Forecasting Models

10

Causal Models
(Chapter 3)
Causal forecasting seeks to identify specific cause-effect relationships that will influence the pattern of future data. Causes appear as independent variables, and effects as dependent , response variables in forecasting models. Independent variable Price Decrease in population Number of teenager Dependent, response variable demand decrease in demand demand for jeans

The issue is to determine the approximate functional relationships, the model, and the parameter of the model that relate the input(independent) and output(dependent) variables.
Forecasting Models 11

Causal Models
(Chapter 3)

Regression analysis Curve Fitting: Simple Linear Regression

One Independent Variable (X) is used to predict one Dependent Variable (Y): Y = a + b X

Find the regression line with Excel

Use Function: a = INTERCEPT(Y range; X range) b = SLOPE(Y range; X range) Use Solver Use Excels Tools | Data Analysis | Regression
12

Forecasting Models

Causal Models
(Chapter 3)

Curve Fitting: Multiple Regression

Two or more independent variables are used to predict the dependent variable: Y = b0 + b1X1 + b2X2 + + bpXp Use Excels Tools | Data Analysis | Regression

Forecasting Models

13

Evaluation of Forecasting Model

To judge how well a forecasting model, or indeed any forecast, fit the past observation , both precision and bias must be considered. a- Measuring the precision of a forecasting model: There are four possible measures used to evaluate precision of forecasting systems, each based on the error or deviation between the forecasted and actual values: Average of the deviation, MAD, MAS, MAPE b - Measuring the bias of a forecasting model:

The bias of a forecasting model is examined on the basis of the spread of a set of data which can be measured by its variance, which depends on the sum of squares of the differences between the values and their mean. The more of the spread that is accounted for by the fitted model , the more precise the fit of the model to the data.
R2 used only for curve fitting model such as regression

Forecasting Models

14

Evaluation of Forecasting Model

The arithmetic mean of the errors (the average deviation )
BIAS

(Actual - Forecast) Error

n n

n is the number of forecast errors Excel: =AVERAGE (error range)

Period 1 2 3 4 Demad Forecast Deviation 33 36 3 C2-B2 37 29 -8 C3-B4 32 41 9 C4-B4 35 30 -5 C5-B4 -0.25 AVERAGE(E2:E5)

Forecasting Models

15

Evaluation of Forecasting Model

Mean Absolute Deviation - MAD
BIAS

(Actual - Forecast) Error

n n

No direct Excel function to calculate MAD

Period 1 2 3 4 Demad 33 37 32 35 Forecast 36 29 41 30 Absollute Deviation 3 8 9 5 6.25

ABS(C2-B2) ABS(C3-B4) ABS(C4-B4) ABS(C5-B4) AVERAGE(E2:E5)

Forecasting Models

16

Evaluation of Forecasting Model

Mean Square Error - MSE
(Actual - Forecast) MSE n
2

(Error) n

Excel: =SUMSQ(error range)/COUNT(error range)

Period 1 2 3 4 Demad 33 37 32 35 Forecast 36 29 41 30 Squared Deviation 9 64 81 25 6.68954

(C2-B2)^2 (C3-B3)^3 (C4-B4)^4 (C5-B5)^5 SQRT(AVERAGE(E2:E5))

Forecasting Models

17

Evaluation of Forecasting Model

Mean Absolute Percentage Error - MAPE
| Actual - Forecast| *100% Actual M APE n
Period 1 2 3 4 Demad 33 37 32 35 Forecast 36 29 41 30 Squared Deviation 9.09% 21.62% 28.13% 14.29% 18.28%

ABS((C2-B2)/B2) ABS((C3-B3)/B3) ABS((C4-B4)/B4) ABS((C5-B5)/B5) AVERAGE(E2:E5)

Forecasting Models

18

Which of the measure of forecast accuracy should be used?

Straight average is not used because positive and negative deviations cancel out.
The most popular measures are MAD and MSE.

The problem with the MAD is that it varies according to how big the number are.
MSE is preferred because it is supported by theory, and because of its computational efficiency.
Forecasting Models 19

Which of the measure of forecast accuracy should be used?

The ratio of MAD or MSE to the average demand which describes the relative percentage of error, may be used
MAPE is not often used. In general, the lower the error measure (BIAS, MAD, MSE) or the higher the R2, the better the forecasting model

Forecasting Models

20

Good Fit Bad Forecast

As its discussed that neither MAD nor MSE gives an accurate indication of validity of forecast. Thus, judgment must be used. Raw data sample should always be subjected to managerial judgment, and analyzed and adjusted before formal quantitative techniques can be applied.

Forecasting Models

21

a- Dirty Data
Outlier: may result from simple data entry errors, or they may be correct but atypical observed values (ex can occur in time periods when the product was just introduced or about to be phased out). So experienced analyst are well aware that raw data sample may not be clear.
Demand data with an outlier
100 90 80 70 60 50 40 30 20 10 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb

Forecasting Models

22

b- Causal data adjustment

Before quantitative analysis is performed, the historical data sample needs to be examined from the point of view of causeand-effect relationships.

A multitude of causes may affect the patterns in data sample :

The data sample before a particular year may not be applicable because:

- Economic conditions have changed

- The product line was changed Data for a particular year may not be applicable because:

- There was an extraordinary marketing effort

- A natural disaster prevented demand from occurring
Forecasting Models 23

c- Illusory (misleading) patterns

The meaning of a :good fit is subject to interpretation, so before a forecast is accepted for action, quantitative techniques must be augmented by such judgmental approaches as decision conferencing and expert consultations.

Forecasting Models

24

To prepare a valid forecast, the following factors that influence the forecasting model must be examine:
Company actions

Competitors actions
Industry demand Market share Company sales Company costs

Environmental factors
25

Forecasting Models

Time series forecasting model

Time Series Model Building

Historical data collection

Data plotting (time series plot)

Forecasting model building

Evaluation and selection of model Forecasting with the final selected model
27

Forecasting Models

Components of A Time Series

Trend: long term overall up or down

movement
Seasonality: periodic pattern repeating every

year
Cycles: up & down movement repeating over long time frame

Random Variations: random movements follow no pattern Forecasting Models

28

Components of A Time Series

Trend Cycle

Random movement Time Seasonal pattern Time Trend with seasonal pattern

Time
Forecasting Models

Demand

Time
29

First : Forecasting directly from the data value : Moving average

-the forecast is the mean of the last n observation. The choice of n is up to the manager making the forecast -If n is too large then the forecast is slow to respond to change -If n is too small then the forecast will be overinfluenced by chance variations

Forecasting Models

30

First : Forecasting directly from the data value : Moving average

-This approach is considered as a quick and dirty approach for forecasting -This approach can be used where a large number of forecasting needed to be made quickly, for example in a stock control system where next weeks demand for every item needs to be forecast

Forecasting Models

31

Mounth

Demand

Moving Avarage Forecast

Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb

6 5 5 1.63 1.95 7.5 2.49 6.18 9.18 5.24 8.3 2.72 7.43 7.49 9.58 8.02 4.13

5.33 3.88 2.86 3.69 3.98 5.39 5.95 6.87 7.57 5.42 6.15 5.88 8.17 8.36

AVARAGE(B 3:B 5) AVARAGE(B 4:B 6) AVARAGE(B 5:B 7) AVARAGE(B 6:B 8) AVARAGE(B 7:B 9) = = = = = = = = =

12 10 8 6 4 2 0 1 2 3 4 5 6 7 8

Demand

Forecast
9 10 11 12 13 14 15 16 17

Forecasting Models

32

Longer-period moving averages (larger n) react to actual changes more slowly

Forecasting Models

33

First : Forecasting directly from the data value : Exponentional smoothing

-it gives weight to all past observations, in such a way that the most resent observation has the most influence on the forecast, and older observation always has less influence than the more recent one. -It is only necessary to store two values (the last actual observation and the last forecast, plus the value of the smoothing constant) in order to make the next periods forecast. -Smoothing constant () the proportion of the different between the actual value and the forecast. -F2 = *D1 +(1- )*F1
Forecasting Models 34

First : Forecasting directly from the data value : Exponentional smoothing

Alpha (smoothing constant) must set between 0 and 1. Normally the value of the smoothing constant is chosen to lie in the range 0.1 to 0.3.
Typically, a value closer to 0 is used for demand that is changing slowly, and a value closer to 1 for demand that is changing more rapidly. There is no way to calculate F1 because each forecast is based on the previous forecasts.

Forecasting Models

35

First : Forecasting directly from the data value : Exponential smoothing

How to select smoothing constant Sensitivity analysis is an analysis used to test how sensitive the forecast is to the change in alpha or smoothing constant. A general rule for selecting alpha is to perform scenario analysis and pick the value that produces a reasonable value for the MAD and a forecast that is reasonably close to the actual demand.
Forecasting Models 36

Trend-Adjusted Exponential Smoothing

With trend-adjusted exponential smoothing, the trend is calculated and included in the forecast. This allows the forecast to be smoothed without losing the trend. Trend-adjusted exponential smoothing requires two parameters: the alpha value used by exponential smoothing and beta value used to control how the trend component enters the model. Both values must be between 0 and 1. The formula to calculate the forecast component is : F2 = FiT1+ *(D1-FiT1)

The formula to calculate the trend component is

T2 = T1 + * *(D1-FiT1)
Forecasting Models 37

Optimizing Trend-Adjust Exponential Smoothing

Optimizing alpha and beta with trend-adjusted exponential smoothing has a marginal impact.
To find the optimum value for alpha and beta:

First the original value of alpha and beta will be used in the forecasting model. Once the spreadsheet is ready, Solver is used to vary alpha and beta in order to minimize the MAD.

Forecasting Models

38