Forecasting

Forecasting is the projection or estimation of the occurrence

of uncertain future events or level of activity.
Used for predicting
Demand, Revenues, Costs, Profits, Prices,
Technological changes, Environment problems,
Rainfall, etc.
Forecast is one input to many types of planning and control
Policy decisions (economic, social, political,
technological conditions)

Product design (product lines, services and market)

Process decision (process and methods)

Forecasting

Plant decision (facility location and layout)

Operations decisions (output scheduling and

control)

Fig. 1 Master forecasting

Financial planning (financial aggregate, cash

flow, balance sheets, income statement)

Market planning (product lines, pricing, and

Forecasting promotion

Production planning (aggregate output levels)

Master scheduling (product output levels)

Fig. 2 Functional forecasting

 Forecasting usually involves the following
considerations
Item to be forecasted (products, product groups,
assemblies, etc)
Top down or bottom up forecasting
Forecasting techniques (quantitative or
qualitative model)
Units of measure (Rs, units, weights, etc)
Time interval (weeks, months, quarters, etc)
Forecast horizons (how many time intervals to
include)
Forecasting components (levels, trends, seasonal,
cycles and random variations)
Forecast accuracy (error measurement)
Exception reporting and special situations
Revision of forecasting model parameters
Sales Forecasting
Sales forecasts are used to establish product levels,
facilitate scheduling, set inventory levels, determine
manpower loading, make purchasing decisions,
establish sales conditions pricing and advertising,
and financial planning cash budgeting and capital
budgeting
Generally, sales forecast is used to estimate the
demand of independent items
 Many environmental factors influence the demand for
products and services of an organisation.
Some major environmental factors are
1. General business conditions and state of the
economy
2. Competitor actions and reactions
3. Governmental legislative actions
4. Marketplace trend
a) Product life cycle
b) Style and fashion
c) Changing consumer demands
5. Technological innovations
Presence of randomness preclude a perfect forecast
Forecast for groups of items tend to be more accurate
than forecast for individual items
Error potential increases as time horizon of a forecast
increases
We are interested in estimating the level of future
demand. Statistical techniques are used to forecast.
Statistical methods use historical (past) data
All statistical forecasting techniques assume to some
extent that forces that have existed in the past will
persist in the future.
 New product demand (with little or no history of past
demand) rely more on subjective phenomenon and
solicitation of opinions
Direct survey approach asking prospective
customers of their buying interest
Indirect survey approach information from
salesmen, wholesalers, area managers, etc
Comparison with substitute or comparable products
Limited market test of the new product
Basic demand forecasting models
Time series analysis, soliciting opinions, economic
indicators and econometric models
These are short range forecasting models
Generally, these forecasts give starting point for
making the final forecast
Final forecast usually requires an additional input in
the form of judgment, intuition, and experience and
requires periodic review
Note on economic indicators and econometric
models
Economic Indicators
Knowledge of one variable is used to predict the
value of another (prediction by association)
Certain economic indicators are
Gross domestic product (GDP), Personal
income, Bank deposits, Freight car loadings, etc
 One or more of these indicators have relationship
with the forecast variable
Econometric Models
Involves a set of simultaneous equations that explains
the interactions of variables involved in a business
situation
Attempt to show the relationships between relevant
variables such as supply, demand, prices and
purchasing power of the consumer
Time Series Analysis
Time series analysis predict future demand from past
interval data.
A time series is a set of time ordered observations on
a variable during successive and equal time periods
Period Jan Feb Mar Apr May Jun
Demand (in units) 75 70 82 76 87 90
The above table shows a time series. This table shows the
past demand in successive and equal interval of time
Period Jan Mar Apr May Jul Sep
Demand (in units) 75 70 82 76 87 90
This table is not representing a time series as it is not
showing demand in equal interval of time.
Interactive components: levels, trends, seasonal
variations, cyclical variations, and random variations
Fig. 3 illustrates the various components of time
series
 Levels indicates the scale or magnitude of a time
series
Trend identify the rate of growth or decline of a series
over time (Long-term historical pattern of demand
over time)
Seasonal variations consists of annually recurring
movements above and below the trend line
o Demand fluctuates in a repetitive pattern from
year to year
o Seasonal periodic peaks and valleys should occur
at the same time every year
o Seasonal variations should be of larger
magnitude than the random variations
Cyclical variations are long term oscillations or
swings about a trend line
The cycles may or may not be periodic, but they often
are the result of business cycles of expansion and
contraction of economic activity over a number of
years
Business cycles may be due to one or more of the
following: prosperity, recession, depression and
recovery
The cycles may vary with respect to the time of
occurrence, the length of the phases, and the
amplitude of the fluctuations
 Raw Data

Trend Component

Seasonal Component

Cyclic Component

Random Component

Time (years)

Fig. 3 Various components of a time series

Random variations have no particular pattern and

usually are without specific assignable cause
They represent all influences not included in trend,
seasonal, and cyclical variations
Erratic occurrence may be isolated and removed from
the data, but there are no general techniques for doing
so
Averaging process will help to eliminate its influence
 Random variations are often referred to as noise,
residuals, or irregular variations
Various techniques in time series analysis
Last period demand
Arithmetic average
Simple moving average
Weighted moving average
Exponentially weighted moving average (EWMA)
Simple exponentially weighted moving
average
Trend adjusted exponentially weighted moving
average
Seasonally adjusted exponentially weighted
moving average
Trend and Seasonally adjusted exponentially
weighted moving average
Regression analysis (Linear forecasting technique)

The time series contains interactive components. The

models representing interactive components of
demand are classified as
o Multiplicative model
o Additive model
o Mixed model (partially additive, partially
multiplicative)
 The demand in period (t) for a multiplicative model is
represented as
Demand = (Trend) (seasonal) (cycle) (random)
Dt = b F c t
The demand in period (t) for a additive model is
represented as
Demand = level + trend + seasonal + cyclic +
random
Dt = a + b t + Ft + Ct + t
Generally, demand process can be modelled as
Dt = a + t (level model additive type)
Dt = a + b t + t (trend model additive type)
Dt = (a + b t) Ft + t (mixed model type-
trend part is additive and seasonal
part is in multiplicative in form)
Some Notations
Dt Actual demand for the period t
ft - forecast for the period t
Simple Moving Average
This method is used to represent a demand process of
type
Dt = a + t
That is, the demand is represented as a level with
random noise.
 Parameter a is not really known and is subjected to
random changes from time to time.
Using the simple moving average procedure we can
get an estimate for a and it can be get updated as time
progresses.
Estimating procedure (updating procedure)
The procedure involves the determination of average
of demand of last N periods.
As new period demand observation is available, the
old period demand data is removed from average
calculation.
Number of periods considered for average calculation
is same but, demand data considered for the
calculation is different at different time periods.
This way of estimation is actually an updating
procedure also.
MAt,N = (Dt + Dt-1 + Dt-2 + . Dt-N+1)/N
Where, N is the period of moving average, Dt is the
actual demand at period t and MAt,N is the moving
average at period t based on demand of N periods.
The estimate of a, at the end of the period t is
represented as

a t = MAt,N
This estimate of a results from minimizing the sum of
squares of error over the preceding N period.
 A slightly simple updating procedure for this method
is
Dt Dt N
MAt,N = MAt-1,N + N
2

D aj
t

at minimizes the standard error, s j

j t N 1

Forecast equations are

ft+1 = MAt,N
ft+n = MAt,N (forecast for n period ahead)
Simple EWMA
Underlying demand model is
Dt = at + t
where, t is normally distributed with mean zero
A best estimates for at is the exponentially weighted
moving average.
The equation for simple exponential smoothing uses
only two pieces of information: (1) actual demand for
the most recent period and (2) the most recent
average
Let Xt = exponentially weighted moving average for
the period t
X t Dt (1 ) X t 1
Forecast equation is
ft+1 = Xt
 The above equation for Xt can be written as
X t X t 1 ( Dt X t 1 )

That is, X t f t ( Dt f t )
This equation indicates that using exponential
average in one period as a forecast for the next
period; it is possible to revise the average upward or
downward, depending on the forecast error.
Weights for the past data and for the initial average
can be easily identified from the equation given
below.
t 1 k

Xt 1 D
k 0
t k (1 )t X 0

The weight for demand in a period k from now (t) is

(1 ) k
Expansion of exponentially weighted moving average
equation
Xt = Dt (1 )[Dt 1 (1 ) X t 2 ]
= Dt (1 ) Dt 1 (1 ) 2 X t 2
Dt (1 ) Dt 1 (1 ) 2 [ Dt 2 (1 ) X t 3 ]

Dt (1 ) Dt 1 (1 ) 2 Dt 2 (1 ) 3 X t 3
If exponential average is determined for third period,
the weight for the demand of various periods and the
initial average can be clearly seen from the equation
below
 X 3 D3 (1 ) D2 (1 ) 2 D1 (1 ) 3 X 0
For = 0.2, the weight assigned for the current period
demand and the demand of past 9 periods in EWMA
is as given in the table below.
Period 1 2 3 4 5 6 7 8 9 10
Weight 0.2 0.16 0.128 0.102 0.082 0.066 0.052 0.042 0.034 0.027

Values given in the above table are shown graphically

next. This graph shows that weight for the past
demand in the current period demand forecast is
exponentially decreasing.

For the demand process, the best estimate of at which

minimize the following the sum of discounted
squares of residuals
2

S= d j 1
D
t j a t
j 0

where, d = a distant factor (0 < d < 1)

 The resulting estimate of at satisfies the following
updating formation
a t Dt 1 a t 1
Average age of data in a simple EWMA is 1/
period. In a N month moving average the average age
of data is (N+1)/2
1/ = (N+1)/2
Relationship between N (period of moving average)
2
and is N 1
Initialization
When significant historical data exists, simply use the
average demand in the first several periods as the
initial estimate of Xt.
Forecast for future periods
ft+1 = Xt
ft+n = Xt (forecast for n period ahead)
Forecast Error Measurement
The forecast error measurement belongs to any one of
the following
to know the magnitude of error
to get an idea on biasness of forecast
to get an idea on revision of parameters
Magnitude of Error (extent of error)
Mean Absolute Deviation (MAD)
 n | Dt f t |
MAD = where, n is the number
t 1 n
deviations available
n ( Dt f t ) 2
Mean Square Error, MSE = n
t 1

MSE penalise deviations with large magnitude

n Dt f t 2
Standard deviation, S r2 n2
t 1

The 2 in the denominator represents the number of

degree of freedom loss.
Sr =1.25MAD for error normally distributed.
Bias measurement Direction
Running Average Forecast Error (RAFE)

n ( Dt f t )
RAFE = n
t 1
Revision
Tracking Signal (TS)

RAFE
TS
MAD
1 TS 1
The limiting conditions are achieved if all errors are
positive or all errors are negative.
Error updating procedure
= smoothing constant

MADt ( Dt f t ) (1 ) MADt 1
 MSEt ( Dt f t ) 2 (1 ) MSEt 1
Problem from Economic Indicators
The General Manager of a building materials production plant
feels the demand for plaster board shipments may be related
to the number of construction permits issued in the district
during the previous quarter. The manager has collected the
data shown in the accompanying table. Derive a regression
forecasting equation and determine a point estimate for plaster
board shipments when the number of construction permits is
30
Construction 15 9 40 20 25 25 15 35
permits
Plaster 6 4 16 6 13 9 10 16
board
shipments

Solution
Consider construction permit as independent variable
(X) and plaster board shipments as dependent variable
(Y) and establish a linear relationship.
Let the linear relationship be Y = aX + b
Normal equations to find a and b are
Y a X nb
X Y a X b x
2

Forecasting equation is Y 0.395 X 0.915

The point estimate for the plaster board shipments is
12.765 13