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Forecasting

CHAPTER

Forecasting

Homework Problems: # 2,3,4,8(a),22,23,25,27 on pp. 118-124.

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Forecasting

Forecast

Forecast a statement about the future value of a variable of interest

We make forecasts about such things as weather, demand, and resource availability Forecasts are an important element in making informed decisions

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Forecasting

Uses of Forecasts
Accounting Finance Human Resources Marketing MIS Operations Product/service design Cost/profit estimates Cash flow and funding Hiring/recruiting/training Pricing, promotion, strategy IT/IS systems, services Schedules, MRP, workloads New products and services

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Forecasting

Two Important Aspects of Forecasts

Expected level of demand

The level of demand may be a function of some structural variation such as trend or seasonal variation Related to the potential size of forecast error

Accuracy

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Forecasting

Features Common to All Forecasts


1. 2. 3. 4.

Techniques assume some underlying causal system that existed in the past will persist into the future Forecasts are not perfect Forecasts for groups of items are more accurate than those for individual items Forecast accuracy decreases as the forecasting horizon increases I see that you will
get an A this semester.

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Forecasting

Elements of a Good Forecast


The forecast should be timely should be accurate should be reliable should be expressed in meaningful units should be in writing technique should be simple to understand and use should be cost effective

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Forecasting

Steps in the Forecasting Process


1. 2. 3. 4. 5. 6.

Determine the purpose of the forecast Establish a time horizon Select a forecasting technique Obtain, clean, and analyze appropriate data Make the forecast Monitor the forecast

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Forecasting

Types of Forecasts

Judgmental - uses subjective inputs Time series - uses historical data assuming the future will be like the past Associative models - uses explanatory variables to predict the future

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Forecasting

Forecast Accuracy and Control

Forecasters want to minimize forecast errors

It is nearly impossible to correctly forecast realworld variable values on a regular basis So, it is important to provide an indication of the extent to which the forecast might deviate from the value of the variable that actually occurs

Forecast accuracy should be an important forecasting technique selection criterion

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Forecast Accuracy and Control (contd.)

Forecast errors should be monitored

Error = Actual Forecast If errors fall beyond acceptable bounds, corrective action may be necessary

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Forecast Accuracy Metrics

Actual MAD = ( Actual MSE =

Forecast t n Forecast t )
2

MAD weights all errors evenly MSE weights errors according to their squared values

n 1

MAPE =

Actual t Forecast t 1 00 Actual t n

MAPE weights errors according to relative error

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Forecast Error Calculation


Period 1 2 3 4 5 Actual (A) 107 125 115 118 108 Forecast (F) 110 121 112 120 109 (A-F) Error -3 4 3 -2 1 Sum |Error| 3 4 3 2 1 13 n=5 MAD = 2.6 Error2 9 16 9 4 1 39 n-1 = 4 MSE = 9.75 [|Error|/Actual]x100 2.80% 3.20% 2.61% 1.69% 0.93% 11.23% n=5 MAPE = 2.25%

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Forecasting Approaches

Qualitative Forecasting

Qualitative techniques permit the inclusion of soft information such as:

Human factors Personal opinions Hunches These factors are difficult, or impossible, to quantify
Quantitative techniques involve either the projection of historical data or the development of associative methods that attempt to use causal variables to make a forecast These techniques rely on hard data

Quantitative Forecasting

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Judgmental Forecasts

Forecasts that use subjective inputs such as opinions from consumer surveys, sales staff, managers, executives, and experts

Executive opinions Sales force opinions Consumer surveys Delphi method

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Time Series Forecasts

Forecasts that project patterns identified in recent time-series observations

Time-series - a time-ordered sequence of observations taken at regular time intervals

Assume that future values of the time-series can be estimated from past values of the timeseries

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Time Series Forecasts

Trend - long-term movement in data Seasonality - short-term regular variations in data Cycle wavelike variations of more than one years duration Irregular variations - caused by unusual circumstances Random variations - caused by chance

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Forecast Variations
Figure 3.1
Irregular variation

Trend

Cycles
90 89 88 Seasonal variations

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Naive Forecasts

Nave Forecast

Uses a single previous value of a time series as the basis for a forecast The forecast for a time period is equal to the previous time periods value Can be used when The time series is stable There is a trend There is seasonality

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Time-Series Forecasting-- Averaging

These Techniques work best when a series tends to vary about an average

Averaging techniques smooth variations in the data They can handle step changes or gradual changes in the level of a series Techniques

Moving average Weighted moving average Exponential smoothing

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Moving Averages

Technique that averages a number of the most recent actual values in generating a forecast

Ft = MA t =

A
i =1

t i

where Ft = Forecast for time period t MA t = n period moving average At 1 = Actual value in period t 1 n = Number of periods in the moving average

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Moving Averages

As new data become available, the forecast is updated by adding the newest value and dropping the oldest and then recomputing the average The number of data points included in the average determines the models sensitivity

Fewer data points used-- more responsive More data points used-- less responsive

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Weighted Moving Averages

The most recent values in a time series are given more weight in computing a forecast

The choice of weights, w, is somewhat arbitrary and involves some trial and error

F =w A +w 1 t(n1+.. +wA 1 . t n tn n A ) 1 t wr he e w =wgtf rpro e h o ei d i t, w 1 egtf rpro i i t1t . , ec t t =w h o e d A =t e culvl ef rpro h at a au o ei d t, A 1 h at avl ef rpro u u i t t =t e c l a o e d t1t . , ec

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Moving Averages Example


Given the following data:
A). Prepare the forecasts for period 6 using a 3period, 5-period moving average. B). Prepare a weighted moving average forecast for period 6 using weights of 0.3, 0.2, and 0.1. Period 1 2 3 4 5 # of complaints 60 65 55 58 64

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Simple Moving Average


Actual 47 45 43 41 3 9 3 7 3 5 1 2 3 4 5 6 7 8 9 1 1 1 0 1 2 MA5

MA3

Q. What n to use? Large or small?

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Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)


Premise--The most recent observations might have the highest predictive value.

Therefore, we should give more weight to the more recent time periods when forecasting.

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Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

Weighted averaging method based on previous forecast plus a percentage of the forecast error A-F is the error term, is the % feedback

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Example - Exponential Smoothing


Period Actual 1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 Alpha = 0 1 Error . 42 40 43 40 41 3 9 46 44 45 3 8 40 42 418 . 419 . 2 4173 . 416 . 6 413 . 9 418 . 5 4207 . 423 . 6 419 . 2 4173 . Alpha = 0 4 Error . -200 . 12 . 0 -192 . -0.73 -266 . 4.6 1 21 . 5 29 . 3 -4.36 -192 . 42 412 . 419 . 2 411 . 5 4109 . 40.2 5 425 . 5 43 3 .1 43 8 .8 415 . 3 40.9 2 -2 18 . -192 . -0. 15 -209 . 575 . 145 . 18 . 7 -588 . -153 .

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Picking a Smoothing Constant


5 0 Demand 45 40 3 5 1 2 3 4 5 6 7 Period 8 9 1 11 12 0
Actual = .4 = .1

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Other Forecasting Methods Focus

Focus Forecasting

Some companies use forecasts based on a best current performance basis


Apply several forecasting methods to the last several periods of historical data The method with the highest accuracy is used to make the forecast for the following period This process is repeated each month

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Other Forecasting Methods - Diffusion

Diffusion Models

Historical data on which to base a forecast are not available for new products

Predictions are based on rates of product adoption and usage spread from other established products Take into account facts such as

Market potential Attention from mass media Word-of-mouth

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Technique for Trend

Linear trend equation Non-linear trends

Parabolic trend equation Exponential trend equation Growth curve trend equation

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Linear Trend Equation

A simple data plot can reveal the existence and nature of a trend Linear trend equation
Ft = a+b t w ere h Ft =F recast fo p d o r erio t a=V of Ft at t =0 alue b=S p o th lin lo e f e e t =S ecifiednu b o tim perio s fro p m er f e d m

t =0

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Estimating slope and intercept

Slope and intercept can be estimated from historical data


b= n ty t y n t
2

y b t a=
n

( t)

or y bt

where n = Number of periods y = Value of the time series

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Linear Trend Equation Example


t W 1 2 3 4 5 t 1 5 t = 2 ( t ) =2 2 5
2

e e k

t 1 4 9 1 6 2 5

y S 1 1 1 1 1 a 5 5 6 6 7 le s 0 7 2 6 7 t y 1 5 3 1 4 8 6 6 8 8 0 4 6 4 5

=5 5 y

8 1 2 t y 2= 4 9 9 =

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Linear Trend Calculation


5 (2499) - 15(812) 12495-12180 b = = = 6.3 5(55) - 225 275 -225

812 - 6.3(15) a = = 143.5 5

y = 143.5 + 6.3t

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Associative Forecasting

Home values may be related to such factors as home and property size, location, number of bedrooms, and number of bathrooms

Associative techniques are based on the development of an equation that summarizes the effects of predictor variables

Predictor variables - variables that can be used to predict values of the variable of interest

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Simple Linear Regression

Regression - a technique for fitting a line to a set of data points

Simple linear regression - the simplest form of regression that involves a linear relationship between two variables

The object of simple linear regression is to obtain an equation of a straight line that minimizes the sum of squared vertical deviations from the line (i.e., the least squares criterion)

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Least Squares Line


yc = a + bx where yc = Predicted (dependent) variable x = Predicted (independent) variable b = Slope of the line a = Value of yc when x = 0 (i.e., the height of the line at the y intercept) and b= n xy x y n x
2

y b x a=
n where

( x)

or y bx

n = Number of paired observations

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Standard Error

Standard error of estimate A measure of the scatter of points around a regression line If the standard error is relatively small, the predictions using the linear equation will tend to be more accurate than if the standard error is larger
Se = where S e = standard error of estimate y = the value of each data point n = number of data points

( y yc ) 2
n2

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Linear Model Seems Reasonable


X 7 2 6 4 1 4 1 5 1 6 1 2 1 4 2 0 1 5 7 Y 1 5 1 0 1 3 1 5 2 5 2 7 2 4 2 0 2 7 44 3 4 1 7

Computed relationship
5 0 40 3 0 2 0 1 0 0 0 5 1 0 1 5 2 0 2 5

A straight line is fitted to a set of sample points.

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Correlation Coefficient

Correlation A measure of the strength and direction of relationship between two variables Ranges between -1.00 and +1.00 r2, square of the correlation coefficient A measure of the percentage of variability in the values of y that is explained by the independent variable Ranges between 0 and 1.00

n y x x y 2 r = 2 2 n 2 x x n 2 y y

( )( ) ) ( ( )( ) ( )( )

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Regression and Correlation Example


Given the following values of X and Y, (a) obtain a linear regression line for the data, and (2) what percentage of the variation is explained by the regression line? x y xy x2 y2 15.00 74.00 1110.0 225.0 5476.0 25.00 80.00 2000.0 625.0 6400.0 40.00 84.00 3360.0 1600.0 7056.0 32.00 81.00 2592.0 1024.0 6561.0 51.00 96.00 4896.0 2601.0 9216.0 47.00 95.00 4465.0 2209.0 9025.0 30.00 83.00 2490.0 900.0 6889.0 18.00 78.00 1404.0 324.0 6084.0 14.00 70.00 980.0 196.0 4900.0 15.00 72.00 1080.0 225.0 5184.0 22.00 85.00 1870.0 484.0 7225.0 24.00 88.00 2112.0 576.0 7744.0 33.00 90.00 2970.0 1089.0 8100.0

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Simple Linear Regression Assumptions

1. 2.

3.

Variations around the line are random Deviations around the average value (the line) should be normally distributed Predictions are made only within the range of observed values

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Issues to consider

Always plot the line to verify that a linear relationships is appropriate The data may be time-dependent.

If they are

use analysis of time series use time as an independent variable in a multiple regression analysis

A small correlation may indicate that other variables are important

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Controlling the Forecast

Control chart

A visual tool for monitoring forecast errors Used to detect non-randomness in errors

Forecasting errors are in control if

All errors are within the control limits No patterns, such as trends or cycles, are present

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Sources of Forecast errors

Model may be inadequate Irregular variations Incorrect use of forecasting technique

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Choosing a Forecasting Technique

No single technique works in every situation Two most important factors

Cost Accuracy

Other factors include the availability of:

Historical data Computers Time needed to gather and analyze the data Forecast horizon

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Using Forecast Information

Reactive approach

View forecasts as probable future demand React to meet that demand Seeks to actively influence demand Advertising Pricing Product/service modifications Generally requires either and explanatory model or a subjective assessment of the influence on demand

Proactive approach

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