Chapter 1: Introduction to Forecasting

Chapter 1 Introduction to Forecasting

1.1 Introduction

1.1.1 Definition Forecasts Predictions of future events and conditions Forecasting The act of making predictions of future events and conditions 1.1.2 Why forecasting? Predictions of future events must be incorporated into the decision-making process Very important in many types of organizations

1.2

Forecasting in Management
Managing a business in a steady state environment is easy o Managers can fairly make accurate decisions for tomorrow based on the knowledge as provided by past experience o What happened previously will continue in the future Many changes may take place that may affect all aspects of our lives o Changes in business and commercial environment o Changes in the physical and social structure of the country o Changes in the behavior and the needs of the population o Changes in their taste and preference o Changes in the levels of publics awareness on environmental and social issues Changes create uncertainties o Subsequently alter the regular pattern that has been established over a period of time in which the society regularly conducts its activities o Forecasting becomes more difficult and uncertain Accuracy important criterion in forecasting o Inaccurate forecast will affect the strategic planning o Over optimistic the firm spend more than what is actually required o Over pessimistic the firm produces less than the market demand

1.2.1 Forecasting and strategic planning Planning o Setting objectives and goals o Developing alternative courses of actions within management control o Good planning procedure requires data/information pertinent to the future Forecasting o Whole process of developing the necessary methods to generate the future values o As a decision-making tool capture signals of the impending future outcomes SQQS 3033 Business Forecasting 1

Chapter 1: Introduction to Forecasting Forecast values o Used as the inputs for goals and objectives of the firm o Should be able to provide the management with the sound basis for most decision-making activities, particularly in the area of planning and control Work of planners is to set up alternative courses of actions in the face of ever-increasing uncertainties in the future o This can only be done with adequately accurate data/information of the future (the forecast values)

1.2.2 Management issues in forecasting Technical or methodological issues Human and managerial issues Forecasters tend to be viewed as number crunchers or people who have the skill at analyzing numbers o people fail to realize the forecasters role and how the forecasters can also mesh their functions within the organization given their broader responsibilities in the decision making process Very few forecasters are willing to admit that he/she can produce perfect forecasts o Forecaster can only endeavor is to minimize the inevitable errors o Leads to critics like if a forecast is unreliable or inaccurate then why use it at all 1.2.3 Preparer of forecasts There is no standard procedure that determines how the forecasts should be prepared within each organization Forecasting is treated as a line function o Forecaster prepares the plans and then makes decision o Might be all in one collects data, forecasts, plans and decides The forecaster may be part of a staff function o Located away from other decision-makers o Example A specialist sales or marketing or business analyst A statistician A management scientist 1.2.4 Managing the forecasts When a forecast value is generated, it does not mark the end of the forecasting process Prior to its final acceptance by the management o The forecast has to pass through several stages o At each stage some form of modifications and amendments are performed, in line with the policies of the firm During application stage o Forecast values need to be regularly revised and updated o The changing environment affects the forecasts o Review data and the model formulation used

SQQS 3033 Business Forecasting

Chapter 1: Introduction to Forecasting 1.2.5 Users of forecasts Finance department o Predict interest rate o Forecast receipts and expenditures to predict cash flows and maintain company liquidity Marketing department o Forecast demand Personnel management o Forecast number of workers required in different job categories o Prediction of the supply of labor Production scheduling o Forecast raw material requirement and demand for each product line Process control o Forecast future behavior of the process 1.2.6 Main results of forecasting Accurate forecasting of future business or economic activities can guide the firm in the right direction in the formulation of corporate strategies in an uncertain environment Inaccurate forecast can put a firm in a very difficult financial situation

1.3

Forecasting Techniques
Forecasting can be performed in many and varied situations o Data are scarce o A large amount of data/information is available Forecasts are generated to provide o General information o Critical planning purposes of the firms The adverts of modern computers and development of more sophisticated forecasting software, have made the work of forecasting extremely easier o Provide opportunities to experiment with large selections of model types o Compare the forecasting performance of the competing models

1.3.1 Types of forecasting techniques Two main types of forecasting techniques o Qualitative techniques Subjective or judgmental o Quantitative techniques Objective Statistical in nature There is no single technique can be safely said as the best to be applied in all situations It is the responsibility of the forecaster to determine the best technique that satisfies the organizations needs

SQQS 3033 Business Forecasting

Chapter 1: Introduction to Forecasting

Qualitative (subjective)

Delphi Method Jury of executive opinion Sales force composite Consumer market survey

Forecast methods

Quantitative (objective)

Univariate time series Time series decomposite Nave method Methods of average Exponential smoothing Box-Jenkins method (AR, MA, ARMA, ARIMA) Causal models Time series & crosssectional regression Bivariate (simple) regression Multiple regression

1.3.1.1 Qualitative techniques Commonly used in both business and non-business organization Generally used when the available data are scarce and insufficient to formulate the necessary mathematical models Use the opinions of experts to predict future events o Human judgment personal opinion to translate qualitative assessments into quantitative estimates Widely used in forecasting of o New products o New technologies or developments o Future scenarios o Social condition Main weakness o The forecast values generated are difficult to be evaluated and assessed for accuracy o Different individuals/groups tend to differ in opinion almost always bias o Not consistently accurate over time o It takes years of experience for someone to learn how to convert intuitive judgment into good forecasts Examples of qualitative technique o Jury of executive opinion Combining the subjective opinions of the managers and executives Collects opinions in individual interviews or in a meeting where the participants have an opportunity to discuss various points of view

SQQS 3033 Business Forecasting

Chapter 1: Introduction to Forecasting o Delphi Method An iterative group process that allows a panel of experts to make forecasts Involve conducting sample surveys on these experts Steps in this method i. Participating panel members are selected ii. Questionnaires asking for opinion about the variables to be forecast are distributed to the panel members iii. Results from the panel members are collected, tabulated and summarized iv. Summarized results are distributed to panel members for their review and consideration v. Panel members revise their individual estimates, taking account of the information received from the other, unknown panel members vi. Repeat step (iii) through (v) until no significant changes result Through this process, usually movement toward centrality There is no interaction among the experts who may located in different part of the country who receive the questionnaire via mail or the internet o Sales force composite A rich source of information about future trends and changes in buyer behavior Familiar with the products and the characteristics of the market o Consumer market survey Inputs from customers or potential customers of their future purchasing plans Random selection procedure is applied to ensure that the data collected are unbiased and representative of the population Collects sample data and then estimates the population values 1.3.1.2 Quantitative techniques Objective in nature Generally classified as either projective or causal Need significant amount of historical data (in form of time series) to develop the mathematical models Designed to produce in an objective manner accurate and unbiased estimates of future values in the presence of uncertainty Supported by forecasting software such as 4CAST/2, RATS, SPSS, S-Plus, Forecast-X, SAS etc. Projective method o Usually referred as univariate modeling techniques o Comprised of single variable models o Other variables are ignored no matter how potential they are to the variable being investigated o Forecast values are the projections of the past values on the assumption the past characteristics of the time series will continue into the future SQQS 3033 Business Forecasting 5

Chapter 1: Introduction to Forecasting when changes do occur, the amount is not expected to be significant enough to affect the estimated model

Causal method o Involved construction of multiple variables models o Generally termed as regression technique o Econometric modeling is a special case of causal method

1.3.2 Issues to be considered when formulating quantitative models Forecasts accuracy o Top most consideration - degree of accuracy of the forecast, involve determining The degree of errors acceptable to the forecaster/decision maker The periodicity of updating the forecasts when new information is available o Increase in accuracy results in increasing in cost Additional data acquisition Increase in computer time Purchase of sophisticated (expensive) software Personnel/expert involvement Forecast horizon o The time in future at which the forecasts are required o Influence the decision on the model type to be used o Not all models suit all forecast horizons Long-term forecasts several years ahead Medium-term forecasts 6 months to 2 years ahead Short-term forecasts 1 month to 6 months ahead Immediate-term forecasts less than 1 month o The longer the time horizon, the less accurate the forecast Due to changes during the intervening periods Change in technology o Bring to immense change in Physical environment of the country Production process Consumers taste Information technologies led to development of new ideas and concepts of work, reducing work time o Difficulty in making accurate forecasts increase Barrier to entry o The more barrier to enter (all other things being equal), the more accurate will be the forecasts o Less number of existing independent variable to affect the dependent variable

SQQS 3033 Business Forecasting

Chapter 1: Introduction to Forecasting Dissemination of information o More and more people are able to obtain similar information o More and more people are able to forecast accurately Elastic demand o Degree of change in the demand level of a particular product when there is a change in its price o The more elastic the demand, the more sensitive will the dependent variable o Forecasting is difficult for highly elastic products as compared to inelastic products Aggregated versus individual forecasts o Wrong choice of model may lead to inaccurate forecasts Firm would incur unnecessary costs arising from over or under forecast o Ensure the number of models employed is manageable so that time available can be used to improve the models o Choice for multi-products forecast Aggregate selection Use same model fore all products A single forecasting method is applied to the population of product lines Individual selection Use different models for different product lines A method or model is selected to suit an individual product line

1.3.3 Selecting the forecasting technique Factors to be considered for successful forecasting practices are o Time frame o Choice of technique o Costs consideration o Level of accuracy o Availability of data o Models complexity

SQQS 3033 Business Forecasting

Chapter 1: Introduction to Forecasting

1.4

Forecasting Process
A good forecasting model is one which is dynamic, allows the estimated models to be regularly updated when new information or new data become available

1.4.1 Stages in the forecasting process There are 10 stages in the forecasting process 1. Determine the purpose and objective of the forecasting exercise 2. Select the relevant theory 3. Collect the data 4. Get to know your data 5. Estimate the initial model 6. Evaluate and revise the model 7. Present the initial forecast 8. Make the final revision 9. Distribute the forecasts 10. Establish monitoring system Stage 1: Determine the purpose and objective of the forecasting exercise o It is important that the forecaster also understands the intended managerial use of the projection o Different objectives need different types of forecast models Stage 2: Select the relevant theory o Ability to understand the underlying theory that describing and explaining the occurrence or non-occurrence of a particular phenomenon is important o Enables the forecaster to easily identify the correct model structure o Provide a useful basis to segregate the factors/variables that influence the subject being investigated Stage 3: Collect the data o Data can be classified as either internal or external data, depends on how and where the data are collected o Internal data By-products of the administrative procedures Within the managers domain Usually within the control of the organization Examples: number of employees, data pertaining to quality control, forms income/expenditure, number of industrial accidents, etc. o External data Obtained outside the normal operational activities of the firms Beyond the managements control Examples: consumers income level, rates of inflation, the countrys unemployment rate, banks interest rate, etc. o Primary data Data collected within or outside the firm using suitable sampling scheme directly from the source or individuals concerned

SQQS 3033 Business Forecasting

Chapter 1: Introduction to Forecasting o Secondary data Data obtained from secondary sources o Proper documentation of the collected data is necessary to facilitate future references Stage 4: Get to know your data o The simplest method at understanding and identifying the data characteristics is to plot the graphs. Simple line graph is ideal o How to deal with missing data? Take the average of the neighboring periods as an estimate of the missing value At advanced level, use sophisticated statistical formulation Stage 5: Estimate the initial model o Begin the forecasting process by initially developing a simple model o Example: Autoregressive model of order one, AR(1) yt 0 1 yt 1 t Simple linear regression with one independent variable yt 0 1x1t t o The modeler will then attempt to improve the estimated model Restructuring or reformulating the model Stage 6: Evaluate and revise the model o It is necessary before the modeler can formally claim that the estimated model is the best and can subsequently be used to generate the forecast values o Can be performed either within or outside the sample by comparing the estimated against the actual values using various error measures o Evaluating outside sample can be done in two ways Ex-ante technique 'Beforehand' Based on prior assumptions Results of a particular action, or series of actions, are forecast in advance Based on anticipated changes or activity in an economy Evaluate single variable model Ex-post technique Afterward' Based on analysis of past performance Measure of past performance Popular amongst the econometricians

SQQS 3033 Business Forecasting

Chapter 1: Introduction to Forecasting Stage 7: Present the initial forecast o The forecast results have to sufficiently provide necessary inputs to the decision makers o Further revision will be made by the decision-maker incorporate subjective elements in the form of value judgment that will affect future demand of the products o There is nothing wrong to adjust the forecasts subjectively, provided that the subjective elements are derived from objective consensus of many managers o Conductive and cordial relationship need to be established to allow easy flow of information between the manager and forecaster Stage 8: Make the final revision o The modeler needs to explain and make known to the managers the forecasting methodology used o Forecast values need to be revised in the light of availability of new data or when there is evidence of the occurrence of the changes in the data pattern or data structure Stage 9: Distribute the forecasts o Forecast values need to be delivered to the management in a timely and in a consistent format o The management has to make decisions quickly and correctly in order to maintain the edge over their competitors o Two way communication between forecaster and decision-maker Forecaster determine Who should receive the forecasts How detailed should the forecasts be How frequently the users need to be provided with updates Forecaster needs to be regularly updated regarding new policy change affecting the organization and hence forecasts Stage 10: Establish monitoring system o Allow the forecaster to respond to unexpected events o Calls for immediate revision when there is a change in the environment o Comparisons of the actual achieved can be made against target figures to see whether the initial objectives of the firm are met at the end of the financial year o Continuous monitoring create a tracking signal in the form of a series of values representing the errors When the value cross the controlling line (upper or lower limits), they would trigger an alarm system o Systematic fluctuations need to be differentiate from random fluctuations o Occurrence of large deviations (outliers) from the norm requires immediate attention Determine the cause Take suitable corrective measures to ensure similar problems do not recur in future

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Chapter 1: Introduction to Forecasting o From time to time, forecaster can re-examine the model(s) being used i. Re-examine the date See whether the historical data being used to develop the model are still relevant Add new data to the series ii. Estimate a new model iii. Evaluate the new model To determine its adequacy If insufficient, repeated step (i) and (ii) The process is performed repeatedly until the forecaster is satisfied with the model performance as measured in terms of its forecast accuracy

1.4.2 Forecasting scenario

Historical part: modelling/estimation part

Evaluation ex-post forecast (historical)

Future/ex-ante forecast

two-steps-ahead one-step-ahead 2 ... t-2 t-1 t ... n one-step-ahead

t+1

t+2

n+1

forecast point of origin (current time point)

There are three parts in forecasting scenario as shown in the figure above Part I Modelling/estimation o Use historical data to build up the model o Different techniques will result in different models o More data points is needed than evaluation part Part II Evaluation ex-post forecast o Involve a few historical data points o Forecast with the built up models o Evaluating different models by using error measures o Choose the best model (usually with smallest error measures) to forecast for future Part III Future/ex-ante forecast o Using the best model, forecast for future o Forecast values will be used for policy planning and control o Target for organization

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Chapter 1: Introduction to Forecasting 1.4.3 What can go wrong with forecasting? Some of the common mistakes made by forecasters that result in poor forecasting Selection of wrong forecasting model o To avoid this mistake, it is important to firstly understand data characteristics before finally picking the model type that best suites the data structure Insufficient diagnostic testing o Too much emphasis by the forecaster on certain testing procedures whilst ignoring others may result in a model that fits well but performed badly in forecasting False assumptions o Reasons necessitate the assumptions employed to be reviewed periodically to ensure that they hold in the past as well as in the future Mistake in fundamental assumption that relationships driving demand in the past would continue unaltered into the future Need to decide whether or how to use the past information to tell about the future The assumption of stability of the relationship as embedded in any model structure may not hold Need to be investigated prior to its application o The assumptions pertaining to data structure and method of data collection need also to be checked Forecast bias o The occurrence of bias in forecast could be a result of Limited choices of alternative model or techniques to be applied to a particular data set Theoretical and model formulation error leading to the application of false assumptions Performing insufficient testing and model evaluations on the estimated model(s) The availability of limited data points to fit the model Wrong variable selections included in the model Human judgment in the forecast adjustment subjective adjustment has to be made in a careful manner

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