Bmlec6 4

BUSINESS FORECASTING
Definition
Forecasting involves making the best possible judgment about

some future event.
It is no longer reasonable to rely solely on intuition, or one s

feel for the situation, in projecting sales, inventory needs,
personnel requirements, and other important economic or
business variables.
Who uses forecasts?
Accountants - costs, revenues, tax-planning

Personnel Departments - recruitment of new employees
Financial Experts - interest rates
Production Managers - raw materials needs, inventories
Marketing Managers - sales forecasts for promotions
Major Types of Forecasting Methods
Subjective Methods
Sales Force Composites
Customer Surveys
Jury of Executive Opinions
Delphi Method
BMLec6_4: Forecasting Page: 2
Quantitative Methods
Exponential smoothing family
Sources Of Data
Internal records of the organization
Outside the Firm

U.S. Department of Commerce
Survey of Current Business
Business Conditions Digest (300 eco. series)
Business Statistics (historical data)
Handbook of Cyclical Indicators
International Financial Statistics
Federal Reserve Bulletin
Economic Report of the President
Business Outlook
Industrial Outlook
etc.
Time Domain
High frequency data (intra day: 5min, hourly, etc.)

Daily
Lower frequencies (monthly, quarterly)
FIN 460 Class Notes Prepared by: Dr. Gordon H. Dash, Jr.
These notes contain copyrighted information Last Update: 24-JUN-03
www.GHDash.net Do not quote or copy without permission
Traditional View: Components of a Time Series
Secular Trend
The growth of the economic system is tied to the growth
of business and industry.
Based primarily in growth of the population.
Found in prices as well as in physical volume time
series.
Seasonal Variation
Variation in business and economic activity that results
from changing seasons.
Periodic fluctuations in consumer spending ===>
Periodic Sales ===> Periodic production
Cyclical Fluctuations
Cyclical fluctuations are not very predictable.
Business cycles -- Expansion and Contraction
Expanding the non-Traditional view: Erratic Fluctuations
Are the fluctuations really erratic (chaotic)? Here is where our

work with high-frequency data (daily level or greater frequency)
and new modeling / forecasting methods will prove to be most
useful. That is, time-series that appeared to have no economic
value are now being modeled quite successfully with new
methods like Artificial Neural Networks (ANN).
Quantitative Forecasting Methods
Charting Approaches
Moving average
Weighted moving average
Exponential Smoothing (our immediate focus)
- Single
- Adaptive Rate of Response Single Exp. Smoothing
- Holts
- Winters
Our First Focus: The Exponential Smoothing Family
Simple Exponential Smoothing
Single parameter exponential smoothing (Unadjusted) is an easy

to implement method of smoothing that overcomes some of the
problems associated with moving averages.
In contrast to moving averages, exponential smoothing permits

the researcher to weight observations. It is not unusual for
recent observations to contain more relevant information for
forecasting purposes than older ones.
The method also generates self-correcting forecasts through its

ability to produce forecast values which reflect adjustment for
earlier errors.
Advantages:
1. Simplifies forecasting calculations
2. Has small data requirements
3. Produces self-correcting forecasts with built-in adjustments
that regualte forecast values by changing them in the opposite
direction of earlier errors.
4. Simple! Only the last period s forecast must be saved.
Disadvantages:
1. Specification of the smoothing constant is a problem. Alpha
close to 1 implies that the new forecast includes a substantial
adjustment for the error in the previous forecast. If alpha is
close to zero, the new forecast will include only a small
adjustment for error.
2. Forecast accuracy is affected when the time series reflects a
consistent pattern.
3. In general the forecasts trail the pattern in the sample data.
Notation for Single Unadjusted Exp. Smoothing
Dt := Actual value at time t

Ft+1 := Forecast value for time t+1
:= Smoothing constant
Ft+1 = Dt + (1 - )Ft-1
where: 0.0 1.0
Fo = D1 or user input.
From the above equations it is apparent that there are two

specific data input required for the unadjusted option. These
are:
1. Smoothing Constant (Alpha = ).

2. Time Series Base (D1)
Test Of Predictive Ability (Unadjusted)
Time Series: B
138
137
136
135
134
133
132
131
130
129
128
127
Actual & Predicted
126
125
124
123
122
121
120
119
118
117
116
115
114
113
112
111
110
109
295 300 305 310 315 320 325 330 335

Observation
Predicted PointSeries2
A Second Focus: Charting Approaches
Arithmetic Charts (Scatter Plots)
Definition
The purpose of the arithmetic charts is to show actual movement

of the time series from one period to the next.
Unless the axis markings (scaling) are the same it is not

possible to compare and interpret two different charts.
A chart drawn on the arithmetic scale compares the amounts
of change.
Data with a wide dispersion in values may not be acurately
reflected.
Trade Weighted Exchange Rate
129.000
128.000
127.000
126.000
125.000
Value
Series1
124.000
123.000
122.000
121.000
120.000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
2001
Semi Logarithmic Charts
Definition
The purpose of the semi-logarithmic chart is to show the rate of

change from one period to another.
The ruling on the chart is such that the figures are

automatically reduced to a percentage basis.
Note that the same vertical distance anywhere on the chart
shows the same percentage change.
Thus, if the interest is in percentage changes in the data, the
semi-logarithmic chart is the preferred choice.
If two or more series are shown on the same chart, the slope
of each line shows the percentage change in the series.
By comparing the slopes of the two lines, it is possible to
compare the percentage changes in the series.
Trade Weighted Exchange Rate
1000.000
100.000
TWER
Value
10%
1%
10.000
1.000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
2001
Constant Rate of Change Reference Lines
It should be noted that a straight line on a semi-logarithmic

chart represents a constant rate of change.
The primary use of the constant rate of change reference line
is to permit the analyst to visually compare the slope of a
known rate of change to that of the actual data series.
These lines are extremely useful in time series analysis.
If semi-logarithmic graph paper is not available, then use Excel

2000 or higher. Choose the Logarithmic option under Custom
Chart.
Computing the Compound Rate of Change
All references are made to Excel applications.
1. Create a new column with the natural log transformation of

the time series using the =LN function.
2. Create another column with a time series variable (1, 2,
3, ).
3. Use the TOOLS / DATA ANALYSIS / REGRESSION
menu option to generate a simple linear regression where
the dependent variable is the LN transformation and the
independent variable is the time series. (NOTE: this is not
the only method in Excel to obtain the solution. Our focus
here is on a basic theory approach).
4. Obtain the growth factor (1+g) by taking the anti-log of the
regression parameter. Use the function =EXP(cell
reference). Obviously, g is equal to 1 minus this result.
Example: Compound Rate of Growth

Actual Data: Ln Transformation of MMH 7-3
Observation Sales Advertising Price Time

D I
Obs1 6.205 6.802 5.011 1

Obs2 6.319 7.090 5.193 2
Obs3 6.142 6.620 4.905 3
Obs4 6.515 7.208 4.905 4
Obs5 5.886 6.397 4.787 5
Obs6 6.004 6.397 4.787 6
Obs7 6.600 7.313 5.011 7
Obs8 6.075 6.620 5.011 8
Obs9 6.346 6.957 5.106 9
Obs10 6.397 7.090 5.011 10
Growth Model Regression Results
Parameter Standard t For Ho: P-Value

Variable Estimate Error Est = 0 (95%=0.05)
Intercept 6.184 0.163 37.997 0.994

Time 0.012 0.026 0.452 0.665
Dependent: Ln(Sales)
1. Forecast for next period:

a. Ln(Ft+1) = 6.184 + (0.012*11) = 6.314
b. Ft+1 = e6.314 {use =EXP(6.314)}
c. Ft+1 = 552.286
2. Compound rate of growth:

a. The regression parameter (0.012)
b. take anti-log: =EXP(0.12); 1 +g = 1.01192
c. Sales10 = 600; Salest+1 = Sales10 * (1+g) = 607.151
Note: when the regression parameter is negative (-0.12) then: a)

take the antiog (=EXP(-0.12) = 0.8891) and b) subtract 1
(0.8891 -1.0 = -0.1131) for the compound rate of DECAY (g = -
0.1131).
Third Focus (least used): Moving Averages
The moving average approach calculates an average of the

sample observations and then employs that average as the
forecast for the next period.
The number of sample observations included in the calculation

of the average is specified at the start of this process.
The term MOVING average means that as a new observation

becomes available a new average is calculated by dropping the
oldest observation in order to include the newest one.
Month Period Observed 3-Month 5-Month Log Obs Growth Series:

Values MA MA Values 0.001%
Jan 1 262.8 2.420 2.410
Feb 2 262.9 2.420 2.412
Mar 3 262.6 2.419 2.415
Apr 4 263.2 262.8 2.420 2.417
May 5 263.9 262.9 2.421 2.420
Jun 6 265.4 263.2 263.1 2.424 2.422
Jul 7 266.5 264.2 263.6 2.426 2.424
Aug 8 267.1 265.3 264.3 2.427 2.427
Sep 9 268.5 266.3 265.2 2.429 2.429
Oct 10 269.7 267.4 266.3 2.431 2.432
Nov 11 270.4 268.4 267.4 2.432 2.434
Dec 12 269.4 269.5 268.4 2.430 2.437
Source: Business Forecasting Methods, by Jarrett, (Basil Blackwell, 1991).
Month Moving Average

Sample Date
272
270
268
266 Actual
Values
3 Mnth
264 5 Mnth
262
260
258
1 2 3 4 5 6 7 8 9 10 11 12
Observation
Advantages:
1. Data requirements are small.
2. Better than using a simple arithmetic mean because it can be
adjusted to reflect the observable patterns in the data.
Disadvantages:
1. The past n sample observations must be available.
2. Equal weights are given to all past observations and no weight
is given to observations earlier than period t-n+1.
3. Assumes that the data has a stationary distribution (not always
true).
Accuracy of Forecasts
By now it should be somewhat apparent that exponential

smoothing techniques tend to lag behind the turning points of
the actual time series data.
The usefulness of the forecast is best determined by evaluating

its associated error. Of course, smaller error values are better
than larger errors when comparing different values of the
smoothing parameters.
The same holds when comparing different forecasting models.

Generally, in business and economics the focus shifts to MAD,
MAPE, or MSE.
Types Error Measurements In Use

Average Error
This is the arithmetic average of the forecast error.
Mean Percent Error (MPE %)
The mean percent error shows the error as a percentage of the

actual series. This measure is generally more informative than
average error when the original series have large differences in
their actual values.
Standard Deviation
This is the standard deviation of forecast errors.
Mean Squared Error (MSE) And Root MSE (RMSE)
This is a very common measure for evaluating the accuracy of

the forecast. The square root of this measure is also used
(RMSE).
Both MSE and RMSE tend to be overly affected by outliers.

However, it is implicitly assumed that the MSE measure is zero.
Stated differently, when the MSE is zero, then the forecasting
model is unbiased.
Mean Absolute Deviation (MAD)
MAD is less sensitive to outliers than MSE.
Other than that, it is similar in concept to MSE; the primary

difference is in its use of absolute deviations.
The use of absolute deviations is more effective if the economic

impact of forecast errors is proportional to the amount of the
errors.
Mean Absolute Percentage Error (MAPE)
MAPE is similar in concept to MAD. The major difference is

that the error terms are converted into percentage format. This
allows for direct comparison between different forcasting
values.
Graphical Analysis
After each execution of the forecasting method, the actual,

predicted and residual terms can be compared graphically.
Graphical analysis used to augment the interpretation of the
forecast. Overall quality of fit can be judged from the graphical
analysis.
Constant Variance
Error Bars
Predictive Ability
Residual Analysis

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BUSINESS FORECASTING

Forecasting involves making the best possible judgment about

It is no longer reasonable to rely solely on intuition, or one s

Who uses forecasts?

Accountants - costs, revenues, tax-planning

Major Types of Forecasting Methods

Internal records of the organization

Outside the Firm

High frequency data (intra day: 5min, hourly, etc.)

Traditional View: Components of a Time Series

Expanding the non-Traditional view: Erratic Fluctuations

Are the fluctuations really erratic (chaotic)? Here is where our

Quantitative Forecasting Methods

Our First Focus: The Exponential Smoothing Family

Simple Exponential Smoothing

Single parameter exponential smoothing (Unadjusted) is an easy

In contrast to moving averages, exponential smoothing permits

The method also generates self-correcting forecasts through its

Notation for Single Unadjusted Exp. Smoothing

Dt := Actual value at time t

From the above equations it is apparent that there are two

1. Smoothing Constant (Alpha = ).

295 300 305 310 315 320 325 330 335

A Second Focus: Charting Approaches

Arithmetic Charts (Scatter Plots)

The purpose of the arithmetic charts is to show actual movement

Unless the axis markings (scaling) are the same it is not

Trade Weighted Exchange Rate

Semi Logarithmic Charts

The purpose of the semi-logarithmic chart is to show the rate of

The ruling on the chart is such that the figures are

Trade Weighted Exchange Rate

Constant Rate of Change Reference Lines

It should be noted that a straight line on a semi-logarithmic

If semi-logarithmic graph paper is not available, then use Excel

Computing the Compound Rate of Change

All references are made to Excel applications.

1. Create a new column with the natural log transformation of

Example: Compound Rate of Growth

Observation Sales Advertising Price Time

Obs1 6.205 6.802 5.011 1

Growth Model Regression Results

Parameter Standard t For Ho: P-Value

Intercept 6.184 0.163 37.997 0.994

1. Forecast for next period:

2. Compound rate of growth:

Note: when the regression parameter is negative (-0.12) then: a)

Third Focus (least used): Moving Averages

The moving average approach calculates an average of the

The number of sample observations included in the calculation

The term MOVING average means that as a new observation

Month Period Observed 3-Month 5-Month Log Obs Growth Series:

Month Moving Average

By now it should be somewhat apparent that exponential

The usefulness of the forecast is best determined by evaluating

The same holds when comparing different forecasting models.

Types Error Measurements In Use

This is the arithmetic average of the forecast error.

Mean Percent Error (MPE %)

The mean percent error shows the error as a percentage of the

This is the standard deviation of forecast errors.

Mean Squared Error (MSE) And Root MSE (RMSE)