Forecasting

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

Elements: Timely, Accurate, Reliable, Expressed in meaningful units, In writing, Technique should be simple to understand
and use, Cost effective

Steps:

 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

Forecasting Approaches:

 Qualitative Forecasting
o Qualitative techniques permit the inclusion of soft information such as:
 Human factors
 Personal opinions
o These factors are difficult, or impossible, to quantify
 Quantitative Forecasting
o 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
o These techniques rely on hard data

Forecasting Models

Qualitative Forecasting Methods:

1. Delphi Method
 Iterative group process allows experts to make forecasts
 Participants:
o decision makers: 5 -10 experts who make the forecast
o staff personnel: assist by preparing, distributing, collecting, and summarizing a series of questionnaires
and survey results
o respondents: group with valued judgments who provide input to decision makers
2. Jury of executive opinion
 Opinions of a small group of high-level managers, often in combination with statistical models.
 Result is a group estimate.
3. Sales force composite
  Each salesperson estimates sales in his region.
 Forecasts are reviewed to ensure realistic.
 Combined at higher levels to reach an overall forecast.
4. Consumer market survey
 Solicits input from customers and potential customers regarding future purchases.
 Used for forecasts and product design & planning

Features of Qualitative forecasting methods:

 Grass Roots: deriving future demand by asking the person closest to the customer.
 Market Research: trying to identify customer habits; new product ideas.
 Panel Consensus: deriving future estimations from the synergy of a panel of experts in the area.
 Historical Analogy: identifying another similar market.
 Delphi Method: similar to the panel consensus but with concealed identities.

Good and Bad about Qualitative forecasts

Advantages of Qualitative forecast:

1. The mass of information (both quantifiable & unquantifiable) to come up with a prediction.

Disadvantages :

1. There is no systematic way to measure or improve the accuracy of the forecast

2. There is a chance that the forecast may contain built in biases of the experts.

Time Series and Extrapolation

 A time series is a stream of data (e.g., demand).

 Data are recorded at different time periods – monthly, weekly, daily, etc.
 Forecasters predict (by extrapolation) the value(s) at a future time.
 The pattern of the series is considered to be time-dependent. External causes are not brought into the picture.

The data in time series may consist of several different kinds of variations.

Important among them are:

1. random variations

2. increasing or decreasing trend

3. seasonal variations

Time Series (Random Variations)

 There are no specific assignable causes for random variations.

 Values are a result of the economic environment and the marketplace.

Time Series (Random Variations and Increasing Trend)

There is a constant rate of change (increasing values) as time goes by.

Time Series (Random Variations and Decreasing Trend)

There is a constant rate of change (decreasing values) as time goes by.

Time Series (Random Variations and Seasonal Variations)

o Seasonal (cyclical) variations may also be present.

o Examples: demand for resort hotels & home heating oil.

Time Series (Random Variations, Seasonal Variations and Increasing Trend)

All three components – random variations, an increasing (or decreasing) trend, and seasonal variations (cycles) may be
present simultaneously in a time series.

Forecasting Methods for Time Series

The following techniques are discussed:

1. Naïve method

2. Moving Average

3. Weighted Moving Average

4. Exponential Smoothing
Naïve Forecasts

 Uses a single previous value of a time series as the basis of a forecast.

 Virtually no cost
 Data analysis is nonexistent
 Easily understandable
 Cannot provide high accuracy
o If it were true, future will always be the same as the past
 Some notation: Forecast at time t is F(t)
 Actual observation at time t is A(t)
o Today is temperature is 98 F, A(Today)=98
o F(Tomorrow)=98
 F(Day after)=98

Uses for Naïve Forecasts

 Stable time series data

o Forecast is the same as the last actual observation
o F(t) = A(t-1)
 Seasonal variations
o Forecast is the same as the last actual observation when we were in the same point in the cycle, where a
cycle lasts n periods.
o F(t) = A(t-n)
 Data with trends
o There is constant trend, the change from (t-2) to (t-1) will be exactly as the change from (t-1) to (t)
o F(t) = A(t-1) + (A(t-1) – A(t-2))
 Check if the resulting accuracy is acceptable
 The higher the accuracy, often the higher the cost.
 Do we really need our forecast that accurate? Is it worth the additional resources?

Time Series Models: Variations

What is random and what is not?

• Historical data contain random variations or noise

• Random variations are caused by relatively unimportant factors.

• The objective is to remove all randomness and have real variations.

• Minor variations are random and large ones are real.

Techniques for Averaging

 Moving averages (MA)

o Naïve methods just trace the actual data with a lag of one period, F(t)=A(t-1)
o They don’t smooth
o MA uses several of the most recent actual data to smooth
 Weighted moving averages
 Exponential smoothing

Simple Moving Average

Note the sensitivity of forecasts
t 1

A i
Ft  MA t ,n  i t  n
,
n
MAt ,n : MA forecast made in period t - 1 using n actual observatio ns

Weighted Moving Average

 The weighted moving average (WMA) makes forecasts more responsive to the most recent actual occurrences
(e.g., demand).
 The most recent n periods are used in forecasting.
  Each period is assigned a weight between 0 and 1.
 The total of all weights adds up to one (1).

Differences with weighted moving average

Moving Average

• Advantage=Easy to compute and easy to understand

• Disadvantage=All values in the average are weighted equally

Weighted Moving Average

• Similar to moving average

• It assigns more weight to the most recent values in a time series

• Idea: most recent observations must be better indicators of the future than older observations

Exponential Smoothing

Ft  Ft 1   ( At 1  Ft 1 )  At 1  (1   )Ft 1

Idea--The most recent observations might have the highest predictive value along with the most recent forecast errors. Let us
balance them:

Picking a Smoothing Constant: Responsiveness vs. Smoothing

 The quickness of forecast adjustment to error is determined by the smoothing constant.

 The closer the alpha is to zero, the slower the forecast will be to adjust to forecast errors.
 Conversely, the closer the value of alpha is to 1.00, the greater the responsiveness to the actual observations and
the less the smoothing
 Select a smoothing constant that balances the benefits of responding to real changes if and when they occur.

Causal (Associative) forecasting

 Regression Analysis establishes a relationship between two sets of numbers that are time series.
 For example, when a series of Y numbers (such as the monthly sales of cameras over a period of years) is causally
connected with the series of X numbers (the monthly advertising budget), then it is beneficial to establish a
relationship between X and Y in order to forecast Y.
 In regression analysis X is the independent variable and Y is the dependent variable.

Regression

The regression analysis gives the relationship between X and Y by the following equation.

y = a + bx

y = Predicted (dependent) variable

x = Predictor (independent) variable

b = Slope of the line

a = Value of y when x = 0 (i.e., the height of the line at the y intercept)

Equations to calculate regression coefficients

Forecast Accuracy

Measurement is the first step to improve an activity

 What value of smoothing constant is good?

Accuracy measurement is a vital aspect of forecasting

Impossible to correctly predict future values

Important to include an indication of how big the forecast deviate from the actual values

Forecast Accuracy

Error - difference between actual value and predicted value

Mean absolute deviation (MAD)

 Average absolute error (weights all errors evenly)

Mean squared error (MSE)

 Average of squared error (weights errors according to their squared values)

Tracking signal

 Ratio of cumulative error and MAD

MAD & MSE

Forecast error  Actual  Forecast

n

| A  F | t t
MAD  t 1

n
n n

 (A  F )
t t
2
(A  F ) t t
2

MSE  t 1
 t 1
n 1 n
n

A F t t
Tracking Signal  t 1
MAD
Estimate of (forecast error) standard deviation  s  MSE
Statistics says : MSE is the unbiased estimator for the variance of forecast error.

Controlling the quality of forecast

Necessary to monitor forecast to ensure that the forecast is performing adequately

This is accomplished by comparing forecast errors to predetermined values

Errors that fall within the limits are considered acceptable

Errors outside either limit indicates that corrective action is needed.

Tracking signal values are compared to predetermined limits (+4,-4) based on judgment and experience

Upper and lower limits for individual forecast errors are calculated using control chart techniques. We will learn about
control charts in quality chapters.

Tracking Signal
Adaptive Forecasting

It’s possible to use the computer to continually monitor forecast error and adjust the values of the a and b coefficients used in
exponential smoothing to continually minimize forecast error

This technique is called adaptive smoothing.

For monitoring error randomness

Choosing a forecasting technique

 No single technique works best in every situation

 The forecast horizon
 Forecasting frequency
o Forecasting is not free
o Consider cost and accuracy
o Weigh cost-accuracy trade-offs carefully
 Forecast detail, part / product level?
 Availability of
o historical data
o computers
o able users / decision makers