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Quantitative Analysis and Business Forecasting

Chapter 05: Forecasting
Prepared by
Tasneema Khan
Assistant Professor
Dept. of Banking and Insurance
University of Dhaka
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Introduction
n Every day, managers make decisions without knowing what
will happen in the future.

n Managers are always trying to reduce this uncertainty and to

make better estimates of what will happen in the future.

n Accomplishing this is the main purpose of forecasting.

n In numerous firms (especially smaller ones), the entire

process is subjective.

n There are also many quantitative forecasting models, such as

moving averages, exponential smoothing, trend projections,
and least squares regression analysis.

n No single method is superior. Whatever works best should

be used.
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Eight Steps to Forecasting
1. Determine the use of the forecast—what objective are we
trying to obtain?

2. Select the items or quantities that are to be forecasted.

3. Determine the time horizon of the forecast—is it 1 to 30

days (short term), 1 month to 1 year (medium term), or
more than 1 year (long term)?

4. Select the forecasting model or models.

5. Gather the data or information needed to make the

forecast.

6. Validate the forecasting model.

7. Make the forecast.

8. Implement the results.

+ Types of Forecasts
+ Types of Forecasts
1. Time-Series Models

Time-series models attempt to predict the future by using historical data.

These models make the assumption that what happens in the future is a
function of what has happened in the past.

n moving average, exponential smoothing, trend projections, and

decomposition.

2. Causal Models

Causal models incorporate the variables or factors that might influence

the quantity being forecasted into the forecasting model.

Causal models may also include past sales data as time- series models do,
but they include other factors as well.

3. Qualitative Models

Whereas time-series and causal models rely on quantitative data,

qualitative models attempt to incorporate judgmental or subjective
factors into the forecasting model.
+ n who
Delphi method. This iterative group process allows experts,
may be located in different places, to make forecasts.
1. Decision maker
2. Staff personnel
3. Respondents

n Jury of executive opinion. This method takes the opinions of a

small group of high-level managers, often in combination with
statistical models, and results in a group estimate of demand.

n Sales force composite. In this approach, each salesperson

estimates what sales will be in his or her region; these forecasts
are reviewed to ensure that they are realistic and are then
combined at the district and national levels to reach an overall
forecast.

n Consumer market survey. This method solicits input from

customers or potential customers regarding their future
purchasing plans. It can help not only in preparing a forecast
but also in improving product design and planning for new
products.
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Exploring Data Pattern
n One of the most time-consuming and difficult part of
forecasting is collection of valid and reliable data.

n Most sophisticated forecasting model will fail if it is applied

to unreliable data. (GIGO)

n Four criteria are applied to the determination of whether data

will be useful:

1. Data should be reliable and accurate.

2. Data should be relevant.

3. Data should be consistent.

4. Data should be timely.

 n Types of data
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1. Cross sectional data:

Data on one or more variables collected at one point in time.

Unemployment rate Bangladesh India Pakistan Sri Lanka

2019
Year Unemployment
2. Time series data: rate
Bangladesh
Data collected over a period of time. 2019
2018
2017
2016
3. Pooled data:
2015

Year Bangladesh India Pakistan

2019
2018
2017
2016
2015
+ Time Series Forecasting :
nA time series is based on a sequence of evenly
spaced (weekly, monthly, quarterly, and so on) data
points.

Examples include weekly sales of HP personal

computers, quarterly earnings reports of Microsoft
Corporation, daily shipments of Eveready batteries,
and annual U.S. consumer price indices.

n Forecasting time series data implies that future

values are predicted only from past values, and
other variables, no matter how potentially
valuable, are ignored.
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Time Series Data Patterns:
n A time series typically has four components:

1. Trend (T) is the long term component that represents the

growth or decline in the time series over an extended period of
time.

2. Cycles (C) are patterns in annual data that occur every

several years. They are usually tied into the business cycle. The
wavelike fluctuations around the trend

3. Seasonality (S) is a pattern of the demand fluctuation above

or below the trend line that repeats at regular intervals.

4. Random variations (R) are “blips” in the data caused by

chance and unusual situations; they follow no discernible
pattern.
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Forecasting Models

Simple
Average
Naïve Model
Simple Moving
Average
Based on
Time Series
Averaging
Weighted
Moving
Average
Exponential
Smoothing
Double
Moving
Average
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Basic Forecasting Notation
n Yt = value of a time series at period t

n Ŷt = Forecast value of Yt

n et = residual or forecast error, Yt- Ŷt

Year (t) Forecast Sales Actual Sales Forecast Error

(Ŷt) (Yt) (Yt- Ŷt)

2024 500 400 -100

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Naïve Model
n Many forecasting techniques require large amount of data.

n Naïve forecasts are based solely on the most recent

information available.

Ŷt+1 = Yt

ü The naïve forecast for each period is the immediately

preceding observation.

ü 100% weight is given to the current value of the series.

ü Also called “no change” forecast

+ Simple Average
n A simple average uses the mean of all relevant historical
observations as the forecast of the next period.
+ Simple Moving Average
n A moving average of order n is the mean value of n
consecutive observations. The most recent moving average
value provides a forecast for the next period

For example, a four-month moving average is found simply by

summing the demand during the past four months and dividing
by 4. With each passing month, the most recent month’s data
are added to the sum of the previous three months’ data, and
the earliest month is dropped. This tends to smooth out short-
term irregularities in the data series.

Moving average forecast = Sum of demands in previous n

period/ n
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+ Weighted Moving Average
n A simple moving average gives the same weight to each of the past
observations being used to develop the forecast. On the other hand, a
weighted moving average allows different weights to be assigned to the
previous observations.

n As the weighted moving average method typically assigns greater weight

to more recent observations, this forecast is more responsive to changes
in the pattern of the data that occur.

n Wallace Garden Supply decides to use a 3-month weighted moving

average forecast with weights of 3 for the most recent observation, 2 for
the next observation, and 1 for the most distant observation. This would
be implemented as follows:
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+ Exponential smoothing
n Exponential smoothing is a forecasting method that is easy to
use and is handled efficiently by computers. Although it is a type
of moving average technique, it involves little record keeping of
past data. The basic exponential smoothing formula can be
shown as follows:

New Forecast = Last period’s forecast + α(Last period’s actual

demand - Last period’s forecast)

Or

New Forecast= α(new observation)+ (1-α)(old forecast)

n Where αis a weight (or smoothing constant) that has a value

between 0 and 1.

n The latest estimate of demand is equal to the old estimate

adjusted by a fraction of the error (last period’s actual demand
minus the old estimate).
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+ Measures of Forecast Accuracy
To see how well one model works, or to compare that model with other
models, the forecasted values are compared with the actual or
observed values. The forecast error (or deviation) is defined as
follows:

Forecast error = Actual value - Forecast value

et = Yt – Ŷt

A residual is the difference between an actual observed value and its

forecast value.
1. Mean Absolute Deviation (MAD)
2. Mean Squared Error (MSE)
3. Mean Absolute Percent Error (MAPE)
4. Mean Percentage Error (MPE)

The five measures of forecast accuracy just described are used

ü To compare the accuracy of two (or more) different techniques.
ü To measure a particular technique’s usefulness or reliability.
ü To help search for an optimal technique.
ü To measure biasness of a particular technique.
 1. Mean Absolute Deviation (MAD)
+ One measure of accuracy is the mean absolute deviation
(MAD). This is computed by taking the sum of the absolute
values of the individual forecast errors and dividing by the
numbers of errors (n).

MAD = Σ|forecast error|/n

 Mean Squared Error (MSE)

+ Another most common is the mean squared error (MSE), which is the
average of the squared errors:

Root Mean Squared Error (RMSE)

Mean Absolute Percent Error (MAPE)

n The mean absolute percentage error (MAPE) is computed by finding the

absolute error in each period, dividing this by the actual observed value
for that period, and averaging these absolute percentage errors.

n The final result is then multiplied by 100 and expressed as a percentage.

n This approach is useful when the error relative to the respective size of the
time series value is important in evaluating the accuracy of the forecast.

n The MAPE is especially useful when the Yt values are large.

n The MAPE has no units of measurement (it is a percentage) and can be

used to compare the accuracy of the same or different techniques on two
entirely different series.
Mean Percentage Error (MPE)
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Sometimes it is necessary to determine whether a forecasting
method is biased (consistently forecasting low or high).

The mean percentage error (MPE) is used in these cases. It is

computed by finding the error in each period, dividing this by
the actual value for that period, and then averaging these
percentage errors. The result is typically multiplied by 100 and
expressed as a percentage.

If the forecasting approach is unbiased, the MPE will produce a

number that is close to zero. If the result is a large negative
p e rc e n t a ge, t h e f o re c a s t i n g m e t h o d i s c o n s i s t e n t ly
overestimating. If the result is a large positive percentage, the
forecasting method is consistently underestimating.
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