Quant DTUT Chap5 Forecasting

CHAPTER 5
Forecasting
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Quantitative Method_ Ms. Dang Thi Uyen Thao
1. Forecasting?
OUTLINE 2. Time series
3. Time series forecasting models

1. Forecasting?
Ø Forecasting
Ø Qualitative and Quantitative models
Ø Forecasting accuracy
Forecasting
• Managers are always trying to reduce uncertainty and make better estimates
of what will happen in the future
• Forecasting includes short-term (few days, weeks, months), medium-term (1 to 3
years), and long-term (beyond medium-term).
• Short and medium-term forecasting is typically based on identifying, modeling,
and extrapolating the patterns found in historical data.
• We about to use statistical methods that are very useful for short and medium-
term forecasting.
4
Forecasting techniques
Qualitative Quantitative
Delphi
Forecasting
Time series Causal
method
Models Jury of
Executive
opinion
Averages/
Smoothing Regression
Market Trend Multiple

Survey Projections regression
Seasonal
Variations
5
1. Qualitative Models
• Qualitative models incorporate judgmental or subjective factors
• Useful when subjective factors are thought to be important or when accurate
quantitative data is difficult to obtain
• Common qualitative techniques are
• Delphi method- an iterative group process where (possibly geographically
dispersed) respondents provide input to decision makers
• Jury of executive opinion- collects opinions of a small group of high-level
managers, possibly using statistical models for analysis
• Sales force composite - individual salespersons estimate the sales in their region
and the data is compiled at a district or national level
• Consumer market surveys - input is solicited from customers or potential
customers regarding their purchasing plans
2. Quantitative Models
Quantitative forecasting makes formal use of historical data and a
forecasting model
• Time-times models assume that the future data is only related to its
own past patterns. And that other variables, no matter how potentially
valuable, are ignored.
• Causal forecasting models assume that some factors may affect the
variable we are trying to predict. They may also include past sales data as
time series models do, but they include other factors as well. Regression
analysis is the most common technique used in causal modeling

Steps in forecasting
1. Determine the time horizon of
the forecast
2. Select the forecasting models
3. Gather the data needed to
make the forecast
4. Validate and make the
forecasting model

8
Scatter Diagrams
• Sales appear to be
• Scatter diagrams are helpful when constant over time: Sales
= 250
forecasting time-series data • A good estimate of future
sales (in year 11) is 250
because they depict the relationship
between variables.
• A naïve forecasting model: sales

for each year to be the sales that
were achieved in the previous year
9
-Sales appear to
increase at a constant
rate of 10 radios each
year.
-The equation
Sales = 290 + 10(Year )
best describes this
relationship between
sales and time.
-A reasonable estimate
of radio sales in year 11
is 400, in year 12, 410
radios.

10
-This trend line may
not be perfectly
accurate
-Sales appear to be
increasing
-If we forecast future

sales, we would
probably pick a
larger figure each
year.

11
Forecast Accuracy
• We compare forecasted values with
actual values to see how well one model
works or to compare models.
Error = Actual value – Forecast value
• One measure of accuracy is the mean

absolute deviation (MAD)

12
13
Forecast Accuracy
There are other popular measures of forecast accuracy:
• The mean squared error (MSE)- the average of the squared errors:
• The mean absolute percent error (MAPE) - the average of the absolute values of
the errors expressed as percentages of the actual values:
• Bias is the average error and tells whether the forecast tends to be too high or too
low and by how much. Thus, it can be negative or positive.
14
2. Time series
Ø Time series
Ø Times series components

What is Time Series?
Time series data is data that is collected at different points in time
For example, you

might record the
outdoor temperature
at noon every day for
a year.

16
Components of a Time Series
Understanding the components of a time series will support in selecting

an appropriate forecasting technique
• Trend (T) the overall movement or general direction of the data over time
• Seasonality (S): regularly repeating patterns of highs and lows related to
calendar time such as seasons, quarters, months, days,…
• Cycles (C): Relatively long-term patterns of oscillation in the data, may take
many years to play out and usually tied into the business cycle.
• Random variations (R): random fluctuations or variations due to
uncontrolled factors, by chance or due to unusual situations, …

17
Time series components

18
Trend, Seasonal and Cyclic Pattern
• There is an increasing trend in 2000–2006, a decreasing trend in home sales in 2007-

2012 due to big financial crisis and increasing trend again till 2018.
• There is seasonality as usually the market is not active at the beginning of a year and sales
usually go high in mid-year and again sales getting lower by the end of the year. Seems
like warmer seasons (summer) is the good season for the American housing market.
23
3. Time series forecasting models
Ø Averaging/ Smoothing models: SMA, WMA, EMA

Ø Trend (only) adjusted models: Double EMA, Trend projection
Ø Seasonal adjusted models (with and without trend)
Time-Series Forecasting Models
• Understanding the components of a time series will support in selecting an

appropriate forecasting technique.
• A time series may include:

Averaging or
• No trend and no seasonal patterns smoothing models
• Trend and no seasonal patterns Trend adjusted models
• Seasonal patterns without trend
Seasonal Variations
• Seasonal patterns with trend
25
Averaging or
smoothing models
tend to smooth out short-term irregularities in the data series
1. Simple Moving Averages (SMA)
2. Weighted Moving Averages (WMA)
3. Exponential Moving Averages (EMA)

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Averaging or smoothing models
1. Simple Moving Averages (SMA): the next forecast is the average of the most
recent n data values from the time series
2. Weighted Moving Averages (WMA): use weights to put more emphasis on

recent periods and more responsive to changes in the pattern

Wallace Garden Supply
Wallace Garden Supply wants to forecast demand for its Storage Shed. Given previous monthly
sales are Jan-10, Feb-12, Mar-13, Apr-16, May-19, Jun-23, Jul-26, Aug-30, Sep-28, Oct-18,
Nov-16, Dec-14; calculate the demand in January next year:
a. Using a 3-month SMA
b. Using a 3-month WMA with weights of 3 for the most recent observation, 2 for the next
observation, and 1 for the most distant observation
c. Which model provides a more accurate projection between SMA and WMA?

30
Wallace Garden Supply
SMA WMA
WMA is always more accurate than SMA?

31
Source: Finamark

32
35
Averaging or smoothing models
3. Exponential Moving Averages (EMA): also known as Exponential Smoothing,
requires little data record, use weights that are decaying exponentially as the
observations get older. The basic exponential smoothing formula:
where
** Larger alpha gives more importance to recent data while a smaller value gives
more importance to past data
Why is it called "Exponential"?
Prove the formula
for any α between 0 and 1, the weights attached to the observations

decrease exponentially as we go back in time

37
Port of Baltimore
The port of Baltimore has unloaded large quantities of grain from ships during the past eight
quarters. The forecast of grain unloaded in the first quarter was 175 tons. Estimate the next
quarter’s data using alpha = .1 and alpha = .5. Which apha provides a more accurate result?

40
Selecting the best value of a? Larger alpha gives more importance to recent data
while a smaller value gives more importance to past data

41
• Stable demand => use
lower alpha to smooth
out random fluctuations
• Fluctuated demand =>

use higher alpha to be
more responsive to real
changes

43
PM Computer Services
PM Computer assembles customized personal computers from generic parts. The owners
purchase components in volume at a discount from a variety of sources. It is important that they
develop a good forecast of demand so they can purchase component parts efficiently. Compute
the demand for next January (Period 13)
a. Using a 3-month SMA
b. Using a 3-month WMA with weights of 4,2,1
c. Using EMA with alpha = 0.7, previous forecast of 40.
d. Using MAD, what forecast is most accurate?

45
How to get more accurate forecast?
Consider the time series with nine periods of data: 34, 38, 46, 41, 43, 48, 51, 50, 56
Assume F2 = Y1 = 34 and α = 0.2.
Use exponential smoothing to forecast the value for period 10.
How can we improve the sensitivity of the forecast by changing α upward or downward?

46
Problems with EMA
1. Does not project trends
=> solution: the exponential smoothing with trend model (known as double
exponential smoothing or Holt’s Linear method)
2. Does not recognize seasonal patterns
=> solution: the triple exponential smoothing model (or Holt-Winters

method)

Trend adjusted models
to forecast a time series with trend and irregular patterns only
4. Trend-Adjusted Exponential Smoothing (Double EMA)
5. Trend Projection

4. Trend-Adjusted Exponential Smoothing
(Double EMA)
• EMA does not respond to trends. A more complex model to adjust for trends is the
Trend-Adjusted Exponential Smoothing or Double EMA
• Simple EMA is then often referred to as first-order smoothing. Trend-adjusted
smoothing is called second-order, double EMA, double exponential smoothing, or
Holt’s Linear method
• Use two smoothing constants alpha and beta (both between 0 and 1): The
level of the forecast is adjusted by multiplying the first smoothing constant, alpha,
by the most recent forecast error and adding it to the previous forecast. The trend
is then adjusted by multiplying the second smoothing constant, beta, by the most
recent error or excess amount in the trend.
• A higher value gives more weight to recent observations and thus responds more
quickly to changes in the patterns.
4. Trend-Adjusted Exponential Smoothing
(Double EMA)
Step 1: Compute the smoothed forecast F(t + 1) for time period t+1
Step 2: Update the trend T(t+1) using the equation
Step 3: Calculate the trend-adjusted exponential smoothing forecast FIT(t+1)

Midwestern Manufacturing
Midwestern Manufacturing Company has a demand for electrical generators over 2004 to
2010. Assuming that F1 is perfect (F1 =74) and T1 is 0 and picking 0.3 and 0.4 for the
smoothing constants. Forecast the demand in 2011 using the trend-adjusted exponential
smoothing

53
Midwestern Manufacturing Company

54
5. Trend Projection
• Another method for forecasting time series with trend
• Trend projection fits a trend line to a series of historical data points. A trend
line is a linear regression equation in which the independent variable is the
time period, and the dependent variable is the actual observed value
! = a + bx
𝒚
• Several trend equations can be developed based on exponential or quadratic
models, but in this section we look at linear (straight line) trends only
5. Trend Projection
The mathematical form is ! = a + bx
𝒚
b= a=
where
! = predicted value
𝒚
a = intercept
b = slope of the line
x = time period
Midwestern Manufacturing Company has a demand for electrical generators over

2004 to 2010. Develop a trend line and forecast the demand in 2011 using the trend
projection

65
• (sum(t))^2 = 784
• b = 10.5; a = 56.7
! = 56.7 + 10.5x
• The trend line is 𝒚
• To make sale forecast for year 2011,
we denote the year 2011 as x=8 and
substitute x=8 to the trend line:
F(2011) = 56.7+10.5*8 = 141.03
• Likewise for x = 9:
F(2012) = 56.7+10.5*9 = 151.6

66
Seasonal
Variations models
to forecast a time series with seasonal patterns and with or without trend
6. Seasonal Variations in a model without trend
7. Seasonal Variations in a model with trend (A multiplicative decomposition

model)

Seasonal Variations
• Is to predict the movements in the data that contains seasonal patterns.
• Two general forms (Yt) of a time series in statistics are the product or the sum of
individual factors (Trend factor-Tt, Seasonal factor-St, Cyclic factor-Ct, Random factor-Rt)
• If the magnitude of the seasonal fluctuations does not vary with the level of time
series, a time series can be measured by an additive model in the form
Yt = Tt + Ct + St + Rt
• If the magnitude of the seasonal fluctuations increase or decrease proportionally with
increases and decreases in the level of the series, a time series can be measured by
a multiplicative model in the form Yt = Tt × Ct × St × Rt
• Seasonal patterns in a multiplicative time series can be measured by a seasonal index
which indicates how a particular season compares with an average season
• Seasonal patterns in an additive time series can be measured by seasonal dummies in
multiple regression which present seasons
75
Multiplicative and Additive models

Seasonal Variations in a multiplicative model
• Seasonal patterns in a multiplicative time series can be measured by a seasonal

index (SI) which indicates how a particular season compares with an average
season
• Model 6: When no trend is present, a seasonal index is a ratio of an average
season to an overall average.
• Model 7: When both trend and seasonal components are present, the seasonal
indices can be computed by a centered moving average (CMA) approach.
Season patterns are removed from a time series by dividing actual data by
seasonal indices
6. Seasonal Variations in with no trend
• When no trend is present, a seasonal index (SI) can be found by dividing the
average value for a particular season by the overall average of all the data
(grand average). SI is used to adjust future forecasts
• An index of 1 means the season is average.
• For ex, if the average sales in January were 120 and the average sales in all
months were 200, the seasonal index for January = 120/200 = .6
=> January is below average

Eichler Supplies
Eichler Supplies sells telephone answering

machines. Monthly sales been collected for the
past two years.
Suppose we expected the third year’s annual
demand for answering machines to be 1,200 units.
Create a forecast that includes seasonality

79
Eichler Supplies
Step 1: Calculate the average demand in each month

80
Eichler Supplies
Step 2: Calculate the overall average of all data

81
Eichler Supplies
Step 3: Calculate the seasonal index for each month by dividing the average
demand in each month by the overall average

82
Eichler Supplies
Step 4: Use seasonal indices to adjust future forecasts

83
7. Seasonal Variations with Trend
• A change from one month to the
next could be due to a trend, to a
seasonal variation, or simply to
random fluctuations.
• The seasonal indices can be
computed by a centered moving
average (CMA) approach to
prevent a variation due to trend
from being incorrectly interpreted
as a variation due to the season.
7. Seasonal Variations with Trend
• The process of isolating linear trend and seasonal factors to develop more accurate
forecasts is called decomposition.
• The original time series is often split into 3 component series:

o Seasonal: Patterns that repeat with a fixed period of time.
o Trend: The underlying trend of the metrics.
o Random: the residuals after the seasonal and trend series are removed.

Step 1. Deseasonalization is to remove
seasonal patterns from the data by
dividing each data by its seasonal index
to get a new time series with no
seasonal factors.
Calculate the seasonal index using

CMAs (center moving average)
* Compute a CMA
* Seasonal ratio = Observation/CMA
* Average seasonal ratios to get SI
* If seasonal indices do not add to
the number of seasons, multiply each
index by (Number of seasons)/(Sum of
the indices)
Step 2. Develop a trend line using the
deseasonalised data
Step 3. Forecast for future periods

using the trend line and incorporate
seasonal patterns by multiplying
appropriate SI back to a trend line

Turner Industries
Quarterly sales figures for Turner Industries are shown below.

a. Do we observe any trends and/or seasonality in the data? Determine what the
systematic component is composed of
b. Apply the appropriate forecasting technique to forecast the sales data

94
Turner Industries_ Fit to a trend line
• There is a definite trend as

the total each year is
increasing
• There is an increase for each

quarter from one year to the
200 – next => The seasonal
150 – component is obvious as
100 –
there is a similar pattern over
years of the definite drop
Sales
50 – from the fourth quarter of one

0– year to the first quarter of the
| | | | | | | | | | | |
next.
1 2 3 4 5 6 7 8 9 10 11 12
Time Period
95
Turner Industries_ Forecasting
Step 1. Deseasonalise with Seasonal Index (by CMAs)

* Compute CMAs

96

* Seasonal ratio = Observation/CMA

97
* Average seasonal ratios to get SI

98

* If seasonal indices do not add to the number of seasons, multiply each index
by (Number of seasons)/(Sum of the indices)
0.85 + 0.96 + 1.13 + 1.06 = 4

=> stop here

99

100

101
Turner Industries
Industries_ Forecasting
Step 2. Develop a trend line using the deseasonalised data
b = 2.34; a = 124.78
Yˆ = 124.78 + 2.34X

102
Turner Industries_
Industries Forecasting
Step 3. Forecast for future periods using the trend line and incorporate
seasonal patterns by multiplying appropriate SI back to a trend line
= 124.78 + 2.34*x
= 155.2 x 0.85

103
Turner Industries_
Industries Forecasting
180
170
160
150
140
130
120
110
100
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
SALES Deseasonaliz ed Trend Forecast

104
8. Seasonal Variations in an additive model
• Multiple regression may be used to forecast an additive model with both trend
and seasonal components present in a time series.
• Multiple regression with one independent variable (time values) and other
dummy variables to indicate the season (one fewer than the number of periods)
• The basic model is an additive decomposition model as follows:
Yˆ= a + b1 X1 + b2 X 2 + b3 X 3 + b4 X 4
Where X1. = time period
X2 = 1 if quarter 2, 0 otherwise
Turner
Turner Industries
Industries_ Fit to a trend line
If X2 = X3 = X4 = 0, then the quarter would be quarter 1.
The model is expressed as:
Yˆ = a + b1X1 + b2X2 + b3X3 + b4X4
Excel output are:

a = 104.1, b1 = 2.3, b2 = 15.7, b3 = 38.7, b4 = 30.1
Or, Y = 104.1 + 2.3X1 + 15.7X2 + 38.7X3 + 30.1X4
Forecast sales in Q1 of Y4
Y = 104.1 + 2.3 * 13 + 15.7 * 0 + 38.7 * 0 + 30.1 * 0 = 134F
Forecast sales in Q2 of Y4
Y = 104.1 + 2.3 * 14 + 15.7 * 1 + 38.7 * 0 + 30.1 * 0 = 152F
*** These are not the same values using the multiplicative decomposition method
=> compare the MAD to check which one is better
108
Averaging or 1. Simple Moving Average (SMA)
Smoothing
techniques 2. Weighted Moving Average (WMA)
Time series with no
trends or seasonal
patterns 3. Exponential Moving Average (EMA)
4. Double EMA
Forecasting Time series
with trend patterns
only 5. Trend projection
Models Time series 6. Seasonal Variations in a multiplicative
with
seasonal patterns model without trend
(with/without trend)
in a multiplicative 7. A multiplicative decomposition model
and
an additive model
8. An additive decomposition model

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CHAPTER 5

© 2018 Slidefabric.com All rights reserved.

OUTLINE 2. Time series

3. Time series forecasting models

Market Trend Multiple

© 2018 Slidefabric.com All rights reserved.

© 2018 Slidefabric.com All rights reserved.

• A naïve forecasting model: sales

© 2018 Slidefabric.com All rights reserved.

-If we forecast future

© 2018 Slidefabric.com All rights reserved.

Error = Actual value – Forecast value

• One measure of accuracy is the mean

© 2018 Slidefabric.com All rights reserved.

Quantitative Method_ Ms. Dang Thi Uyen Thao

For example, you

© 2018 Slidefabric.com All rights reserved.

Understanding the components of a time series will support in selecting

© 2018 Slidefabric.com All rights reserved.

© 2018 Slidefabric.com All rights reserved.

• There is an increasing trend in 2000–2006, a decreasing trend in home sales in 2007-

Ø Averaging/ Smoothing models: SMA, WMA, EMA

• Understanding the components of a time series will support in selecting an

• A time series may include:

1. Simple Moving Averages (SMA)

2. Weighted Moving Averages (WMA)

3. Exponential Moving Averages (EMA)

2. Weighted Moving Averages (WMA): use weights to put more emphasis on

© 2018 Slidefabric.com All rights reserved.

© 2018 Slidefabric.com All rights reserved.

WMA is always more accurate than SMA?

© 2018 Slidefabric.com All rights reserved.

Prove the formula

for any α between 0 and 1, the weights attached to the observations

© 2018 Slidefabric.com All rights reserved.

© 2018 Slidefabric.com All rights reserved.

© 2018 Slidefabric.com All rights reserved.

• Fluctuated demand =>

© 2018 Slidefabric.com All rights reserved.

© 2018 Slidefabric.com All rights reserved.

© 2018 Slidefabric.com All rights reserved.

2. Does not recognize seasonal patterns

=> solution: the triple exponential smoothing model (or Holt-Winters

© 2018 Slidefabric.com All rights reserved.

4. Trend-Adjusted Exponential Smoothing (Double EMA)

© 2018 Slidefabric.com All rights reserved. 49

Step 2: Update the trend T(t+1) using the equation

Step 3: Calculate the trend-adjusted exponential smoothing forecast FIT(t+1)

© 2018 Slidefabric.com All rights reserved.

© 2018 Slidefabric.com All rights reserved.

© 2018 Slidefabric.com All rights reserved.

Midwestern Manufacturing Company has a demand for electrical generators over

© 2018 Slidefabric.com All rights reserved.

© 2018 Slidefabric.com All rights reserved.

6. Seasonal Variations in a model without trend

7. Seasonal Variations in a model with trend (A multiplicative decomposition

© 2018 Slidefabric.com All rights reserved. 74

© 2018 Slidefabric.com All rights reserved.

• Seasonal patterns in a multiplicative time series can be measured by a seasonal

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Eichler Supplies sells telephone answering

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Step 1: Calculate the average demand in each month

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