Forecasting

Basic Concepts
And
Stationary Models
 What is Forecasting?
Forecasting is the process of predicting the future.
Forecasting is an integral part of almost all business
enterprises including
Manufacturing firms that forecast demand for their products, to
schedule manpower and raw material allocation.
Service organizations that forecast customer arrival patterns to
maintain adequate customer service.
Security analysts who forecast revenues, profits, and debt
ratios, to make investment recommendations.

Firms that consider economic forecasts of indicators (housing

starts, changes in gross national profit) before deciding on
capital investments.
 Benefits of Forecasting
Good forecasts can lead to
Reduced inventory costs
Lower overall personnel costs and increased
customer satisfaction
A higher likelihood of making profitable
financial decisions
A reduced risk of untimely financial decisions
 How Does One Prepare a
Forecast?
The forecasting process can be based on:
Educated guess.
Expert opinions.
Past history of data values, known as a time
series.
 Components of a Time Series
Long-term Trend Effects
Long-term trend is typically modeled as a linear, quadratic or
exponential.
A time series that does not exhibit any trend over time is a
stationary model.

Seasonal Effects
When a predictable, repetitive pattern is observed, the time
series is said to have seasonal effects.
Seasonal effects can be associated with calendar/climatic
changes or tied to yearly, quarterly, monthly, etc. data

Cyclical Effects
An unanticipated temporary upturn or downturn that is not
explained by seasonal effects are said to be cyclical effects.
Cyclical effects can result from changes in economic
conditions.

Random Effects
 Example
Motorhome Sales 1975-2000
Seasonal Effects Long Term Trend
Qtr 4 Lower than qtr 3
Qtr 3 Higher than qtr 2
Qtr 2 Higher than qtr 1
Qtr 1 Higher than qtr 4

Cyclical Effects
Recessions of Early 80s and 90s
75.1
75.4
76.3
77.2
78.1
78.4
79.3
80.2
81.1
81.4
82.3
83.2
84.1
84.4
85.3
86.2
87.1
87.4
88.3
89.2
90.1
90.4
91.3
92.2
93.1
93.4
94.3
95.2
96.1
96.4
97.3
98.2
99.1
99.4
00.3
Year
 Steps in the Time Series
Forecasting Process
The goal of a time series forecast is to identify
factors that can be predicted.
This is a systematic approach involving the
following steps.
Step 1: Hypothesize a form for the time series.
Collect historical data and graph the data vs. time.
Hypothesize and statistically verify a form for the time series.

Step 2: Select a forecasting technique from a set of

possible methods for the form of the time series.
Statistically determine which method best forecasts the data.

Step 3: Prepare a forecast.

Stationary Forecasting Models
A stationary model is one that forecasts a
constant time series value over time.
The general form of such a model is:
Assumptions for t
yt = b 0 + e t independent
normally distributed
have a mean of 0

Value of the True stationary Value of the

time series value of the random error
at time t time series at time t
 Determining if a Stationary Model
Is Appropriate
Is there trend?
Use Linear Regression -- Check the p-value for b1
Is there seasonality?
Visually check of time series graph
Autocorrelation measures the relationship between
the values of the time series every k periods; this is
called autocorrelation of lag k.
There are tests for doing this, but we will just do a visual
check.
Lag 7 autocorrelation indicates one week seasonality
(daily data); lag 12 autocorrelation indicates 12-month
seasonality (monthly data), etc.
Are there cyclical effects?
Visually check of time series graph.
 Moving Averages
There are t observations: y1 (oldest), y2, y3,
, yt (most recent)
In stationary forecasting models, the
forecast for the constant value, 0, for the
next time period t+1, Ft+1, is the average (or
a weighted average) of 1 or more of the
immediately prior observations, yt, yt-1, etc.
Since the time series is stationary, this
forecast for time period t+1, will be the
forecast for all future periods: t+2, t+3, etc.
The forecast changes only after more data is
collected.
 Moving Average Methods
Last Period
Ft+1 = yt
Use the last observed value of the time series

n period Moving Average

Ft+1 = (yt + yt-1 + + yt-n+1)/n
Average the last n observed values of the time series

n period Weighted Moving Average

Ft+1 = wtyt + wt-1yt-1 + wt-n+1yt-n+1
Weight the last n observed values (the ws sum to 1)

Exponential Smoothing* (*Discussed in another module)

All observations are weighted with decreasing weights
 Example
Galaxy Industries needs to forecast weekly
demand for the next three weeks for its
Yoho brand yoyo based on the past 52
weeks demand. If demand is deemed to be
stationary, use:
Last Period Technique
4-Period Moving Average Technique
4-Period Weighted Moving Average
Technique (.4, .3, .2, .1)
Time Series For the Past 52 Weeks
Week Demand Week Demand Week Demand Week Demand
1 415 14 365 27 351 40 282
2 236 15 471 28 388 41 399
3 348 16 402 29 336 42 309
4 272 17 429 30 414 43 435
5 280 18 376 31 346 44 299
6 395 19 363 32 252 45 522
7 438 20 513 33 256 46 376
8 431 21 197 34 378 47 483
9 446 22 438 35 391 48 416
10 354 23 557 36 217 49 245
11 529 24 625 37 427 50 393
12 241 25 266 38 293 51 482
13 262 26 551 39 288 52 484
 Determining if the Model Is
Stationary
No discernable seasonal
Graph the time series.
or cyclical effects.
Demand For Past 52 Weeks

700

600

500
Demand

400

300

200

100

0
0 10 20 30 40 50 60
Week
Using Regression to Test for Trend

Select Regression from

Data Analysis in Tools Menu
Using Regression to Test for Trend

Demand

Time Periods
Where output
is to begin
 Is Linear Trend Present?
Check p-value for 1.

High p-value = .71601

No indication of linear trend
Stationary model is appropriate.
 Forecasts
Since we have concluded that this is a stationary
model, we can use moving average methods.
Last Period: F53 = y52 = 484
Since model is stationary, F55 = F54 = F53 = 484
4 Period Moving Average:
F53 = (y52 + y51 + y50 + y49)/4 = (484 + 482 + 393 + 245)/4 = 401
Since model is stationary, F55 = F54 = F53 = 401
4 Period Weighted (.4, .3, .2, .1) Moving Average:
F53 = .4y52 + .3y51 + .2y50 + .1y49 =
.4(484) + .3(482) + .2(393) + .1(245) = 441.3
Since model is stationary, F55 = F54 = F53 = 441.3
 EXCEL: Last Period

=B2

Drag cell C3 down to cell C54

=C54

Drag cell C55 down to cell C56

Note:
Rows 8-43
are hidden
Excel: Moving Average Forecast

=Average(B2:B5)

Drag cell C6 down to cell C54

=C54

Drag cell C55 down to cell C56

Note:
Rows 8-43
are hidden
Excel: Weighted Moving Average

=.4*B5+.3*B4+.2*B3+.1*B2

Drag cell C6 down to cell C54

=C54

Drag cell C55 down to cell C56

Note:
Rows 8-43
are hidden
 Review
Possible Factors in a Time Series Model
Trend, Seasonal, Cyclical, Random Effects
Determining if the Time Series is Stationary
No noticeable seasonal or cyclical effects on time series
plot
Use Regression to test for 1 = 0
High p-value (No trend stationary)
Moving Average Forecasting Methods
Last Period, Moving Average, Weighted Moving
Average, Exponential Smoothing
Forecasts for next period will be the forecasts for all
future periods until additional time series values occur
Excel approach