Forecasting

Dr. Chang-Hun Lee

Learning Objectives
1. Forecasting Components
2. Time Series Methods
3. Forecast Accuracy
4. Time Series Forecasting Using Excel
5. Regression Methods
Forecasting?
• A Forecast is a prediction of what will occur in the future.
Example)
o Meteorologists forecasts weather
o Sportscasters predicts the winners of football game
o Managers of business firms attempt to predict the future demand,
making decisions in the present.

à How? : Judgement, opinion, or past experiences

+ a number of mathematical methods
Forecasting Components
• A variety of forecasting methods are available for use
depending on the time frame of the forecast and the
existence of patterns.

• Time Frames:
– Short-range (one to two months)

– Medium-range (two months to one or two years)

– Long-range (more than one or two years)

Forecasting Components
• Patterns:
• Trend - A long-term movement of the item being forecast.
• Cycle - A movement, up or down, that repeats itself over
a lengthy time span.
• Seasonal pattern - Oscillating movement in demand that
occurs periodically in the short run.
• Random variations - movements that are not predictable
and follow no pattern
Trend Component
• Overall Upward or Downward Movement

• Data Taken Over a Period of Years

Sales
pw ard trend
U

Time
Cyclical Component

• Upward or downward Swings

• May vary in Length

• Usually lasts 2 - 10 Years

Cycle

Sales

Time
Seasonal Component

• Upward or Downward Swings

• Regular Patterns

• Observed Within 1 Year or short-term

Sales seasonality

Time (Monthly or Quarterly)

Random or Irregular Component
• Erratic, Nonsystematic, Random, ‘Residual’ Fluctuations

• Due to Random Variations of

– Nature
– Accidents

• Short Duration and Non-repeating

Patterns
Figure: (a) Trend; (b) Cycle; (c) Seasonal; (d) Trend with Season
Forecasting Methods
1. Times Series - Statistical techniques that use historical
data to predict future behavior.

2. Regression Methods - Regression (or causal) methods

that attempt to develop a mathematical relationship
between the item being forecast and factors that cause
it to behave the way it does.

3. Qualitative Methods - Methods using judgment,

expertise and opinion to make forecasts.
Qualitative Methods
• “Jury of executive opinion,” a qualitative technique, is the
most common type of forecast for long-term strategic planning.
– Performed by individuals or groups within an organization,
sometimes assisted by consultants and other experts,
whose judgments and opinions are considered valid for
the forecasting issue.

– Usually includes specialty functions such as marketing,

engineering, purchasing, etc., in which individuals have
experience and knowledge of the forecasted item.
Time Series Methods Overview
• Statistical techniques that make use of historical data
collected over a long period of time.
• Methods assume that what has occurred in the past
will continue to occur in the future.
• Forecasts based on only one factor - time.
Moving Average
• Moving average uses values from the recent past to develop
forecasts.
• This dampens random increases and decreases.
• Useful for forecasting relatively stable items that do not
display any trend or seasonal pattern.
• Formula for moving average (MA):
n
å Di
MAn = i =1
n
where:
n = number of periods in the moving average
D = data in period i
i
Moving Average
Ex: Instant Paper Clip Supply Company wants to forecast orders for the month of
November.

Develop (1) three-month and (2) five-month moving averages using the data.

Month Orders Delivered per Month

(1) Three-month moving average
January 120
February 90 3
å Di
March 100 MA3 = i =1 = 90 +110 +130 =110 orders
April 75 3 3
May 110
June 50 (2) Five-month moving average
July 75 5
August 130 å Di
MA5 = i =1 = 90 +110 +130 + 75 + 50 = 91 orders
September 110 5 5
October 90
Moving Average
Comparison: Three- and five-month moving averages

Month Orders per Month 3-Month Moving Average 5-Month Moving Average
January 120 — —
February 90 — —
March 100 — —
April 75 103.3 —
May 110 88.3 —
June 50 95.0 99.0
July 75 78.3 85.0
August 130 78.3 82.0
September 110 85.0 88.0
October 90 105.0 95.0
November — 110.0 91.0
Moving Average
Comparison: Three- and five-month moving averages
Moving Average
• Longer-period moving averages react more slowly to
changes in demand than do shorter-period moving
averages.
• The appropriate number of periods to use often requires
trial-and-error experimentation.
• A moving average does not react well to changes
(trends, seasonal effects, etc.) but is easy to use and
inexpensive.
• Good for short-term forecasting.
Weighted Moving Average
• In a weighted moving average, weights are assigned to the most
recent data.
n
WMA = å W D
n i =1 i i

where Wi = the weight for period i, between 0% and 100% (0.00 – 1.00)
åWi = 1.00
Example: Paper clip company weight 50% for October, 33% for
September, 17% for August:
3
WMA = å W D = (.50)(90) + (.33)(110) + (.17)(130) = 103.4 orders
3 i =1 i i

• Determining precise weights and the number of periods requires

trial-and-error experimentation.
Exponential Smoothing: simple exponential smoothing

• Exponential smoothing weights recent past data more strongly

than more distant data.
• Two forms: (1) simple exponential smoothing and (2) adjusted
exponential smoothing.
a
• Simple exponential smoothing: • Most commonly used
Ft +1 values : 0.10 ~0.50

where: • Determination is usually

judgmental and
Ft +1 = the forecast for the next period subjective, and often
based on trial-and-error
experimentation
Dt = actual demand in the present period
Ft = the previously determined forecast for the present period
a = a weighting factor (smoothing constant)
 Exponential Smoothing: simple exponential smoothing
PM Computer Services example: Exponential smoothing forecasts using
smoothing constant of .30, and .50
Period Month Demand Forecast, Ft +1 a = .30 Forecast, Ft +1 a = .50

1 January 37 37 37
2 February 40 37.00 37.00
3 March 41 37.90 38.50
4 April 37 38.83 39.75
5 May 45 38.28 38.37
6 June 50 40.29 41.68
7 July 43 43.20 45.84
8 August 47 43.14 44.42
9 September 56 44.30 45.71
10 October 52 47.81 50.85
11 November 55 49.06 51.42
12 December 54 50.84 53.21
13 January — 51.79 53.61

• Forecast for period 2 (February): F2 = a D1 + (1 - a )F1 = (.30 )(.37 ) + (1 - .30 )(.37 ) = 37 units
• Forecast for period 3 (March): F3 = a D2 + (1 - a )F2 = (.30 )(.40 ) + (1 - .30 )( 37 ) = 37.9 units
Exponential Smoothing: simple exponential smoothing
Comparison : Exponential smoothing forecasts

• The forecast that uses the higher smoothing constant (.50) reacts more strongly to changes in
demand than does the forecast with the lower constant (.30).
à Low smoothing constants are appropriate for stable data without trend
à higher constants appropriate for data with trends.

• Both forecasts lag behind actual demand.

• Both forecasts tend to be consistently lower than actual demand.
Exponential Smoothing : Adjusted exponential smoothing

• Adjusted exponential smoothing

=exponential smoothing + a trend adjustment factor
Formula AFt +1 = Ft +1 + Tt +1
where:
T = an exponentially smoothed trend factor

Tt = the last period trend factor

b = smoothing constant for trend (a value between zero and one).

• Reflects the weight given to the most recent trend data.

• Determined subjectively.
Exponential Smoothing : Adjusted exponential smoothing

Example: PM Computer Services exponentially smoothed

forecasts with a = .50 and b = .30 (see Table next slide).

Adjusted forecast for period 3:

T3 = b (F3 - F2 ) + (1 - b )T2
= (.30 )( 38.5 - 37.0 ) + (.70 )( 0 ) = 0.45
AF3 = F3 + T3 = 38.5 + 0.45 = 38.95
Exponential Smoothing : Adjusted exponential smoothing
Table: Adjusted exponentially smoothed forecast values
Period Month Demand Forecast ( Ft +1 ) Trend (Tt +1 )
. Adjusted Forecast ( AFt +1 )
1 January 37 — — —
2 February 40 37.00 0.00 37.00
3 March 41 38.50 0.45 38.95
4 April 37 39.75 0.69 40.44
5 May 45 38.37 0.07 38.44
6 June 50 41.68 1.04 42.73
7 July 43 45.84 1.97 47.82
8 August 47 44.42 0.95 45.37
9 September 56 45.71 1.05 46.76
10 October 52 50.85 2.28 53.13
11 November 55 51.42 1.76 53.19
12 December 54 53.21 1.77 54.98
13 January — 53.61 1.36 54.96
Exponential Smoothing : Adjusted exponential smoothing
Comparison: Adjusted exponentially smoothed forecast

• The adjusted forecast is consistently higher than the simple exponentially

smoothed forecast.

• It is more reflective of the generally increasing trend of the data.

Linear Trend Line
• When demand displays an obvious trend over time, a least
squares regression line, or linear trend line, can be used to
forecast.
• Formula:
y = a + bx b = å xy - nxy
å x2 - nx
Where
a = y - bx
a = intercept (at period 0) where:
b = slope of the line n = number of periods
x = the time period x = ånx
y = forecast for demand for period x y = åny
Linear Trend Line : PM Computer Service example
Table: Least squares calculations
x (period) y (demand) xy
xy

x2
x squared.

1 37 37 1
2 40 80 4
3 41 123 9
4 37 148 16
5 45 225 25
6 50 300 36
7 43 301 49
8 47 376 64
9 56 504 81
10 52 520 100
11 55 605 121
12 54 648 144
(sum) :78 :557 :3,867 :650
Linear Trend Line
Comparison: Linear trend line

• A trend line does not adjust to a change in the trend as does the
exponential smoothing method.

• This limits its use to shorter time frames in which the trend will not change.
Seasonal Adjustments
• A seasonal pattern is a repetitive up-and-down movement in demand.

• Seasonal patterns can occur on a quarterly, monthly, weekly, or daily basis.

• A seasonal factor can be determined by dividing the actual demand for

each seasonal period by total annual demand:
Di
Si =
åD
• Seasonal factors lie between zero and one and represent the portion of total
annual demand assigned to each season.

• A seasonally adjusted forecast can be developed by multiplying the

normal forecast by a seasonal factor.
Seasonal Adjustments
Example: Demand for turkeys at Wishbone Farms

Year Demand Demand Demand Demand Total D1 42.0

S1 = = = 0.28
å D 148.7
(1,000s) (1,000s) (1,000s) (1,000s)
Quarter 1 Quarter 2 Quarter 3 Quarter 4

1 12.6 8.6 6.3 17.5 45.0 D2 29.5

S2 = = = 0.20
2 14.1 10.3 7.5 18.2 50.1
å D 148.7
3 15.3 10.6 8.1 19.6 53.6
D3 21.9
Total 42.0 29.5 21.9 55.3 148.7 S3 = = = 0.15
å D 148.7
D4 55.3
S4 = = = 0.37
å D 148.7
Seasonal Adjustments
• Multiply forecasted demand for an entire year by
seasonal factors to determine the quarterly demand.
• Forecast for entire year (trend line for data of Wishbone Farms):
y = 40.97 + 4.30 x = 40.97 + 4.30 ( 4 ) = 58.17
• Seasonally adjusted forecasts:
SF1 = (S1 )(F5 ) = (.28 )( 58.17 ) = 16.28
SF2 = (S2 )(F5 ) = (.20 )( 58.17 ) = 11.63
SF3 = (S3 )(F5 ) = (.15 )( 58.17 ) = 8.73
SF4 = (S4 )(F5 ) = (.37 )( 58.17 ) = 21.53
Forecast Accuracy- Overview
• Forecasts will always deviate from actual values.
• Difference between forecasts and actual values are
referred to as forecast error.
• We would like forecast error to be as small as possible.
• If forecast error is large, either the technique being used
is the wrong one, or the parameters need adjusting.
Forecast Accuracy- Overview
• Measures of forecast errors:
– Mean Absolute deviation (MAD)
– Mean absolute percentage deviation (MAPD)
– Cumulative error (E bar)
– Average error, or bias (E)
Mean Absolute Deviation
• MAD is the average absolute difference between the forecast and
actual demand.
• The most popular and simplest-to-use measures of forecast error.
• Formula:

å Dt -Ft
MAD = n
Where
t = the period number
Dt = demand in period t
Ft = the forecast for period t
n = the total number of periods
Mean Absolute Deviation: PM Computer Services
Table: Computational values for MAD and error
Forecast, Ft , (α = .30) Error, (Dt - Ft ) Dt - Ft
vertical bar, D sub t minus

Period Demand, Dt
1 37 37.00 — —
2 40 37.00 3.00 3.00
3 41 37.90 3.10 3.10
4 37 38.83 −1.83 1.83
5 45 38.28 6.72 6.72
6 50 40.29 9.71 9.71
7 43 43.20 −0.20 0.20
8 47 43.14 3.86 3.86
9 56 44.30 11.70 11.70
10 52 47.81 4.19 4.19
11 55 49.06 5.94 5.94
12 54 50.84 3.16 3.16
Blank 520* Blank 49.31 53.41

å Dt - Ft 53.41
MAD = n = = 4.85
11
Mean Absolute Deviation
• The lower the value of MAD relative to the magnitude of
the data, the more accurate the forecast: Compare
accuracies of different forecasts using MAD
• When viewed alone, MAD is difficult to assess : MAD
must be considered in light of magnitude of the data.
Mean Absolute Deviation
• Can be used to compare the accuracy of different forecasting
techniques working on the same set of demand data (P M
Computer Services):
– Exponential smoothing (a = .50): MAD = 4.04
– Adjusted exponential smoothing (a = .50, b = .30): MAD =
3.81
– Linear trend line: MAD = 2.29
• The linear trend line has the lowest MAD; increasing a from .30
to .50 improved the smoothed forecast.
Mean Absolute Deviation – percentage deviation

• A variation on MAD is the mean absolute percent deviation (MAPD).

• Measures the absolute error as a percentage of demand rather than per

period.

• Eliminates the problem of interpreting the measure of accuracy relative to the

magnitude of the demand and forecast values.

• Formula:
å Dt - Ft 53.41
MAPD = = = .103 or 10.3%
åDt 520
• MAPD for other three forecasts:
• Exponential smoothing (a = .50): MAPD = 8.5%
• Adjusted exponential smoothing (a = .50, b = .30): MAPD= 8.1%
• Linear trend: MAPD = 4.9%
Cumulative Error
• Cumulative error is the sum of the forecast errors (E = å et ).
• A relatively large positive value indicates the forecast is biased
low, a large negative value indicates the forecast is biased high. A
value close to zero implies “lack of bias”
• The cumulative error for a trend line is always almost zero, and
is therefore not a good measure for this method.
• The cumulative error for PM Computer Services can be read directly
from the table

• E = å et = 49.31, indicating the forecasts are frequently below

actual demand.
• Average error for the exponential smoothing forecast:
ået 49.31
E= n = = 4.48
11
Example Forecasts by Different Measures
Table: Comparison of forecasts for PM Computer Services
E power minus
Forecast MAD MAPD (%) E E
Exponential smoothing 4.85 10.3 49.31 4.48
( α = .30).
Exponential smoothing 4.04 8.5 33.21 3.02
(α = .50).
Adjusted exponential smoothing 3.81 8.1 21.14 1.92
(α = .50, β = .30).
Linear trend line 2.29 4.9 — —

Results consistent for all forecasts:

• Larger value of alpha is preferable for the exponential smooting.
• Adjusted forecast is more accurate than exponential smoothing.
• Linear trend is more accurate than all the others.
Time Series Forecasting Using Excel
Time Series Forecasting Using Excel
Time Series Forecasting Using Excel
Time Series Forecasting Using Excel
Overview - Linear Regression
• Time series techniques relate a single variable being
forecast to time.
• Regression is a forecasting technique that measures the
relationship of one variable to one or more other
variables.
• The simplest form of regression is linear regression.
Linear Regression
Linear regression relates demand (dependent variable )
to an independent variable.
y = a + bx
a = y - bx

b = å xy2 - nxy
å x - nx
2

where:
x = ånx = mean of the x data

y = åny = mean of the y data

Linear Regression Example
State University Athletic Department.

x (wins) y (attendance, x y. x
Wins Attendance 1,000s) xy x2
square
4 36,300 d.
6 40,100 4 36.3 145.2 16
6 41,200 6 40.1 240.6 36
8 53,000 6 41.2 247.2 36
6 44,000 8 53.0 424.0 64
7 45,600 6 44.0 264.0 36
5 39,000 7 45.6 319.2 49
7 47,500 5 39.0 195.0 25
7 47.5 332.5 49
49 346.7 2,167.7 311

Table 15.10 Least squares computations

Linear Regression Example

x = 49 = 6.125
8

y = 346.9 = 43.34
8

b = å xy - nxy = (2,167.70 -(8)(6.125)(43.34) = 4.06

2 2 (311) - (8)(6.125)2
å x - nx

a = y - bx = 43.34 -(.406)(6.125) =18.46

Therefore, y =18.46 + 4.06 x
Attendance forecast for x = 7 wins is
y =18.46 + 4.06(7) = 46.88 or 46,880
Linear Regression Example
Figure 15.6 Linear regression line
Correlation
• Correlation is a measure of the strength of the
relationship between independent and dependent
variables.
Formula: nå xy - å x å y
r=
ê nå x - ( å x ) ú ê nå y - ( å y ) ú
é 2 2ùé 2 2ù
ë ûë û

• Value lies between +1 and −1.

• Value of zero indicates little or no relationship
between variables.
• Values near 1.00 and −1.00 indicate a strong linear
relationship.
Correlation
Value for State University example:

r= (8)(2,167.7) -(49)(346.7) =.948

ê(8)(311) - (49) ú ê(8)(15,224.7) - (346.7) ú
é 2 ùé 2 ù
ë ûë û

Since the value is close to one, we have evidence of a

strong linear relationship.
Coefficient of Determination
• The coefficient of determination is the percentage of the
variation in the dependent variable that results from the
independent variable.
• Computed by squaring the correlation coefficient, r.

For the State University example:

r = .948, r 2 = .899

• This value indicates that 89.9% of the amount of variation in

attendance can be attributed to the number of wins by the
team, with the remaining 10.1% due to other, unexplained,
factors.
Regression Analysis with Excel
Regression Analysis with Excel
Regression Analysis with Excel
Regression Analysis with Excel
Regression Analysis with Excel
Multiple Regression with Excel
Multiple regression relates demand to two or more
independent variables.
General form:
y = b0 + b1x1 + b2 x2 + . . . + bk xk
where β0 = the intercept
β1 . . . βk = parameters representing
contributions of the independent
variables
x1 . . . xk = independent variables
Multiple Regression with Excel
State University example revisited; does the addition of
promotional and advertising expenditures to wins improve
the prediction of attendance?
Wins Promotion ($) Attendance
4 29,500 36,300
6 55,700 40,100
6 71,300 41,200
8 87,000 53,000
6 75,000 44,000
7 72,000 45.600
5 55,300 39,000
7 81,600 47,500
Multiple Regression with Excel
Multiple Regression with Excel