forecasting

Definition
A planning tool that helps management in its attempts to cope with the uncertainty of the future, relying mainly on data from the past and present and analysis of trends. Forecasting starts with certain assumptions based on the management's experience, knowledge, and judgment. These estimates are projected into the coming months or years using one or more techniques such as BoxJenkins models, Delphi method, exponential smoothing, moving averages, regression analysis, and trend projection. Since any error in the assumptions will result in a similar or magnified error in forecasting, the technique of sensitivity analysis is used which assigns a range of values to the uncertain factors (variables). A forecast should not be confused with a budget. See also backcasting.
Managers use forecasts for budgeting purposes. A forecast aids in determining volume of production, inventory needs, labor hours required, cash requirements, and financing needs. A variety of forecasting methods are available. However, consideration has to be given to cost, preparation time, accuracy, and time period. The manager must understand clearly the assumptions on which a particular forecast method is based to obtain maximum benefit. This post provides overview of available forecasting methods, particularly the qualitative approach. Management in both private and public organizations typically operates under conditions of uncertainty or risk. Probably the most important function of business is forecasting, which is a starting point for planning and budgeting. The objective of forecasting is to reduce risk in decision making. In business, forecasts form the basis for planning capacity, production and inventory, manpower, sales and market share, finances and budgeting, research and development, and top managements strategy. Sales forecasts are especially crucial aspects of many financial management activities, including budgets, profit planning, capital expenditure analysis, and acquisition and merger analysis. Which Area and Why Use Forecasts Forecasts are needed for marketing, production, purchasing, manpower, and financial planning. Further, top management needs forecasts for planning and implementing long-term strategic objectives and planning for capital expenditures. More specifically, here are who and why they need to forecast: Marketing managers use sales forecasts to determine optimal sales force allocations, set sales goals, and plan promotions and advertising. Market share, prices, and trends in new product development are also required. Production planners need forecasts in order to: schedule production activities, order materials, establish inventory levels and plan shipments. Other areas that need forecasts include material requirements (purchasing and procurement), labor scheduling, equipment purchases, maintenance requirements, and plant capacity planning. As soon as the company makes sure that it has enough capacity, the production plan is developed. If the company does not have enough capacity, it will

require planning and budgeting decisions for capital spending for capacity expansion. On this basis, the manager must estimate the future cash inflow and outflow. He or she must plan cash and borrowing needs for the companys future operations. Forecasts of cash flows and the rates of expenses and revenues are needed to maintain corporate liquidity and operating efficiency. In planning for capital investments, predictions about future economic activity are required so that returns or cash inflows accruing from the investment may be estimated. Forecasts are needed for money and credit conditions and interest rates so that the cash needs of the firm may be met at the lowest possible cost. Forecasts also must be made for interest rates, to support the acquisition of new capital, the collection of accounts receivable to help in planning working capital needs, and capital equipment expenditure rates to help balance the flow of funds in the organization. Sound predictions of foreign exchange rates are increasingly important to managers of multinational companies. Long-term forecasts are needed for the planning of changes in the companys capital structure. Decisions on issuing stock or debt to maintain the desired financial structure require forecasts of money and credit conditions. The personnel department requires a number of forecasts in planning for human resources. Workers must be hired, trained, and provided with benefits that are competitive with those available in the firms labor market. Also, trends that affect such variables as labor turnover, retirement age, absenteeism, and tardiness need to be forecast for planning and decision making. Managers of nonprofit institutions and public administrators also must make forecasts for budgeting purposes. Hospital administrators forecast the healthcare needs of the community. In order to do this efficiently, a projection has to be made of: growth in absolute size of population, changes in the number of people in various age groupings, and varying medical needs these different age groups will have. Universities forecast student enrollments, cost of operations, and, in many cases, the funds to be provided by tuition and by government appropriations. The service sector, which today accounts for two-thirds of the U.S. gross domestic product, including banks, insurance companies, restaurants, and cruise ships, needs various projections for its operational and long-term strategic planning. The bank has to forecast: Demands of various loans and deposits Money and credit conditions so that it can determine the cost of money it lends.

Forecasting Methods The company may choose from a wide range of forecasting techniques. There are basically two approaches to forecasting, qualitative and quantitative: [1]. Qualitative approach forecasts based on judgment and opinion: Executive opinions Delphi technique

Sales force polling Consumer surveys [2]. Quantitative approach [a]. Forecasts based on historical data Naive methods Moving average Exponential smoothing Trend analysis Decomposition of time series [b]. Associative (causal) forecasts Simple regression Multiple regression Econometric modeling Selection of Forecasting Method The choice of a forecasting technique is influenced significantly by the stage of the product life cycle and sometimes by the firm or industry for which a decision is being made. In the beginning of the product life cycle, relatively small expenditures are made for research and market investigation. During the first phase of product introduction, these expenditures start to increase. In the rapid growth stage, considerable amounts of money are involved in the decisions, so a high level of accuracy is desirable. After the product has entered the maturity stage, the decisions are more routine, involving marketing and manufacturing. These are important considerations when determining the appropriate sales forecast technique. After evaluating the particular stages of the product and firm and industry life cycles, a further probe is necessary. Instead of selecting a forecasting technique by using whatever seems applicable, decision makers should determine what is appropriate. Some of the techniques are quite simple and rather inexpensive to develop and use. Others are extremely complex, require significant amounts of time to develop, and may be quite expensive. Some are best suited for short-term projections, others for intermediate- or long-term forecasts. What technique or techniques to select depends on six criteria: What is the cost associated with developing the forecasting model, compared with potential gains resulting from its use? The choice is one of benefit-cost trade-off.

How complicated are the relationships that are being forecasted? Is it for short-run or long-run purposes? How much accuracy is desired? Is there a minimum tolerance level of errors? How much data are available? Techniques vary in the amount of data they require. Quantitative models work superbly as long as little or no systematic change in the environment takes place. When patterns or relationships do change, by themselves, the objective models are of little use. It is here where the qualitative approach, based on human judgment, is indispensable. Because judgmental forecasting also bases forecasts on observation of existing trends, they too are subject

to a number of shortcomings. The advantage, however, is that they can identify systematic change more quickly and interpret better the effect of such change on the future. We discuss the qualitative forecasting method in the next section [I will take several quantitative methods, along with their illustrations, next time]. Qualitative Forecasting Methods The qualitative (or judgmental) approach can be useful in formulating short-term forecasts and can also supplement the projections based on the use of any of the quantitative methods. Four of the better-known qualitative forecasting methods are executive opinions, the Delphi method, sales-force polling, and consumer surveys: [1]. Executive Opinions The subjective views of executives or experts from sales, production, finance, purchasing, and administration are averaged to generate a forecast about future sales. Usually this method is used in conjunction with some quantitative method, such as trend extrapolation. The management team modifies the resulting forecast, based on their expectations. The advantage of this approach is; that the forecasting is done quickly and easily, without need of elaborate statistics. Also, the jury of executive opinions may be the only means of forecasting feasible in the absence of adequate data. The disadvantage: however, is that of group think. This is a set of problems inherent to those who meet as a group. Foremost among these are high cohesiveness, strong leadership, and insulation of the group. With high cohesiveness, the group becomes increasingly conforming through group pressure that helps stifle dissension and critical thought. Strong leadership fosters group pressure for unanimous opinion. Insulation of the group tends to separate the group from outside opinions, if given. [2]. Delphi Method This is a group technique in which a panel of experts is questioned individually about their perceptions of future events. The experts do not meet as a group, in order to reduce the possibility that consensus is reached because of dominant personality factors. Instead, the forecasts and accompanying arguments are summarized by an outside party and returned to the experts along with further questions. This continues until a consensus is reached. This type of method is useful and quite effective for long-range forecasting. The technique is done by questionnaire format and eliminates the disadvantages of group think. There is no committee or debate. The experts are not influenced by peer pressure to forecast a certain way, as the answer is not intended to be reached by consensus or unanimity. Low reliability is cited as the main disadvantage of the Delphi method, as well as lack of consensus from the returns. [3]. Sales Force Polling Some companies use as a forecast source salespeople who have continual contacts with customers. They believe that the salespeople who are closest to the ultimate customers may have significant insights regarding the state of the future market. Forecasts based on sales force polling may be averaged to develop a future forecast. Or they may be used to modify other quantitative and/or qualitative forecasts that have been generated internally in the company. The advantages of this forecast are: It is simple to use and understand. It uses the specialized knowledge of those closest to the action. It can place responsibility for attaining the forecast in the hands of those who most affect the actual results.

The information can be broken down easily by territory, product, customer, or salesperson. The disadvantages include: salespeoples being overly optimistic or pessimistic regarding their predictions and inaccuracies due to broader economic events that are largely beyond their control. Consumer Surveys Some companies conduct their own market surveys regarding specific consumer purchases. Surveys may consist of telephone contacts, personal interviews, or questionnaires as a means of obtaining data. Extensive statistical analysis usually is applied to survey results in order to test hypotheses regarding consumer behavior.

Common Features and Assumptions Inherent in Forecasting As pointed out, forecasting techniques are quite different from each other. But four features and assumptions underlie the business of forecasting. They are: Forecasting techniques generally assume that the same underlying causal relationship that existed in the past will continue to prevail in the future. In other words, most of our techniques are based on historical data. Forecasts are rarely perfect. Therefore, for planning purposes, allowances should be made for inaccuracies. For example, the company should always maintain a safety stock in anticipation of a sudden depletion of inventory. Forecast accuracy decreases as the time period covered by the forecast (i.e., the time horizon) increases. Generally speaking, a long-term forecast tends to be more inaccurate than a short-term forecast because of the greater uncertainty. Forecasts for groups of items tend to be more accurate than forecasts for individual items, because forecasting errors among items in a group tend to cancel each other out. For example, industry forecasting is more accurate than individual firm forecasting. Grassroots Forecasting The Grassroots technique is based on the concept of asking those who are close to the eventual consumer, such as salespeople, about what they are going to sell next period, and added the forecasts to predict total demand. Requires an experienced stable work force that knows the customer base. Not good at retail! Can be expensive. Takes sales people away from sales effort. Results can be biased. In more sophisticated systems, forecasts may be adjusted on the basis of the historical correlation between the salespersons forecasts and the actual sales.

Consulting Customers (Market Research) Market research is a large and important topic which includes a variety of techniques, from consumer panels through consumer surveys and on to test marketing.

The goal of market research is to make predictions about the size/structure of the market for specific goods and/or services.

These predictions (forecasts) are usually based on small samples and are qualitative in the sense that the original data typically consist of subjective evaluations of consumers.

Market research is an important activity in most consumer product firms. It also plays an increasingly important role in the political and electoral process.

Delphi method
From Wikipedia, the free encyclopedia

The Delphi method (

/dlfa/ DEL-fy) is a structured communication technique, originally developed as a

systematic, interactive forecasting method which relies on a panel of experts.[1] In the standard version, the experts answer questionnaires in two or more rounds. After each round, a facilitator provides an anonymous summary of the experts forecasts from the previous round as well as the reasons they provided for their judgments. Thus, experts are encouraged to revise their earlier answers in light of the replies of other members of their panel. It is believed that during this process the range of the answers will decrease and the group will converge towards the "correct" answer. Finally, the process is stopped after a pre-defined stop criterion (e.g. number of rounds, achievement of consensus, stability of results) and the mean or median scores of the final rounds determine the results.[2] Other versions, such as the Policy Delphi,[3] have been designed for normative and explorative use, particularly in the area of social policy and public health.[4] In Europe, more recent web-based experiments have used the Delphi method as a communication technique for interactive decision-making and e-democracy.[5] Delphi is based on the principle that forecasts (or decisions) from a structured group of individuals are more accurate than those from unstructured groups.[6] This has been indicated with the term "collective intelligence".[7] The technique can also be adapted for use in face-to-face meetings, and is then called miniDelphi or Estimate-Talk-Estimate (ETE). Delphi has been widely used for business forecasting and has certain advantages over another structured forecasting approach, prediction markets.[8]

Introduction

Delphi forecasting is a non-quantitative technique for forecasting. It draws its name from the Oracles of Delphi, which in Greek Antiquity advised people based on intuition and common sense. Unlike many other methods that use so-called objective predictions involving quantitative analysis, the Delphi method is based on expert opinions. It has been demonstrated that predictions obtained this way can be at least as accurate as other procedures. The essence of the procedure is to use the assessment of opinions and predictions by a number of experts over a number of rounds in carefully managed sequences. One of the most important factors in Delphi forecasting is the selection of experts. The persons invited to participate must be knowledgeable about the issue, and represent a variety of backgrounds. The number must not be too small to make the assessment too narrowly based, nor too large to be difficult to coordinate. It is widely considered that 10 to 15 experts can provide a good base for the forecast.

2. Procedure
The procedure begins with the planner/researcher preparing a questionnaire about the issue at hand, its character, causes and future shape. These are distributed to the respondents separately who are asked to rate and respond. The results are then tabulated and the issues raised are identified. The results are then returned to the experts in a second round. They are asked to rank or assess the factors, and justify why they made they their choices. During a third or subsequent rounds their ratings along with the group averages, and lists of comments are provided, and the experts are asked to re-evaluate the factors. The rounds would continue until an agreed level of consensus is reached. The literature suggests that by the third round a sufficient consensus is usually obtained. The procedure may take place in many ways. The first step is usually undertaken by mail. After the initial results are obtained the subsequent round could be undertaken at a meeting of experts, assuming it would be possible to bring them together physically. Or, the subsequent rounds could be conducted again by mail. E-Mail has greatly facilitated the procedure. The basic steps are as follows: 1. Identification of the problem. Researcher identifies the problem for which some predictions are required, e.g. what is the traffic of port x likely to be in

2.

3.

4.

5.

6.

7.

10 years time. Researcher prepares documentation regarding past and present traffic activity. Questionnaire is formulated concerning future traffic estimates and factors that might influence such developments. A level of agreement between the responses is selected, i.e. if 80% of the experts can agree on a particular traffic prediction. Selection of experts. In the case of a port scenario this might include terminal managers, shipping line representatives, land transport company representatives, intermediaries such as freight forwarders, and academics. It is important to have a balance, so that no one group is overly represented. Administration of questionnaire. Experts are provided with background documentation and questionnaire. Responses are submitted to researcher within a narrow time frame. Researcher summarizes responses. Actual traffic predictions are tabulated and means and standard deviations calculated for each category of cargo as in the case of a port traffic prediction exercise. Key factors suggested by experts are compiled and listed. Feedback. The tabulations are returned to the experts, either by mail or in a meeting convened to discuss first round results. The advantage of a meeting is that participants can confront each other to debate areas of disagreement over actual traffic predictions or of key factors identified. The drawback is that a few individuals might exert personal influence over the discussion and thereby sway outcomes, a trend that the researcher must be alert to and seek to mitigate. Experts are invited to review their original estimates and choices of key factors in light of the results presented, and submit a new round of predictions. These new predictions are tabulated and returned to the experts either by mail or immediately to the meeting, if the level of agreement does not meet the pre-determined level of acceptance. Thespecific areas of disagreement are highlighted, and the experts are again requested to consider their predictions in light of the panels overall views. The process is continued until the level of agreement has reached the predetermined value. If agreement is not possible after several rounds, the researcher must terminate the process and try to pinpoint where the disagreements occur, and utilize the results to indicate specific problems in the traffic prediction process in this case. This method could be applied in a classroom setting, with students serving as experts for a particular case study. The traffic at the local airport or port might be an appropriate example. On the basis of careful examination of traffic trends and factors influencing business activity, the class could be consulted to come up with predictions

that could then be compared with those of some alternate method such as trend extrapolation.

FORECASTING
Learning Objectives:

To recognize that different forecasting methods are appropriate in different situations To become familiar with the various methods of forecasting To learn measures for analyzing the performance of forecast methods To learn to use Excel for different types of forecasting problems

Contents
Introduction to Forecasting Forecasting Methods:

Qualitative Time Series

o o o o o

Simple Moving Average Weighted Moving Average Exponential Smoothing Adjusting for trends - Double Exponential Smoothing Multiplicative Seasonal Method

Causal Methods Focus Forecasting Back to Index

FORECASTING - a method for translating past experience into estimates of the future

Read: The University Bookstore Student Computer Purchase Program page 497 in the text. Key questions which must be answered:

what is the purpose of the forecast? what specifically do we wish to forecast? how important is the past in predicting the future? what system will be used to make the forecast?

forecasting horizons:

long-term: more than 2 years medium-term: 3 months to 2 years short-term: 0 to 3 months

forecasting methods: qualitative methods quantitative methods - causal methods - time series methods

QUALITATIVE FORECASTING METHODS

qualitative forecasting methods are based on educated opinions of appropriate persons 1. delphi method: forecast is developed by a panel of experts who anonymously answer a series of questions; responses are fed back to panel members who then may change their original responses - very time consuming and expensive - new groupware makes this process much more feasible 2. market research: panels, questionnaires, test markets, surveys, etc.

3. product life-cycle analogy: forecasts based on life-cycles of similar products, services, or processes 4. expert judgement by management, sales force, or other knowledgeable persons

QUANTITATIVE FORECASTING METHODS

TIME SERIES FORECASTING METHODS time series forecasting methods are based on analysis of historical data (time series: a set of observations measured at successive times or over successive periods). They make the assumption that past patterns in data can be used to forecast future data points. 1. moving averages (simple moving average, weighted moving average): forecast is based on arithmetic average of a given number of past data points 2. exponential smoothing (single exponential smoothing, double exponential smoothing): a type of weighted moving average that allows inclusion of trends, etc. 3. mathematical models (trend lines, log-linear models, Fourier series, etc.): linear or non-linear models fitted to time-series data, usually by regression methods 4. Box-Jenkins methods: autocorrelation methods used to identify underlying time series and to fit the "best" model COMPONENTS OF TIME SERIES DEMAND 1. average: the mean of the observations over time 2. trend: a gradual increase or decrease in the average over time 3. seasonal influence: predictable short-term cycling behaviour due to time of day, week, month, season, year, etc. 4. cyclical movement: unpredictable long-term cycling behaviour due to business cycle or product/service life cycle 5. random error: remaining variation that cannot be explained by the other four components

SIMPLE MOVING AVERAGE moving average techniques forecast demand by calculating an average of actual demands from a specified number of prior periods each new forecast drops the demand in the oldest period and replaces it with the demand in the most recent period; thus, the data in the calculation "moves" over time simple moving average: At = Dt + Dt-1 + Dt-2 + ... + Dt-N+1 N where N = total number of periods in the average forecast for period t+1: Ft+1 = At Key Decision: N - How many periods should be considered in the forecast Tradeoff: Higher value of N - greater smoothing, lower responsiveness Lower value of N - less smoothing, more responsiveness - the more periods (N) over which the moving average is calculated, the less susceptible the forecast is to random variations, but the less responsive it is to changes - a large value of N is appropriate if the underlying pattern of demand is stable - a smaller value of N is appropriate if the underlying pattern is changing or if it is important to identify short-term fluctuations

WEIGHTED MOVING AVERAGE a weighted moving average is a moving average where each historical demand may be weighted differently average: At = W1 Dt + W2 Dt-1 + W3 Dt-2 + ... + WN Dt-N+1 where:

N = total number of periods in the average Wt = weight applied to period t's demand
Sum of all the weights = 1

forecast: Ft+1 = At = forecast for period t+1

EXPONENTIAL SMOOTHING exponential smoothing gives greater weight to demand in more recent periods, and less weight to demand in earlier periods average: At = a Dt + (1 - a) At-1 = a Dt + (1 - a) Ft forecast for period t+1: Ft+1 = At where: At-1 = "series average" calculated by the exponential smoothing model to period t-1 a = smoothing parameter between 0 and 1 the larger the smoothing parameter , the greater the weight given to the most recent demand

DOUBLE EXPONENTIAL SMOOTHING (TREND-ADJUSTED EXPONENTIAL SMOOTHING) when a trend exists, the forecasting technique must consider the trend as well as the series average ignoring the trend will cause the forecast to always be below (with an increasing trend) or above (with a decreasing trend) actual demand double exponential smoothing smooths (averages) both the series average and the trend forecast for period t+1: Ft+1 = At + Tt

average: At = aDt + (1 - a) (At-1 + Tt-1) = aDt + (1 - a) Ft average trend: Tt = B CTt + (1 - B) Tt-1 current trend: CTt = At - At-1 forecast for p periods into the future: Ft+p = At + p Tt where: At = exponentially smoothed average of the series in period t Tt = exponentially smoothed average of the trend in period t CTt = current estimate of the trend in period t a = smoothing parameter between 0 and 1 for smoothing the averages B = smoothing parameter between 0 and 1 for smoothing the trend

MULTIPLICATIVE SEASONAL METHOD What happens when the patterns you are trying to predict display seasonal effects? What is seasonality? - It can range from true variation between seasons, to variation between months, weeks, days in the week and even variation during a single day or hour. To deal with seasonal effects in forecasting two tasks must be completed: 1. a forecast for the entire period (ie year) must be made using whatever forecasting technique is appropriate. This forecast will be developed using whatever 2. the forecast must be adjust to reflect the seasonal effects in each period (ie month or quarter) the multiplicative seasonal method adjusts a given forecast by multiplying the forecast by a seasonal factor

Step 1: calculate the average demand y per period for each year (y) of past data by dividing total demand for the year by the number of periods in the year Step 2: divide the actual demand Dy,t for each period (t) by the average demand y per period (calculated in Step 1) to get a seasonal factor fy,t for each period; repeat for each year of data Step 3: calculate the average seasonal factor t for each period by summing all the seasonal factors fy,t for that period and dividing by the number of seasonal factors Step 4: determine the forecast for a given period in a future year by multiplying the average seasonal factor t by the forecasted demand in that future year Seasonal Forecasting (multiplicative method) Actual Demand
Year 1 2 3 Q1 100 120 134 Q2 70 80 80 Q3 60 70 70 Q4 90 110 100 Total 320 380 381 Avg 80 95 96

Seasonal Factor
Year 1 2 3 Avg. Seasonal Factor Q1 1.25 1.26 1.4 1.30 Q2 .875 .84 .83 .85 Q3 .75 .74 .73 .74 Q4 1.125 1.16 1.04 1.083

Seasonal Factor - the percentage of average quarterly demand that occurs in each quarter. Annual Forecast for year 4 is predicted to be 400 units.

Average forecast per quarter is 400/4 = 100 units. Quarterly Forecast = avg. forecast seasonal factor.

Q1: 1.303(100) = 130 Q2: .85(100) = 85 Q3: .74(100) = 74 Q4: 1.083(100) = 108

CAUSAL FORECASTING METHODS causal forecasting methods are based on a known or perceived relationship between the factor to be forecast and other external or internal factors 1. regression: mathematical equation relates a dependent variable to one or more independent variables that are believed to influence the dependent variable 2. econometric models: system of interdependent regression equations that describe some sector of economic activity 3. input-output models: describes the flows from one sector of the economy to another, and so predicts the inputs required to produce outputs in another sector 4. simulation modelling

MEASURING FORECAST ERRORS There are two aspects of forecasting errors to be concerned about - Bias and Accuracy Bias - A forecast is biased if it errs more in one direction than in the other - The method tends to under-forecasts or over-forecasts. Accuracy - Forecast accuracy refers to the distance of the forecasts from actual demand ignore the direction of that error. Example: For six periods forecasts and actual demand have been tracked The following table gives actual demand Dt and forecast demand Ft for six periods:

t 1 2 3 4 5 6 Total

Dt 170 230 250 200 185 180

Ft 200 195 210 220 210 200

Et -30 35 40 -20 -25 -20 -20

(Et)2 900 1225 1600 400 625 400 5150

|Et| | 30 35 40 20 25 20 170

Et|/Dt 17.6% 15.2% 16.0% 10.0% 13.5% 11.1% 83.5%

Forecast Measure 1. 2. 3. 4. 5. cumulative sum of forecast errors (CFE) = -20 mean absolute deviation (MAD) = 170 / 6 = 28.33 mean squared error (MSE) = 5150 / 6 = 858.33 standard deviation of forecast errors = 5150 / 6 = 29.30 mean absolute percent error (MAPE) = 83.4% / 6 = 13.9%

What information does each give? 1. 2. 3. 4. 5. conclusions: forecast has a tendency to over-estimate demand average error per forecast was 28.33 units, or 13.9% of actual demand sampling distribution of forecast errors has standard deviation of 29.3 units.

CRITERIA FOR SELECTING A FORECASTING METHOD Objectives: 1. Maximize Accuracy and 2. Minimize Bias Potential Rules for selecting a time series forecasting method. Select the method that 1. 2. 3. 4. gives the smallest bias, as measured by cumulative forecast error (CFE); or gives the smallest mean absolute deviation (MAD); or gives the smallest tracking signal; or supports management's beliefs about the underlying pattern of demand

or others. It appears obvious that some measure of both accuracy and bias should be used together. How? What about the number of periods to be sampled?

if demand is inherently stable, low values of and and higher values of N are suggested if demand is inherently unstable, high values of and and lower values of N are suggested

FOCUS FORECASTING

"focus forecasting" refers to an approach to forecasting that develops forecasts by various techniques, then picks the forecast that was produced by the "best" of these techniques, where "best" is determined by some measure of forecast error. FOCUS FORECASTING: EXAMPLE For the first six months of the year, the demand for a retail item has been 15, 14, 15, 17, 19, and 18 units. A retailer uses a focus forecasting system based on two forecasting techniques: a twoperiod moving average, and a trend-adjusted exponential smoothing model with = 0.1 and = 0.1. With the exponential model, the forecast for January was 15 and the trend average at the end of December was 1. The retailer uses the mean absolute deviation (MAD) for the last three months as the criterion for choosing which model will be used to forecast for the next month.

a. What will be the forecast for July and which model will be used? b. Would you answer to Part a. be different if the demand for May had been 14 instead of 19?
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Forecast error
From Wikipedia, the free encyclopedia

It has been suggested that Calculating demand forecast accuracy be merged into this article or section. (Discuss) Proposed since January 2012. This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. (December 2009)
In statistics, a forecast error is the difference between the actual or real and the predicted or forecast value of a time series or any other phenomenon of interest. In simple cases, a forecast is compared with an outcome at a single time-point and a summary of forecast errors is constructed over a collection of such time-points. Here the forecast may be assessed using the difference or using a proportional error. By convention, the error is defined using the value of the outcome minus the value of the forecast. In other cases, a forecast may consist of predicted values over a number of lead-times; in this case an assessment of forecast error may need to consider more general ways of assessing the match between the time-profiles of the forecast and the outcome. If a main application of the forecast is to predict when certain thresholds will be crossed, one possible way of assessing the forecast is to use the timing-errorthe difference in time between when the outcome crosses the threshold and when the forecast does so. When there is interest in the maximum value being reached, assessment of forecasts can be done using any of:

the difference of times of the peaks; the difference in the peak values in the forecast and outcome; the difference between the peak value of the outcome and the value forecast for that time point.

Forecast error can be a calendar forecast error or a cross-sectional forecast error, when we want to summarize the forecast error over a group of units. If we observe the average forecast error for a time-series of forecasts for the same product or phenomenon, then we call this a calendar forecast error or time-series forecast error. If we observe this for multiple products for the same period, then this is a cross-sectional performance error. Reference class forecasting has been developed to reduce forecast error. Combining forecasts has also been shown to reduce forecast error.[1][2]

FORECASTING
Learning Objectives:

To recognize that different forecasting methods are appropriate in different situations To become familiar with the various methods of forecasting To learn measures for analyzing the performance of forecast methods To learn to use Excel for different types of forecasting problems

Contents
Introduction to Forecasting Forecasting Methods:

Qualitative Time Series

o o o o o

Simple Moving Average Weighted Moving Average Exponential Smoothing Adjusting for trends - Double Exponential Smoothing Multiplicative Seasonal Method

Causal Methods Focus Forecasting Back to Index

FORECASTING - a method for translating past experience into estimates of the future Read: The University Bookstore Student Computer Purchase Program page 497 in the text. Key questions which must be answered:

what is the purpose of the forecast? what specifically do we wish to forecast? how important is the past in predicting the future? what system will be used to make the forecast?

forecasting horizons:

long-term: more than 2 years medium-term: 3 months to 2 years short-term: 0 to 3 months

forecasting methods: qualitative methods quantitative methods - causal methods - time series methods

QUALITATIVE FORECASTING METHODS

qualitative forecasting methods are based on educated opinions of appropriate persons 1. delphi method: forecast is developed by a panel of experts who anonymously answer a series of questions; responses are fed back to panel members who then may change their original responses - very time consuming and expensive - new groupware makes this process much more feasible 2. market research: panels, questionnaires, test markets, surveys, etc. 3. product life-cycle analogy: forecasts based on life-cycles of similar products, services, or processes 4. expert judgement by management, sales force, or other knowledgeable persons

QUANTITATIVE FORECASTING METHODS

TIME SERIES FORECASTING METHODS time series forecasting methods are based on analysis of historical data (time series: a set of observations measured at successive times or over successive periods). They make the assumption that past patterns in data can be used to forecast future data points. 1. moving averages (simple moving average, weighted moving average): forecast is based on arithmetic average of a given number of past data points 2. exponential smoothing (single exponential smoothing, double exponential smoothing): a type of weighted moving average that allows inclusion of trends, etc. 3. mathematical models (trend lines, log-linear models, Fourier series, etc.): linear or non-linear models fitted to time-series data, usually by regression methods 4. Box-Jenkins methods: autocorrelation methods used to identify underlying time series and to fit the "best" model COMPONENTS OF TIME SERIES DEMAND 1. average: the mean of the observations over time 2. trend: a gradual increase or decrease in the average over time 3. seasonal influence: predictable short-term cycling behaviour due to time of day, week, month, season, year, etc. 4. cyclical movement: unpredictable long-term cycling behaviour due to business cycle or product/service life cycle 5. random error: remaining variation that cannot be explained by the other four components

SIMPLE MOVING AVERAGE moving average techniques forecast demand by calculating an average of actual demands from a specified number of prior periods

each new forecast drops the demand in the oldest period and replaces it with the demand in the most recent period; thus, the data in the calculation "moves" over time simple moving average: At = Dt + Dt-1 + Dt-2 + ... + Dt-N+1 N where N = total number of periods in the average forecast for period t+1: Ft+1 = At Key Decision: N - How many periods should be considered in the forecast Tradeoff: Higher value of N - greater smoothing, lower responsiveness Lower value of N - less smoothing, more responsiveness - the more periods (N) over which the moving average is calculated, the less susceptible the forecast is to random variations, but the less responsive it is to changes - a large value of N is appropriate if the underlying pattern of demand is stable - a smaller value of N is appropriate if the underlying pattern is changing or if it is important to identify short-term fluctuations

WEIGHTED MOVING AVERAGE a weighted moving average is a moving average where each historical demand may be weighted differently average: At = W1 Dt + W2 Dt-1 + W3 Dt-2 + ... + WN Dt-N+1 where: N = total number of periods in the average Wt = weight applied to period t's demand
Sum of all the weights = 1

forecast: Ft+1 = At = forecast for period t+1

EXPONENTIAL SMOOTHING exponential smoothing gives greater weight to demand in more recent periods, and less weight to demand in earlier periods average: At = a Dt + (1 - a) At-1 = a Dt + (1 - a) Ft forecast for period t+1: Ft+1 = At where: At-1 = "series average" calculated by the exponential smoothing model to period t-1 a = smoothing parameter between 0 and 1 the larger the smoothing parameter , the greater the weight given to the most recent demand

DOUBLE EXPONENTIAL SMOOTHING (TREND-ADJUSTED EXPONENTIAL SMOOTHING) when a trend exists, the forecasting technique must consider the trend as well as the series average ignoring the trend will cause the forecast to always be below (with an increasing trend) or above (with a decreasing trend) actual demand double exponential smoothing smooths (averages) both the series average and the trend forecast for period t+1: Ft+1 = At + Tt average: At = aDt + (1 - a) (At-1 + Tt-1) = aDt + (1 - a) Ft average trend: Tt = B CTt + (1 - B) Tt-1 current trend: CTt = At - At-1 forecast for p periods into the future: Ft+p = At + p Tt

where: At = exponentially smoothed average of the series in period t Tt = exponentially smoothed average of the trend in period t CTt = current estimate of the trend in period t a = smoothing parameter between 0 and 1 for smoothing the averages B = smoothing parameter between 0 and 1 for smoothing the trend

MULTIPLICATIVE SEASONAL METHOD What happens when the patterns you are trying to predict display seasonal effects? What is seasonality? - It can range from true variation between seasons, to variation between months, weeks, days in the week and even variation during a single day or hour. To deal with seasonal effects in forecasting two tasks must be completed: 1. a forecast for the entire period (ie year) must be made using whatever forecasting technique is appropriate. This forecast will be developed using whatever 2. the forecast must be adjust to reflect the seasonal effects in each period (ie month or quarter) the multiplicative seasonal method adjusts a given forecast by multiplying the forecast by a seasonal factor Step 1: calculate the average demand y per period for each year (y) of past data by dividing total demand for the year by the number of periods in the year Step 2: divide the actual demand Dy,t for each period (t) by the average demand y per period (calculated in Step 1) to get a seasonal factor fy,t for each period; repeat for each year of data

Step 3: calculate the average seasonal factor t for each period by summing all the seasonal factors fy,t for that period and dividing by the number of seasonal factors Step 4: determine the forecast for a given period in a future year by multiplying the average seasonal factor t by the forecasted demand in that future year Seasonal Forecasting (multiplicative method) Actual Demand
Year 1 2 3 Q1 100 120 134 Q2 70 80 80 Q3 60 70 70 Q4 90 110 100 Total 320 380 381 Avg 80 95 96

Seasonal Factor
Year 1 2 3 Avg. Seasonal Factor Q1 1.25 1.26 1.4 1.30 Q2 .875 .84 .83 .85 Q3 .75 .74 .73 .74 Q4 1.125 1.16 1.04 1.083

Seasonal Factor - the percentage of average quarterly demand that occurs in each quarter. Annual Forecast for year 4 is predicted to be 400 units. Average forecast per quarter is 400/4 = 100 units. Quarterly Forecast = avg. forecast seasonal factor.

Q1: 1.303(100) = 130 Q2: .85(100) = 85

Q3: .74(100) = 74 Q4: 1.083(100) = 108

CAUSAL FORECASTING METHODS causal forecasting methods are based on a known or perceived relationship between the factor to be forecast and other external or internal factors 1. regression: mathematical equation relates a dependent variable to one or more independent variables that are believed to influence the dependent variable 2. econometric models: system of interdependent regression equations that describe some sector of economic activity 3. input-output models: describes the flows from one sector of the economy to another, and so predicts the inputs required to produce outputs in another sector 4. simulation modelling

MEASURING FORECAST ERRORS There are two aspects of forecasting errors to be concerned about - Bias and Accuracy Bias - A forecast is biased if it errs more in one direction than in the other - The method tends to under-forecasts or over-forecasts. Accuracy - Forecast accuracy refers to the distance of the forecasts from actual demand ignore the direction of that error. Example: For six periods forecasts and actual demand have been tracked The following table gives actual demand Dt and forecast demand Ft for six periods:
t 1 2 Dt 170 230 Ft 200 195 Et -30 35 (Et)2 900 1225 |Et| | 30 35 Et|/Dt 17.6% 15.2%

3 4 5 6 Total

250 200 185 180

210 220 210 200

40 -20 -25 -20 -20

1600 400 625 400 5150

40 20 25 20 170

16.0% 10.0% 13.5% 11.1% 83.5%

Forecast Measure 1. 2. 3. 4. 5. cumulative sum of forecast errors (CFE) = -20 mean absolute deviation (MAD) = 170 / 6 = 28.33 mean squared error (MSE) = 5150 / 6 = 858.33 standard deviation of forecast errors = 5150 / 6 = 29.30 mean absolute percent error (MAPE) = 83.4% / 6 = 13.9%

What information does each give? 1. 2. 3. 4. 5. conclusions: forecast has a tendency to over-estimate demand average error per forecast was 28.33 units, or 13.9% of actual demand sampling distribution of forecast errors has standard deviation of 29.3 units.

CRITERIA FOR SELECTING A FORECASTING METHOD Objectives: 1. Maximize Accuracy and 2. Minimize Bias Potential Rules for selecting a time series forecasting method. Select the method that

1. 2. 3. 4.

gives the smallest bias, as measured by cumulative forecast error (CFE); or gives the smallest mean absolute deviation (MAD); or gives the smallest tracking signal; or supports management's beliefs about the underlying pattern of demand

or others. It appears obvious that some measure of both accuracy and bias should be used together. How? What about the number of periods to be sampled?

if demand is inherently stable, low values of and and higher values of N are suggested if demand is inherently unstable, high values of and and lower values of N are suggested

FOCUS FORECASTING

"focus forecasting" refers to an approach to forecasting that develops forecasts by various techniques, then picks the forecast that was produced by the "best" of these techniques, where "best" is determined by some measure of forecast error. FOCUS FORECASTING: EXAMPLE For the first six months of the year, the demand for a retail item has been 15, 14, 15, 17, 19, and 18 units. A retailer uses a focus forecasting system based on two forecasting techniques: a twoperiod moving average, and a trend-adjusted exponential smoothing model with = 0.1 and = 0.1. With the exponential model, the forecast for January was 15 and the trend average at the end of December was 1. The retailer uses the mean absolute deviation (MAD) for the last three months as the criterion for choosing which model will be used to forecast for the next month. a. What will be the forecast for July and which model will be used? b. Would you answer to Part a. be different if the demand for May had been 14 instead of 19?
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