Forecasting

“Prediction is very difficult,

especially if it's about the future. ”
Nils Bohr

Dr. N. S. Mugadur
Assistant Professor
Department of Economics
Karnatak University Dharwad
 Objectives

• Give the fundamental rules of forecasting

• Calculate a forecast using a moving average,

weighted moving average, and exponential
smoothing

• Calculate the accuracy of a forecast

What is forecasting?

Forecasting is a tool used for predicting

future demand based on
past demand information.
Why is forecasting important?

Demand for products and services is usually uncertain.

Forecasting can be used for…
• Strategic planning (long range planning)
• Finance and accounting (budgets and cost controls)
• Marketing (future sales, new products)
• Production and operations
What is forecasting all about?

Demand for Mercedes E Class We try to predict the

future by looking back
at the past

Predicted
demand
looking
Time back six
Jan Feb Mar Apr May Jun Jul Aug months

Actual demand (past sales)

Predicted demand
Some general characteristics of forecasts

• Forecasts are always wrong

• Forecasts are more accurate for groups or families of
items
• Forecasts are more accurate for shorter time periods
• Every forecast should include an error estimate
• Forecasts are no substitute for calculated demand.
 What Makes a Good Forecast?

• It should be timely
• It should be as accurate as possible
• It should be reliable
• It should be in meaningful units
• It should be presented in writing
• The method should be easy to use and
understand in most cases.
Key issues in forecasting

1. A forecast is only as good as the information included in

the forecast (past data)
2. History is not a perfect predictor of the future (i.e.: there is
no such thing as a perfect forecast)

REMEMBER: Forecasting is based on the assumption

that the past predicts the future! When forecasting, think
carefully whether or not the past is strongly related to
what you expect to see in the future…
What should we consider when looking at
past demand data?

• Trends

• Seasonality

• Cyclical elements

• Autocorrelation

• Random variation
Some Important Questions

• What is the purpose of the forecast?

• Which systems will use the forecast?
• How important is the past in estimating the future?

Answers will help determine time horizons, techniques,

and level of detail for the forecast.
Types of forecasting methods

Qualitative methods Quantitative methods

Rely on subjective Rely on data and

opinions from one or analytical techniques.
more experts.
 Forecasting Models
Forecasting
Techniques

Qualitative Time Series

Models Methods

Delphi
Naive
Method
Moving
Jury of Executive
Average
Opinion
Weighted
Sales Force
Moving Average
Composite
Exponential
Consumer Market
Smoothing
Survey

Trend Analysis
Causal
Methods
Seasonality
Simple Analysis
Regression
Analysis Multiplicative
Decomposition
Multiple
Regression
Analysis
 Qualitative Forecasting Methods
• Delphi method
Iterative group process allows experts to make forecasts
Participants:
 decision makers: 5 -10 experts who make the forecast
 staff personnel: assist by preparing, distributing, collecting, and
summarizing a series of questionnaires and survey results
 respondents: group with valued judgments who provide input to decision
makers
• Jury of executive opinion
–Opinions of a small group of high level managers, often in combination with
statistical models.
– Result is a group estimate.
• Sales force composite
–Each salesperson estimates sales in his region.
–Forecasts are reviewed to ensure realistic.
–Combined at higher levels to reach an overall forecast.
• Consumer market survey.
–Solicits input from customers and potential customers regarding future
purchases.
–Used for forecasts and product design & planning
 Qualitative forecasting methods
Grass Roots: deriving future demand by asking the person closest to
the customer.
Market Research: trying to identify customer habits; new product
ideas.
Panel Consensus: deriving future estimations from the synergy of a
panel of experts in the area.
Historical Analogy: identifying another similar market.
Delphi Method: similar to the panel consensus but with concealed
identities.

Advantages of Qualitative forecast:

The mass of information (both quantifiable & unquantifiable) to come up
with a prediction.
Disadvantages :
1. There is no systematic way to measure or improve the accuracy of the forecast
2. There is a chance that the forecast may contain built in biases of the experts.
Quantitative forecasting methods
Time Series: models that predict future demand based on past
history trends

Causal Relationship: models that use statistical techniques to

establish relationships between various items and demand

Simulation: models that can incorporate some randomness and non-

linear effects

Advantages of Quantitative Forecast:

1.One of the choice of independent variable is made, forecast are based only on
their predetermined values.
2.There are ways to measure the accuracy of the forecast.
3.Once the models are constructed, it is less time-consuming to generate
forecasts.
4.They have a means of forecasting point estimates/interval estimates.
How should we pick our forecasting model?

1. Data availability
2. Time horizon for the forecast
3. Required accuracy
4. Required Resources
Time Series: Naïve
– Naïve
• Whatever happened
recently will happen again
this time (same time
period) Ft Yt  1
• The model is simple and
flexible
• Provides a baseline to
measure other models Ft Yt  4 : Quarterly data
• Attempts to capture
seasonal factors at the Ft Yt  12 : Monthly data
expense of ignoring trend
Time Series: Moving average

• The moving average model uses the last t periods in order to

predict demand in period t+1.
• There can be two types of moving average models: simple
moving average and weighted moving average
• The moving average model assumption is that the most
accurate prediction of future demand is a simple (linear)
combination of past demand.
Time Series: Simple Moving Average

In the simple moving average models the forecast value is

At + At-1 + … + At-n
Ft+1 =
n

t is the current period.

Ft+1 is the forecast for next period
n is the forecasting horizon (how far back we look),
A is the actual sales figure from each period.
Example: forecasting sales at Kroger

Kroger sells (among other stuff) bottled spring water

Month Bottles
Jan 1,325
Feb 1,353 What will
Mar 1,305 the sales
Apr 1,275 be for
May 1,210
July?
Jun 1,195
Jul ?
What if we use a 3-month simple moving average?

AJun + AMay + AApr

FJul = = 1,227
3

What if we use a 5-month simple moving average?

AJun + AMay + AApr + AMar + AFeb

FJul = = 1,268
5
 1400
1350
1300
5-month
1250
MA forecast
1200 3-month
1150 MA forecast
1100
1050
1000
0 1 2 3 4 5 6 7 8

What do we observe?

5-month average smoothes data more;

3-month average more responsive
Time Series: Weighted Moving Average
We may want to give more importance to some of the data…

Ft+1 = wt At + wt-1 At-1 + … + wt-n At-n

wt + wt-1 + … + wt-n = 1

t is the current period.

Ft+1 is the forecast for next period
n is the forecasting horizon (how far back we look),
A is the actual sales figure from each period.
w is the importance (weight) we give to each period
Why do we need the WMA models?

Because of the ability to give more importance to what

happened recently, without losing the impact of the past.

Demand for Mercedes E-class Actual demand (past sales)

Prediction when using 6-month SMA
Prediction when using 6-months WMA

For a 6-month
SMA, attributing
equal weights to all
past data we miss
Time the downward trend
Jan Feb Mar Apr May Jun Jul Aug
Example: Kroger sales of bottled water

Month Bottles
Jan 1,325
Feb 1,353 What will
Mar 1,305 be the
sales for
Apr 1,275
July?
May 1,210
Jun 1,195
Jul ?
6-month simple moving average…

AJun + AMay + AApr + AMar + AFeb + AJan

FJul = = 1,277
6

In other words, because we used equal weights, a slight downward

trend that actually exists is not observed…
What if we use a weighted moving average?

Make the weights for the last three months more than the first
three months…

6-month WMA WMA WMA

SMA 40% / 60% 30% / 70% 20% / 80%

July
1,277 1,267 1,257 1,247
Forecast

The higher the importance we give to recent data, the more we

pick up the declining trend in our forecast.
How do we choose weights?

1. Depending on the importance that we feel past data has

2. Depending on known seasonality (weights of past data
can also be zero).

WMA is better than SMA

because of the ability to
vary the weights!
Time Series: Exponential Smoothing (ES)

Main idea: The prediction of the future depends mostly on the

most recent observation, and on the error for the latest forecast.

Smoothi
ng Denotes the importance
constant of the past error
alpha α
Why use exponential smoothing?

1. Uses less storage space for data

2. Extremely accurate
3. Easy to understand
4. Little calculation complexity
5. There are simple accuracy tests
Exponential smoothing: the method

Assume that we are currently in period t. We calculated the

forecast for the last period (Ft-1) and we know the actual demand
last period (At-1) …

Ft Ft 1  ( At 1  Ft 1 )

The smoothing constant α expresses how much our forecast will

react to observed differences…
If α is low: there is little reaction to differences.
If α is high: there is a lot of reaction to differences.
Example: bottled water at Kroger

Month Actual Forecasted  = 0.2

Jan 1,325 1,370

Feb 1,353 1,361

Mar 1,305 1,359

Apr 1,275 1,349

May 1,210 1,334

Jun ? 1,309
Example: bottled water at Kroger

Month Actual Forecasted  = 0.8

Jan 1,325 1,370

Feb 1,353 1,334

Mar 1,305 1,349

Apr 1,275 1,314

May 1,210 1,283

Jun ? 1,225
Impact of the smoothing constant

1380
1360
1340
1320 Actual
1300
a = 0.2
1280
1260 a = 0.8
1240
1220
1200
0 1 2 3 4 5 6 7
Summary of Moving Averages
 Advantages of Moving Average Method
 Easily understood
 Easily computed
 Provides stable forecasts

 Disadvantages of Moving Average Method

 Requires saving lots of past data points: at least the N
periods used in the moving average computation
 Lags behind a trend
 Ignores complex relationships in data
 Comparison of MA and ES
• Similarities
– Both methods are appropriate for stationary series
– Both methods depend on a single parameter
– Both methods lag behind a trend
– One can achieve the same distribution of forecast error by
setting:
= 2/ ( N + 1) or N = (2 - 

• Differences
– ES carries all past history (forever!)
– MA eliminates “bad” data after N periods
– MA requires all N past data points to compute new forecast
estimate while ES only requires last forecast and last
observation of ‘demand’ to continue
 Trend Analysis
What do you think will happen to a moving average or
exponential smoothing model when there is a trend in the
data?
Impact of trend
Sales
Actual
Regular exponential
Data smoothing will always
Forecast lag behind the trend.
Can we include trend
analysis in exponential
smoothing?

Month
Trend Analysis
 Trend is the long-term sweep or general direction of movement
in a time series.
 We’ll now consider some nonstationary time series techniques
that are appropriate for data exhibiting upward or downward
trends.

Seasonality Analysis
 adjustment to time series data due to variations at certain periods.
 adjust with seasonal index – ratio of average value of the item in a
season to the overall annual average value.
 example: demand for coal & fuel oil in winter months.
Linear Regression in Forecasting

Linear regression is based on

1. Fitting a straight line to data
2. Explaining the change in one variable through changes in
other variables.

dependent variable = a + b  (independent variable)

By using linear regression, we are trying to explore which

independent variables affect the dependent variable
Example: do people drink more when it’s cold?

Alcohol Sales

Which line best

fits the data?

Average Monthly
Temperature
The best line is the one that minimizes the error

The predicted line is …

Y^ a  bX

So, the error is …

εi y i - Yi ^

Where: ε is the error

y is the observed value
Y^ is the predicted value
Least Squares Method of Linear Regression

The goal of LSM is to minimize the sum of squared errors…

Min i
 2
What does that mean?

Alcohol Sales ε ε
ε

So LSM tries to
minimize the distance
between the line and
the points!

Average Monthly
Temperature
Least Squares Method of Linear Regression

Then the line is defined by

Y a  bX

a  y  bx

b
 xy  nx y
 x  nx
2 2
How can we compare across forecasting models?

We need a metric that provides estimation of accuracy

Errors can be:

Forecast Error 1. biased (consistent)
2. random

Forecast error = Difference between actual and forecasted value

(also known as residual)
 Measuring Accuracy
 We need a way to compare different time series techniques
for a given data set.
 Four common techniques are the:
n 
Yi  Y
 Mean Absolute Deviation,
MAD = 
i 1 n
i

100 n Yi  Ŷi
 Mean Absolute Percent Error, MAPE = 
n i 1 Yi
 Mean Square Error,
MSE = 
n
Yi Y
i 
2

i 1 n
 Root Mean Square Error. RMSE  MSE
• We will focus on MSE.
Theil’s Inequality Coefficient (U)

RMSE("new" model)
U=
RMSE("no change" model)

 U>1 worse than "no change" model

 U=1 as good as "no change" model

 U<1 better than "no change" model

Measuring Accuracy: MFE

MFE = Mean Forecast Error (Bias)

It is the average error in the observations

A  t Ft
MFE  i 1
n

1. A more positive or negative MFE implies worse

performance; the forecast is biased.
Measuring Accuracy: MAD

MAD = Mean Absolute Deviation

It is the average absolute error in the observations

n 
Yi  Y
MAD = i 1 n
i

1. Higher MAD implies worse performance.

2. If errors are normally distributed, then σε=1.25MAD
THE END