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FORECASTING

FORECASTING
Forecasting is the art and science of predicting future events. It may involve taking historical data and projecting them into the future with some sort of mathematical model. It may be a subjective or intuitive prediction of the future, or it may involve a combination of these, that is, a mathematical model adjusted by a managers good judgment.

FORECASTING
Forecasting Time Horizon Categories 1. Short-range forecast - generally less than three months 2. Medium-range forecast or intermediate forecast that generally spans from three months up to three years. 3. Long-range forecast generally three years or more in time span.

FORECASTING
Types of Forecasts

1. Economic Forecasts model of this type are valuable in helping business prepare medium-to-long range forecasts. 2. Technological Forecasts are concerned with the rates of technological progress. 3. Demand forecasts is a projection of a companys sales (assuming they are equal to demand) for each time period in the planning horizon. This serves as a key to other forecasts used in financial planning, facility openings and closing, new equipment planning, staffing, raw material procurement, and marketing planning.

FORECASTING
FORECASTING TECHNIQUES

Qualitative Models
Delphi Method Jury of Executive Opinion Sales Force Composite Consumer Market Survey

Time Series Methods


Moving Average Exponential Smoothing Trend Projection Decomposition

Causal Methods
Regression Analysis Multiple Regression

FORECASTING
Key Equations
S [forecast errors] 1. MAD = ------------------------n A measure of overall forecast error called mean absolute deviation. S demand in pervious n periods 2. Moving average = ------------------------------------------n An equation for computing a moving average forecast.

S (weight for period n) (demand in period n) 3. Weighted Moving average = ----------------------------------------------------------S weights An equation for computing a weighted moving average forecast.

FORECASTING
Key Equations
4. New forecast = last periods forecast + a (last periods actual demand last periods forecast)
A equation for computing an exponential smoothing forecast.

5. Ft = Ft-1 + a (At-1 Ft-1)


Equation no. 4 rewritten mathematically.

6. Tt = (1- b)Tt-1 + b(Ft-Ft-1)


Trend component of an exponential smoothing model. 7. Y = a + bX A least squares straight line used in trend projection and regression analysis forecasting.

FORECASTING
Key Equations
S XY n XY 8. b = -----------------S X2 nX2 An equation used to compute the slope (b) of a regression line. 9. A = Y bX

An equation used to compute a the Y-intercept (a) of a regression line.


10. SY,X= S (Y - Y)2 -------------- Standard error of the estimate n-2 S Y2 a SY b SXY ---------------------------n-2 Another way to express Equation no.10

11. SY,X=

FORECASTING
Key Equations
n SXY n SX SY 12. r = -------------------------------------[n SX2 (SX)2][n SY2 (SY)2] Correlation coefficient. 13. Y = a + b1X1 + b2X2

The least squares line used in multiple regression.


RSFE 14. Tracking signal = ---------MAD S (actual demand in period i forecast demand in period i) = ------------------------------------------------------------------------------MAD An equation for monitoring forecasts.

FORECASTING
B. Time Series Forecasting Models is based on a sequence of evenly spaced data points

Decomposition of a Time Series 1. Trend (T) is the gradual upward or downward movement of the data over time. 2. Seasonality (S) is a pattern of the demand fluctuation above or below the trend line that occurs every year. 3. Cycle (C) are pattern in the data that occurs every several years. They are usually tied into the business cycle. 4. Random variations (R) are blips in the data caused by chance and unusual situations; they follow no discernible pattern.

FORECASTING
Month January February March Actual Sales Month (1000s) 10 July 12 August 13 September Actual Sales (1000s) 26 30 28

April May June

16 19 23

October November December


Table 1

18 16 14

FORECASTING
1.a. Moving Averages are useful if we can assume that market demands will stay fairly steady over time. A three-month moving average is found by simply summing the demand during the past three months and dividing by 3. With each passing month, the most recent data are added to the sum of the previous two months data, and the earliest month is dropped. Mathematically it is expressed as:
S Demands in previous n periods Moving Average = -----------------------------------------------n Moving Average = 10 + 12 + 13 ----------------- = 11 2/3 3

FORECASTING
1.b. Weighted Moving Averages. When there is a trend or pattern, weights can be used to place more emphasis on recent values. This makes the techniques more responsive to changes since more recent periods may be more heavily weighted. Mathematically it is expressed as:
S (Weight for period n) (Demand in period n) Weighted Moving Average = -------------------------------------------------------------S weights Weighted Moving Average = 10(1) + 12(2) + 13(3) 1 ---------------------------- = 12 /6 6

FORECASTING
2. Exponential Smoothing is a forecasting method that is easy to use and efficiently handled by computers. Although it is a type of moving average technique. It involves very little record keeping of past data. The basic exponential smoothing formula can be shown as follows:
New Forecast =

last periods forecast + a (last periods actual demand last periods forecast)

It can also be written mathematically as:

Ft = Ft+1 + a (At-1 Ft-1)


Where: Ft = the new forecast Ft-1 = the previous forecast a = smoothing constant At-1 = previous periods actual demand

FORECASTING
Example: In January, a car dealer predicted a February demand for 1450 Panasonic Television sets. Actual February demand was 1516 Panasonic TV sets. Using a smoothing constant of a = 0.20, can you forecast the demand for March, using the exponential smoothing model?
Solution: Ft New forecast (for march demand) = 1450 + 0.2 (1516 1450) = 1450 + 0.2 (66) = 1450 + 13.2 Ft = 1463.2

Thus, the demand forecast for Panasonic TV sets in March is 1463 units.

FORECASTING
3. Trend Projection This technique fits a trend line to a series of historical data points and then projects the line into the future for medium to long-range forecasts. To illustrate this, let us consider the time series data for car sales of a particular manufacturer the past 10 years and graph of the car sales time series. Car Sales Data Year (X) Sales in K (Y) Year (X) Sales in K (Y) 1 25.5 6 31.2 2 27.2 7 30.6 3 28.1 8 28.6 4 26.4 9 31.4 5 29.3 10 32

FORECASTING

Trend represent by a Linear Function for Car Sales After we view the time series in the table and graph of the car sales, we might agree that a linear trend as shown in the graph of the trend represented by a linear function for car sales has the potential of providing a reasonable description of the long-run movement in the series. Thus we can now concentrate on finding the linear function that best approximates the trend. Graph of the Car Sales Time Series

FORECASTING
A least squares line is described in terms of its Y-intercept (the height at which it intercepts the Y-axis) and its slope (the angle of the line). It expressed in equation: Y = a + bX
where: Y = trend value for car sales in period (dependent variable a = Y-axis intercept of the trend line b = slope of the trend line (or the rate of change in Y for given change in X X = time in years (independent variable)

FORECASTING
The formulas that can be used to compute the values of a and b for any straight line. The slope (b) is found by: S XY n XY b = ------------------S X2 n X2
where: b = slope of the straight line S = summation sign for n data points X = values of the independent variable (time) Y = values of the dependent variable (car sales) X = average of the values of the Xs Y = average of the values of the Ys n = number of data points or observation (10 in this case)

The Y-intercept (a) is then computed as

a = Y bX

FORECASTING
Transforming time variables X Y 1 25.5 2 27.2 3 28.1 4 26.4 5 29.3 6 31.2 7 30.6 8 28.6 9 31.4 10 32 SX = 55 SY = 290.3 XY 25.2 54.4 84.3 105.6 146.5 187.2 214.2 228.8 282.6 320 X2 1 4 9 16 25 36 49 64 81 100 SX2 = 385

___________________________________________________________

SXY = 1649.1

FORECASTING
55 X = ---- = 5.5 10 290.3 Y = -------- = 29.03 10 1649.1 10(5.5)(29.03) b = -------------------------------385 10(5.5)2 1649.1 1596.65 b = ----------------------385 302.5 52.45 b = --------- = 0.636 82.5

a = 29.03 0.636(5.5) = 25.53


Hence, the least squares trend equation is Y = 25.33 + 0.636X. The regression for the linear trend component of the car sales time series.

FORECASTING
The slope of 0.636 indicates that over the pass 10 years the firm has experienced an average growth in sales of around 636 units per year. If we assume that the past 10 year trend in sales is a good indicator of the future, then this can be used to project the trend component of the series. For example, if we let X = 11 Y = 25.33 + 0.636 (11) Y = 25.33 + 6.996 Y = 32.33 Thus using the trend component, we would forecast sales of 32,330 cars next year.

FORECASTING
Seasonal Variations Recurring variations at certain seasons of the year make a seasonal adjustment in the trend line forecast necessary. Seasonal index indicates how a particular season compares with an average time period. When no trend is present, the index can be found by dividing the average value for a particular season by the average of all the data. This index could then be used to adjust the forecast for the next same month.

FORECASTING
SALES DEMAND MONTH January February March April May June July August September October November December YEAR 1 80 85 80 110 115 120 100 110 85 75 85 80 YEAR 2 100 75 90 90 131 110 110 90 95 85 75 80 AVERAGE TWO-YEAR DEMAND 90 80 85 100 123 115 105 100 90 80 80 80 AVERAGE MONTHLY DEMAND 94 94 94 94 94 94 94 94 94 94 94 94 SEASONAL b INDEX 0.957 0.851 0.904 1.064 1.309 1.223 1.117 1.064 0.957 0.851 0.851 0.851

Total average demand = 1,128

1,128/12

A2YD/AMD

FORECASTING
Seasonal Variations with Trend When trend is present, the seasonal indices should be computed using a centered moving average (CMA) approach. Using this approach prevents a variation due to trend from being incorrectly interpreted as a variation due to the season. QUARTER 1 YEAR 1 YEAR 2 YEAR 3 108 116 123 AVERAGE 115.67

2
3 4 Average

125
150 141

134
159 152

142
168 165

133.67
159.00 152.67

131.00 140.25 149.50 140.25 108(0.5) + 125 +150 + 141 + 116(0.5) CMA (quarter 3 of year 1) = -------------------------------------------------- = 132.00 4 Sales in quarter 3 150 Seasonal ratio = ------------------------ = ---------- = 1.136 CMA 132.00

FORECASTING
Steps use to compute seasonal indices based on CMAs

1. Compute a CMA for each observation (where possible). 2. Compute seasonal ratio = observation/CMA for each observation. 3. Average seasonal ratios to get seasonal indices. 4. If seasonal indices do not add to the number of seasons, multiply each index by (number of seasons)/(sum of the indices).

FORECASTING
4. Decomposition Method of Forecasting with Trend and Seasonal Components Steps to develop a forecast using the decomposition method 1. Compute seasonal indices using CMAs 2. Deseasonalize the data by dividing each number by its seasonal index. 3. Find the equation of a trend line using the deseasonalized data. 4. Forecast for future periods using the trend line. 5. Multiply the trend line forecast by the appropriate seasonal index.

FORECASTING
C. Causal Forecasting Models usually consider several variables that are related to the variable being predicted. When these related variables have been found, a statistical model is built and used to forecast the variable of interest. 1. Regression Analysis Y = a + bX
where: Y = predicted or estimated value of the dependent variable a = Y-axis intercept b = slope of the regression line X = independent variable

FORECASTING
The calculations for a and b: We determine a and b (the Y-intercept and slope) using the least squares formula. SX 18 Sales (Y) Payroll (X) X2 XY X = ----- = ------ = 3 2.0 1 1 2.0 6 6 3.0 3 9 9.0 SY 15 2.5 4 16 10.0 Y = ----- = ------ = 2.5 2.0 2 4 4.0 6 6 2.0 1 1 2.0 a = Y bX 3.5 7 49 24.5 = 2.5 (0.25)(3) = 1.75 SX2 = SY = 15.0 SX = 18 80 SXY = 51.5 SXY nXY 51.5 (6)(3)(2.5) b = ---------------- = ------------------------ = 0.25 SX2 nX2 80 (6)(32)

The estimated regression equation therefore is:


Y = 1.75 + 0.25X

FORECASTING
2. Multiple Regression Analysis. It allows to build a model with several independent variable. Y = a + b1X1 + b2X2
where: Y = predicted value of dependent variable a = Y-intercept b1 and b2 = slopes of X1 and X2, respectively X1 and X2 = values of the two independent variables

The mathematics of multiple regression become quite complex, especially when more than two independent variables are considered, so we leave formulas a, b1, and b2 to statistics texts.

FORECASTING
Correlation Coefficients for Regression Lines The regression equation is one way of expressing the nature of the relationship between two variables. The equation shows how one variable relates to the value and changes in another variable. Another way to evaluate the relationship between two variables is to compute the coefficient of correlation.
n SXY n SX SY r = -------------------------------------[n SX2 (SX)2][n SY2 (SY)2]

FORECASTING

References: 1. Quantitative Analysis for Management 8th edition, by Barry Render, Ralph M. Stair, Jr. & Michael E. Hanna. 2. Quantitative Techniques for Business 1999 edition by the Committee, University of the East. 3. Wikipedia

EXAMINATION
Problem #1. Room registration in the Century Plaza Hotel have been recorded for the past nine years. Management would like to determine the mathematical trend of guest registration in order to project future occupancy. This estimate would help the hotel determine whether a future expansion will be needed. Given the following time-series data, develop a regression equation relating registrations to time. Then forecast year 11s registrations. Room registrations are in thousands: Year (X) Registrants (Y) X2 XY 1 2 3 4 5 6 7 8 9 SX = 17 16 16 21 20 20 23 25 24 SY = SX2 = SXY =

EXAMINATION
Year (X) 1 2 Registrants (Y) 17 16 X2 1 4 XY 17 32

3
4 5 6 7

16
21 20 20 23

9
16 25 36 49

48
84 100 120 161

8
9 SX = 45

25
24 SY = 182

64
81 SX2 = 285

200
216 SXY = 978

SX 45 X = ----- = ------ = 5 9 9

Y =

SY 182 ----- = ------ = 20.22 9 9

EXAMINATION
SXY nXY 978 (9)(5)(20.22) 978 909.9 68.1 b = ---------------- = -------------------------- = ----------------- = ------ = 1.135 SX2 nX2 285 (9)(25) 285 225 60 a = Y bX = 20.22 (1.135)(5) = 20.22 5.675 = 14.545 Y (registrations) = 14.454 + 1.135X The projection of registration in year 11 is

Y = 14.545 + 1.135(11) = 27.03


or 27,030 guests in year 11

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