1 1 Slide © 2000 South-Western College Publishing/ITP Slides Prepared by JOHN LOUCKS

2 2 Slide Chapter 16 Forecasting n Quantitative Approaches to Forecasting n The Components of a Time Series n Measures of Forecast Accuracy n Forecasting Using Smoothing Methods n Forecasting Using Trend Projection n Forecasting with Trend and Seasonal Components n Forecasting Using Regression Models n Qualitative Approaches to Forecasting

3 3 Slide Quantitative Approaches to Forecasting n Quantitative methods are based on an analysis of historical data concerning one or more time series. n A time series is a set of observations measured at successive points in time or over successive periods of time. n If the historical data used are restricted to past values of the series that we are trying to forecast, the procedure is called a time series method. n If the historical data used involve other time series that are believed to be related to the time series that we are trying to forecast, the procedure is called a causal method.

4 4 Slide Time Series Methods n Three time series methods are: smoothingsmoothing trend projectiontrend projection trend projection adjusted for seasonal influencetrend projection adjusted for seasonal influence

5 5 Slide Components of a Time Series n The trend component accounts for the gradual shifting of the time series over a long period of time. n Any regular pattern of sequences of values above and below the trend line is attributable to the cyclical component of the series. n The seasonal component of the series accounts for regular patterns of variability within certain time periods, such as over a year. n The irregular component of the series is caused by short-term, unanticipated and non-recurring factors that affect the values of the time series. One cannot attempt to predict its impact on the time series in advance.

6 6 Slide Measures of Forecast Accuracy n Mean Squared Error In this measure the average of the squared forecast errors for the historical data is calculated. The forecasting method or parameter(s) which minimize this mean squared error is then selected. n Mean Absolute Deviation In this measure, the mean of the absolute values of all forecast errors is calculated, and the forecasting method or parameter(s) which minimize this measure is selected. The mean absolute deviation measure is less sensitive to individual large forecast errors than the mean squared error measure.

7 7 Slide Smoothing Methods n In cases in which the time series is fairly stable and has no significant trend, seasonal, or cyclical effects, one can use smoothing methods to average out the irregular components of the time series. n Four common smoothing methods are: Moving averagesMoving averages Centered moving averagesCentered moving averages Weighted moving averagesWeighted moving averages Exponential smoothingExponential smoothing

8 8 Slide Smoothing Methods n Moving Average Method The moving average method consists of computing an average of the most recent n data values for the series and using this average for forecasting the value of the time series for the next period.

9 9 Slide Smoothing Methods n Centered Moving Average Method The centered moving average method consists of computing an average of n periods' data and associating it with the midpoint of the periods. For example, the average for periods 5, 6, and 7 is associated with period 6. This methodology is useful in the process of computing season indexes.

10 Slide Smoothing Methods n Weighted Moving Average Method In the weighted moving average method for computing the average of the most recent n periods, the more recent observations are typically given more weight than older observations. For convenience, the weights usually sum to 1.

11 Slide Smoothing Methods n Exponential Smoothing Using exponential smoothing, the forecast for the next period is equal to the forecast for the current period plus a proportion (  ) of the forecast error in the current period.Using exponential smoothing, the forecast for the next period is equal to the forecast for the current period plus a proportion (  ) of the forecast error in the current period. Using exponential smoothing, the forecast is calculated by:Using exponential smoothing, the forecast is calculated by:  [the actual value for the current period] +  [the actual value for the current period] + (1-  )[the forecasted value for the current period], (1-  )[the forecasted value for the current period], where the smoothing constant, , is a number between 0 and 1.

12 Slide Trend Projection n If a time series exhibits a linear trend, the method of least squares may be used to determine a trend line (projection) for future forecasts. n Least squares, also used in regression analysis, determines the unique trend line forecast which minimizes the mean square error between the trend line forecasts and the actual observed values for the time series. n The independent variable is the time period and the dependent variable is the actual observed value in the time series.

13 Slide Trend Projection n Using the method of least squares, the formula for the trend projection is: T t = b 0 + b 1 t. where: T t = trend forecast for time period t where: T t = trend forecast for time period t b 1 = slope of the trend line b 1 = slope of the trend line b 0 = trend line projection for time 0 b 0 = trend line projection for time 0 b 1 = n  tY t -  t  Y t b 0 = Y - b 1 t b 1 = n  tY t -  t  Y t b 0 = Y - b 1 t n  t 2 - (  t ) 2 n  t 2 - (  t ) 2 where: Y t = observed value of the time series at time period t where: Y t = observed value of the time series at time period t Y = average of the observed values for Y t Y = average of the observed values for Y t t = average time period for the n observations t = average time period for the n observations

14 Slide Example: Roberts’s Drugs During the past ten weeks, sales of cases of Comfort brand headache medicine at Robert's Drugs have been as follows: Week Sales Week Sales Week Sales Week Sales If Robert's uses exponential smoothing to forecast sales, which value for the smoothing constant ,  =.1 or  =.8, gives better forecasts?

15 Slide Example: Robert’s Drugs n Exponential Smoothing To evaluate the two smoothing constants, determine how the forecasted values would compare with the actual historical values in each case. Let: Y t = actual sales in week t F t = forecasted sales in week t F 1 = Y 1 = 110 F 1 = Y 1 = 110 For other weeks, F t +1 =.1 Y t +.9 F t

16 Slide Example: Robert’s Drugs n Exponential Smoothing For  =.1, 1 -  =.9 F 1 = 110 F 2 =.1 Y F 1 =.1(110) +.9(110) = 110 F 3 =.1 Y F 2 =.1(115) +.9(110) = F 4 =.1 Y F 3 =.1(125) +.9(110.5) = F 5 =.1 Y F 4 =.1(120) +.9(111.95) = F 6 =.1 Y F 5 =.1(125) +.9(112.76) = F 7 =.1 Y F 6 =.1(120) +.9(113.98) = F 8 =.1 Y F 7 =.1(130) +.9(114.58) = F 9 =.1 Y F 8 =.1(115) +.9(116.12) = F 10 =.1 Y F 9 =.1(110) +.9(116.01) =

17 Slide Example: Robert’s Drugs n Exponential Smoothing For  =.8, 1 -  =.2 F 1 = 110 F 2 =.8(110) +.2(110) = 110 F 3 =.8(115) +.2(110) = 114 F 4 =.8(125) +.2(114) = F 5 =.8(120) +.2(122.80) = F 6 =.8(125) +.2(120.56) = F 7 =.8(120) +.2(124.11) = F 8 =.8(130) +.2(120.82) = F 9 =.8(115) +.2(128.16) = F 10 =.8(110) +.2(117.63) =

18 Slide Example: Robert’s Drugs n Mean Squared Error In order to determine which smoothing constant gives the better performance, calculate, for each, the mean squared error for the nine weeks of forecasts, weeks 2 through 10 by: [( Y 2 - F 2 ) 2 + ( Y 3 - F 3 ) 2 + ( Y 4 - F 4 ) ( Y 10 - F 10 ) 2 ]/9

19 Slide Example: Robert’s Drugs  =.1  =.8  =.1  =.8 Week Y t F t ( Y t - F t ) 2 F t ( Y t - F t ) 2 Week Y t F t ( Y t - F t ) 2 F t ( Y t - F t ) Sum Sum Sum Sum MSE Sum/9 Sum/9 MSE Sum/9 Sum/

20 Slide Example: Auger’s Plumbing Service The number of plumbing repair jobs performed by Auger's Plumbing Service in each of the last nine months are listed below. Month Jobs Month Jobs Month Jobs Month Jobs Month Jobs Month Jobs March 353 June 374 September 399 March 353 June 374 September 399 April 387 July 396 October 412 April 387 July 396 October 412 May 342 August 409 November 408 May 342 August 409 November 408 Forecast the number of repair jobs Auger's will perform in December using the least squares method. Also, forecast for December using a three-period weighted moving average with weights of.6,.3, and.1. Then, compare the two forecasts.

21 Slide Example: Auger’s Plumbing Service n Trend Projection (month) t Y t tY t t 2 (month) t Y t tY t t 2 (Mar.) (Apr.) (Apr.) (May) (May) (June) (June) (July) (July) (Aug.) (Aug.) (Sep.) (Sep.) (Oct.) (Oct.) (Nov.) (Nov.) Sum

22 Slide Example: Auger’s Plumbing Service n Trend Projection (continued) t = 45/9 = 5 Y = 3480/9 = t = 45/9 = 5 Y = 3480/9 = n  tY t -  t  Y t (9)(17844) - (45)(3480) n  tY t -  t  Y t (9)(17844) - (45)(3480) b 1 = = = 7.4 b 1 = = = 7.4 n  t 2 - (  t ) 2 (9)(285) - (45) 2 n  t 2 - (  t ) 2 (9)(285) - (45) 2 b 0 = Y - b 1 t = (5) = b 0 = Y - b 1 t = (5) = T 10 = (7.4)(10) = T 10 = (7.4)(10) =

23 Slide Example: Auger’s Plumbing Service n Three-Month Weighted Moving Average The forecast for December will be the weighted average of the preceding three months: September, October, and November. F 10 =.1 Y Sep. +.3 Y Oct. +.6 Y Nov. F 10 =.1 Y Sep. +.3 Y Oct. +.6 Y Nov. =.1(399) +.3(412) +.6(408) =.1(399) +.3(412) +.6(408) = = Due to the positive trend component in the time series, the least squares method produced a forecast that is more in tune with the trend that exists. The weighted moving average, even with heavy (.6) placed on the current period, produced a forecast that is lagging behind the changing data

24 Slide Forecasting with Trend and Seasonal Components n Steps of Multiplicative Time Series Model 1. Calculate the centered moving averages (CMAs). 2. Center the CMAs on integer-valued periods. 3. Determine the seasonal and irregular factors ( S t I t ). 4. Determine the average seasonal factors. 5. Scale the seasonal factors ( S t ). 6. Determine the deseasonalized data. 7. Determine a trend line of the deseasonalized data. 8. Determine the deseasonalized predictions. 9. Take into account the seasonality.

25 Slide Example: Terry’s Tie Shop Business at Terry's Tie Shop can be viewed as falling into three distinct seasons: (1) Christmas (November-December); (2) Father's Day (late May - mid-June); and (3) all other times. Average weekly sales (in $'s) during each of these three seasons during the past four years has been as follows: Year Year Season Season Determine a forecast for the average weekly sales in year 5 for each of the three seasons.

26 Slide Example: Terry’s Tie Shop Dollar Moving Scaled Dollar Moving Scaled Year Season Sales ( Y t ) Average S t I t S t Y t / S t Year Season Sales ( Y t ) Average S t I t S t Y t / S t

27 Slide Example: Terry’s Tie Shop n 1. Calculate the centered moving averages. There are three distinct seasons in each year. Hence, take a three season moving average to eliminate seasonal and irregular factors. For example the first moving average is: ( )/3 = n 2. Center the CMAs on integer-valued periods. The first moving average computed in step 1 ( ) will be centered on season 2 of year 1. Note that the moving averages from step 1 center themselves on integer-valued periods because n is an odd number.

28 Slide Example: Terry’s Tie Shop n 3. Determine the seasonal and irregular factors ( S t, I t ). Isolate the trend and cyclical components. For each period t, this is given by: Y t /(Moving Average for period t ). Y t /(Moving Average for period t ). n 4. Determine the average seasonal factors. Averaging all S t I t values corresponding to that season: Season 1: ( ) /3 = Season 1: ( ) /3 = Season 2: ( ) /4 = Season 2: ( ) /4 = Season 3: ( ) /3 =.587 Season 3: ( ) /3 =.587

29 Slide Example: Terry’s Tie Shop n 5. Scale the seasonal factors ( S t ). Divide each seasonal factor by the average of the seasonal factors. Then average the seasonal factors = ( )/3 = Season 1: 1.180/1.002 = Season 1: 1.180/1.002 = Season 2: 1.238/1.002 = Season 2: 1.238/1.002 = Season 3:.587/1.002 =.586 Season 3:.587/1.002 =.586 Total = Total = 3.000

30 Slide Example: Terry’s Tie Shop n 6. Determine the deseasonalized data. Divide the data point values, Y t, by S t. n 7. Determine a trend line of the deseasonalized data. Using the least squares method for t = 1, 2,..., 12, gives: Using the least squares method for t = 1, 2,..., 12, gives: T t = t T t = t

31 Slide Example: Terry’s Tie Shop n 8. Determine the deseasonalized predictions. Substitute t = 13, 14, and 15 into the least squares equation: T 13 = (33.96)(13) = 2022 T 13 = (33.96)(13) = 2022 T 14 = (33.96)(14) = 2056 T 14 = (33.96)(14) = 2056 T 15 = (33.96)(15) = 2090 T 15 = (33.96)(15) = 2090 n 9. Take into account the seasonality. Multiply each deseasonalized prediction by its seasonal factor to give the following forecasts for year 5: Season 1: (1.178)(2022) = Season 1: (1.178)(2022) = Season 2: (1.236)(2056) = Season 2: (1.236)(2056) = Season 3: (.586)(2090) = Season 3: (.586)(2090) =

32 Slide Qualitative Approaches to Forecasting n Delphi Approach A panel of experts, each of whom is physically separated from the others and is anonymous, is asked to respond to a sequential series of questionnaires.A panel of experts, each of whom is physically separated from the others and is anonymous, is asked to respond to a sequential series of questionnaires. After each questionnaire, the responses are tabulated and the information and opinions of the entire group are made known to each of the other panel members so that they may revise their previous forecast response.After each questionnaire, the responses are tabulated and the information and opinions of the entire group are made known to each of the other panel members so that they may revise their previous forecast response. The process continues until some degree of consensus is achieved.The process continues until some degree of consensus is achieved.

33 Slide Qualitative Approaches to Forecasting n Scenario Writing Scenario writing consists of developing a conceptual scenario of the future based on a well defined set of assumptions.Scenario writing consists of developing a conceptual scenario of the future based on a well defined set of assumptions. After several different scenarios have been developed, the decision maker determines which is most likely to occur in the future and makes decisions accordingly.After several different scenarios have been developed, the decision maker determines which is most likely to occur in the future and makes decisions accordingly.

34 Slide Qualitative Approaches to Forecasting n Subjective or Interactive Approaches These techniques are often used by committees or panels seeking to develop new ideas or solve complex problems.These techniques are often used by committees or panels seeking to develop new ideas or solve complex problems. They often involve "brainstorming sessions".They often involve "brainstorming sessions". It is important in such sessions that any ideas or opinions be permitted to be presented without regard to its relevancy and without fear of criticism.It is important in such sessions that any ideas or opinions be permitted to be presented without regard to its relevancy and without fear of criticism.

35 Slide The End of Chapter 16