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Dr Valentina Plekhanova
CISM02: Decision Support for Management
Unit 9
Unit 9
"I have seen the future and it is very much like the present, only longer."
Kehlog Albran, The Profit
This nugget of pseudo-philosophy is actually a concise description of statistical forecasting.
We search for statistical properties of a time series that are constant in time--levels, trends,
seasonal patterns, correlations and autocorrelations, etc. We then predict that those
properties will describe the future as well as the present.
Unit 9
Forecasting in Management
Forecasting is used in various domains of management, such as:
Personnel management
Resource management
Finance management
Organisational management
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Forecasting (0)
All forecasting methodologies can be divided into three broad headings, i.e.
forecasts based on:
The data from past activities
are cheapest to collect but
may be outdated and past
behaviour is not necessarily
indicative of future behaviour.
Lucey, 2002
CISM02 Decision Support for Management
Forecasting (1)
An important use of quantitative models is in the prediction of the future. In
order to plan and control effectively, management needs estimates of future
levels of sales, costs, manpower requirements, and a variety of other factors.
Before taking almost any decision, a manager must make a number of
forecasts about future conditions and the effects of various courses of action.
These forecasts may be made only mentally, even subconsciously, but they are
a necessary part of decision making.
When forecasts have to be made on the basis of past data, managers has two
main approaches available to them
using intuition
using a model.
The use of intuition involves experience, knowledge of the market, flair etc. and
its importance should not be underestimated.
From Hull, et. al. Model Building Techniques
for Management, Saxon House, 1977
CISM02 Decision Support for Management
Unit 9
Forecasting (2)
However, when used alone, it does have a number of drawbacks:
Intuitive forecasts tend to be biased. This is partly due to the personality of the
forecaster and whether he/she is an optimist or a pessimist, but also to confusion
between targets and forecasts. If the forecasts is to be used as a target,
individuals will set forecasts on the low side. On the other hand, if the forecast is
to be used as a basis for budget allocations, individuals will set forecasts on the
high side to increase their share of the total budget.
It is difficult to forecast the limits of accuracy for an intuitive forecast.
The time of people with the skill and knowledge to make such forecasts is
expensive.
In many forecasting situations, for example, stock control, a very large number
of separate forecasts have to be made and the use of intuitive forecasting can be
very time-consuming.
Model building is a way of overcoming these drawbacks. If the model is chosen
correctly there will be no bias.
CISM02 Decision Support for Management
Unit 9
Forecasting (3)
Furthermore, the error is a forecast can be estimated and, generally, if a large
number of forecasts are required, they can be produced in a routine way by
either a junior clerk or a computer at relatively low cost.
However, a forecast which is produced by model building is sometimes no more
than an extrapolation of past data. It may ignore the effects of changes some
external important factors such as government policy, increases in the number of
competitors and any other events which are not reflected in the past data.
Unit 9
(1)
There are several dimensions that can be used in grouping existing forecasting
methodologies. Many of these are technical in their orientation.
For example, the distinction between statistical methods and non-statistical
methods might be considered, or that between time series methods and causal
methods.
Still another technical distinction can be made between those methods that are
quantitative in their orientation and those that are qualitative.
The most general distinction is between informal forecasting approaches and
formal forecasting methods.
The informal forecasting methodologies are based largely on intuitive feel and
lack systematic procedures that would make them easily transferable for
application by others.
The formal forecasting methodologies seek to overcome this weakness by
systematically outlining the steps to be followed so that they can be repeatedly
applied to obtain suitable forecasts in a range of situations.
CISM02 Decision Support for Management
Unit 9
(2)
Formal forecasting methodologies can be divided into those that are qualitative
and those that are quantitative.
Qualitative forecast methods
subjective
Quantitative forecast methods
based on mathematical formulas
The quantitative methods, in turn, can be subdivided into the categories of
time series techniques and causal or regression techniques.
The qualitative segment also includes two categories:
???
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Forecasting: Framework
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Forecasting Methods
Qualitative: Delphi method, Surveys, Forecast by analogy, Scenario
building
use management judgment, expertise, and opinion to predict future
demand
Time series
statistical techniques that use historical demand data to predict future
demand
Causal/ Econometric methods: Regression methods
attempt to develop a mathematical relationship between demand and
factors that cause its behavior
Other Methods: Simulation
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Qualitative Methods
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Quantitative Methods
Time Series Models:
Assumes the future will follow same patterns as the past
Relate the forecast to only one factor - time
Include
moving average
exponential smoothing
linear trend line
Causal / Econometric Models:
Explores cause-and-effect relationships
Uses leading indicators to predict the future,
e.g. housing starts and appliance sales
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Quantitative Forecasting:
Time-Series Models
Two factors are important in a time-series model: the series we want to
forecast (such as weekly supermarket sales) and the period of time to
which we are referring.
Advantage of time-series models is that the basic rules of accounting
are oriented toward sequential time period. This means that in most
firms data is readily available on the basis of these time periods and
can be used in the application of a time-series forecasting technique.
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10
Quantitative Forecasting:
Time-Series Models Time Horizon
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Trend
Seasonality
Cycle
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11
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Moving Average
Naive forecast
demand the current period is used as next periods forecast
Simple moving average
stable demand with no pronounced behavioral patterns
Weighted moving average
weights are assigned to most recent data
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12
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13
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Di
i=1
MAn =
where
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14
ORDERS
PER MONTH
Jan
Feb
Mar
Apr
May
June
July
Aug
Sept
Oct
Nov
99.0
85.0
82.0
88.0
95.0
91.0
120
90
100
75
110
50
75
130
110
90
-
Calculations:
MOVING
AVERAGE
Di
i=1
MA5 =
90 + 110 + 130+75+50
5
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Demand
Total demand
in last 6
months
6 month
moving
average
Forecast
(1)
(2)
(3)
(4)
(5)
31
29
30
33
34
29
186
31
31
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30
15
Demand
Total demand in
last 6 month
6 month moving
average
37
192
32
Forecast
32
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Month
Demand
Total demand
in last 6
months
6 month
moving
average
Forecast
(1)
(2)
(3)
(4)
(5)
37
192
32
33
196
32.67
32
32.67
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16
Sales
400
o
300
o
o
200
forecast
100
o
Time (month)
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17
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WMAn =
i=1
Wi Di
where
Wi = 1.00
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18
Weight
Data
17%
33%
50%
130
110
90
3
November Forecast:
WMA3 =
i=1
Wi Di
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Forecasting with
Smoothing Techniques (1)
One type of problem that managers frequently face is that of preparing shortterm forecast for a number of different items. As a result of the nature of these
situations, the variable to be forecast can generally be assumed to change only
slightly during each subsequent time period.
Obviously there can be occasions on which it might change a considerable
amount in a single period, but generally speaking many of these items exhibit a
fairly stable series of values over a short time horizon.
In the government sector forecasting situations would include predicting
unemployment figures for each of several industries on a short-term basis and
perhaps changes in the price index for each of several commodities.
The techniques that are used most often in the above situations are referred to
as smoothing methods.
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19
Forecasting with
Smoothing Techniques (2)
The historical data is used to obtain a smoothing value for the series
which becomes the forecast for some future period.
In applying a smoothing techniques there are two steps:
1. In the first some kind of smoothing values is computed based on
historical data.
2. In the second that value is used as a forecast for some future time.
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Forecasting with
Smoothing Techniques (3)
The basic notion inherent in some smoothing techniques such as
moving average, exponential smoothing and other forms is that there is
some underlying pattern in the values of the variables to be forecast and
that the historical observations of each variable represent the
underplaying pattern as well as random fluctuations.
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20
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21
Exponential Smoothing
Averaging method
Weights most recent data more strongly
Reacts more to recent changes
Widely used, accurate method
Exponential smoothing:
popular technique for short-run forecasting by business forecasters. It
uses a weighted average of past data as the basis for a forecast. The
procedure gives heaviest weight to more recent information and smaller
weights to observations in the more distant past. The reason for this is
that the future is more dependent upon the recent past than on the
distant past.
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22
Exponential Smoothing
Forecasting Method
Ft +1 = Dt + (1 - )Ft
where:
Ft +1 =forecast for next time period
Dt =actual value/demand for present period
Ft =previously determined forecast for present period (i.e. the forecast for
the present time period t )
=weighting factor, exponential smoothing constant; a value between 0
and 1
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Why is it Exponential?
By direct substitution of the defining equation for simple exponential smoothing
back into itself we find that
Ft +1 = Dt + (1 - )Ft = Dt + (1 - ) [ Dt-1 + (1 - )Ft-1 ]= Dt + (1 - ) Dt-1 +
(1 - )Ft-1 = [Dt + (1 - ) Dt-1 + (1 - )Dt-2 + (1 - )Dt-3 + ] + (1)t D0
In other words, as time passes the smoothed statistic Ft +1 becomes the weighted
average of a greater and greater number of the past observations Dtn, and the
weights assigned to previous observations are in general proportional to the
terms of the geometric progression {1, (1), (1)2, (1)3, }.
A geometric progression is the discrete version of an exponential function, so this
is where the name for this smoothing method originated from.
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23
Geometric Progression
In mathematics, a geometric progression, also known as a geometric sequence,
is a sequence of numbers where each term after the first is found by multiplying
the previous one by a fixed non-zero number called the common ratio.
For example, the sequence 2, 6, 18, 54, ... is a geometric progression with
common ratio 3 and 10, 5, 2.5, 1.25, ... is a geometric sequence with common
ratio 1/2. The sum of the terms of a geometric progression is known as a
geometric series.
Thus, the general form of a geometric sequence is a , ar , ar2 , ar3 , ar4 ,
and that of a geometric series is
a + ar + ar2 + ar3 + ar4 +
where r 0 is the common ratio and a is a scale factor, equal to the sequence's
start value.
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If = 1, then Ft +1 = 1 Dt + 0 Ft = Dt
Forecast based only on most recent data
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24
Month
Demand
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
37
40
41
37
45
50
43
47
56
10 Oct
11 Nov
12 Dec
F2 = D1 + (1 - )F1
= (0.30)(37) + (0.70)(37)
= 37
F3 = D2 + (1 - )F2
= (0.30)(40) + (0.70)(37)
= 37.9 .
F13 = D12 + (1 - )F12
52
55
54
= (0.30)(54) + (0.70)(50.84)
= 51.79
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Exponential Smoothing
Period
1
2
3
4
5
6
7
8
9
10
11
12
13
Jan 37
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan
40
41
37
45
50
43
47
56
52
55
54
Unit 9
FORECAST, Ft + 1
( = 0.5)
37.00
37.90
38.83
38.28
40.29
43.20
43.14
44.30
47.81
49.06
50.84
51.79
37.00
38.50
39.75
38.37
41.68
45.84
44.42
45.71
50.85
51.42
53.21
53.61
50
25
Exponential Smoothing
70
60
= 0.50
Actual
Orders
50
40
= 0.30
30
20
10
0
Month
|
1
|
2
|
3
|
4
|
5
|
6
|
7
|
8
|
9
|
10
|
11
|
12
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13
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Exponential Smoothing
Forecasting Method
Most frequently used time series method because of
ease of use and minimal amount of data needed
Need just three pieces of data to start:
Last periods forecast (Ft)
Last periods actual value (Dt)
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26
280
Trend Line
260
o
240
o
220
Error
200
Time (weeks)
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y y = b (x x)
where
y = the value of the item to be forecast, in this case sales, during a
particular time period;
x = the corresponding time period;
b = the trend, in this case average increase in sales per month;
y = the mean of the y values for which data are available;
x = the mean of the x values for which data are available.
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27
y"
and
y
n
x y
xy n
b
( x)
x
2
As the trend is likely to change over time, only the more recent data can be
used to estimate the trend. Table below shows a calculation of the regression
line for example which considers sales figures for the last five months.
CISM02 Decision Support for Management
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Sales
xy
x2
46
46
47
94
52
156
45
180
16
x =15
55
275
y =245
Unit 9
xy =751
25
x 2 =55
Regression
analysis
using
previous five
months
sales
56
28
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Measurement: Remarks
Measurement is the determination of the size or magnitude of something.
Measurement is not limited to physical quantities, but can extend to quantifying
almost anything imaginable.
In physics and engineering, measurement is the process of comparing physical
quantities of real-world objects and events. Established standard objects and
events are used as units, and the measurement results in at least two numbers
for the relationship between the item under study and the referenced unit of
measurement, where at least one number estimates the statistical uncertainty in
the measurement, also referred to as measurement error (in a philosophical
distinction). Measuring instruments are the means by which this translation is
made.
In scientific research, measurement is essential. It includes the process of
collecting data which can be used to make claims about learning. Measurement
is also used to evaluate the effectiveness of a program or product (known as an
evaluand).
A measurement is a comparison to a standard. -- William Shockley
CISM02 Decision Support for Management
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Forecast Accuracy
Questions!
What is the accuracy of a particular forecast?
How to measure the suitability of a particular forecasting method for a
given data set?
Forecast error
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Remarks The error can be determined only when actual (future) data
are available.
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30
Absolute Error
Absolute error - absolute uncertainty. Compare with relative error.
The uncertainty in a measurement, expressed with appropriate units.
For example, if three replicate weights for an object are 1.00 g, 1.05 g,
and 0.95 g, the absolute error can be expressed as 0.05 g.
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Relative Error
Relative error - relative uncertainty.
Compare with absolute error.
The uncertainty in a measurement compared to the size of the
measurement.
For example,
if three replicate weights for an object are 2.00 g, 2.05 g, and 1.95 g,
the absolute error can be expressed as 0.05 g and the relative error is
0.05 g / 2.00 g = 0.025 = 2.5%.
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31
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Gross Error
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32
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33
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ME At Ft / n
i 1
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34
MAE ( At Ft ) / n
i 1
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Measures: Remarks
The previous three measures are series specific; i.e., they only allow
evaluation of the series that generated the errors.
The next two measures, by using the percentage of the error relative to
the actual, are designed to allow comparison of the results with different
models.
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100
/ n
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36
n At Ft
MAPE
t 1
At
100
/n
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MAD =
Dt - Ft
n
where
t = period number
t
Ft = forecast for period t
n = total number of periods
Dt = demand in period
= absolute value
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37
MAD: Example
DEMAND, Dt
1
2
3
4
5
6
7
8
9
10
11
12
Ft ( =0.3)
(Dt - Ft)
37
37.00
40
37.00
41
37.90
Dt -38.83
Ft
37
MAD
45 =
38.28
n
50
40.29
53.39
43
43.20
=
47
1143.14
56
44.30
52 = 4.8547.81
55
49.06
54
50.84
3.00
3.10
-1.83
6.72
9.69
-0.20
3.86
11.70
4.19
5.94
3.15
3.00
3.10
1.83
6.72
9.69
0.20
3.86
11.70
4.19
5.94
3.15
49.31
53.39
557
CISM02 Decision Support for Management
Unit 9
|Dt - Ft|
PERIOD
75
MAPD =
|Dt - Ft|
Dt
Cumulative error
E = et
Average error
et
E= n
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Comparison of Forecasts
FORECAST
MAD
MAPD
Unit 9
(E)
4.48
3.02
1.92
77
Statistical Measures
of Goodness of Fit
In trend analysis the following measures will be used:
The Correlation Coefficient
The Determination Coefficient
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It has a value between zero and one, with a high value indicating a good
fit.
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40