GE 03 - Fundamentals of Business Mathematics

Forecasting
Forecasting is the term which refers to projecting the occurrence of uncertain events
for a future period analyzing the past and present history of data. Due to increasing
competition and complexity in business activities in almost all sectors of business,
there is a necessity for every organization to know the key decision variable to be
occurred in advance. This may help the organizations to assess the future plans of
actions or strategies. Forecasting activities can be viewed as a part of the management
information system and it is concerned with two main tasks:
(a) First, the determination of the best basis available for the formulation of
efficient managerial expectations.
(b) Second, the handling of uncertainty about the future, so that the implication of
decisions become very comprehensible.

Features of Forecasting
- Forecasting in concerned with future events.
- It shows the probability of happening of future events.
- It analysis past and present data.
- It uses statistical tools and techniques.
- It uses personal observations

Limitations of Forecasting
(a) Forecasting is to be made on the basis of certain assumptions and human
judgements which yield wrong result.
(b) It cannot be considered as a scientific method for guessing future events.
(c) It does not specify any concrete relationship between past and future events.
(d) It requires high degree of skill.
(e) It needs adequate reliable information which is so difficult.
(f) Heavy cost and time consuming.
(g) It cannot be applied to a long period.

Steps in Forecasting
A systematic way of initiating, designing and implementing a forecasting needs the
following steps to be followed:
1. Purpose and policy implication of forecasting.
2. Selection of variables.
3. Determination of time horizon.
4. Collection of Data.
5. Selection of appropriate model for forecasting.
6. Select the model that best explains the given time series data.
7. Make forecast.

TIME SERIES ANALYSIS & FORECASTING 1

 GE 03 - Fundamentals of Business Mathematics

Requirements of a Good Forecasting System

A forecasting system to be instrumental in contributing to better management or
business decision making, needs to fulfill certain criteria.
- It must involve managers or businessmen whose decisions are affected.
- Individual forecasts or group of forecasts have to be specifically relevant to the
decision being taken.
- The forecasts must not claim too much validity or authority.
- Implications of various probable errors in the prediction for the organizations
need to be thoroughly worked so that management can evaluate the
consequences of the probable outcomes.
- Management must at least know how badly things could go wrong if all the
forecasts turned out wrong.

Difference between Budget and Forecast

Basis Budget Forecast
A budget is a financial plan Forecast means estimation of
expressed in quantitative terms, future trends and outcomes,
Meaning
prepared by the management in based on the past and present
advance for forthcoming period. data.
It is the prediction of
It is the financial expression of a upcoming events or trends in
What is it?
business plan or target. business, on the basis of
present business conditions.
Target Budget sets target. There are no targets.
Updation Annual basis At regular intervals
Estimates What business wants to achieve What business will achieve
Variance Yes No
Analysis

TIME SERIES ANALYSIS & FORECASTING 2

 GE 03 - Fundamentals of Business Mathematics

What is Time Series Analysis?

Time series analysis is one approach to forecasting more complex scenarios. A time
series is a set of numerical measurements on a time dependent variable of interest
arranged over a regular interval of time. It is a statistical technique that deals with time
series data, or trend analysis. Time series data means that data is in a series of
particular time periods or intervals.

Objectives of Time Series Analysis

The main objective of analyzing the time series data is to get a concrete idea about the
past behaviour of data so that appropriate course of action for future can be taken.
However, the objectives can be pointed out as follows:
- To identify the pattern and trends and isolate the influencing factors or effects.
- To apply the idea obtained from analyzing the pattern of time series data for a
future planning and control.

Importance of Time Series Analysis in Business Decision Making:

Time series analysis is of great importance to business executives. It is extremely
useful for them in decision making due to the following reasons:
- This is the most popular and so far, the effective method for business forecasting.
- It helps in understanding the past behaviour of economic process and in predicting
the future behaviour.
- It helps in planning future operations.
- It helps in evaluating current achievement.
- It facilitates comparison of same phenomenon over two or more periods.

Limitations of Time Series

1. Analyzing the Impact of Single Events: While trying to assess the impact of a
single event, the major problem is that there are always many events occurring
at any one time. It's difficult to say which type of problem is more intractable,
but they do seem to be two different types of problem.

2. Analyzing Causal Patterns: The problems in analyzing causal patterns are

difficult. One problem with such research is that because the observations within
each series are not independent of each other, the probability of finding a high
correlation between the two series may be higher than is suggested by standard
formulas. A second problem is that it is rarely reasonable to assume that the time
sequence of the causal patterns matches the time periods in the study. A third
problem in analyzing causal patterns is the familiar problem that correlation
does not imply causation.

TIME SERIES ANALYSIS & FORECASTING 3

 GE 03 - Fundamentals of Business Mathematics

Components of Time series

There are considered to be four components of variation in time series:
1. Trend (T): In a time series the trend is the general, overall movement of the
variable with any sharp fluctuations largely smoothed out. It is often called the
underlying trend, and any other components are considered to occur around this
trend.

2. Seasonal Component (S): It accounts for the regular variations that certain
variables show at various times of the year. It has two situations, peaks and
troughs, around the trend which are explained by the seasonal component. In
general, if a variable is recorded weekly, monthly or quarterly, it will tend to
display seasonal variations, whereas data recorded annually will not.

3. Cyclical Component (C): It explains much longer-term variations caused by

business cycles. These cyclic variations cover periods of many years and so have
little effect in the short-term.

4. Residual Component (R): It is the part of a variable that cannot be explained by

the factors mentioned above. It is caused by random fluctuations and
unpredictable or freak events. It will have little effect if the first three
components are explaining the variable’s behaviour well.

Models of Time Series:

The four components of variation are assumed to be combined to produce the variable
in one of two ways. Thus, we have two mathematical models of variable.
- In the first case there is the additive model, in which the components are
assumed to add together to give the variable Y.
Y=T+S+C+R
- The second, multiplicative model considers the components as multiplying to
give Y.
Y=T×S×C×R

TIME SERIES ANALYSIS & FORECASTING 4

 GE 03 - Fundamentals of Business Mathematics

Underlying Trend
There are several factors that affect trend in time series data. Some of the important
factors are:
i. Population - The ever-increasing population of a country is responsible for
increasing trends in series like prices, production, sales etc.
ii. Technology, Institution & Culture - Downward or upward trends in some factors
are caused by technological, institutional or cultural changes.

Reasons for studying trends in a time series data are pointed below:
1. It allows us to describe the historical pattern of time series data.
2. It permits us to project past pattern or trends, into the future.
3. It facilitates us to eliminate the trend component from the series in order to
obtain the de-trended series that is useful for studying other components of time
series data.

There are many ways of forecasting time series variables. Two important methods of
determining the trend are:
(a) If wee assume a linear trend, then we can determine the trend lime using linear
regression, Y = a + bx.
(b) For situations where the assumption of a linear trend is not reasonable, then the
alternative is to use moving averages.

Least Square Method

Least square is a method of fitting trend line by which it is possible to obtain linear or
non-linear trend by establishing suitable functional relationship between the time
variable and the objective variable. The name is due to the fact that sum of the squares
of differences between the observed value and the predicted trend value is the least.
The trend line obtained by this method is considered as the best line. The equation of
the straight line or linear trend is given by, y = a + bx, where y represents the variable,
x represents the transformed time period, a and b are two constants where a is intercept
and b is the slope of line.

TIME SERIES ANALYSIS & FORECASTING 5

 GE 03 - Fundamentals of Business Mathematics

Translating, Converting or Coding Time Variable

Usually the independent variable time is measured in terms of weeks, quarters, months
or years. In order to fit a trend equation of observed variable on the time period, it is
convenient to convert theses traditional measures of time into the form that can
simplify the computation process. The process of conversion is called coding.
- In case of odd number, the convenient way of coding is to find the mean time
and setting its code as 1 and then subtract that value from each of other sample
periods. An example is given here:
Year 1999 2000 2001 2002 2003 2004 2005
Coded Period
-3 -2 -1 0 1 2 3
(x)

- In case of even number, the mean will obtain a value of 0.5 which will be
inconvenient. In that case, to simplify the computation by removing the fraction,
each period code is multiplied by 2.
Year 2001 2002 2003 2004 2005 2006
Coded Period -2.5 -1.5 -0.5 0.5 1.5 2.5
Coded Period
-5 -3 -1 1 3 5
Simplified (x)

Fitting Linear Trend Line:

We know this method is based on two conditions such as:
- The sum of deviations of the actual values of y and the fitted trend values is zero.
- The sum of squares of deviations of the actual and fitted values is the least from the
fitted line.
𝑛 ∑ 𝑥𝑦 − ∑ 𝑥 ∑ 𝑦
The trend line is y = a + bx, where b = and a = 𝑦 - b𝑥
𝑛 ∑ 𝑥 2 −(∑ 𝑥)2

Merits of the method:

a. This is a mathematical method of measuring trend and as such there is no
possibility of subjectivity.
b. The trend line obtained by this method is called the line of best fit, because from
this lone the sum of squares of differences between the observed time series and
estimated trend values is the least.
c. This method enables us to compute the trend values for all the given time period
in the series.
d. This method is only technique, which enables us to obtain the rate of growth per
annum for yearly data in case of linear trend.
e. The projected trend values obtained by this method are more reliable than any
other method.

TIME SERIES ANALYSIS & FORECASTING 6

 GE 03 - Fundamentals of Business Mathematics

Demerits of the method:

a. For using this method, one needs to have higher mathematical knowledge.
b. Calculations required in this method are quite tedious and time consuming as
compared with other methods.
c. If the functional form of the relationship between time period and observations
cannot be defined rightly, the trend values obtained by this method may be
misleading.
d. Fresh calculations become necessary if even single new observations are added.
e. Future predictions based on this method completely ignore the cyclical, seasonal
and random fluctuations.

Moving Average Method

A mathematical method of determining non-linear trend of a time series data is the moving
average method. A moving average for a time period is the simple arithmetic meant of the
values in that time period. The effect of averaging is to give a smoother curve, lessening
the influence of the fluctuations that pull the annual figures away from the general trend.

When to use MA method for non-linear trend:

The moving average method of analyzing non-linear trend of time series data is
recommended under the following situations:
- When the purpose of investigation does not call for current analysis or forecast.
- When the trend line is non-linear
- The cyclical variations are regular both in period and amplitude.

Merits of MA Method:
a. This method is simple as compared to the method of least squares.
b. It is a flexible method of measuring trend. If a few more figures are added to the
data, this method does not need to calculate the trend afresh.
c. Most of the components of time series data can be eliminated by this method,
particularly, the irregular components can be completely eliminated by this
method.

Limitations of MA Method:
a. The main limitation of this method is that trend values cannot be computed for all
the periods. The longer the period of moving average, the greater the number of
periods for which trend values cannot be obtained.
b. The second important limitation of this method is that a mathematical model does
not represent the method, hence this method cannot be used in forecasting which is
one of the major objectives of trend analysis.
c. Moving averages are highly affected by the extreme values as they use arithmetic
mean in computations.

TIME SERIES ANALYSIS & FORECASTING 7

 GE 03 - Fundamentals of Business Mathematics

Seasonal Variation
It accounts for the regular variations that certain variables show at various times of the
year. It has two situations, peaks and troughs, around the trend which are explained by
the seasonal component. In general, if a variable is recorded weekly, monthly or
quarterly, it will tend to display seasonal variations, whereas data recorded annually
will not.

Reasons for Studying Seasonal Component:

- It allows us to establish the pattern of past changes.
- It is useful to project past patterns for the future.
- Once the seasonal pattern that exists in a time series data has been established,
it is possible to eliminate its effect from the data.

We are often presented with a single figure for weekly revenue, monthly profit, or
whatever and it is difficult to make adjustments without some idea of the extent to
which the figure has been distorted by seasonal factors and consequently does not give
a good indication of the trend. Thus, we need to remove the seasonal effect and one
main approach is to deseasonalize or remove the seasonal effect from the figure.

In this context the following points are notable.

1. In an additive time series model, where the cyclical and irregular components
are absent, the seasonal component is given by the difference between actual
data values and the trend values, i.e. S = Y - T.

2. In a multiplicative time series mode, the seasonal component is found by

detrending. Detrending (making data free of trend component) of a time series
means the time series which is free from trend component. Detrending of a time
series is made dividing actual data series by estimated trend components, i.e.
𝑌
S= .
𝑇

3. A point to be noted that, in both of the above cases, Cyclical and random
components are ignored because the cyclical components are not seen in short-
run and random or irregular components are not expected to occur.

4. The process of eliminating seasonal variation from a time series is known as

depersonalization or seasonal adjustment. It is made dividing actual data series
𝑌
by the estimated seasonal components, i.e. T =
𝑆

TIME SERIES ANALYSIS & FORECASTING 8