Overview of Forecasting Techniques

Forecasting
Definition
A Statement of Future To Estimate or Calculate in Advance (Webster)
Forecasting methods are used to predict:
future weather conditions student enrollment, performance sales of existing or new products production capacity requirements interest rates stock market trends
FORECASTING
Marketing - forecasts sales for new and existing products. Production - uses sales forecasts to plan production and operations; sometimes involved in generating sales forecasts;
Forecast Characteristics
A good forecast is more than a single number Aggregate forecasts are more accurate The longer the time horizon, the less accuracy They are often wrong.
Forecasting Horizons
Short term
Intermediate term Long term
Forecasting Horizons
Short-range forecasts

Generally less than 3 months: could be up to a year Used for purchase planning, work force scheduling and job assignment Varies from 3 months to 3 years Used for sales planning, production planning, budgeting and operating plan analysis Varies from 5 years and up Used for new products planning, capital expenditures, facility location, research and development
Medium-range forecasts

Long-range forecasts

Traditional Sales Forecasting Methods...
Most companies seem to use simple techniques that are easy to comprehend and mostly those that involve judgment by company employees. A method widely used results in forecast goal-setting, this is not really forecasting.

Here companies begin their planning process with a corporate goal to increase sales by some percentage. This target often comes directly from the chief executive officer. Then everyone backs into their target based on what each business unit manager thinks they can deliver. Finally, if they dont meet the target when totaled the CEO either assigns targets to particular business units or puts a financial plug in place hoping someone will over deliver.
Current Sales Forecasting Methods and Techniques Being Used
More focus on utilizing time series methods to predict baseline sales demand

Primarily using Winters Exponential Smoothing Also, some Decomposition/Census X-11
Very little ARIMA/Box-Jenkins
Judgmental techniques still seem to be the dominant method of choice

Sales Force Composites Jury of Executive Opinion Delphi Approach
Multiple Regression is beginning to be utilized

More Universities are teaching Regression Applications Accessing causal data is becoming easier Regression is required to evaluate and predict sales promotions
Underlying Theory of Forecasting Methods...
Forecast = Pattern + Randomness
This simple equation is really saying that when the average pattern of the underlying data has been identified some deviation will occur between the forecasting method applied and the actual occurrence.
Sales Forecasting Methods...
Two Types Of Sales Forecasting Methodologies
Qualitative
Also Known as Judgmental or Subjective
Quantitative
Also known as Mathematical or Objective
10
Qualitative Methods
Are also known as Judgmental Rely on subjective assessments of a person or group of people Using intuitive or gut feelings based on their experience and savvy Who understand the current marketplace and whats likely to occur
11
Qualitative Methods
Subjective or judgmental derived forecasts using intuitive or gut feelings
Independent Judgment Committees Sales Force Estimates
12
Qualitative Methods

Also known as Sales Force Composites
13
Qualitative Methods

Also known as Sales Force Composites
Juries of Executive Opinion
14
Qualitative Methods
Advantages

Low cost to develop Executives usually have a solid understanding of the broad-based factors and how they affect sales demand Provides input from the firms key functional areas Can provide sales forecasts fairly quickly
15
Qualitative Methods
Disadvantages

They are always biased toward the user group They are not consistently accurate over time
Some executives may not really understand the firms sales situation since they are too far removed from the actual marketplace
Not well suited for firms with a large number of products
16
Quantitative Methods
One Dimensional or Reactive Methods

Time Series Techniques, using only past sales history alone
Time Series
F o r e c a s t
Shipments
18
One Dimensional or Reactive Methods

Time Series Techniques, using only past sales history alone
Multidimensional or Proactive Methods

Causal Techniques, built on a relationship(s) between past sales and
some other variable(s)
Time Series
F o r e c a s t
Causal
Price Shipments
F o r e c a s t
Shipments
Promo
19
Time Series Methods

(One Dimensional or Reactive Methods)
Advantages

They are well suited to situations where sales forecasts are needed for a large number of products They work very well for products with fairly stable sales They can smooth out small random fluctuations They are simple to understand and use They can be easily systematized and require little data storage Software packages are usually accessible, and They are generally good at short-term forecasting
21
Time Series Methods

(One Dimensional or Reactive Methods)
Disadvantages

They require a large amount of historical data They adjust slowly to changes in sales A great deal of searching may be needed to find the weighted (Alpha) value They usually fall apart when the forecast horizon in long, and Forecasts can be thrown into great error because of large fluctuations in current data
22
Objective mathematically derived forecasts.
Times Series Techniques

Time Series Patterns Nave Forecast Simple Moving Averaging Exponential Smoothing

Simple Exponential Smoothing Holt's Two Parameter Exponential Smoothing Winters Three Parameter Exponential Smoothing
20
Time Series Patterns
Trend
Cyclical
Seasonal
Random
Trend
Persistent, overall upward or downward pattern Due to population, technology etc. Several years duration
Trend
Time
Cycle
Repeating up & down movements Due to interactions of factors influencing economy Usually 2-10 years duration
Sales
Years
Season

Regular pattern of up & down fluctuations Due to weather, customs etc. Occurs within 1 year
Sales
Time Periods
Random Pattern

Erratic, unsystematic, fluctuations Due to random variation or unforeseen events
Union strike
Tornado
Short duration & non repeating
sales
Time Periods
Real Life Pattern ( MUL Sales 1993-2001)
45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0
Time Series Forecasting Techniques
Nave Forecast
Assumes demand in next period is the same as demand in most recent period
e.g., If May sales were 48, then June sales will be 48
Sometimes cost effective & efficient
Moving Averages
MA is a series of arithmetic means Used if little or no trend Used often for smoothing
Provides overall impression of data over time
Equation
Demand in previousn periods MA

n
Moving Averages
Time
Response Moving Total Moving Yi (L=3) Avg (L=3)

4 + 6 + 5 = 15 15/3 = 5.0
1991 4 1992 6 1993 5 1994 3 1995 7 1996 6
Moving Averages
Time

NA NA 4 + 6 + 5 = 15 15/3 = 5.0
1991 4 1992 6 1993 5 1994 3 1995 7 1996 6
Moving Averages
Time

NA NA 4 + 6 + 5 = 15 15/3 = 5.0 6 + 5 + 3 = 14 14/3 = 4.7
1991 4 1992 6 1993 5 1994 3 1995 7 1996 6
Moving Averages
Time

NA NA 4 + 6 + 5 = 15 15/3 = 5.0 6 + 5 + 3 = 14 14/3 = 4.7 5 + 3 + 7 = 15 15/3 = 5.0
1991 4 1992 6 1993 5 1994 3 1995 7 1996 6
Moving Averages
Forecast vs. Actual Sales Forecast
Actual
8 6 4 2
0 91 92 93 94 95 96
Weighted MA(3) = Ft+1 = wt1(Dt) + wt2(Dt-1) + wt3(Dt-2) Month Demand 1 120 2 110 3 90 4 115 5 125 6 117 7 121 8 126 9 132 10 128 It is decided to use a weighting scheme of 0.5, 0.3, 0.2 and calculated the weighted moving average for the 11th month as follows.
Weighted MA(3): F11 = 0.5(128) + 0.3(132) + 0.2(126) = 64 + 39.6 + 25.2 = 128.2
Double Moving Average

Actual Single Error Double Trend Forecast Error Data MA MA 1 2 2 4 3 2 6 4 4 2 8 6 5 2 6 10 8 6 2 8 2 0 12 10 12 7 2 10 2 0 14 12 14 8 2 12 2 0 16 14 16 9 2 14 2 0 18 16 18 10 2 16 2 0 20 18 20 Thus linear MA has three steps: Use of single MA at time t ( St) Adjustment i.e. difference of single MA and Double MA at time t (St-St) Adjustment for trend from t to t+1 e.g. forecast for period 6 is calculated as 8+(8-6)+2 = 12 St =Xt + Xt-1 + Xt-2+.Xt-N+1 St =St + St-1 + St2+.St-N+1 N At = 2 St- St Bt = 2*( St- St) / (N-1) Forecast : F t+m = At + Bt *m N Period
Moving Averages
Increasing the size of n (the number of periods averaged) does smooth out fluctuations better, it makes the method less sensitive to real changes in data. Moving averages cannot pick up trends very well. Because they are averages, they will always stay within past levels and will not predict changes to either higher or lower levels. That is, they lag the actual values.
Moving averages require extensive records of past data
Exponential Smoothing
Form of weighted moving average

Weights decline exponentially Most recent data weighted most
Requires smoothing constant ()

Ranges from 0 to 1 Subjectively chosen
Involves little record keeping of past data
Ft+1 = Xt+ (1- ) Ft
where: Ft+1= Forecast for the period t+1. Ft = Forecast for the period t. = Smoothing constant Xt= Actual value at time t.
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0
Forecast f^ + 1 t NA
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0
Forecast f^ + 1 t NA
4.0
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2)
Forecast f^ + 1 t NA 4.0
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6)
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
Forecast f^ + 1 t NA 4.0 4.4
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
(.2)
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
(.2)(5)
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
(.2)(5) + (1-.2)
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
(.2)(5) + (1-.2)(4.4)
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
(.2)(5) + (1-.2)(4.4)=4.5
4.5
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
(.2)(5) + (1-.2)(4.4)=4.5
(.2)
4.5
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
(.2)(5) + (1-.2)(4.4)=4.5
(.2)(3)
4.5
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
(.2)(5) + (1-.2)(4.4)=4.5
(.2)(3)+ (1-.2)
4.5
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
(.2)(5) + (1-.2)(4.4)=4.5
(.2)(3)+ (1-.2)(4.5)
4.5
1997 1998
7 NA
Ft+1 = Xt+ (1- ) Ft
Time 1993 1994 1995 1996
Xt
4 6 5 3
Calculation ( = 0.2) 4.0 (.2) (6) + (1-.2)(4.0) = 4.4
(.2)(5) + (1-.2)(4.4)=4.5
(.2)(3)+ (1-.2)(4.5)=4.2
4.5
4.2
1997 1998
7 NA
Double Exponential Smoothing

St = * Yt + (1- ) * St-1 St = * St + (1- ) * St-1 At = 2* St St Bt = ( / (1- ) ) *( St S t) Forecast = At + Bt
Sr.No 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Data 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 S't 2.0 2.6 3.6 4.9 6.5 8.1 9.9 11.7 13.6 15.5 17.5 19.4 21.4 23.4 S"t 2.0 2.2 2.6 3.3 4.3 5.4 6.8 8.2 9.9 11.6 13.3 15.2 17.0 18.9 At 2.0 3.0 4.6 6.6 8.7 10.8 13.0 15.2 17.4 19.5 21.6 23.7 25.8 27.8 Bt Forecast
-0.4 -0.9 -1.4 -1.9 -2.3 -2.7 -3.0 -3.2 -3.4 -3.5 -3.7 -3.7 -3.8
2.7 3.8 5.2 6.8 8.5 10.3 12.2 14.1 16.1 18.1 20.0 22.0 24.0
Applications of Single Exponential Smoothing Methods:

SES can be used only when the data is stationary. Stationary data means that the data is constant around a constant value and that the variance around the mean remains constant over time. This forecasting method requires very less storage and very less computations. Hence SES is attractive when large number of data are available.
Alfa :Alfa is called smoothing coefficient, the value of which varies from 0 to 1 High value of alfa gives more weight to the recent data patterns Thus a large value of alfa gives little smoothing in forecast where as smaller alfa gives considerable smoothing
Holts Method
Double Exponential Smoothing
Holts method is a type of double exponential smoothing designed to track time series with a linear trend. Two smoothing constants: for series (intercept) - for trend (slope)
Holts Method
Ft Lt + T t L t X t - 1 + ( 1 - )(L t - 1 + T t - 1) T t ( L t - L t - 1 ) + ( 1 - )T t - 1
Ft Forecast for period t
Lt Tt Xt-1
Level term (intercept) Trend term (slope) Last period actual value Smoothing constant for Level L Smoothing constant for Trend T
Holts Method
= 0.1
Initial Month Jan Feb 0.1 Average Level Calculation
= 0.1
Level 4801 Level 4801 Trend 112 Trend 112
Sales Forecast 2000 4913
Holts Method
= 0.1
Initial Average
= 0.1
Month Level Calculation Jan Feb (0.1)(2000)
Holts Method
= 0.1
Initial Average
= 0.1
Month Level Calculation Jan Feb (0.1)(2000) + (1-0.1)
Holts Method
= 0.1
Initial Average
= 0.1
Month Level Calculation Jan Feb (0.1)(2000) + (1-0.1)(4801 +
Holts Method
= 0.1
Initial Average
= 0.1
Month Level Calculation Jan Feb (0.1)(2000) + (1-0.1)(4801 + 112)
Holts Method
= 0.1
Initial Average
= 0.1
Trend 112 Trend 112
Level 4801 Month Level Calculation Level Jan 4801 Feb (0.1)(2000) + (1-0.1)(4801 + 112) 4622
Holts Method
= 0.1
Initial Month Jan Feb (0.1) Average Trend Calculation
= 0.1
Level 4801 Level 4801 4622 Trend 112 Trend 112
Holts Method
= 0.1
Initial Average
= 0.1
Month Trend Calculation Jan Feb (0.1)(4622
Holts Method
= 0.1
Initial Average
= 0.1
Month Trend Calculation Jan Feb (0.1)(4622- 4801)
Holts Method
= 0.1
Initial Average
= 0.1
Month Trend Calculation Jan Feb (0.1)(4622- 4801)+(1-01)
Holts Method
= 0.1
Initial Average
= 0.1
Month Trend Calculation Jan Feb (0.1)(4622- 4801)+(1-01)(112)
Holts Method
= 0.1
Initial Average
= 0.1
Level 4801 Level 4801 4622 Trend 112 Trend 112 82.87
Holts Method
= 0.1
Initial Average
= 0.1
Level 4801 Level 4801 4622 Trend 112 Trend 112 82.87
Sales Forecast 2000 4913 4705
Holts Method
Holts Method is more effective for the data that exhibits trend because both Simple exponential smoothing and Moving average fail to catch up with trend
Seasonal Model
This method is employed for computing seasonal factors for a time series with seasonal variation and no trend. (Let N = number of time periods in a cycle). Calculate the sample mean of all the data. Average the demand for like time periods to obtain N averages. Divide the N averages by the sample mean to obtain the seasonal factors for each of the N time periods in a cycle. The resulting ratios are N seasonal factors, and these seasonal factors will sum to N.
Winters Model
A winters model is used for data series which exhibit combined Season and trend
F t (L t + T t )x St L t X t - 1 + ( 1 - )(L t - 1 + T t - 1) T t ( L t - L t - 1 ) + ( 1 - )T t - 1 St = (Xt-s/Lt-s) +( 1- )S t-s

Overview of Forecasting Techniques

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Forecasting

Intermediate term Long term

Traditional Sales Forecasting Methods...

Current Sales Forecasting Methods and Techniques Being Used

Primarily using Winters Exponential Smoothing Also, some Decomposition/Census X-11

Very little ARIMA/Box-Jenkins

Judgmental techniques still seem to be the dominant method of choice

Sales Force Composites Jury of Executive Opinion Delphi Approach

Multiple Regression is beginning to be utilized

Underlying Theory of Forecasting Methods...

Forecast = Pattern + Randomness

Underlying Theory of Forecasting Methods...

Forecast = Pattern + Randomness

Underlying Theory of Forecasting Methods...

Forecast = Pattern + Randomness

Sales Forecasting Methods...

Two Types Of Sales Forecasting Methodologies

Independent Judgment Committees Sales Force Estimates

Independent Judgment Committees Sales Force Estimates

Independent Judgment Committees Sales Force Estimates

Juries of Executive Opinion

One Dimensional or Reactive Methods

One Dimensional or Reactive Methods

Multidimensional or Proactive Methods

some other variable(s)

Time Series Methods

Time Series Methods

Times Series Techniques

Time Series Patterns

Erratic, unsystematic, fluctuations Due to random variation or unforeseen events

Short duration & non repeating

Real Life Pattern ( MUL Sales 1993-2001)

45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0

Time Series Forecasting Techniques

e.g., If May sales were 48, then June sales will be 48

Sometimes cost effective & efficient

Provides overall impression of data over time

Demand in previousn periods MA

Response Moving Total Moving Yi (L=3) Avg (L=3)

1991 4 1992 6 1993 5 1994 3 1995 7 1996 6

Response Moving Total Moving Yi (L=3) Avg (L=3)

1991 4 1992 6 1993 5 1994 3 1995 7 1996 6

Response Moving Total Moving Yi (L=3) Avg (L=3)

1991 4 1992 6 1993 5 1994 3 1995 7 1996 6

Response Moving Total Moving Yi (L=3) Avg (L=3)

1991 4 1992 6 1993 5 1994 3 1995 7 1996 6

Double Moving Average

Moving averages require extensive records of past data

Form of weighted moving average

Weights decline exponentially Most recent data weighted most

Requires smoothing constant ()

Ranges from 0 to 1 Subjectively chosen

Involves little record keeping of past data

Ft+1 = Xt+ (1- ) Ft

Ft+1 = Xt+ (1- ) Ft

Time 1993 1994 1995 1996

Calculation ( = 0.2) 4.0

Ft+1 = Xt+ (1- ) Ft

Time 1993 1994 1995 1996

Calculation ( = 0.2) 4.0

Ft+1 = Xt+ (1- ) Ft

Time 1993 1994 1995 1996

Calculation ( = 0.2) 4.0 (.2)