Introduction to Forecasting

Predicting the future Not an exact science but instead consists of a set of statistical tools and techniques that are

supported by human judgment and intuition.

Introduction to Forecasting

Introduction to Forecasting

• Business forecasting generally attempts to predict future customer demand for a firm’s goods or services

• Macroeconomic forecasting attempts to predict future behavior of the economy and identify business cycle turning points.

Applications of forecasting

Operations management: forecast of product sales; demand for services

Marketing: forecast of sales response to advertisement procedures, new promotions etc.

Finance & Risk management: forecast returns from investments Economics: forecast of major economic variables, e.g. GDP,

population growth, unemployment rates, inflation; useful for monetary & fiscal policy; budgeting plans & decisions

Industrial Process Control: forecasts of the quality characteristics of a production process

Demography: forecast of population; of demographic events (deaths, births, migration); useful for policy planning

Forecast Methodstwo types of

forecasting methods: Qualitative methods are based on: -judgement -opinion -past experience -best guesses

Qualitative Techniques

• Delphi method (technological forecasting)

• Market research

• Panel of consensus (CEFC in Maine)

• Visionary forecasts

• Historical analogies

Useful for long forecast horizons and/or when the amount of historical data is limited.

Quantitative [Statistical] Techniques

Stochastic methods including:

summary statistics; moving averages; exponential smoothing; time series decomposition; regression models; trend projections; Box-Jenkins methodology.

Make use of historical data & of a forecasting model.

The three most widely used forecasting models -time series -Smoothing models - regression

Components of Demand Forecasting2 main factors help determine the type of forecasting method to be used: - Time Frame - Behavior & Possible Existence of Patterns

Short to Mid-Range forecasts : from daily to up to two years in length. commonly used to determine production and delivery schedules and to establish inventory levels. Long-Range forecasts : over two years into the future. usually used for strategic planning ; establish long-term goals, plan new products, enter new markets and develop new facilities & technology.

Definitions

Time Series A set of chronologically ordered points of

data.

In forecasting a time series it is generally assumed that factors which caused demand in the past will persist into the future.

Definitions

Decomposition Techniques Separating a time series into several

unobservable components, generally in an additive or multiplicative fashion.

Such components usually include a trend, seasonal, cycle, and residual or irregular.

Definitions

Seasonal Component Regularly occurring, systematic variation in

a time series according to the time of year.

Not found in annual data, or data of lower frequencies.

100

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700

1975 1980 1985 1990 1995 2000 2005

Residential Electricity Sales in Maine

(Millions of kWh)

January 1973 - May 2005

260

280

300

320

340

360

380

400

1995 1996 1997 1998 1999

Ice Storm in

January 1998

Residential Electricity Sales in Maine

1995 - 1999

Residential Electricity Demand in Maine Seasonal Means

220

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260

280

300

320

340

360

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Definitions

Trend Component The tendency of a variable to grow over time,

either positively or negatively.

Residential Electricity Demand in Maine (millions of kWh)

150

200

250

300

350

400

450

74 76 78 80 82 84 86 88 90 92 94 96 98

Definitions

Cycle Cyclical patterns in a time series which are

generally irregular in depth and duration.

Such cycles often correspond to periods of economic expansion or contraction.

Also know as the business cycle.

The Solar Cycle: 1749 - 1999 Sunspot activity peaks about every 11 years.

0

50

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60 80 00 20 40 60 80 00 20 40 60 80 00

8000

10000

12000

14000

16000

18000

20000

22000

10 20 30 40 50 60 70 80 90 00

US Residents

Less Than 5 Years Old

The Business Cycle Real GDP: 1947 - 1999

(billions of 1992 dollars)

0

2000

4000

6000

8000

50 55 60 65 70 75 80 85 90 95

Nominal GDP: 1990 - 1997 There are seasonal variations in GDP.

5 0 0 0

6 0 0 0

7 0 0 0

8 0 0 0

9 0 0 0

1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7

Definitions

Irregular Component The unexplained variation in a time series.

Residential Electricity Demand in Maine Irregular Component

-40

-20

0

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90 91 92 93 94 95 96 97 98 99

Examples of Time Series Behavior A trend is a gradual, long-term, upward or downward movement in demand. A current trend is the steady increase in sales of personal computers over the past few years. A cycle is an up-and-down movement in demand that repeats itself over a longer time span. Automotive sales often behave in a cyclical pattern. A seasonal pattern is a repetitive movement in demand that occurs periodically. Sales of winter sports equipment is seasonal by nature.

Problem Definition

• Expectations of customer

• Ask questions: - Desired form of forecast (e.g. monthly forecasts)

- Forecast horizon

- Forecast interval (how often to be revised)

Inputs to the Forecasting Process (data collection)

• Finding sources of data about the item to be forecast.

• Obtaining information about external conditions --- those factors in the environment that will influence a forecast.

• Determining the needs of the user of the forecast.

Inputs to the Forecasting Process (data collection)

• Putting together the human & financial resources required to produce a forecast.

• Listing the available alternatives for forecasting techniques.

Data Analysis

Identify the components of a time series.

• Trend: Does the series exhibit some slope when graphed?

• Seasonal: Does the series exhibit regular peaks and troughs during the year?

• Cycle: Are there identifiable cycles which last longer than 1 year?

Data Analysis

Identify the components of a time series.

• Irregular: Are there observations which cannot be associated with either the trend or seasonal components?

(The Ice Storm of 1998)

• Looking for irregularities is the primary focus of data analysis.

Data Quality

• Check for accuracy.

• Check for conformity: the data must adequately represent the phenomenon for which it is being used.

Macroeconomic indicators should reflect business cycles.

Data Quality

• Timeliness: When are the data available?

• Preliminary versus revised data?

• Are the data consistent across time?

BLS is experimenting with new measures of employment and the CPI that are not

completely consistent with historical data.

Exploratory Data Analysis

• Begin with a plot for your series and look for predominant features.

• Calculate summary statistics for the series.

• Fit a time trend to the series and look for outliers. Calculate (fitted - actual) values.

• Can you decompose the series?

Model Selection & Fitting

• Choose one or more forecasting models

• Fit the model to the data (estimate the unknown parameters, e.g. OLS)

• Evaluate the quality of the model fit

Model validation

• Examine fit to historical data

• Examine magnitude of forecast errors

• Evaluate the quality of the model fit

The forecasting process