FORECASTING

What is forecasting?

Forecasting is a tool used for predicting

future scenario based on
past information.
Why is forecasting important?

Many processes and the inputs and outputs or products and services is usually
uncertain.
Forecasting can be used for…
• Strategic planning (long range planning)
• Finance and accounting (budgets and cost controls)
• Marketing (future sales, new products)
• Production and operations
What is forecasting all about?

# of patients We try to predict the

future by looking back
at the past

Predicted
demand
looking
Time back six
Jan Feb Mar Apr May Jun Jul Aug months
Actual demand (past sales)
Predicted demand
Some general characteristics of forecasts

• Forecasts are always wrong

• Forecasts are more accurate for groups or families of
items
• Forecasts are more accurate for shorter time periods
• Every forecast should include an error estimate
• Forecasts are no substitute for calculated demand.
Key issues in forecasting

1. A forecast is only as good as the information included in

the forecast (past data)
2. History is not a perfect predictor of the future (i.e.: there is
no such thing as a perfect forecast)

REMEMBER: Forecasting is based on the assumption

that the past predicts the future! When forecasting,
think carefully whether or not the past is strongly
related to what you expect to see in the future…
Example: Diabetes vs. CVD
Month Diabetes CVD
Jan 2,345 -
Feb 2,034 -
Mar 2,453 -
Apr 2,897 -
May 2,561 -
Jun 2,684 -
Jul ? ?

Question: Can we predict the number of CVD patients based on

the data on Diabetes patients?

Answer: Maybe... We need to consider how much the two

markets have in common
What should we consider when looking at
past demand data?

• Trends

• Seasonality

• Cyclical elements

• Autocorrelation

• Random variation
Some Important Questions

• What is the purpose of the forecast?

• Which systems will use the forecast?
• How important is the past in estimating the future?

Answers will help determine time horizons, techniques,

and level of detail for the forecast.
Types of forecasting methods

Qualitative methods Quantitative methods

Rely on subjective opinions from Rely on data and analytical

one or more experts. techniques.
Qualitative forecasting methods
Grass Roots: deriving future demand by asking the person
closest to the customer.
Market Research: trying to identify customer habits; new
product ideas.
Panel Consensus: deriving future estimations from the
synergy of a panel of experts in the area.
Historical Analogy: identifying another similar market.
Delphi Method: similar to the panel consensus but with
concealed identities.
Quantitative forecasting methods

Time Series: models that predict future demand based

on past history trends
Causal Relationship: models that use statistical
techniques to establish relationships between various
items and demand
Simulation: models that can incorporate some
randomness and non-linear effects
How should we pick our forecasting model?

1. Data availability
2. Time horizon for the forecast
3. Required accuracy
4. Required Resources
Time Series Models: Components
Random Trend

Composite
Seasonal
 Product Demand over Time
Trend component
Seasonal peaks
Demand for product or service

Actual demand
Random line
variation
Year Year Year Year
1 2 3 4
Now let’s look at some time series approaches to forecasting…
Time Series: Moving average

• The moving average model uses the last t periods in order to

predict demand in period t+1.
• There can be two types of moving average models: simple
moving average and weighted moving average
• The moving average model assumption is that the most
accurate prediction of future demand is a simple (linear)
combination of past demand.
Time series: simple moving average

In the simple moving average models the forecast value is

At + At-1 + … + At-n
Ft+1 =
n

t is the current period.

Ft+1 is the forecast for next period
n is the forecasting horizon (how far back we look),
A is the actual sales figure from each period.
Example

MNO sells energy drinks

Month Bottles
Jan 1,325
Feb 1,353
Mar 1,305 What will
the sales be
Apr 1,275
for July?
May 1,210
Jun 1,195
Jul ?
What if we use a 3-month simple moving average?

AJun + AMay + AApr

FJul = = 1,227
3

What if we use a 5-month simple moving average?

AJun + AMay + AApr + AMar + AFeb

FJul = = 1,268
5
Stability versus responsiveness in moving averages

1000
900
800
700 Demand
600
3-Week
500
6-Week
1 2 3 4 5 6 7 8 9 10 11 12

Week
Time series: weighted moving average
We may want to give more importance to some of the data…

Ft+1 = wt At + wt-1 At-1 + … + wt-n At-n

wt + wt-1 + … + wt-n = 1

t is the current period.

Ft+1 is the forecast for next period
n is the forecasting horizon (how far back we look),
A is the actual sales figure from each period.
w is the importance (weight) we give to each period
Why do we need the WMA models?

Because of the ability to give more importance to what

happened recently, without losing the impact of the past.

Patients Actual demand (past sales)

Prediction when using 6-month SMA
Prediction when using 6-months WMA

For a 6-month
SMA, attributing
equal weights to all
past data we miss
Time the downward
Jan Feb Mar Apr May Jun Jul Aug
trend
6-month simple moving average…

AJun + AMay + AApr + AMar + AFeb + AJan

FJul = = 1,277
6

In other words, because we used equal weights, a slight

downward trend that actually exists is not observed…
What if we use a weighted moving average?

Make the weights for the last three months more than the first
three months…

6-month WMA WMA WMA

SMA 40% / 60% 30% / 70% 20% / 80%

July
1,277 1,267 1,257 1,247
Forecast

The higher the importance we give to recent data, the more we

pick up the declining trend in our forecast.
How do we choose weights?

1. Depending on the importance that we feel past data has

2. Depending on known seasonality (weights of past data
can also be zero).

WMA is better than SMA

because of the ability to
vary the weights!
Time Series: Exponential Smoothing (ES)

Main idea: The prediction of the future depends mostly on the

most recent observation, and on the error for the latest forecast.

Smoothin
g constant
Denotes the importance
alpha α of the past error
Why use exponential smoothing?

1. Uses less storage space for data

2. Extremely accurate
3. Easy to understand
4. Little calculation complexity
5. There are simple accuracy tests
Exponential smoothing: the method

Assume that we are currently in period t. We calculated the

forecast for the last period (Ft-1) and we know the actual demand
last period (At-1) …

Ft Ft 1  ( At  1  Ft  1 )

The smoothing constant α expresses how much our forecast will

react to observed differences…
If α is low: there is little reaction to differences.
If α is high: there is a lot of reaction to differences.
Example:

 = 0.2
Month Actual Forecasted

Jan 1,325 1,370

Feb 1,353 1,361

Mar 1,305 1,359

Apr 1,275 1,349

May 1,210 1,334

Jun ? 1,309
Example:

 = 0.8
Month Actual Forecasted

Jan 1,325 1,370

Feb 1,353 1,334

Mar 1,305 1,349

Apr 1,275 1,314

May 1,210 1,283

Jun ? 1,225
Impact of the smoothing constant

1380
1360
1340
1320
Actual
1300
a = 0.2
1280
1260 a = 0.8
1240
1220
1200
0 1 2 3 4 5 6 7
Impact of trend

Sales
Actual
Regular exponential
Data smoothing will always lag
Forecast behind the trend.
Can we include trend
analysis in exponential
smoothing?

Month
ARIMA models (autoregressive integrated
moving average)

1. While exponential smoothing models are based on a

description of the trend and seasonality in the data,
ARIMA models aim to describe the autocorrelations in
the data.
2. Stationarity : A stationary time series is one whose
properties do not depend on the time at which the
series is observed. Thus, time series with trends, or with
seasonality, are not stationary. On the other hand, a
white noise series or a time series with cyclic behavior is
stationary.
Linear regression in forecasting

Linear regression is based on

1. Fitting a straight line to data
2. Explaining the change in one variable through changes in
other variables.

dependent variable = a + b  (independent variable)

By using linear regression, we are trying to explore which

independent variables affect the dependent variable
Example: do people take more cough syrup when
it’s cold?
Cough syrup Sales

Which line best

fits the data?

Average Monthly
Temperature
What does that mean?

Cough Syrup Sales ε ε

ε

So LSM tries to
minimize the distance
between the line and
the points!

Average Monthly
Temperature
The best line is the one that minimizes the error

The predicted line is …

Y a  bX

So, the error is …

εi y i - Yi

Where: ε is the error

y is the observed value
Y is the predicted value
Least Squares Method of Linear Regression

Then the line is defined by

Y a  bX

a  y  bx

b
 xy  nx y
 x  nx
2 2
How can we compare across forecasting models?

We need a metric that provides estimation of accuracy

Errors can be:

Forecast Error 1. biased (consistent)

2. random

Forecast error = Difference between actual and forecasted value

(also known as residual)
Measuring Accuracy: MFE

MFE = Mean Forecast Error (Bias)

It is the average error in the observations

A  t Ft
MFE  i 1
n

1. A more positive or negative MFE implies worse

performance; the forecast is biased.
Measuring Accuracy: MAD

MAD = Mean Absolute Deviation

It is the average absolute error in the observations

AF t t
MAD  i1
n

1. Higher MAD implies worse performance.

2. If errors are normally distributed, then σε=1.25MAD
 General Guiding Principles for Forecasting

1. Forecasts are more accurate for larger groups of items.

2. Forecasts are more accurate for shorter periods of time.
3. Every forecast should include an estimate of error.
4. Before applying any forecasting method, the total system should
be understood.
5. Before applying any forecasting method, the method should be
tested and evaluated.
6. Be aware of people; they can prove you wrong very easily in
forecasting