Introduction to Forecasting

Introduction to Forecasting

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 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 Methods two 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 Forecasting 2 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.

700 600 500 Residential Electricity Sales in Maine (Millions of kwh) 400 300 200 100 January 1973 - May 2005 1975 1980 1985 1990 1995 2000 2005

400 Residential Electricity Sales in Maine 1995-1999 380 360 Ice Storm in January 1998 340 320 300 280 260 1995 1996 1997 1998 1999

360 Residential Electricity Demand in Maine Seasonal Means 340 320 300 280 260 240 220 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.

450 Residential Electricity Demand in Maine (millions of kwh) 400 350 300 250 200 150 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.

300 The Solar Cycle: 1749-1999 Sunspot activity peaks about every 11 years. 250 200 150 100 50 0 60 80 00 20 40 60 80 00 20 40 60 80 00

22000 US Residents Less Than 5 Years Old 20000 18000 16000 14000 12000 10000 8000 10 20 30 40 50 60 70 80 90 00

8000 The Business Cycle Real GDP: 1947-1999 (billions of 1992 dollars) 6000 4000 2000 0 50 55 60 65 70 75 80 85 90 95

Nominal GDP: 1990-1997 There are seasonal variations in GDP. 9000 8000 7000 6000 5000 1990 1991 1992 1993 1994 1995 1996 1997

Definitions Irregular Component The unexplained variation in a time series.

Residential Electricity Demand in Maine Irregular Component 60 40 20 0-20 -40 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