FUNDAMENTALS OF BUSINESS ANALYTICS
Module 9 : FORECASTING
Learning Objectives:
Define Forecasting
Explain how judgmental approaches are used for forecasting.
List different types of statistical forecasting models.
Apply moving average and exponential smoothing models to stationary time series
What is Forecasting
“A forecast is a prediction and its purpose is to calculate and predict some future
events or condition.”
Allen L.A., “Forecasting is a systematic attempt to probe the future by inference
from known facts.”
Netter and Wasserman, “ Business forecasting refers to statistical analysis of the
past and current movements in the given time series so as to obtain clues about
the future pattern of this movement.
FORECASTING METHODS
Forecasting methods can generally be divided into three groups:
(1) judgmental methods,
(2) extrapolation (or time series) methods
(3) econometric (or causal) methods.
Qualitative and Judgmental Methods
Qualitative and judgmental techniques rely on experience and intuition; they are
necessary when historical data are not available or when the decision maker needs
to forecast far into the future.
Another use of judgmental methods is to incorporate nonquantitative information in
a quantitative forecast.
historical analogy
Delphi method
Indicators and indexes
Judgmental Forecasting Method
In historical analogy, a forecast is obtained through a comparative analysis with a
previous situation.
The Delphi method, also known as the estimate-talk-estimate technique (ETE), is a
systematic and qualitative method of forecasting by collecting opinions from a group of
experts through several rounds of questions. The Delphi method relies on experts who are
knowledgeable about a certain topic so they can forecast the outcome of future
scenarios, predict the likelihood of an event, or reach consensus about a particular
Indicators are measures that are believed to influence the behavior of a variable we wish
to forecast. Indicators are often combined quantitatively into an index, a single measure
that weights multiple indicators, thus providing a measure of overall expectation.
Extrapolation models
Extrapolation models are quantitative models that use past data of a time series variable—
and nothing else, except possibly time itself—to forecast future values of the variable.
A time series is a stream of historical data, such as weekly sales. Time series generally have
one or more of the following components: random behavior, trends, seasonal effects, or
cyclical effects.
Time series that do not have trend, seasonal, or cyclical effects but are relatively constant
and exhibit only random behavior are called stationary time series.
A trend is a gradual upward or downward movement of a time series over time.
A seasonal effect is one that repeats at fixed intervals of time, typically a year, month,
week, or day.
Cyclical effects describe ups and downs over a much longer time frame, such as several
years.
Extrapolation models
A variety of statistically-based forecasting methods for time series are commonly
used.
moving average methods
exponential smoothing
regression analysis.
Moving Average Models
The simple moving average method is a smoothing method based on the idea
of averaging random fluctuations in the time series to identify the underlying
direction in which the time series is changing.
Because the moving average method assumes that future observations will be
similar to the recent past, it is most useful as a short-range forecasting method.
Chart of Weekly Tablet Computer Sales Chart of Units Sold and Moving Average Forecast
Error Metrics and Forecast Accuracy
To analyze the effectiveness of different forecasting models, we can define
error metrics, which compare quantitatively the forecast with the actual
observations.
Three metrics that are commonly used:
mean absolute deviation
mean square error, and
mean absolute percentage error.
Error Metrics and Forecast Accuracy
The mean absolute deviation (MAD) is the absolute difference between the
actual value and the forecast, averaged over a range of forecasted values:
where At is the actual value of the time series at time
t, Ft is the forecast value for time t, and n is the
number of forecast values (not the number of data
points since we do not have a forecast value
associated with the first k data points). MAD provides
a robust measure of error and is less affected by
extreme observations.
Error Metrics and Forecast Accuracy
Mean square error (MSE) is probably the most commonly used error metric. It
penalizes larger errors because squaring larger numbers has a greater impact than
squaring smaller numbers. The formula for MSE is
Again, n represents the number of forecast values used in computing the average.
Sometimes the square root of MSE, called the root mean square error (RMSE), is used:
Error Metrics and Forecast Accuracy
A fourth commonly used metric is mean absolute percentage error (MAPE).
MAPE is the average of absolute errors divided by actual observation values.
Exponential Smoothing Models
Simple exponential smoothing. The basic simple exponential smoothing model is
where Ft+1is the forecast for time period t + 1, Ft is the forecast for period t, At is the
observed value in period t, and a is a constant between 0 and 1 called the smoothing
constant. To begin, set F1 and F2 equal to the actual observation in period 1, A1.
Econometric Models
Econometric Models – a forecasting models based on regression, where
other time series variables are used as explanatory variables (also called
causal or regression-based models)
