Slide 1

Chapter 5
DR.NORAZNIN ABU BAKAR
Slide 2
Business and Economic Forecasting

Demand Forecasting is a critical
managerial activity which comes in two
forms:
Quantitative Forecasting
+2.1047% Gives the precise amount
or percentage
Qualitative Forecasting
Gives the expected direction
Up, down, or about the same

Slide 3
What Went Wrong With
SUVs at Ford Motor Co?
Chrysler introduced the Minivan
in the 1980s
Ford expanded its capacity to produce the
Explorer, its popular SUV
Explorers price was raised substantially in 1995
at same time competitors expanded their
offerings of SUVs.
Must consider response of rivals in pricing
decisions
Slide 4
Significance of Forecasting
Both public and private enterprises operate under
conditions of uncertainty.
Management wishes to limit this uncertainty by
predicting changes in cost, price, sales, and
interest rates.
Accurate forecasting can help develop strategies
to promote profitable trends and to avoid
unprofitable ones.
A forecast is a prediction concerning the future.
Good forecasting will reduce, but not eliminate, the
uncertainty that all managers feel.
Slide 5
Hierarchy of Forecasts
The selection of forecasting techniques depends in
part on the level of economic aggregation involved.
The hierarchy of forecasting is:
National Economy (GDP, interest rates,
inflation, etc.)
sectors of the economy (durable goods)
industry forecasts (all automobile manufacturers)
> firm forecasts (Ford Motor Company)
Product forecasts (The Ford Focus)
Slide 6
Forecasting Criteria
The choice of a particular forecasting method
depends on several criteria:
1.costs of the forecasting method compared with
its gains
2.complexity of the relationships among
variables
3.time period involved
4.accuracy needed in forecast
5.lead time between receiving information and
the decision to be made
Slide 7
Accuracy of Forecasting
The accuracy of a forecasting model is measured
by how close the actual variable, Y, ends up to the
forecasting variable, Y.
Forecast error is the difference. (Y - Y)
Models differ in accuracy, which is often based on
the square root of the average squared forecast
error over a series of N forecasts and actual figures
Called a root mean square error, RMSE.
RMSE = { (Y - Y)
2
/ N }
^
^
^
Slide 8
Quantitative Forecasting
Deterministic Time
Series
Looks For Patterns
Ordered by Time
No Underlying Structure
Econometric Models
Explains relationships
Supply & Demand
Regression Models
Like technical
security analysis
Like fundamental
security analysis
Slide 9
Time Series
Examine Patterns in the Past
TIME


T
o
X
X
X
Dependent Variable
Secular Trend
Cyclical Variation
Forecasted Amounts
The data may offer secular trends, cyclical variations, seasonal
variations, and random fluctuations.
Slide 10
Elementary Time Series Models
for Economic Forecasting
1. Naive Forecast

Y
t+1
= Y
t

Method best when
there is no trend, only
random error
Graphs of sales over
time with and without
trends
When trending down,
the Nave predicts too
high
NO Trend
Trend









^
time
time
Slide 11
2. Nave forecast with adjustments
for secular trends
Y
t+1
= Y
t
+ (Y
t
- Y
t-1
)
This equation begins with last periods
forecast, Y
t
.
Plus an adjustment for the change in the
amount between periods Y
t
and Y
t-1
.
When the forecast is trending up, this
adjustment works better than the pure
nave forecast method #1.

^
Slide 12
3. Linear & 4. Constant rate of growth
Used when trend has a
constant AMOUNT of
change
Y
t
= a + bT, where
Y
t
are the actual
observations and
T is a numerical time
variable
Used when trend is a
constant
PERCENTAGE rate
Log Y
t
= a + bT,
where b is the
continuously
compounded growth
rate
Linear Trend Growth Uses a Semi-log Regression
Slide 13
More on Constant Rate of Growth Model
a proof
Suppose: Y
t
= Y
0
( 1 + G)
t
where g is the
annual growth rate
Take the natural log of both sides:
Ln Y
t
= Ln Y
0
+ t Ln (1 + G)
but Ln ( 1 + G ) g, the equivalent
continuously compounded growth rate
SO: Ln Y
t
= Ln Y
0
+ t g
Ln Y
t
= a

+ b t
where b is the growth rate
^
^
Slide 14
Numerical Examples: 6 observations
MTB > Print c1-c3.
Sales Time Ln-sales

100.0 1 4.60517
109.8 2 4.69866
121.6 3 4.80074
133.7 4 4.89560
146.2 5 4.98498
164.3 6 5.10169

Using this sales
data, estimate
sales in period 7
using a linear and
a semi-log
functional
form


Slide 15
The regression equation is
Sales = 85.0 + 12.7 Time

Predictor Coef Stdev t-ratio p
Constant 84.987 2.417 35.16 0.000
Time 12.6514 0.6207 20.38 0.000

s = 2.596 R-sq = 99.0% R-sq(adj) = 98.8%

The regression equation is
Ln-sales = 4.50 + 0.0982 Time

Predictor Coef Stdev t-ratio p
Constant 4.50416 0.00642 701.35 0.000
Time 0.098183 0.001649 59.54 0.000

s = 0.006899 R-sq = 99.9% R-sq(adj) = 99.9%

Slide 16
Forecasted Sales @ Time = 7
Linear Model
Sales = 85.0 + 12.7 Time
Sales = 85.0 + 12.7 ( 7)
Sales = 173.9
Semi-Log Model
Ln-sales = 4.50 + 0.0982
Time
Ln-sales = 4.50 +
0.0982 ( 7 )
Ln-sales = 5.1874
To anti-log:
e
5.1874
= 179.0
linear

Slide 17
Sales Time Ln-sales

100.0 1 4.60517
109.8 2 4.69866
121.6 3 4.80074
133.7 4 4.89560
146.2 5 4.98498
164.3 6 5.10169
179.0 7 semi-log
173.9 7 linear

Which prediction
do you prefer?
Semi-log is
exponential
7
Slide 18
5. Declining Rate of Growth Trend
A number of marketing penetration models
use a slight modification of the constant rate
of growth model
In this form, the inverse of time is used
Ln Y
t
= b
1
b
2
( 1/t )
This form is good for patterns
like the one to the right
It grows, but at continuously
a declining rate time
Y
Slide 19
6. Seasonal Adjustments: The Ratio to Trend Method
Take ratios of the actual to
the forecasted values for past
years.
Find the average ratio. This
is the seasonal adjustment
Adjust by this percentage by
multiply your forecast by the
seasonal adjustment
If average ratio is 1.02, adjust
forecast upward 2%
12 quarters of data
I II III IV I II III IV I II III IV












Quarters designated with roman numerals.
Slide 20
Let D = 1, if 4th quarter and 0 otherwise
Run a new regression:
Y
t
= a + bT + cD
the c coefficient gives the amount of the adjustment for the
fourth quarter. It is an I ntercept Shifter.
With 4 quarters, there can be as many as three dummy variables;
with 12 months, there can be as many as 11 dummy variables
EXAMPLE: Sales = 300 + 10T + 18D
12 Observations from the first quarter of 2002 to 2004-IV.
Forecast all of 2005.
Sales(2005-I) = 430; Sales(2005-II) = 440; Sales(2005-III) = 450;
Sales(2005-IV) = 478
7. Seasonal Adjustments: Dummy Variables
Slide 21

Soothing Techniques
8. Moving Averages
A smoothing forecast
method for data that
jumps around
Best when there is no
trend
3-Period Moving Ave.
Y
t+1
= [Y
t
+ Y
t-1
+ Y
t-2
]/3
*
*
*
*
*

Forecast
Line

TIME
Dependent Variable
Slide 22
Smoothing Techniques
9. First-Order Exponential Smoothing
A hybrid of the Naive
and Moving Average
methods
Y
t+1
= wY
t
+(1-w)Y
t


A weighted average of
past actual and past
forecast.
Each forecast is a function
of all past observations
Can show that forecast is
based on geometrically
declining weights.
Y
t+1
= w .Y
t
+(1-w)wY
t-1
+
(1-w)
2
wY
t-1
+

Find lowest RMSE to pick
the best alpha.
^ ^
^
^
Slide 23
First-Order Exponential
Smoothing Example for w = .50
Actual Sales Forecast
100 100 initial seed required
120 .5(100) + .5(100) = 100
115
130
?
1
2
3
4
5
Slide 24
First-Order Exponential
Smoothing Example for w = .50
Actual Sales Forecast
100 100 initial seed required
120 .5(100) + .5(100) = 100
115 .5(120) + .5(100) = 110
130
?
1
2
3
4
5
Slide 25
First-Order Exponential
Smoothing Example for w = .50
Actual Sales Forecast
100 100 initial seed required
120 .5(100) + .5(100) = 100
115 .5(120) + .5(100) = 110
130 .5(115) + .5(110) = 112.50
? .5(130) + .5(112.50) = 121.25
Period 5
Forecast
MSE = {(120-100)
2
+ (110-115)
2
+ (130-112.5)
2
}/3 = 243.75
RMSE = 243.75 = 15.61
1
2
3
4
5
Slide 26
Direction of sales can be indicated by other variables.
TIME
Index of Capital Goods
peak
PEAK
Motor Control Sales
4 Months
Example: Index of Capital Goods is a leading indicator
There are also lagging indicators and coincident indicators
Qualitative Forecasting
10. Barometric Techniques

Slide 27
LEADING INDICATORS*
M2 money supply (-12.4)
S&P 500 stock prices (-11.1)
Building permits (-14.4)
Initial unemployment claims
(-12.9)
Contracts and orders for
plant and equipment (-7.4)
COINCIDENT
INDICATORS
Nonagricultural payrolls
(+.8)
Index of industrial
production (-1.1)
Personal income less
transfer payment (-.4)
LAGGING INDICATORS
Prime rate (+2.0)
Change in labor cost per unit
of output (+6.4)
*Survey of Current Business, 1994
See pages 206-207 in textbook
Time given in months from change
Slide 28
Handling Multiple Indicators
Diffusion Index: Wall Street With Louis
Ruykeyser has eleven analysts. If 4 are
negative about stocks and 7 are positive, the
Diffusion Index is 7/11, or 63.3%.
above 50% is a positive diffusion index
Composite Index: One indicator rises
4% and another rises 6%. Therefore, the
Composite Index is a 5% increase.
used for quantitative forecasting

Slide 29
Qualitative Forecasting
11. Surveys and Opinion Polling Techniques
Sample bias--
telephone, magazine
Biased questions--
advocacy surveys
Ambiguous questions
Respondents may lie on
questionnaires
New Products have no
historical data -- Surveys
can assess interest in new
ideas.
Survey Research Center
of U. of Mich. does repeat
surveys of households on
Big Ticket items (Autos)
Common Survey Problems
Slide 30
Qualitative Forecasting
12. Expert Opinion
The average forecast from several experts
is a Consensus Forecast.
Mean
Median
Mode
Truncated Mean
Proportion positive or negative
Slide 31
EXAMPLES:

IBES, First Call, and Zacks Investment --
earnings forecasts of stock analysts of companies

Conference Board macroeconomic predictions

Livingston Surveys--macroeconomic forecasts
of 50-60 economists

Individual economists tend to be less
accurate over time than the consensus
forecast.
Slide 32
13. Econometric Models
Specify the variables in the model
Estimate the parameters
single equation or perhaps several stage methods
Q
d
= a + bP + cI + dP
s
+ eP
c
But forecasts require estimates for future prices,
future income, etc.
Often combine econometric models with time series
estimates of the independent variable.
Garbage in Garbage out
Slide 33
example
Q
d
= 400 - .5P + 2Y + .2P
s

anticipate pricing the good at P = $20
Income (Y) is growing over time, the estimate
is: Ln Y
t
= 2.4 + .03T, and next period is T
= 17.
Y = e
2.910
= 18.357
The prices of substitutes are likely to be
P = $18.
Find Q
d
by substituting in predictions for P, Y,
and P
s
Hence Q
d
= 430.31
Slide 34
14. Stochastic Time Series
A little more advanced methods incorporate into time
series the fact that economic data tends to drift
y
t
= a + by
t-1
+ e
t
In this series, if a is zero and b is 1, this is essentially
the nave model. When a is zero, the pattern is called a
random walk.
When a is positive, the data drift. The Durbin-Watson
statistic will generally show the presence of
autocorrelation, or AR(1), integrated of order one.
One solution to variables that drift, is to use first
differences.
Slide 35
Cointegrated Time Series
Some econometric work includes several stochastic
variable, each which exhibits random walk with drift
Suppose price data (P) has positive drift
Suppose GDP data (Y) has positive drift
Suppose the sales is a function of P & Y
Sales
t
= a + bP
t
+ cY
t
It is likely that P and Y are cointegrated in that they
exhibit comovement with one another. They are not
independent.
The simplest solution is to change the form into first
differences as in: DSales
t
= a + bDP
t
+ cDY
t