Chapter 10 10 -1

Business Forecasting
Chapter 4
Data Collection and Analysis in
Forecasting
Chapter Topics
Preliminary Adjustments to Data

Data Transformation

Patterns in Time Series Data

The Classical Decomposition Method
Preliminary Data Adjustments
Trading Day Adjustments

Price Change Adjustments

Population Change Adjustments
Trading Day Adjustments
Yr J F M A M J J A S O N D
05 21 20 23 21 22 22 21 23 22 21 22 22
06 22 20 23 20 23 22 21 23 22 22 22 21
07 23 20 22 21 23 21 22 23 20 23 22 21
Trading Day Adjustment
Average Trading Days for Each Month


Month Average Number of Trading Days


January 22.00
February 20.00
March 22.67
April 20.67
May 22.67
June 21.67
July 21.33
August 23.00
September 21.33
October 22.00
November 22.00
December 21.33

Trading Day Adjustments
Trading Day Computation for October


Trading Day Actual Adjusted
Year Trading Days Coefficient Data Data


2005 21 21/22 = 0.954 5,000,000 5,241,090
2006 22 22/22 = 1.000 5,000,000 5,000,000
2007 23 23/22 = 1.045 4,000,000 3,827,751

Chapter 10 10 -2
Price Change Adjustments
Compunet Sales Data, 19902005


(1) (2) (3) (4) (5) (6)
Compunet Sales Computer Software Price Sales in
in Current $ Price Index Price Index Index* Constant $
Year (Thousands) 1995=100 1995=100 1995=100 (Thousands)


1990 89.0 58.40 63.81 59.48 149.63
1991 90.0 57.03 71.98 60.02 149.94
1992 95.4 66.57 77.61 68.78 138.71
1993 96.6 72.47 86.19 75.21 128.44
1994 98.9 79.27 91.55 81.73 121.01
1995 99.4 100.00 100.00 100.00 99.40
1996 100.2 110.14 114.61 111.03 90.24
1997 106.2 123.15 144.10 127.34 83.40
1998 107.5 131.92 166.22 138.78 77.46
1999 108.3 145.23 204.56 157.10 68.94
2000 120.0 153.40 236.19 169.96 70.60
2001 105.0 129.20 234.18 150.20 69.91
2002 103.8 116.79 224.66 138.37 75.02
2003 102.1 117.70 229.76 140.11 72.87
2004 98.7 124.51 247.05 149.02 66.23
2005 99.6 128.74 260.05 155.01 64.26

Price Change Adjustments
Having computed the price index, we are now
able to deflate the sales revenue with the
weighted price index in the following way:


63 . 149
0 . 48 . 59
100
) 0 . 89 ( 1990 =
|
.
|

\
|
= sales Deflated
Price Change Adjustments
To see the impact of separating the effect of price
level changes, we graph the price of computers in
constant and current dollars.



Figure 4.1 Computer Sales in Current and Constant Dollars
0
20
40
60
80
100
120
140
160
1986 1991 1996 2001 2006
Time
S
a
l
e
s

Current Dollars Constant Dollars
Population Change Adjustments
Disposable Personal Income and Per Capita Income for the
U.S. 1990 and 2005
Disposable Income Population Per Capita Disposable
Year Billions of Dollars (in Millions) Income ($)
1990 4285.8 250.2 17,129.50
1991 4464.3 253.5 17,610.65
. .
. .
1999 6695.0 279.3 23,970.64
2000 7194.0 282.4 25,474.50
2001 7486.8 285.4 26,232.66
2002 7830.1 288.3 27,159.56
2003 8162.5 291.1 28,040.19
2004 8681.6 293.9 29,539.30
2005 9036.1 296.7 30,455.34
Data Transformation
Most appropriate remedial measure for variance
heterogeneity.

Original data are converted into a new scale,
resulting in a new data set that is expected to
satisfy the condition of homogeneity of variance.

Several transformation techniques are available.


Data Transformation
Linear Transformation:
An important assumption in using the regression
model for forecasting is that the pattern of observation
is linear.
Obviously, there are many situations in which this is
not a valid assumption.
For example, if we were forecasting monthly sales and it
was believed that those sales varied according to the
season of the year, then the assumption of linearity
would not hold.
Chapter 10 10 -3
Linear Transformation
A forecasting equation may be of the form:



The above could easily be transformed into a
linear form for estimation purposes:


u . e Y
X |
o =
u X Y log log log + + = | o

Logarithmic Transformation


Southwest Airlines Operating Revenue between 1990 and 2006

Operating Revenue Logarithmic
Year (Million Dollars) Transformation


1990 1237 3.09
1991 1379 3.14
1992 1803 3.26


2003 5937 3.77
2004 6530 3.81
2005 7584 3.88
2006 9086 3.96


Logarithmic Transformation
Time
O
p
e
r
a
t
i
n
g

R
e
v
e
n
u
e

0
2,000
4,000
6,000
8,000
10,000
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
1.00
10.00
L
o
g

o
f

O
p
e
r
a
t
i
n
g

R
e
v
e
n
u
e

Actual Log
Figure 4.2 Actual and Logarithmically Transformed Operating Revenue for Southwest Airlines
Square Root Transformation
Southwest Airlines Operating Revenue for the Years 1990 and 2006


Operating Revenue Square Root
Year (Million Dollars) Transformation


1990 1,237 35.17
1991 1,379 37.13


2002 5,522 74.31
2003 5,937 77.05
2004 6,530 80.81
2005 7,584 87.09
2006 9,086 95.32

Square Root Transformation
(Scaled Square Root Data)
0
2,000
4,000
6,000
8,000
10,000
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Time
0.00
20.00
40.00
60.00
80.00
100.00
120.00
Operating Revenue Square Root
S
q
u
a
r
e

R
o
o
t

O
p
e
r
a
t
i
n
g

R
e
v
e
n
u
e

Square Root Transformation
(Unscaled Square Root Data)


0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
10,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Actual
Transformed
Chapter 10 10 -4
Classical Time Series Model
Secular Trend (T )

Seasonal Variation (S )

Cyclical Variation (C )

Random or Irregular Variation (I)
Trend
Linear Trend


Non-linear Trend



bx a Y
t
+ =
t
b a
t
e Y
+
=
2
cT bT a Y
t
+ + =
Trend
Computing the Linear Trend

The Freehand Method

The Semi-average Method

The Least Squares Method



Freehand Method
U.S. Private Fixed Investment for the Years 19952005


Total Private Fixed Investment
Year ($ Billion)


1995 1,112.9
1996 1,209.9
1997 1,317.8
1998 1,438.4
1999 1,558.8
2000 1,679.0
2001 1,646.1
2002 1,570.2
2003 1,649.8
2004 1,830.6
2005 2,036.2

Freehand Method
Since a linear trend by this method is simply an
approximation of a straight line equation, we have to
determine the intercept and the slope of the line.









bx a Y
t
+ =
x Y
t
48 . 61 2 . 845

+ =
Based on our data, we have:
Freehand Method
0
200
400
600
800
1000
1200
1400
1600
1 2 3 4 5 6 7 8 9 10
Time
M
i
l
l
i
o
n
s
o
f
D
o
l
l
a
r
s
Actual
Trend Line
Chapter 10 10 -5
Freehand Method
Now we can use this equation to make a
forecast of the trend. For example, the
forecast for 2006 would be:

) 12 ( 94 . 83 9 . 112 , 1

+ =
t
Y
Dollars Billion 18 . 120 , 2

2006
= Y

Freehand Method
Based on your understanding, what are
the pitfalls of using the freehand method?
Simple method but not objective.
Why not objective?
The Semi-average Method
Simple but objective method in fitting a trend line.
Divides the data into two equal parts and
computes the average for each part.
The computed averages for each part provide
two points on a straight line.
The slope of the line is computed by taking the
difference between the averages and dividing it
by half of the total number of observations.
The Semi-average Method
Fitting a Straight Line by the Semi-Average Method to
Income from the Export of Durable Goods, 19962005
Year Income Semi-total Semi-average Coded Time
1996 394.9 2
1997 466.2 1
1998 481.2 2,415.1 483.02 0
1999 503.6 1
2000 569.2 2
2001 522.2 3
2002 491.2 4
2003 499.8 2,679 535.8 5
2004 556.1 6
2005 609.7
The Semi-average Method
We see that the intercept of the line is:
483.02
The fitted equation is:
The slope is:
56 . 10
5
02 . 483 80 . 535
=

= b
x Y
t
56 . 10 02 . 483

+ =
The Semi-average Method
For the year 2005, the forecast revenue from
export of durable goods is:


(7) 10.56 483.02

+ =
t
Y
Billion $556.94

=
t
Y
Chapter 10 10 -6
The Least Squares Method
Provides the best method of fitting a trend.
The intercept and the slope are computed as
follows:

n
Y
a

=

=
2
x
xY
b
The Least Squares Method
Using the data from the previous example, we
have:



4 . 509
10
1 . 094 , 5
= = a
79 . 7
330
3 . 571 , 2
= = b
The Least Squares Method
The fitted trend line equation is:
7.79x 509.4 Y
t
+ =

Note: Since x is measured in a half year,

we have to multiply it by two to get the
full year.
x = 0 in 2000
1 x = year
Y = Billions of Dollars
The Least Squares Method
To compare the two methods, we note:
Least squares:
Semi-average:
x Y
t
56 . 10 02 . 483

+ =
15.58x 509.4 Y
t
+ =

Nonlinear Trend
In many business and economic environments
we observe that the time series does not
follow a constant rate of increase or decrease,
but follows an increasing or decreasing
pattern.
Whenever there is dramatic change in
production technology, we expect the trend
line not to follow a constant linear pattern.

Nonlinear Trend
A polynomial function best exemplifies
business conditions.
2

t t t
cx bx a Y + + =
A second-degree parabola provides a good
historical description of an increase or decrease
per time period.
Chapter 10 10 -7
Nonlinear Trend
To solve for the constants a, b, and c in the
previous equation, we use the following
simultaneous equations:



+ =
2
x c na Y

+ =
4 2 2
x c x a Y x

=
2
x
xY
b
Nonlinear Trend
World Carbon Emissions from Fossil Fuel Burning 19821994
Year Million tonnes
1982 4,960 6 29,760 178,560 36 1,296
1983 4,947 5 24,735 123,675 25 625
1984 5,109 4 20,436 81,744 16 256
1985 5,282 3 15,846 47,538 9 81
1986 5,464 2 10,928 21,856 4 16
1987 5,584 1 5,584 5,584 1 1
1988 5,801 0 0 0 0 0
1989 5,912 1 5,912 5,921 1 1
1990 5,941 2 11,882 23,764 4 16
1991 6,026 3 18,078 54,234 9 81
1992 5,910 4 23,640 94,560 16 256
1993 5,893 5 29,465 147,325 25 625
1994 5,925 6 35,550 213,300 36 1,296
72,754 0 17,238 998,061 182 4,550
X Y x xY
Y x
2
2
x
4
x
Nonlinear Trend
The data from the table is used to compute
the following:


2
24 10 71 94 8 739 5 x . x . . , Y

t
+ =
x = 0 in 1988
1x = one year
Y = million tonnes
Logarithmic Trend
When we wish to fit a trend line to percentage
rates of change, we use the logarithmic trend
line.
This is more prevalent when dealing with
economic growth in an environment.

b log x a log Y log
t
+ =
The logarithmic trend equation is:
Logarithmic Trend
The least squares trend is computed as:

n
Y
a

=
log
log
2
) log (
log

=
x
Y x
b
Logarithmic Trend Example
1990 620.9 2.793 15 41.89 225
1991 719.1 2.857 13 37.13 169
1992 849.4 2.929 11 32.22 121
1993 917.4 2.963 9 26.66 81
1994 1,210.1 3.083 7 21.57 49
1995 1,487.8 3.173 5 15.86 25
1996 1,510.5 3.179 3 9.53 9
1997 1,827.9 3.262 1 3.26 1
1998 1,837.1 3.264 1 3.26 1
1999 1,949.3 3.290 3 9.86 9
2000 2,492.0 3.397 5 16.98 25
2001 2,661.0 3.425 7 23.97 49
2002 3,256.0 3.513 9 31.61 81
2003 4,382.28 3.642 11 40.05 121
2004 5,933.2 3.773 13 49.05 169
2005 7,619.5 3.882 15 58.22 225
52.42 0.00 44.89 1360.0
Chinese Exports
Year ($100 Million) log Y x x log Y

2
x
Chapter 10 10 -8
Logarithmic Trend Example (continued)
28 . 3
16
42 . 52
log
log = = =

n
Y
a
033 . 0
1360
89 . 44
) log (
log
2
= = =

x
Y x
b
Logarithmic Trend Example
(continued)
The estimated trend line equation is:
x
t
Y 033 . 0 28 . 3

log + =
2
1
1997 in x 0 =
year x 2
1
= 1
Logarithmic Trend (continued)
Check the goodness of fit by substituting two
data points such as 1992 and 2003, into the
fitted equation.

0.033(-11) + 3.28 = Y Log
1992

For 1992, we will have:

2.917 = Y Log
1992

Logarithmic Trend (continued)

0.033(11) + 3.28 =

Log
2003
Y
For 2003, we will have:
3.643 =

Log
2003
Y
Logarithmic Trend
Interpretation of the estimated trend line would
be similar to a linear trend. However, before we
can interpret the estimated values, we have to
convert the log values into actual values of the
data points.

This is done by taking the antilog.


Logarithmic Trend
The results are:
917 . 2 antilog )

(log antilog

1992
= = Y Y
04 . 826

1992
= Y
And
643 . 3 antilog )

(log antilog

2003
= = Y Y
42 . 395 , 4

2003
= Y
Chapter 10 10 -9
Logarithmic Trend
To determine the rate of change or the slope of
the line we have:
R = antilog 0.033 = 1.079

Since the rate of change (r) was defined as R 1,
then
r = 1.079 1 = 0.079
r = 7.9 percent per half-year

Therefore the growth rate is 15.8% or 16% per
year.

Other Approaches to Trend Line
Two more sophisticated methods of determining
whether there is a trend in the data:
Differencing
Autocorrelation (BoxJenkins Methodology)

Allows the analyst to see whether a linear
equation, a second-degree polynomial, or a
higher-degree equation should be used to
determine a trend.

Differencing
First Difference



1
= A
t t t
Y Y Y
1 2
A A = A
t t t
Y Y Y
Second Difference
Differencing Method Example
First and Second Difference of Hypothetical Data

Yt First Difference Second Difference

20,000
22,000 2,000
24,300 2,300 300
26,900 2,600 300
29,800 2,900 300
33,000 3,200 300

Seasonal Analysis
Seasonal variation is defined as a predictable
and repetitive movement observed around a
trend line within a period of 1 year or less.
There are several reasons for measuring
seasonal variations.
When analyzing the data from a time series, it is
important to be able to know how much of the
variation in the data is due to the seasonal factors.


Seasonal Variation (Continued)
We may use seasonal variation patterns in
making projections or forecasts of a short-
term nature.

By eliminating the seasonal variation from a
time series, we may discover the cyclical
pattern of the time series.

Chapter 10 10 -10
Seasonal Variation
Computation of Ratio of Original Data to Moving Average

Passenger Moving Ratio of Original
Year and Enplanement 12-month Moving Data to Moving
Month (Million) Total Average Average, %
(1) (2) (3) (4) (5)

2001 Jan. 44.107
Feb. 43.177
March 53.055
April 50.792
May 51.120
June 53.471
July 55.803 560.359 46.70 119.50
Aug. 56.405 554.809 46.23 122.00
Sept. 30.546 550.277 45.86 66.61
Oct. 40.291 545.723 45.48 88.60
Seasonal Variation
To compute a seasonal index, we do the following:
sum the modified means

Months

Year Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov. Dec.


2001 119.5 122.0 66.6 88.6 90.4 91.5
2002 87.0 87.9 111.4 102.5 104.7 108.6 111.1 110.3 86.2 103.2 94.2 105.7
2003 91.3 86.6 104.7 97.7 101.5 107.4 114.7 110.8 90.3 101.2 94.4 99.1
2004 86.7 89.0 105.8 103.5 102.2 109.0 113.6 108.6 90.0 101.6 96.7 97.6
2005 88.6 86.6 108.0 100.4 104.8 109.0 114.0


Mean 87.4 87.1 106.2 100.2 102.8 108.3 112.9 109.9 88.8 102.0 95.1 96.1

Seasonal Variation

Mean Middle Seasonal
Month Three Ratios Index

Jan. 87.42 87.68
Feb. 87.05 87.31
March 106.19 106.50
April 100.19 100.50
May 102.80 103.11
June 108.32 108.64
July 112.91 113.25
Aug. 109.90 110.23
Sep. 88.81 89.07
Oct. 102.00 102.31
Nov. 95.09 95.38
Dec. 96.07 96.36

Seasonal Variation
If production is full, we expect the index to equal 100
for each month. If not, we have to adjust it by
computing a correction factor.




Compute the seasonal index.
002 . 1
97 . 1197
1200
Factor Correction = =
Seasonal Variation
Partial Deseasonalized Data for Passenger Enplanement, 20012005

Deseasonalized
Year and Passengers Seasonal Passenger
Month (Million) Index Enplanement
(1) (2) (3) [col 2 col 3] X 100

2001 Jan. 44.107 87.68 50.306
Feb. 43.177 87.31 49.452
March 53.055 106.50 49.814
April 50.792 100.50 50.539
.. ... .
2005 Sept. 50.776 89.07 57.005
Oct. 53.971 102.31 52.754
Nov. 52.962 95.38 55.530
Dec. 53.007 96.36 55.008

Cyclical Variation
Similar to seasonal variation except that it occurs
every 5 to 10 years.
There is a systematic pattern in the data that mirrors
what is happening in the economy.
Movements from a recession to a depression or
recession to recovery follow a cycle.
Every time series data has a random component. If
there were no random components, we would have
perfect prediction of future values. However, this is
not the case with real-world conditions.
The cyclical component is measured as a proportion of
the trend.
Chapter 10 10 -11
Cyclical Variation
Citrus Received by the Cooperative during 19942006, and the Estimated Trend

Boxes of Citrus
Year (in 1,000) Trend
X Y Y
t


1994 6.5 6.7
1995 7.2 7.1
1996 7.6 7.5
1997 8.4 7.9
1998 8.5 8.3
1999 8.0 8.7
2000 8.6 8.9
2001 8.9 8.7
2002 9.5 9.5
2003 10.2 9.9
2004 10.6 10.3
2005 10.8 10.7
2006 11.0 11.1

Cyclical Variation
0
2
4
6
8
10
12
B
o
x
e
s
(
i
n

t
h
o
u
s
a
n
d
s
)
Time
Boxes of Citrus Trend of Boxes of Citrus

Cyclical Fluctuations around the Trend Line
Cyclical Variation
Calculation of Percent of Trend

Boxes of Citrus Percent of
Year (in 1,000) Trend trend
X Y Y
t
(Y/Y
t
100)


1994 6.5 6.7 97.0
1995 7.2 7.1 101.4
1996 7.6 7.5 101.3
1997 8.4 7.9 106.3
1998 8.5 8.3 102.4
1999 8.0 8.7 91.9
2000 8.6 8.9 96.6
2001 8.9 8.7 102.3
2002 9.5 9.5 100.0
2003 10.2 9.9 103.0
2004 10.6 10.3 102.9
2005 10.8 10.7 100.9
2006 11.0 11.1 99.1

Cyclical Variation Example
80
85
90
95
100
105
110
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Time
P
e
r
c
e
n
t

T
r
e
n
d
Percent Trend Linear (Percent Trend)
Chapter Summary
Preliminary Adjustments to Data:
Trading Day Adjustment
Price Adjustment
Population Adjustment

Data Transformation

Patterns in Time Series Data

The Classical Decomposition Method